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Policy makers are rightly focused on boosting demand as a way to pull us out of the current recession. The proposals offered so far will help, but none directly target the price of goods and services that people buy and all will add to our alarming budget deficits. So here’s a simple suggestion. Why don’t we promise future price increases so consumers will have an incentive to spend more now.
Enact a value-added tax (VAT) that phases in starting in 2010. (A VAT, common throughout the rest of the world, is basically a sales tax that is collected in stages from producers and retailers.) If the VAT started at a 5-percent rate, that would push retail prices up by 5 percent (assuming the Fed lets the money supply grow), providing an incentive for consumers to make purchases in 2009 rather than postpone them.
This would reduce the risk of deflation—actual declines in prices—which would tend to exacerbate the economic decline. If consumers expect prices to fall, they have an incentive to postpone purchases, which weakens demand further and depresses prices more.
The VAT revenues could eventually constitute a significant part of overall federal tax revenues, which would help pay off the debt that we are piling up in our efforts to avert economic collapse. When fully phased in, revenues could be used to pay for all or a portion of federal health care costs, allowing for cuts in income and payroll taxes while moving federal finances to a more secure footing. The VAT would hit lower-income people especially hard, but the tax's regressivity could be offset through income tax credits or by pairing the tax with health insurance subsidies targeted at low- and middle-income households. And, since a VAT taxes consumer spending, but not saving, it could help reverse the alarming decline in personal savings in the United States, making the next recession a little less painful.
Moreover, once on the books, the VAT would be a powerful tool to help manage fiscal policy. The rate could be increased to help keep the economy from overheating during booms and cut to spur demand during future recessions.
I’m not underestimating the political and practical problems inherent in enacting a VAT in the United States, but the fact is that there are no painless or perfect solutions to our current economic problems. And this option has the unique advantage of actually diminishing the likelihood of the future budget catastrophe that many of us fear much more than the current economic downturn.
Postscript: After I posted this, I learned that Princeton economist, Alan Krueger, had been thinking along very similar lines. See his excellent post, "A Future Consumption Tax to Fix Today’s Economy," on the NY Times Economix blog. Most interesting, one of his commentators noted that the UK has temporarily cut their VAT to boost demand. And, while we're acknowledging antecedents, I first broached this idea on the National Journal expert's blog back on January 5 as part of a series of "neglected stimulus ideas."
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