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Review of 1989-1990 consumption tax activity.

Review of 1989-1990 Consumption Tax Activity

Consumption taxes received increased congressional and Administration attention in 1989, due largely to concerns over the government's ability to meet future Gramm-Rudman-Hollings deficit reduction targets. This article reviews that activity.

January 1989: Darman "Ducks"

The first major 1989 discussions regarding a consumption or value-added tax (VAT) surfaced early in January, when Office of Management and Budget Director-designate Richard G. Darman addressed the extent to which President-elect Bush would hold the line on taxes. In written statements submitted to the Senate, Mr. Darman stated that certain types of revenue increases must not necessarily be labeled as "tax hikes." Revenue raisers referred to included higher federal excise taxes on gasoline, alcohol, and tobacco; an oil import fee; elimination of the deductibility for interest on certain types of borrowing; taxation of employer-provided fringe benefits; and fees charged to visit national parks and for other government services. In response to these statements, some critics concluded that President Bush's stated opposition to higher taxes was merely a matter of semantics and that the President's pledge to hold the line on taxes essentially referred to income tax rates and other tax increases with which the public could identify.

Mr. Darman said that, in light of the President's "read my lips" pledge against new taxes, the Administration was unwilling to accept any major changes in the tax code. He stated that although consumption taxes would be preferable to income taxes in an economic sense, they did not represent a panacea. Mr. Darman also stated that, from an economic efficiency point of view, a VAT imposed at each stage of production would offer advantages over a general excise tax at a retail or wholesale level. He also stated that a VAT would have advantages in international trade in that (i) it can be imposed on imports to prevent foreign products from gaining an advantage over U.S. goods, and (ii) it can be rebated to exporters without violating international trade agreements. Mr. Darman nevertheless concluded that a VAT would be difficult to administer, as well as enforce, and would also likely lead to a higher level of taxation and spending than an income-based tax:

A broad-based consumption tax would have definitional

and measurement problems which could be as

difficult to handle as the income tax. Moreover,

implementing a brand new tax could be administratively

difficult.

Holling's VAT

Buoyed by the pressure to find new revenue to reduce the federal deficit, Senator Ernest F. Hollings (D-South Carolina) introduced S. 442 on January 26, 1989. Senator Hollings, a member of the Senate Budget Committee, estimated that this proposal would raise $80 billion in fiscal year 1990.

S. 442 would impose a VAT on the sale of property and the performance of services in the United States with respect to commercial transactions. The VAT would also be imposed on the sale or lease of real property and on the importation of property without regard to whether it is with respect to a commercial transaction. Under the Hollings Bill, a five-percent tax would be imposed on the value added to the property sold or the services performed at each stage of production and distribution, including the retail stage. To ensure that the revenues raised by the VAT would go to reduce the federal deficit, S. 442 would require that all revenues net of administrative expenses be placed in a trust fund dedicated to deficit reduction and prohibit their use to finance current expenditures.

S. 442 has four important characteristics:

* It is a consumption-type VAT.

* It uses the credit-invoice method to calculate

tax liability.

* It uses the destination principle for border tax

adjustments.

* It exempts or zero rates certain commodities

such as food, housing, health care and interest.

In addition to the VAT, Senator Hollings also proposed a freeze on spending at the fiscal year 1989 level, except for Social Security and federal retirement cost-of-living adjustments. The proposed freeze was estimated to raise $36 billion.

Center for National Policy Study

January activity concluded with the release of a study performed by the Center for National Policy (CNP). The study concluded that the Bush Administration and Congress would need to raise at least $15-$20 billion in new revenues, and achieve an equal amount in spending cuts in order to meet the federal deficit reduction targets for fiscal year 1990. Although the easiest way to raise the needed funds would be through a general increase of existing taxes, President Bush's "no new taxes" campaign pledge would make it necessary for the government to resort to "loophole closers" to generate new revenue. The CNP study stated that, in the long term, the best option to reduce the deficit and raise revenue may be a national value-added or retail sales tax. According to the study, a five-percent value-added tax could raise $80-$120 billion annually, which would almost equal the "on budget" deficit.

Although conceding the VAT was a definite positive option, the report also stated that there would be problems in adopting such a tax, including likely opposition at the state government level and the need for "an elaborate and detailed" new tax administration system.

February: Coalition for Fiscal Restraint

On February 15, 1989, members of the Coalition for Fiscal Restraint, a broad-based group of businesses and economic associations opposed to higher taxes, endorsed President Bush's proposed flexible spending freeze. In conjunction with that endorsement, Rosalind Wells, the chief economist for the National Retail Merchants Association, told a news conference that if Congress and the White House failed to reach agreement on a spending-cut plan and resort to raising taxes, then imposition of a consumption tax - particularly a value-added tax - should be strongly resisted. Ms. Wells stated that "[a] tax that reduces overall consumption would be particularly ill timed. Any deliberate attempt to further slow consumer spending could push the economy into a recession." She also argued that a VAT is regressive in nature and would be inflationary.

April: Representative Andrews

and Senator Danforth

In April 1989, despite President Bush's "no new taxes" pledge, an aide for Representative Michael A. Andrews (D-Texas), a member of the House Ways and Means Committee, stated that Congress may look to excise tax increases for revenue in the form of user fees. As for a value-added tax, the aide agreed that this will be a future issue for Congress. On the same issue, a staff member for Senator John C. Danforth (R-Missouri) observed that any VAT proposal would take at least 18 months to generate revenue. He also stated that such a tax did not fit well into the congressional mindset since Congress usually is looking for an immediate source of revenue. It was suggested, however, that a VAT provision could possibly be included in a two-year budget agreement.

May: Hearing on S. 442

On May 17, 1989, the Senate Finance Committee held a hearing on the Hollings Bill. At the hearing, Senator Hollings maintained that deficit reduction would be impossible without new revenues. He pointed out that net interest payments in 1989 on the $2.8 trillion national debt would be $174 billion. That amount was 15 percent of the total federal budget. Charls E. Walker of the American Council for Capital Formation and Professor Sijbren Cnossen of Erasmus University, Rotterdam, also spoke in favor of the proposal. Both witnesses agreed that the VAT encouraged savings, capital formation, and exports while producing less economic distortion than alternative taxes raising equivalent amounts of revenue. Although supporting the bill in general, they each opposed the proposed exclusions for food, housing, and medical care. They also suggested that regressivity could be reduced more efficiently through a tax credit for the poor.

The Administration's Response

Dana Trier, the Treasury Department's Tax Legislative Counsel, opposed the Hollings Bill. He explained that the Administration "considers" the VAT to be a tax and, hence, that the proposal was subject to the President's "no new taxes" pledge. Senate Finance Committee Chairman Lloyd Bentsen insisted that Congress would like more information on the proposal, and urged Treasury to provide recommendations of how additional revenue can best be raised if additional taxes proved necessary.

June: The GAO Weighs In

On June 20, 1989, the General Accounting Office (GAO), as part of its effort to assist Congress in considering options to reduce the deficit, released a report on the advantages and disadvantages of the tax credit and subtraction methods for calculating a value-added tax.

The purpose of the report was to allow policymakers to better understand how the method for computing the tax can influence international competitiveness and offset the burden of the tax on the poor. In addition, the report was to aid policymakers in calculating the compliance and administrative costs connected with the VAT.

In commenting on the various proposals, the GAO stated that although a subtraction method is simple to calculate, it may not be fully compatible with certain design features. For example, if policymakers decided to alleviate the regressivity of a VAT by using multiple tax rates, the subtraction method for calculating the tax would not work properly. In addition, there is some doubt over how effective the subtraction method is in precisely eliminating the tax on exports. On the other hand, the GAO stated that the tax credit method would allow greater flexibility in the design and use of a value-added tax. The tax credit method enhances the ability of policymakers to craft the tax to respond to a variety of tax-policy goals. The price of such flexibility, however, would be a tax that was more complex both in terms of administration and compliance.

September: The Conference Board

On September 7, 1989, the Conference Board (a New York-based business research organization) issued a report stating that a VAT could add tremendous amounts of revenue to the budget, but could also have serious drawbacks. The report estimated that a VAT could raise between $13 billion and $22 billion annually in the United States for each percentage point of tax levied. Since the standard rates in other industrial countries run between 15 and 25 percent, it was estimated that a U.S. VAT could raise at least $150 billion.

The Conference Board noted that, although the VAT is regarded as a tremendous revenue raiser, controversy still exists regarding both the cost and administrative burden of implementing the new tax. The Board cited estimates that more than 80,000 new government employees and in excess of $1 billion dollars would be needed to implement such a tax.

September: The GAO Once More

On September 15, 1989, the GAO released a report entitled "Value-Added Tax Issues for U.S. Tax Policymakers." The report discussed many of the issues facing U.S. policymakers in deciding whether to enact a VAT, including how the tax would operate, its relative advantages and disadvantages, and the experience of European countries. The advantages discussed in the report are, as follows:

1. The VAT has a tremendous potential for raising tax

revenues. According to Congressional Budget Office

(CBO) estimates, a five-percent comprehensive

VAT could raise about $125 billion annually, while

one that exempted food could raise $72 billion.

Each percentage point of a VAT has been estimated

to produce approximately $15 billion (even after allowing

for exemptions for certain industries and

groups).

2. Since consumption spending does not fluctuate as

much as income, a consumption tax would be a

more stable source of revenue than an income tax.

3. A VAT that applied equally to labor and capital

factors of production would preserve the relative

prices of goods and services, and would create no

incentive for businesses to substitute factors or

depart from the combination of factors determined

by market prices.

4. If implemented on a credit-invoice method, the VAT

could provide administrative advantages, i.e., accurate

documentation and self-policing.

5. Since a VAT is incurred only when money is spent,

VATs are not biased against savings, whereas under

an income tax, the more a taxpayer saves, the

greater his tax liability on interest income.

The disadvantages to a VAT outlined in the report are, as follows:

1. Regressivity.

2. VATs provide government with an instrument for

enlarging its role and scope. The broad base of the

tax, from which large amounts of revenue can be

generated with small percentage increases, could

create the temptation to increase public expenditures.

3. Administrative burdens and start-up costs have

been estimated to be approximately $700 million

for a single-rate tax.

4. The VAT would be an intrusion upon many states'

tax basis, whereby even a low-rate VAT would restrict

the states' use of sales taxes in the future.

October: The Federal Reserve Gets Involved

On October 12, 1989, Federal Reserve Board Vice Chairman Manuel H. Johnson, Jr. recommended a consumption tax, but said that it should be coupled with expanded incentives for savings in order to remain revenue neutral. Mr. Johnson's proposal would require taxpayers to calculate total income and subtract net contributions from savings. The balance would be taxed, reflecting the net allocated to consumption.

November: Congressional Research Service

On November 27, 1989, the Congressional Research Service (CRS) issued a report entitled "Value-Added Tax: Concepts, Policy Issues, and OECD Experiences." The report stated that the VAT has enormous revenue potential, estimating that a comprehensive U.S. VAT in fiscal year 1989 could have raised approximately $27 billion for each one percent levied. The precise amount raised, of course, would depend upon economic factors and monetary policy.

The CRS report also discussed the concepts of costs, compliance and equity. In discussing these issues, it noted:

1. Although a VAT would require expansion of the Internal

Revenue Service, the high revenue yield would result

in low administrative costs when measured as a percentage

of revenue yield.

2. Of the 23 nations in the Organization for Economic

Cooperation and Development (OECD), the United States is

the only one without a broad-based consumption tax at the

national level. The OECD nations with VATs have experienced

better compliance with the VAT than with either

business or income taxes.

The CRS cited four reasons for the improved compliance. First, a VAT collected using the credit-invoice method offers the opportunity to cross-check returns and invoices. Second, each firm has an incentive not to allow suppliers to understate VAT because each firm is able to credit VAT paid on inputs against VAT collected on sales. Third, tax auditors can compare information about a VAT with information about business income taxation, thereby increasing compliance with both types of taxes. Finally, even if they do not register, firms can only partially evade the VAT because they would not receive credit for the VAT paid by their suppliers.

3. Regressivity is an issue usually associated with the

institution of a VAT. Whether a VAT is regressive depends

on how "ability to pay" is measured. If disposable income

during a one-year period is used as the measure, a VAT is

extremely regressive because the percentage of disposable

income paid in VAT would decrease rapidly as disposable

income increases. If, however, consumption is used as the

measure, a VAT would be proportional in that the percentage

of consumption paid in VAT would be the same as

consumption increases.

The CRS report discussed three policy options to reduce or eliminate the regressivity of the VAT:

* excluding those goods that account for a disproportionally

high percentage of the incomes of lower-income

households, reducing rates on necessities,

and increasing rates on luxuries;

* providing income tax credits that phase out as income

rises; and

* earmarking of some revenue for increased social

spending.

4. The CRS study concluded that, by reducing the federal deficit, a VAT would raise the rate of national savings. It also found that the imposition of a VAT would cause a one-time increase in the country's price level, but have no effect on the future rate of inflation if the Federal Reserve Board exercised a more "expansionary monetary policy." Thus, if the United States continues a policy of flexible exchange rates, a VAT would not have a significant effect on the U.S. balance of trade.

January 1990: CBO Deficit Reduction Options

In January 1990, the CBO released a list of deficit reduction options. One option was the imposition of a value-added or national sales tax. The CBO report stated that a five-percent VAT on a broadly defined consumption base would increase net revenues to the government by approximately $89 billion in fiscal year 1992 and by roughly $532 billion through 1995. At the same rate, a VAT on a narrower base would net about $52 billion in 1992 and about $310 billion through 1995.

The foregoing projections assume that collections would not begin until January 1, 1992. The reason for the anticipated delay was the IRS's estimate that it would take approximately 18 months after the date of enactment to begin administration of a VAT.

The CBO report concluded that, if a large amount of revenue is to be raised, a VAT might be preferable to an income tax increase because it is theoretically neutral between present and future consumption. Accordingly, it would not adversely affect incentives for savings or investment as an equal increase in income taxes normally would. In addition, a broad-based VAT with a single rate would distort economic decisions less than an equal revenue increase in selective consumption taxes.

The report noted that many VAT critics claim the tax is regressive. In reply to that claim, the report states that a VAT could be made less regressive by granting tax exemptions for goods and services consumed by low-income people. Such exemptions, however, would substantially increase the costs of enforcement and compliance, thereby reducing the revenues from a VAT. One suggestion to offset the regressiveness of the tax was to allow additional exemptions or refundable credits for low-income people under the federal income tax. This measure would also reduce revenue gains from the VAT and could cause many people to file income tax returns who otherwise would have no need to file. Another suggested alternative was to include food and medical care in the narrower tax base, but increase payments to low-income individuals through existing means-tested programs.

The CBO report also identified policy concerns with a VAT. First, the imposition of a VAT would cause price levels to rise, which could lead to further rounds of inflation. Second, state and local governments would regard a federal sales tax as interfering with their traditional revenue base. Third, the large revenue-raising potential of a federal VAT might facilitate undue growth of the federal government. Finally, a federal VAT would impose compliance costs on the firms paying the tax and claiming the credits, requiring additional personnel and procedures for collection and enforcement.

February 1990: Senator Hollings Redux

In continuing his efforts to reduce the federal deficit, as well as reconfigure the mix of federal taxes, Senator Hollings introduced S. 2084 on February 6, 1990. This legislation is captioned "The Tax Reform and Competitiveness Act" (TRAC). TRAC has five principal components:

* It would reduce the Social Security (FICA) tax rate

from 6.2 percent to 5.1 percent (as proposed by Senator

Daniel Patrick Moynihan).

* It would provide for enactment of a sliding-scale

preferential tax rate on capital gains.

* It would restore a broad-based deduction for contributions

to individual retirement accounts (IRAs).

* It would provide a targeted tax credit for productive

equipment.

* It would provide for funding of the aforementioned

components by a five-percent national VAT.

The VAT proposal contained in S. 2084 is essentially the same bill that Senator Hollings proposed in 1989. Generally speaking, the bill would impose a five-percent tax on the sale of property or the performance of services in the United States. To reduce regressivity, the bill provides a zero rating for food, housing and medical care. According to Senator Hollings, the five-percent VAT will bring in $53 billion in 1991, rising to $70 billion in 1992, the first full year of implementation. Senate hearings have yet to be held on this proposal.

Michael A. DeLuca is Vice President, Taxes for Household International, Inc. in Prospect Heights, Illinois. Mr. DeLuca holds B.A. and J.D. degrees from Fordham University and an LL.M. (Taxation) degree from New York University. He is a member of the Chicago Chapter of Tax Executives Institute and chairs the Institute's Consumption Tax Committee.
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Author:DeLuca, Michael A.
Publication:Tax Executive
Date:Mar 1, 1990
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