Shadow of VATman.

VATs raise money efficiently and with comparatively small economic effect -- which is exactly the problem. ON February 28, Senate Democrats unveiled a new tax package. A key feature of this package is replacement of the current corporate income tax with a value-added tax (VAT), a kind of sales tax applied at each stage of production and hidden in the prices of goods. The VAT originated in Western Europe and now has been adopted by every country there -- indeed, it is required for entry into the European Union. And it is the principal reason for the vast growth of the welfare state in Europe over the last thirty years. Clearly, Senate Democrats hope an American VAT will have the same effect here.

In 1965, before the VAT was adopted, total taxes as a share of GDP in Western Europe averaged 27.2 percent, according to the Organization for Economic Cooperation and Development (OECD). This figure was only slightly higher than those for Australia and the United States -- the only two OECD countries still without a VAT --where taxes as a share of GDP averaged 23.2 percent and 25.8 per cent, respectively. Most of the nations of Western Europe adopted VATs in the late 1960s and early 1970s. And by 1993 total taxes as a share of GDP averaged 41.4 percent in Western Europe. By contrast, taxes in Australia and the U.S. are not much higher than they were in 1965, at 28.7 percent and 29.7 percent of GDP, respectively.

The reason the VAT has led to such an increase in taxation is that it is nearly invisible and hence the most efficient tax ever devised -- efficient in the sense that it is less discouraging to productive economic activity than other taxes raising the same revenue. The more efficient a tax system is, the more revenue a government can raise before reaching the limit of taxable capacity. Had the European governments attempted to raise the same revenue without the VAT, they would have encountered economic and political limits.

One consequence of the VAT's invisibility is that the rate is easily raised. The 12 OECD countries that adopted VATs before 1973 have seen their VAT rates rise by an average of 71 percent; even those that adopted VATs since 1985 have seen rates rise by an average of 14 percent.

Giving politicians a tax that could be raised incrementally without generating either significant political opposition or negative economic effects sets the stage for a vast expansion of the welfare state. In 1965 government spending as a share of GNP in Western Europe averaged 34.5 percent, according to the OECD. By 1993, spending had risen to 52.1 percent.

Much of this increased spending went into welfare benefits that sharply cut the cost of not working. This has created a poverty trap in which the combination of direct taxes and lost benefits reduces the incentive to work harder to virtually nothing for many people. For example, a 1994 OECD study noted that in the UK, if a married man who had two children and earned e100 per week were to receive e1 extra, he would keep just 3 pence of it. First he would pay 20 pence in income taxes and 9 pence in social security. Then he would lose 50 pence in family benefit, 14 pence in housing benefit, and 4 pence in local tax refund. This is equivalent to a 97 percent marginal tax rate.

Business welfare expanded as well. According to another OECD study, industrial subsidies are at least four times as high in Europe as in the United States. While industrial subsidies amounted to just 0.5 percent of GDP in the U.S. in 1986, they consumed 2.6 percent of GDP in Denmark, 3.3 percent in France, 4.1 percent in Norway, and 7.4 percent in Sweden. These subsidies made European businesses very uncompetitive in international markets. Although subsidies are now being reduced, it will still be many years before most European businesses get their costs down to U.S. or Japanese levels.

Ultimately there still is a limit to taxation, even with a VAT, and Europe seems to have reached it. Taxes and spending as a share of GDP seem to have finally leveled off, after decades of steady increases. International competition and the decline of trade barriers have forced cutbacks in industrial subsidies, while budget deficits and rising unemployment are forcing reforms in welfare benefits. And there is now talk of using VAT revenue to reduce marginal income-tax rates, rather than paying for more spending.

Adoption of the Senate Democrats' plan would be a major move toward following Europe down the path of welfare dependency and uncompetitiveness just as Europeans are seeing the need to return to freer economies. It is a move that conservatives should resist at all costs.