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April 9, 2012
Was the VAT a Money Machine for Europe?

Full Text Published by Tax Analysts®

By Martin A. Sullivan -- martysullivan@comcast.net

In 1965 there was not a big difference between the level of taxes in the United States and in Western Europe. Then the Europeans put their VATs into high gear.

Virtually nonexistent in 1965, Western European VATs had an average rate of 11 percent by 1976 and 20 percent by 2007 (Table 1). As VATs became increasingly prominent, overall tax revenues in Europe grew in tandem. Between 1965 and 2007, average total tax as a percentage of GDP grew by a stunning 11.6 percentage points -- from 27.8 percent to 39.4 percent of GDP (Figure 1). Meanwhile, in the United States -- the only developed country to avoid adopting a VAT -- the overall level of tax grew by only 3.2 percentage points, from 24.7 percent to 27.9 percent of GDP.

These facts lead almost everybody to believe the VAT is a money machine for the high level of social services common in Europe. But that is only part of the story. To understand how Europe is funding its growth of government social services, you must also take into account three other equally important but rarely mentioned facts: (1) the expansion of income taxes; (2) the expansion of payroll taxes; and (3) the decline in excise and sales taxes. This is all compactly summarized in Figure 2 and Table 2.

Looking at the four categories of positive tax increases in Figure 2, we see that VATs had a lot of company in the rising levels of European taxes. On average, VATs accounted for tax increases equal to 6.4 percent of GDP. But income taxes (including corporate) accounted for an average increase equal to 5.3 percent of GDP, payroll taxes on average increased by an amount equal to 4.6 percent of GDP, and other miscellaneous taxes (like property taxes) accounted on average for increases equal to 0.7 percent of GDP. So VATs were responsible for only 38 percent of the average increase in European tax levels. Based on these facts alone, we can conclude that the VAT was not the only money machine funding the expansion of European government. Income and payroll taxes have served the same function. Or to put it differently, if the VAT never existed, Europe would still have 62 percent of the money it needed to fund bigger governments.

Replacement Tax

But what about that big drop of excise and sales taxes in Figure 2? The aforementioned tax increases paid not only for an expansion in revenue equal to 11.6 percent of GDP, but also for a cut in non-VAT consumption taxes equal to 5.5 percent of GDP. The numbers alone do not tell us which of the four categories of tax increases funded the cut in non-VAT consumption taxes and which funded the expansion of government. So one could assume that all the tax increases contributed proportionately to both the expansion of government and the sales and excise tax reduction. But common sense and historical perspective tell us otherwise.

                      Table 1. VAT Rates in Western Europe
 _____________________________________________________________________________

                  First
 Country          Implemented      1976     1980     1990     2000     2007
 _____________________________________________________________________________

 Austria             1973            18       18       20       20       20
 Belgium             1971            18       16       19       21       21
 Denmark             1967            15       22       22       25       25
 Finland             1994            --       --       --       22       22
 France              1968            20     17.6     18.6     20.6     19.6
 Germany             1968            11       13       14       16       19
 Greece              1987            --       --       18       18       19
 Ireland             1972            20       25       23       21       21
 Italy               1973            12       15       19       20       20
 Luxembourg          1970            10       10       12       15       15
 Netherlands         1969            18       18     18.5     17.5       19
 Norway              1970            20       20       20       23       25
 Spain               1986            --       --       12       16       16
 Sweden              1969          17.7     23.5     23.5       25       25
 Switzerland         1995            --       --       --      7.5      7.6
 United Kingdom      1973            8        15       15     17.5     17.5
 Average                           11.7     13.3     15.9     19.1     19.5
 _____________________________________________________________________________

 Source: OECD.

Figure 1. Total Revenue as a Percentage of GDP,
Western Europe and the United States, 1965-2007



Source: OECD.

             Table 2. Tax Changes as a Percentage of GDP, 1965-2007
 _____________________________________________________________________________

                      All             Income    Payroll   Excise,       Other
 Country              Taxes    VAT    Taxes     Taxes     Sales Taxes   Taxes
 _____________________________________________________________________________

 Austria                7.9    7.7       3.9       5.6      -8.8        -0.4
 Belgium               12.5    7.1       7.1       3.8      -7.7         2.3
 Denmark               18.9   10.4      15.3       0.1      -6.5        -0.4
 Finland               12.6    2.8       4.3       8.6      -2.8        -0.3
 France                 9.5    0.4        5        4.1      -2.6         2.6
 Germany                4.4      7       0.6       4.5      -6.9        -0.8
 Greece                  14    7.3       5.9       5.1      -4.4           0
 Ireland                  6    7.5       5.8       3.3      -9.4        -1.1
 Italy                 17.9    6.2      10.1       4.3      -5.3         2.6
 Luxembourg             7.9    5.6       2.5       0.7      -2.6         1.8
 Netherlands            5.9    7.5      -0.8       3.4      -4.9         0.8
 Norway                13.9    8.3         8       5.5      -8.1         0.2
 Spain                 22.5    5.9       8.8       7.9      -2.4         2.4
 Sweden                14.1      9       0.1        11      -6.8         0.8
 Switzerland           11.4    3.7       6.2       4.1      -3.2         0.5
 United Kingdom         5.6    6.6         3       1.9      -6.1         0.2
 Average of above      11.6    6.4       5.3       4.6      -5.5         0.7
 United States          3.2    N/A       1.7       3.2      -0.9        -0.8
 _____________________________________________________________________________

 Source: OECD.

European VATs are taxes on goods and services just like sales and excise taxes. They are widely considered to be efficient substitutes for their inefficient and unfair consumption tax brethren. Commentators on the history of the VAT routinely describe the tax as a replacement for sales and excise taxes. (See, for example, Liam Ebrill et al., The Modern VAT (2001).) If you are willing to accept the standard view of events, then out of the 6.4 percent of tax increases attributable to VATs, 5.5 percent of GDP went to paying for reductions in other consumption taxes. That leaves revenue of only 0.9 percent of GDP available for the overall revenue increase of 11.6 percent. In other words, according to this interpretation of the data, only about 8 percent of the huge expansion in European taxes can be attributed to the VAT.


Figure 2. Breakdown of European Tax Changes, 1965-2007
(percentage of GDP)



Fear and Loathing

The European experience is often used as an argument against considering a VAT in the United States. It would be a "fast track to a European welfare state," according to Daniel J. Mitchell of the Cato Institute ("Will Republicans Hand the Left a VAT Victory?" The Wall Street Journal, Jan. 4, 2012). Even if that were true in Europe, why would it be true in the United States?

Surely, antitax conservatives can beat back tax increases in legislation that includes a VAT just as well as with legislation that does not. And surely, if a VAT is enacted, antitax conservatives will not fold up their tents and let tax-and-spend liberals run amok. And even if antitax groups somehow disappeared, the VAT would not disappear from public view, as voters would be reminded of it every time they went to the checkout counter.

There is another reason to believe conservatives' fears are not justified: the Canadian experience with VATs. In Canada, the tax was first adopted by a conservative government in 1991 as a replacement for an inefficient 13.5 percent tax imposed on sales by manufacturers. The new tax (officially known as a general sales tax) was highly visible, highly unpopular, and subject to a great deal of ongoing political debate. The rate was reduced to 6 percent in July 2006 and to 5 percent in January 2008. Since the adoption of the GST, overall taxation in Canada has declined from 36 percent of GDP in 1990 to 33 percent of GDP in 2007. (For prior analysis, see "VAT Lessons From Canada," Tax Notes, May 3, 2010, p. 493, Doc 2010-9497, or 2010 TNT 84-3.)

Conservatives frequently say they would consider a new broad-based consumption tax if it were used to completely replace the current income tax system. Accordingly, many support a federal retail sales tax (the FairTax) and a VAT split into two parts (the flat tax) only if the income tax is jettisoned. Although there are huge concerns in many quarters about the lack of progressivity in those approaches, there is little doubt the economic benefits would be positive -- and perhaps very large. Given the political impossibility of such radical reform, conservatives with a practical bent for getting things done should consider the adoption of a VAT as a partial replacement for the income tax. That is what professor Michael Graetz proposed (Tax Notes, Dec. 22, 2008, p. 1439, Doc 2008-25405, 2008 TNT 247-41). The same economics that make flat and fair taxes attractive also apply to his plan -- just on a smaller scale. Sometimes half a loaf is better than nothing.

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