Blog Post

AEIdeas

In a Wall Street Journal op-ed today, Senator Rand Paul (R-KY) unveiled his plan to “blow up the tax code and start over.” His plan makes him the most recent public figure to propose a value added tax (VAT).

Senator Paul’s plan would repeal the Social Security and Medicare payroll and self-employment taxes, the corporate income tax, the estate and gift tax, tariffs, and some excise taxes. And, it would dramatically reduce individual income taxes, slashing rates to a flat 14.5% and offering a $50,000 exemption for a family of four while maintaining the earned income tax credit and the child tax credit.

Of course, repealing and reducing those taxes would cause a large revenue loss. The plan would make up a little of the revenue loss by eliminating income tax deductions, other than for charitable contributions and mortgage interest. It would look to unspecified spending cuts to make up part of the revenue loss. But, the plan’s biggest revenue offset is a new 14.5% VAT.

If enough spending cuts come through to reach budget neutrality, the plan would significantly accelerate economic growth by dramatically reducing the tax code’s worst distortion, its penalty on saving and investment. But, this advantage would disappear if, as is likely, the unspecified spending cuts failed to materialize. In that case, the resulting deficits would crowd out investment, undoing the gains from the improved tax incentives.

If the plan includes enough spending cuts to make it budget-neutral, it would shift the fiscal burden downward. Those at the top of the income distribution would receive large tax cuts. Households lower in the distribution would make up the difference, bearing fiscal burdens from the spending cuts and the VAT that would outweigh their payroll tax relief.

By proposing a VAT, Senator Paul is following in the footsteps of Herman Cain, who proposed a 9% VAT (accompanied by a 9% retail sales tax) in the 2012 presidential campaign. Unfortunately, he’s following Mr. Cain’s footsteps in another respect, by steering clear of the V word and calling his VAT a “business activity tax.” Four years ago, I commented, “The biggest issue is one of truth in labeling. Mr. Cain should level with the voters by explaining that he’s proposing a VAT and allow them to weigh the advantages and disadvantages of this approach.” Today, I offer that same advice to Senator Paul.