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PULLING OUT OF THE RECESSION: SHOULD THE U.S. GOVERNMENT

CONSIDER ADOPTING A VALUE ADDED TAX SYSTEM?

By

LUC M. BERLIN UNKAP

April 5, 2010

Abstract
The United States is in the midst of its biggest recession since The Great Depression
of the 1930s. The recent financial meltdown driven arguably by the greed in Wall
Street, the irresponsibility in Main Street, and lack of oversight in Washington D.C.
has revealed the fragility of our economy and left politicians and economists alike
scrambling for solutions. With unemployment as high as 9.7%, our government’s
failure to create better incentives for businesses not to outsource the production of
their goods and services to countries with cheaper labor has left many families
feeling insecure and angry about their future. How can the U.S. government turn the
economy around? In the long run, every option should be on the table. In the
immediate feature, a change in policies around our tax system could have a
significantly positive impact on our economy. One of those changes is to adopt a
value added tax system. This research paper examines the implications of such a
choice by using a cost-benefit analysis economic model to support or refute the case
for value added tax as part of the American tax system.

Luc Berlin is an avid fan of global business management and macroeconomics. He

has held critical business roles with innovative technology and ecommerce
organizations and consults with visionary companies on developing international
expansion strategies. A passionate globetrotter, Luc has lived in three continents,
speaks fluent French, English, moderate Spanish, and is learning Mandarin. He is
also the founder of www.miigle.com, an online platform that allows people to share,
develop, and fund ideas from around the world. He has been a recipient of the ACS
scholar award and a Finalist at the 2011 American Business Awards for Best
Marketing Campaign in Computer Software. Luc is a graduate of Pepperdine
University’s Graziadio School of Business and Management. You may contact him at
luki.berlin@me.com.
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PULLING OUT OF THE RECESSION: SHOULD THE U.S. GOVERNMENT

CONSIDER ADOPTING A VALUE ADDED TAX SYSTEM?

The United States is in the midst of its biggest recession since The Great

Depression of the 1930s. The recent financial meltdown driven arguably by the greed

in Wall Street, the irresponsibility in Main Street, and lack of oversight in Washington

D.C. has revealed the fragility of our economy and left politicians and economists

alike scrambling for solutions. With unemployment as high as 9.7%, our

government’s failure to create better incentives for businesses not to outsource the

production of their goods and services to countries with cheaper labor has left many

families feeling insecure and angry about their future. The Obama administration and

Congress passed an omnibus spending bill in 2009 to rescue banks that suffered

from the housing bubble and give “spending money” through tax rebates to millions

of Americans to keep the economy from sliding into a depression. However, most

people agree that the government spending its way out of a recession is an

unsustainable path to recovery. With our budget deficit estimated to surpass one

trillion dollars within the next 10 years, new measures must be taken to avoid the

risk of our country being unable to repay its debts.

Conventionally, there are two ways a government can reduce its deficit. The

first is to increase taxes. The second is to slash the budget of government spending

on programs, many of them, such as education and healthcare, being essential

pillars of our society. Our ability to compete with the rest of the world would be

seriously compromised without a strong education and healthcare system. Although

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likely, increasing taxes would only amplify the burden most families are already

feeling right now. Wages have been relatively flat over the past couple of decades

while cost of living has been steadily rising. Slashing the spending budget on some

government entitlements could be a viable option but politicians are too divided

about which programs to cut – Republicans argue that many social programs must

be canceled while Democrats argue that our Defense spending is wasteful and

unnecessary. Social programs are important to the welfare of our country and cutting

our Defense spending when fighting two wars is not the smartest of ideas. This is the

dilemma the US has faced over the past decade and Washington D.C. has shown no

signs of having a real solution.

The recent Healthcare Reform Bill signed into law by President Obama on

March 23, 2010 is being sold to the American public as a cost cutting measure

against the deficit. However, the details in the bill address do more to address health

insurance reform than reduce the skyrocketing cost of healthcare. The real and much

needed reform, as we have come to expect, is simply passed along to a future

Congress hoping they will have the courage to make the right and tough decisions

even if it comes at the expense of their political viability.

Can the US government pull out of this recession and reduce its budget deficit

without raising taxes on the middle-class and/or suspend government-sponsored

programs that are critical to our welfare? This might not have much to do with Love

but I think Shakespeare would have concurred with me by saying: “Now, THAT is the

question!”

I believe I have found or if you prefer, agree with the people who have found

the answer to THAT question and I am absolutely ecstatic to present it in greater

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details in my paper. I will also provide supporting arguments derived from my

research by doing a cost-benefit analysis of its adoption. I will conclude my paper

with a few positive and normative statements on the US economy and how policies

derived from facts not emotions could lead us back to economic and social

greatness. Okay, that last part might sound a bit delusional but please bear with me.

There are technically two very good answers to the question: Can the US

government pull out of this recession and reduce its budget deficit without raising

taxes on the middle-class and/or suspend government-sponsored programs that are

critical to our welfare?

The first answer, as many economists have already suggested, would be to let

the laws of supply and demand rule supreme in our economy. This implies creating a

taxable free market even on currently illegal activities such as the consumption of

prostitutes and drugs. According to the National Drug Control Strategy FY 2001

Budget Summary, the United States federal and state governments spent about $38

billion dollars of taxpayers’ money on fighting drugs in the year 2000. Ten years later

we can hardly see a dent in the consumption of drugs while US death rates from

cocaine have jumped up 105% from 2000 to 2006, according to the Centers for

Disease Control and Prevention. In the other hand, a report from the Cato Institute, a

Washington D.C. think tank, showed that deaths from drug usage in Portugal dropped

from 400 to 290 annually, five years after they decriminalized the use and

possession of heroin, cocaine, marijuana, and other illicit street drugs. As Steven D.

Levitt and Stephen J. Dubner stated in their book Superfreakonomics: Global Cooling,

Patriotic Prostitutes, and Why Suicide Bombers Should Buy Life Insurance, “the law
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of unintended consequences is among the most potent laws in existence (Levitt &

Dubner p.139).”

The second answer, a bit less radical depending on whom you ask, is for the

United States to replace its current Federal tax system with a Value Added Tax,

commonly referred to as VAT.

Before I get into more details of what a Value Added Tax is and does, let us

first shed some light on our current federal tax system.

According to the US Department of the Treasury, the US Federal income tax

system resulted from the passage of the 16th amendment to the Constitution

granting the Congress the power to levy a tax on personal income. However, when a

flat rate Federal income tax was enacted in 1894, it was quickly challenged and

ruled unconstitutional in 1895 by the Supreme Court because it was a direct tax not

apportioned according to the population of each State. The States eventually agreed

on an excise tax to be imposed on business income, and a Constitutional

amendment to the Federal government to impose tax on individuals’ lawful incomes

without regard to the population of each State.

The Senate Committee on Finance held a public hearing on April 15, 2008

entitled “Tax: Fundamentals in Advance of Reform.” The document prepared by the

staff of the Joint Committee on Taxation described the current (as of 2008) Federal

tax system as having four elements: (1) an income tax on individuals and

corporations (which consists of both a “regular” income tax and an alternative

minimum tax); (2) payroll taxes on wages (and corresponding taxes on self-

employment income); (3) estate, gift, and generation-skipping transfer taxes, and (4)

excise taxes on selected goods and services. A number of aspects of the Federal tax
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laws such as income thresholds, standard deduction, tax rate brackets, and annual

gift tax exclusion are subject to change over time and are indexed for inflation.

A few concerns have been raised on the effectiveness of our current Federal

tax system. One with which I particularly agree is the mere taxation of income, which

is counter-intuitive and counter-productive especially for a heavily consumption-

based economy such as the United States’. Other valid concerns are complications

and loopholes in our tax system, which has left our shrinking middle-class carrying

most of the tax burden whereas the wealthy have enjoyed limited taxation. Moreover,

the complexity of our Federal tax codes has only led to an astounding growth in the

Federal government tax “industry”. In the 1994 report “Growth of Federal

Government Tax ‘Industry’ Parallels That of Federal Tax Code”, Dr. Arthur Hall, a

senior economist with the Tax Foundation, found that the estimated 136,155 that

would have been employed in the industry in 1995 represented a 114% increase

over the estimated 63,712 people employed in 1955. Therefore, not only is our

current tax system ineffective in maximizing tax-generated revenue for the

government but also costing it millions of dollars in personnel to fight abuses of

loopholes in the system. It is evident that any type of reform is needed! Indeed, the

article “The Tax Reform Revolution” by Murray Weidenbaum reports a poll taken by

macroeconomists at 15 universities where 63% favored a “fundamental reform of

the American tax system towards a consumptions tax” while 37% opposed. Clearly

economists do not rule our country.

Now that we have a basic but clear understanding of our current Federal tax

system, let us examine the impact of a Value Added Tax as a solution for our tax

reform.
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What is Value Added Tax or “VAT”? A Value Added Tax, or VAT, as defined by

the European Commission Taxation and Customs Union, is:

• A general tax that applies, in principle, to all commercial activities involving

the production and distribution of goods and the provision of services.

• A consumption tax because it is borne ultimately by the final consumer. It is

not a charge on businesses.

• Charged as a percentage of price, which means that the actual tax burden is

visible at each stage in the production and distribution chain.

• Collected fractionally, via a system of partial payments whereby taxable

persons (i.e., VAT-registered businesses) deduct from the VAT they have

collected the amount of tax they have paid to other taxable persons on

purchases for their business activities. This mechanism ensures that the tax is

neutral regardless of how many transactions are involved.

• Paid to the revenue authorities by the seller of the goods, who is the "taxable

person", but it is actually paid by the buyer to the seller as part of the price. It

is thus an indirect tax.

In other words, a Value Added Tax is levied at every step in the production of a good

or service where value is added but ultimately paid by the consumer of the good or

service as part of the price. Therefore, consumers only pay a tax based on

consumption not income, thus fostering an increase in private savings. Below are

some major advantages to considering a VAT according to John S. Nolan’s article

“Advantages of Value Added or Other Consumption Tax at the Federal Level” and

Murray Weidenbaum’s “The Tax Reform Revolution”.

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• Coverage and neutrality: Nolan argues that a broadly based tax is a less

painful tax and thus would be more readily accepted by Congress and the

American public. A 3% rate raising $15 billion will produce as much as a

12.5% increase in all individual rates and the corporate rate, a 12.5%

surcharge. Additionally, the impact of such a tax would be neutral on all types

of consumption, unless exceptions are made to soften its regressive nature.

• No penalty for efficiency and no subsidy for waste: Weidenbaum

explains that by focusing on consumption, VAT avoids a double-tax burden on

the returns from capital.

• Over 130 nations have successfully implemented a VAT: “It fits in

better than other taxes with the growing international character of productions

(…) raising about one-fourth of the world’s tax revenue” says Weidenbaum.

• Anticipated foreign trade benefits: Unlike an income tax, sales-based

tax can be imposed on goods entering the country and rebated on items

leaving-supposedly encouraging exports and discouraging imports. Thus

helping to reduce our nation’s large trade deficit.

• Effect on Savings and Investment: Just as I stated above, Nolan also

argues that adopting a consumption tax will relieve the burden on savings and

thereby increasing the rate of return, which would in turn increase total

volume of savings and investments. Unlike an income tax, a VAT “will not

inhibit growth or increases in productivity, objectives we must encourage (…) if

we are to maintain and increase our standard of living in light of increasingly

competitive conditions in world trade today (Weidenbaum).”

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• Administration and regulation: As I explained above, the Federal

government continues to spend a lot of resources both financially and in

personnel trying to regulate our complex tax codes and end abuses of

loopholes. The adoption of VAT would significantly simplify the taxation

process for individuals, corporations, and administration by the government.

Now let me try to put all of these points into perspective. On his show the Global

Public Square (GPS) on February 28, 2010 on CNN, Fareed Zakaria examined the

potential benefits of the United States government adopting a value added tax

system. Assuming a standard VAT rate of 25%, currently the highest in the world and

adopted by countries like Denmark and Sweden, the United States government

would be able to:

-­‐ Eliminate income tax for vast majority of people

o Income tax could be eliminated with a VAT of 10-14% for anyone

earning less than $100K or 90% of the population

-­‐ Balance the budget

-­‐ Provide healthcare for all our citizens

-­‐ Slash the top tax rate from 35% to 25%

From an economic and financial standpoint, this would seem a “no-brainer” for

anyone capable to use a calculator. So why has this “no-brainer” of a solution not

been implemented? Clearly economists do not rule our country.

Although it presents very strong arguments and benefits, adopting a Value

Added Tax is not free of shortcomings. Let us address some of the main arguments in

opposition to a Value Added Tax.

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-­‐ The regressive nature of the tax: According to Weidenbaum, “the

opposition to VAT contends that in the case of any consumption based

revenue source, VAT is inherently regressive; meaning those least able to pay

face the highest rates.” Indeed, unlike income tax which is levied by applying

different tax rates based on income brackets in which individuals fall, VAT is a

flat tax applied to everyone regardless of their income. Therefore, people with

low incomes would technically be contributing a greater portion of their

earnings to pay the tax. To resolve this issue, Weidenbaum points that

“regressivity can be softened by exempting food and medicine or by offering

refunds to low-income taxpayers (p. 12).” Consequently, exemptions and

refunds complicate the collection and administration of the tax. Although

these are valid concerns, in many cases the solutions would be simpler than

the similar situations with income tax.

-­‐ Collection of the new tax: Weidenbaum explains that “a variety of

approaches have been suggested for collecting VAT. The simplest is the credit

method. Under this approach, the tax is computed initially on a company’s

total sales, and the firm is given credit for the VAT paid by its suppliers. To a

substantial degree the VAT would be self-enforce. Each company would have

a powerful incentive to ensure that its suppliers paid their full share of the tax,

because any underpayment would have to be made up by the next firm in the

chain of production and distribution (p. 12).”

-­‐ Impact on State taxes: Unlike most countries, the United States has, in

addition to the Federal income tax, tax codes that differ by States. Indeed,

many States such as California have both an income and sales tax. What
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would be the impact of a VAT on a state like California? Although the question

seems daunting, the solution is actually very simple. The Federal government

could create incentives for states to reform their tax codes as well. In the case

of California, the state legislature could eliminate both income and sales tax

and receive a percentage of the revenue generated by the Value Added Tax

based on the volume of goods and services consumed within the State’s

borders, including online transactions. This would create competition across

states resulting in increased productivity and lower prices to attract demand.

Many of the concerns on adopting a consumption tax such as VAT are well founded

but as presented above we can see that clear and simple solutions can be created to

if not fully address those issues, significantly reduce them.

Conclusion:

My decision to write a research paper on the potential benefit of the US government

adopting a Value Added Tax stems from my passion for understanding how social

and government policies shape economies. The financial crisis although devastating,

in some ways gives us the opportunity to address many issues that have plagued our

country for many years. We have the chance to push the reset button –actually I

would argue that it has already been pushed for us –and forge a new path towards

economical growth and prosperity as a country. Despite the somber times and

pessimism, of which I am most times guilty of, there is no doubt in my mind that the

U.S. economy will bounce back and we will regain our status as the beacon of the

world. Despite the gloom that surrounds us, I again agree with Fareed Zakaria when

during his show on February 28, 2010, stated “the United States remains the world’s
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most dynamic and productive economy by many measures. It still dominates the

world of science and technology with the world’s greatest universities, the best

research, the most Nobel Prizes, the largest strobe of patents. And thanks to

immigration America will stay young, restless, and hardworking.” The United States is

in mire of problems right now, most notably the recession and our growing deficit.

However, these problems are not without solutions. With the right leadership, and

good legislation –one based on facts not sentiments –we can recover but also

emerge as a greater country than we have ever been. Going back to my questions:

Can the US government pull out of this recession and reduce its budget deficit

without raising taxes on the middle-class and/or suspend government-sponsored

programs that are critical to our welfare? And, should the US government consider

adopting a Value Added Tax system? From the findings of my research and from

personal belief my honest answer is YES. But only if our leaders show the courage to

face our problems rather than playing political tricks at the expense of our children’s

future. Clearly economists do not rule our country. But one does not have to be an

economist to understand that it is an innate human behavior to respond to

incentives.
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REFERENCE:

1) Drug Policy Alliance. (2002). Economic Consequences of the War on Drugs.

National Drug Control Strategy FY 2001 Budget Summary, Page 2, Office of
National Drug Control Policy, 2000
http://www.drugpolicy.org/library/factsheets/
economiccons/fact_economic.cfm
2) Dubner, S. Levitt, S., (2009). Superfreakonomics: Global Cooling, Patriotic
Prostitutes, and Why Suicide Bombers Should Buy Life Insurance.
HarperCollins Publishers.
3) European Commission Taxation and Customs Union. (2010). How VAT Works.
http://ec.europa.eu/taxation_customs/taxation/vat/
how_vat_works/index_en.htm
4) Flaneuse. (2009). Drug-Related Deaths Increase. Graphic Sociology.
http://contexts .org/graphicsociology/2009/12/14/drug-related-deaths-in-
the-us/
5) Hall, A. (1994). Federal tax `industry' grows larger each year. Human Events,
50(49), 16. Retrieved from Academic Search Elite database.
6) Nolan, J. (1972). ADVANTAGES OF VALUE ADDED OR OTHER CONSUMPTION
TAX AT THE FEDERAL LEVEL. National Tax Journal, 25(3), 431-435. Retrieved
from Business Source Alumni Edition database.
7) United States Department of The Treasury. (Last viewed 2010). Fact Sheets:
Taxes. http://www.ustreas.gov/education/fact-sheets/taxes/ustax.shtml
8) Vastag, B. (2009). 5 Years After: Portugal’s Drug Decriminalization Policy
Shows Positive Results. Scientific American.
http://www.scientificamerican.com/article .cfm?id=portugal-drug-
decriminalization
9) Weidenbaum, M. (2005). The Tax Reform Revolution. USA Today Magazine,
133(2716), 10-12. Retrieved from Academic Search Elite database.