Finance

Going to Bat for a VAT

Tax solutions for Social Security and Medicare could also heal the states.
by | July 15, 2010

This is the second article in a six-month series on Social Security and Medicare reform.

President Obama's new bipartisan commission on fiscal responsibility is meeting this summer and will report its findings after the November elections. The most important topics it will address are Social Security, Medicare and the financing of them.

In last month's column on "Fixing Social Security and Medicare," I outlined the kind of comprehensive package that will be necessary to fund both systems properly for the 21st century. This month, I'll focus on the revenue and tax side.

The latest reports from trustees for Social Security and Medicare show the two systems to be actuarially deficient by 6 percent of payroll nationwide. If Congress tries to raise payroll taxes by 6 percent, the self-employment tax on individuals would exceed 20 percent -- in addition to the personal income taxes and state and local taxes they also pay. That approaches a taxing level many would call confiscatory. The solution needs to lie elsewhere, so it should not come as a surprise that the commission will dust off a perennial tax topic: the value-added tax.

A VAT is a broad-based consumption tax, which is collected at each stage of economic production. Farmers pay a tax on the wheat they sell, flour mills pay a tax on their flour, bakeries pay a tax on their bread, and restaurants pay a tax on the bread at meals they serve. Each receives a credit for all the taxes paid previously by their suppliers. VATs are common in Europe and Canada.

Some states have also considered a VAT as a replacement for their sales taxes. That's because services compose a greater percentage of the economy every year and most services escape the sales tax. A broad VAT with few exceptions would arguably treat every industry the same and require a lower tax rate than a sales tax. However, businesses that operate nationally would worry that a multistate VAT regime would be ridiculously complex. Uniformity in tax structures across state lines would be an important positive.

To solve the impending Social Security and Medicare crisis, a VAT would serve a broader social purpose: To collect revenues from two generations that failed to fix the fiscal deficits before they started collecting from these underfunded systems. Retirees don't pay much in payroll taxes, but they would pay a VAT on their consumption. Younger generations who will inherit their elders' Social Security and Medicare deficits will consider it more equitable that everybody pays into the solution.

Those who consider a VAT regressive might be mollified if the federal estate tax were also earmarked for Social Security and Medicare. That pairing would cut equitably across all income and wealth levels more fairly than any other alternative or combination.

To win Republican support for the VAT and the earmarking of estate taxes, I suggested last month that the estate tax deductions and rates need to be set at levels that don't penalize successful middle-class families, while making sure that we discourage American aristocracies through inherited wealth. I would also suggest a 12-year limit on capital gains and dividend income taxes at the 20 percent level along with the new Medicare tax on unearned income at no more than 5 percent, to keep American capital formation competitive internationally. Otherwise, Republicans would be crazy to accept a VAT, even as part of a prudent solution to retirement reforms that requires benefits limits, caps on COLAs and higher retirement ages.

I'd also be shocked if any VAT or payroll tax increase were to take effect before 2013. The 2012 presidential election stands in the way, and our fragile economy remains vulnerable to a tax shock -- unless it's just a token increase that will ramp up later to mollify the government bond and global currency markets. One idea is to require the economy as measured by GDP to grow by 3 percent annually before any tax increases are scaled-in prior to 2013.

If Congress ever considers a VAT to fully fund the Social Security and Medicare systems, state and local governments should advance a piggy-back VAT for themselves. Congress could easily add another 2 percent VAT tax to the federal bill to be distributed directly to states where it is collected. A piggyback VAT would be true "revenue sharing" rather than "deficit sharing." States could decline to allow and accept the federal piggyback VAT and its revenues, so that each legislature would decide whether it could properly put the money to good use. California, where constitutional tax limitations apply, would be one state in particular that could make good use of such revenue. States with little pressure on their budgets or with bedrock-conservative anti-tax legislatures could opt out.

To address conservatives' instinctive opposition to new taxes at any level, Congress should attach strings to the piggyback option: All the states' money must be used exclusively for fiscally frugal purposes. No new social programs or operating subsidies. Revenues would be divided between these three categories:

  • A third should be used to match infrastructure replacement spending, with no more than one-quarter used for public buildings. That way, transportation, decayed public utilities and the economic base of the state and the nation are all improved.
  • A third should be used for long-term financial stabilization. Half of this money should be earmarked for local governments and schools to fund deficient retirement plan trust funds first and then air-tight rainy-day escrow accounts. That second half should be used to insure that state budget stabilization reserves can withstand a two-year revenue loss comparable to the great governmental recession of 2008-10, and to properly fund previously incurred (not future) retirement plan deficits. This will avoid future federal bail-outs in the next recession.
  • A third should be used to reduce sales, personal income and residential property taxes.

To win support of local governments and schools, it may be helpful to allocate minimum percentages of all three buckets. However, too much earmarking at the Congressional level will result in gamesmanship somewhere, so I would favor broader discretion for the governors and state legislatures, who must first decide whether such additional taxes are warranted in their states. If they see this as one-sided for localities and schools versus what they could do themselves through a local tax or single-state VAT, they will simply opt out.

State and local leaders and their policy organizations should articulate their interest in this option this summer, before the presidential commission concludes its research and begins to formulate its recommendations. As I see it, this structure offers something to both political parties and deserves bipartisan support at the federal, state and local level.

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