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June 30, 2009
Early Proposals for an American VAT
Joseph J. Thorndike

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Joseph J. Thorndike is a contributing editor for Tax Notes.

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The VAT is a relative newcomer in American policy circles. While the income tax has been a fixture of political debate since the 1860s, the VAT has been the focus of sustained consideration only since the 1970s.

Or so you might think. In fact, the intellectual pedigree of the VAT runs a bit further back. It began long before Richard Nixon flirted with the idea in 1973, and even before European interest in the VAT blossomed during the 1950s. In fact, American interest in a VAT can be traced to the 1920s. In one form or another, Americans have been talking about a VAT for nearly a century.

This article surveys the most influential proposals for a VAT circulating in the United States between World War I and World War II.

Thomas S. Adams

At least one historian has traced the conceptual foundation of the modern VAT to colonial America.1 But the VAT in recognizable form made its first American appearance in 1921, when Thomas S. Adams, the leading tax economist of his generation, suggested it as a replacement for existing business taxes.

Adams's discussion of the VAT emerged from a general reconsideration of business taxation in the United States. Since the early years of the 20th century, policymakers had struggled to identify a rationale for federal and state business taxes. Existing taxes had grown up in ad hoc fashion as a response to political pressure and fiscal necessity.

To many observers, the resulting collection of business taxes seemed deeply flawed. "In recent years there has been an increasing disposition to question the wisdom of taxing business or of laying taxes upon the business unit," Adams observed in a 1917 paper for the National Tax Association.2 But the fiscal obligations of business units -- as distinct from business owners -- were self-evident, Adams insisted. Business taxes were not simply convenient; they were morally necessary:

    Surveyed from one point of view, business ought to be taxed because it costs money to maintain a market and those costs should in some way be distributed over all the beneficiaries of that market. Looking at the same question from another viewpoint, a market is a valuable asset to the social group which maintains it and communities ought to charge for the use of community assets.3

This argument for business taxation, rooted in a long tradition of benefit theory, was compelling, at least for Adams. And it seemed to support the notion -- at least in theory -- of a broad-based tax on gross business income.

In the interest of fairness, the rate of such a tax would necessarily vary between industries, Adams explained, depending on the "normal" relationship between net income and gross business in each trade. But the tax would not spare unprofitable businesses simply because they failed to make the most of the government services they consumed:

    In imposing such a tax the government would say in effect to the business man: "You have come amongst us and have exploited our market; you have trafficked as much as your competitor; whether you have used your opportunity as well as he is not our concern. It is the gross volume of your trade which both represents your opportunity and causes our expense. Upon that you must pay."4

Adams acknowledged that the practical difficulties inherent in a classified tax on gross income were legion. As a result, he endorsed a tax on net income, which would be far less onerous. "In the long run," he declared, "a net income tax is the simpler; it wears better."

By 1921 Adams was starting to rethink his support for a tax on net business income -- if not in practical terms, then at least in theory. The vast expansion of the income tax during World War I gave rise to a host of problems. The tax law became increasingly complex, forcing taxpayers to labor over returns (or hire others to do it for them). It also overwhelmed the Bureau of Internal Revenue, which was struggling to process a huge backlog of unresolved cases and unexamined returns.

The nation, Adams suggested, might reasonably seek a substitute for the income tax. Might it be possible, he wondered, to find a tax that, if not exactly perfect, was at least "more promising -- or less repulsive"?5

Adams surveyed a variety of possible reforms, ultimately concluding that incremental change was better -- or at least more politically viable -- than sweeping overhaul. Experts must make their peace with political realities, he counseled.

Still, Adams could not resist offering a few thoughts on his own vision of a reasonable tax system. "There is or should be nothing sacred about the net income tax," he declared. "It can claim no divine right to supply either the fundamental principle or the practical working measure of business taxation."6 Adams believed that moderate taxes on net income were less likely to be shifted to consumers than taxes on gross business -- a signal virtue, given his benefit argument for business taxes in general. The tax also spared business units when earnings were absent, making it clearly the "more merciful" basis for taxation.7

But the tax was extremely complex. "And complexity is a major evil," Adams pointed out, "involving the taxpayer in a cloud of uncertainty, stimulating evasion and rebellion, clogging the administrative machine, and bringing the tax into disrepute."8 Indeed, Adams considered complexity to be the "supreme problem of federal taxation," the corrosive byproduct of political pressure and fiscal necessity.

In an ideal world, Adams said, policymakers would sacrifice fairness to help limit complexity. "I should vote for simplicity and inequality," he said, "selecting many simple taxes at light rates rather than more equitable but more complex taxes at heavier rates."9

Adams provided the skeletal outlines of a new tax that he believed would advance the cause of simplification. The corporate income tax, he said, could be replaced by a new sort of sales tax:

    In the case of producers and sellers of "goods, wares, and merchandise" further simplicity could be achieved, if desired, by giving the tax the form of a sales tax with a credit or refund for taxes paid by the producer or dealer (as purchaser) on goods bought for resale or for necessary use in the production of goods for sale.10

This was a VAT, in fact if not in name. But Adams was under no illusion about its political viability. "The historical fact is that modern states prefer equity and complexity to simplicity and inequality," he observed with no small degree of dismay. "The cry for equality and justice is louder and more unanswerable than the demand for certainty and convenience."11

Gerhard Colm

Adams's undeveloped plan for a VAT had precisely the impact that he anticipated: none. At least not in Washington, where policymakers happily continued their tortured debates over income tax reform. But Adams's VAT suggestion did seem to prompt scholarly interest in the idea. In the early 1930s, a German émigré, Gerhard Colm, emerged as the leading champion of this new levy.

Colm began his public discussion of the VAT in an article titled "The Ideal Tax System."12 Published in 1934, it considered the structure of federal taxation from a sociological perspective, arguing that tax systems were necessarily linked to economic development of a modern state.

The VAT, according to Colm, was consistent with a stage of capitalist development in which the state operated as a partner in the productive process. "Whereas formerly the state was the guarantor of property," he wrote, "it appears now as a partner in production side by side with capital and labor" (emphasis in original).

    For example, by building roads the state provides an important factor of production; it promotes business efficiency through industrial education, encouragement of technological research, economic and statistical reporting, etc.; in undertaking recovery programs during depression it attempts to reduce cyclical business risks. Thus the state enhances and assures returns from production.13

The services provided to business gave the state a legitimate claim to some share of business profits. And to the extent that these services were general in nature, they required a "general business tax imposing an equal burden upon every branch of industry." The income tax was ill-suited to this role, Colm argued, but a tax on "value added by manufacture" would yield a reasonably equal distribution of the burden.14

Colm did not elaborate on this endorsement of the VAT, but the next year he floated the idea again, this time as a financing mechanism for unemployment insurance.15 Most plans for unemployment insurance assumed some sort of payroll contribution by employers. Such a mechanism made political sense, shielding programs from the social opprobrium attached to "relief" and "charity." But economists complained that payroll taxes imposed unequal burdens on different industries, favoring capital-intensive businesses and penalizing labor-intensive ones.16

Colm suggested that a tax on value added might avoid this problem. "It would burden the industry, roughly speaking, according to the amount of wages plus debt service plus profit," he explained (emphasis in original). As such, it would help equalize tax burdens across industries.

    No tax can burden all branches and every plant of industry equally because the effect of the tax depends in every case on market conditions. But such a tax equalizes the burden on labor-intensive and capital-intensive industries as well as any tax could. A firm cannot avoid the tax by mechanization if the decrease in wages is brought about at the cost of an increased debt service, because both wages and debt service are included in the basis of assessment.17

Social reformers in the New Deal were not convinced by Colm's argument, which was, in any case, more theoretical than practical. Colm continued to endorse the VAT in his academic writing,18 but it fell to another VAT champion to offer a more comprehensive -- and influential -- case for the levy.

Paul Studenski

Paul Studenski, an economics professor at New York University, wrote several influential articles on tax policy during the 1930s, including some for general interest political magazines like The Nation.19 But arguably his most important contribution to the era's tax debate came in 1941, when he proposed the creation of a VAT.

Studenski largely embraced the sociological and economic arguments for business taxation that Adams, and later Colm, pioneered. He argued strenuously that business owed a fiscal debt to society, above and beyond the responsibility shouldered by business owners. Like Adams, he embraced the benefit argument for such taxes:

    All business establishments, whether corporate or unincorporated, should be taxed by the federal government on the ground of the valuable character of the services rendered by the government thereto, and more or less in proportion to the amount and value of such services.20

The best measure of the services provided to an enterprise, Studenski contended, was the volume of business conducted by that entity. In theory, taxes levied on gross receipts would capture the relationship between service and benefit. But gross receipts taxes were unequal in their incidence, Studenski contended, burdening some industries more than others, depending on the cost of materials and services used in the production process.

Better to develop a tax on value added, Studenski concluded, which would more effectively equalize burdens across the economy. It would also compensate government -- and society -- for the cost of providing vital services to private enterprise:

    Government would be treated as an agent of production in private enterprise, just as the entrepreneur, the lender of capital, management, and labor. It would share in the earnings of the enterprise together with the other agents of production, in proportion to its contribution thereto and, moreover, would share in them at the same time as they do.21

Studenski argued that a VAT would be relatively simple to administer and enormously productive of revenue. It would also yield fairly stable revenue -- no small thing for a government still struggling to collect adequate revenue in the midst of a major depression.22

Studenski's paper caught the eye of Treasury officials, who invited his thoughts on the role a VAT might play in a revamped federal tax system. Indeed, Treasury prepared a major survey of the VAT as officials searched for new revenue to pay for the looming war against Germany and Japan.23

Treasury's interest in the VAT proved fleeting. The idea received no serious consideration after 1941, and it would take decades before it gained even a modicum of traction in the policy community. Still, it's worth recalling the early history of the VAT, if only to remind ourselves that this tax is hardly new, even in the American context. In some fashion, it's been the subject of meaningful debate for nearly 100 years.

To be sure, international experience with the VAT carries more weight in contemporary debate. But the American roots of the VAT suggest that this tax -- so often derided as a foreign import unsuited for U.S. shores -- might not be so foreign after all.


1 Robert P. Crum, "Value-Added Taxation: The Roots Run Deep Into Colonial and Early America," Accounting Historians Journal 9, no. 2 (1982), 552. Crum argues that the conceptual underpinnings of the VAT -- including the multistep taxation of net product and the indirect taxation of expenditure -- can be found in 17th-century precursors.

2 Thomas S. Adams, "The Taxation of Business," Proceedings of the National Tax Association, 1917 (1918), 185.

3 Id. at 187.

4 Id. at 189.

5 Thomas S. Adams, "Fundamental Problems of Federal Income Taxation," Quarterly Journal of Economics 35, no. 4 (1921), 528.

6 Id. at 551.

7 Id. at 552.

8 Id.

9 Id. at 553.

10 Id.

11 Id. at 554.

12 Gerhard Colm, "The Ideal Tax System," Social Research 1, no. 3 (1934).

13 Id. at 328.

14 Id. at 329.

15 Gerhard Colm, "Methods of Financing Unemployment Compensation," Social Research 2, no. 1 (1935).

16 Id. at 158.

17 Id. at 161.

18 Gerhard Colm, "The Basis of Federal Fiscal Policy," Taxes 6, no. 17 (1939), 369.

19 Paul Studenski, "Public Finance in the World Crisis," The Nation, Oct. 17, 1934; Paul Studenski, "Tax Program for the Future," The Nation, Mar. 6, 1935.

20 Paul Studenski, "Toward a Theory of Business Taxation," Journal of Political Economy 48, no. 5 (1940), 646.

21 Id. at 648-649.

22 Id. at 649-650.

23 Department of the Treasury, "Federal Tax on Net Value Added, 1941," Records of the Office of Tax Analysis/General Records of the Department of the Treasury, College Park, Md.