Going to Bat for a VAT

Shifting the sales tax approach could solve Social Security and Medicare funding.
August 2010
Baseball homeplate
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

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

The latest reports from trustees for Social Security and Medicare show that the two systems are 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 must lie elsewhere, so it should not come as a surprise that the commission will dust off a perennial tax topic: the value-added tax (VAT).

VAT is a broad-based consumption tax that's collected at each stage of economic production. Farmers pay a tax on 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 they serve at meals. Each receives a credit for all taxes previously paid by their suppliers. VATs are common in Europe and Canada.

Some states also have considered a VAT as a sales tax replacement. That's because every year, services compose a greater percentage of the economy -- and most services escape 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 crises, a VAT would serve a broader social purpose: to collect revenues from two generations that failed to fix 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 inheriting 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.

If Congress ever considers a VAT to fully fund the Social Security and Medicare systems, state and local governments should advance a piggyback VAT for themselves. Congress could easily add another 3 percent VAT to the federal bill to be shared with states where it is collected. States could decline to accept the tax so that each legislature must decide whether it can 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 the 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 states' money must be used exclusively for fiscally frugal purposes. Revenues would be divided between these three categories:

One-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.

One-third should be used for long-term financial stabilization. Half of this money should be earmarked for local governments and schools. The rest should be used to ensure that state rainy-day funds can withstand a two-year revenue loss comparable to the great governmental recession of 2008 to 2010, and to properly fund current (not future) retirement plan deficits. This will avoid future bailouts in the next recession.

One-third should be used to reduce sales, personal income and residential property taxes.

As I see it, this structure offers something to both political parties and deserves bipartisan support.