Cruz is right about the value-added tax

Early in the presidential campaign, Sen. Ted Cruz (R-Texas) discussed an often misunderstood and challenging subject: a business flat tax, which is a key component of his economic platform. It would be a 16 percent tax on a business’s gross receipts from sales of goods and services, less purchases from other businesses, including capital investment.

{mosads}For all intents and purposes, the so-called business flat tax is a value-added tax (VAT). The VAT would replace the business income tax and other taxes such as estate taxes and Social Security payments, as well as reduce personal income taxes to a flat rate of 10 percent.

There is nothing inherently conservative, or social democratic for that matter, in the tax structure put forward by Cruz. However, the proposed tax rates are another matter. As an economist, I understand that Cruz’s proposed tax structure is a major improvement over the present structure, although I do not agree with the proposed tax rates.

Throughout the world, the VAT is to consumption taxes what the metric system is to measurement systems — just about everybody uses it, with the significant exception of the United States. From Europe to Asia, and from Africa to Latin America, the VAT reigns supreme as the most common form of consumption tax worldwide.

The VAT operates through a system of debits and credits. In Cruz’s proposal, businesses would pay to the IRS 16 percent of the value of their sales. However, businesses would get credit for the VAT already paid to their suppliers. Therefore, for $1,000 in sales, a business would pass on to the IRS $160, minus, say, $90 previously paid to suppliers, for a net of $70.

Since the VAT is a broad-based consumption tax, it is much more difficult to avoid than under the present income/Social Security tax system in which fortunes are spent to game the system, both legally and illegally. The consumption tax proposed by Cruz covers about everything, from clothes to cinema tickets, gas to jewelry. Under the proposal, everybody contributes, including undocumented immigrants and drug dealers, every time they consume or purchase something. The tax figure could certainly be included in all sales receipts so that taxpayers know exactly how much is being paid in taxes.

The introduction of the VAT allows for the elimination of other significant taxes. Thus, away goes Social Security contributions by employers and employees, inheritance taxes and corporate income taxes. Eliminating corporate income taxes is a particularly ambitious proposal. The idea behind it is that the profits of corporations belong to some individuals; rather than collect corporate income taxes, it makes sense to collect taxes from individuals, either as a VAT or as individual income taxes. As mentioned before, the proposed structure is neither conservative nor social democratic, just good tax policy.

In today’s world, a company based in Silicon Valley can legally move its profits to an offshore location, thus avoiding U.S. corporate income taxes. However, it needs to be based in Silicon Valley because of the competitive edge that this gives the firm given Silicon Valley’s cluster of experienced personnel, venture capitalists and universities. Thus, it is a more effective tax policy to obtain the same amount of tax revenue from individuals than trying to get a part from individuals and a part from corporations. In addition, eliminating the corporate income tax improves the efficiency of corporate America because decisions would be based on what is best for the success of the firm, not on the best way to avoid taxes.

However, things become complicated when setting up actual tax rates. Cruz proposes a flat 10 percent income tax rate for individuals. According to the Tax Policy Center, Cruz’s plan would result in a decline of some $850 billion in tax revenues a year, primarily because high-income individuals come out very much ahead. The decline in tax revenues would probably also require significant cuts in government spending. Therefore, the rich would be taxed less, while government programs would face cuts.

As an alternative, the aim could be to achieve revenue neutrality using Cruz’s proposed tax structure, but with different tax rates. Perhaps the tax rate on individuals could be 10 percent up to $200,000 in income, 20 percent for incomes between $200,000 and $1 million, and 35 percent for incomes above $1 million. With these rates, the rich would not get tax benefits and government revenues would perform better, while the U.S. economy would still benefit from the tax structure proposed by Cruz.

Setting tax rates entails, among other things, political values, which are beyond the scope of this column. Moreover, there are a gazillion issues and lots of fine print in a tax proposal that do not fit into this column. What needs to be stressed is that the structure of Cruz’s proposal, with a VAT at its core, is the best general structure for U.S. tax policy.

As an economist by profession, I am encouraged by the bold vision that Cruz’s proposed tax structure entails.

Feliciano is president of Advantage Business Consulting. He was an adviser to the Puerto Rico Department of Treasury on its 2015 tax reform, which included the implementation of a value-added tax.