Charles Ballard

John B. Shoven

John Karl Scholz

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: Taxes and Capital Formation
Volume Author/Editor: Martin Feldstein, ed.
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-24079-7
Volume URL: http://www.nber.org/books/feld87-2
Publication Date: 1987
Chapter Title: The Value-added Tax: A General Equilibrium Look at Its Efficiency
and Incidence
Chapter Author: Charles Ballard, John Karl Scholz, John B. Shoven
Chapter URL: http://www.nber.org/chapters/c7697
Chapter pages in book: (p. 105 - 108)13  The Value-added Tax: A 
General Equilibrium Look at 
Its Efficiency and Incidence 
Charles L. Ballard, John Karl Scholz, 
and John B. Shoven 
A value-added tax (VAT) has been considered repeatedly in the United 
States either to replace parts of the existing federal tax system or as 
a new source of revenue to reduce the federal deficit. In this paper (see 
Martin Feldstein, ed., The Effects  of Taxation on Capital Accumulation 
[Chicago: University of Chicago Press, 1987]), we examine the effi- 
ciency and distributional consequences of a VAT  whose revenues are 
used  to reduce personal  or corporate income taxes.  In addition to 
analyzing the VAT as a flat rate tax on consumption, we look at a VAT 
with a rate structure similar to those prevalent in Europe. In Europe 
the actual VATS commonly have several rates,  exempt housing  and 
most services, tax food lightly, and tax luxuries at the highest rate. We 
ask how this rate differentiation affects the efficiency of the tax and 
how effective it is in alleviating the tax’s inherent regressivity. As an 
alternative to rate differentiation, a progressive direct expenditure tax 
is also evaluated. Such a tax would effectively apply the same rate to 
all commodities for an individual consumer but would apply higher 
rates to households with higher levels of expenditure. Finally, the paper 
examines several ways in which VAT  revenues could be used to lower 
existing taxes. Two possible personal tax reductions  are examined, 
along with replacing the corporate income tax with a VAT. 
Our analyses of the tax changes use an applied general equilibrium 
tax model developed with the support of the U.S. Treasury Depart- 
ment. The model has nineteen industrial sectors, fifteen consumer goods, 
and twelve classes of households differentiated by their total economic 
Charles L. Ballard is an assistant professor of economics at Michigan State University. 
John Karl Scholz is a graduate student in the Department of Economics, Stanford Uni- 
versity. John B. Shoven is a professor of economics at Stanford University and a research 
associate of the National Bureau of Economic Research. 
105 106  Charles L.  Ballard, John Karl Scholz, and John B. Shoven 
income in  1973. The model is dynamic in  the sense that consumers 
allocate their income between  consumption and  saving, and saving 
determines the growth rate of  the capital stock. It incorporates the 
entire array of  existing taxes, including the personal and corporate 
income taxes, excise and sales taxes, payroll taxes, and property taxes. 
The analysis involves a comparison of  the path of  the economy fol- 
lowing the introduction of a new tax with the path if the base policy 
had been retained. In the model, the elasticity of  saving with respect 
to the real after-tax interest rate is set at 0.4, and the elasticity of 
aggregate labor supply with respect to the real wage rate is set at 0.15. 
A limited amount of  sensitivity analysis is done with respect to the 
savings elasticity. 
The paper finds that the introduction of  a VAT  and an equal yield 
reduction in the personal income tax would improve the efficiency of 
the economy. This is true because those who are made better off by 
the tax swap would gain more than those who are made worse off. 
Potentially, the losers could be compensated. The magnitude of  the 
improvement in efficiency is significantly larger for a flat VAT  than for 
one with a differentiated rate structure. For the taxes considered in the 
paper, rate differentiation costs about $100  billion in  present value 
terms. While this is only 0.2% of the present value of future GNP and 
leisure simulated in the model, it still is a sizable cost. This $100 billion 
cost of differentiation implies that the gain from a VAT  is reduced 27% 
42% by rate differentiation. Relative to a flat rate VAT,  a progressive 
expenditure tax also loses about $100 billion in efficiency. However, 
all three policies (i.e., a flat VAT, a differentiated VAT, and a progressive 
expenditure tax) are more efficient at the margin than is the present 
personal income tax. The magnitude of the efficiency gain depends to 
a great extent on the manner in which the personal income tax is scaled 
back. Given that the efficiency losses of taxes vary roughly with the 
square of the tax rate, reductions that lower the rates are more efficient 
than reduction for those with lower rates. 
Naturally, the manner in which existing taxes are lowered also dra- 
matically affects the incidence of the introduction of  a VAT.  In fact, 
the use of  the revenue determines the distributional impact of the tax 
swap more than the design of the VAT’s rate structure does. If personal 
tax rates are reduced proportionally, the tax swap is far more regressive 
than if  they are reduced by a fixed number of percentage points. In 
fact, the regressivity of the VAT  with a fixed percentage-point reduction 
in personal tax rates is rather mild. We  show one case of a progressive 
expenditure tax with a proportional reduction in personal income tax 
rates that leaves all income classes better off. 
Previous analyses of the integration of the corporation and personal 
income tax have assumed that the forgone revenues would be made 107  The Value-added Tax 
up by  an  increase  in  personal  income tax  rates.  In this  paper,  we 
examine the possibility of financing the tax integration with the intro- 
duction of a VAT.  The resulting efficiency gain exceeds previous esti- 
mates because a consumption-type VAT  is a more efficient source for 
the needed replacement revenue than a personal income tax surcharge. 
To gain a feeling of how important efficiency matters are, we compare 
four different tax instruments used to raise revenue from households 
by  a given amount: two types of income tax surcharges, a flat VAT, 
and a differentiated VAT.  We  find that a percentage income tax sur- 
charge “hurts”  households almost 28% more than would the intro- 
duction of a flat VAT  that raised the same revenue. 
Given that a number of the tax swaps considered in the paper involve 
efficiency improvements but have a regressive incidence, we investi- 
gate a range of social welfare functions for which the tax changes offer 
an improvement. Because reducing income tax rates by a given number 
of percentage points is more progressive than reducing rates propor- 
tionally, use of a VAT’s revenue for the first type of reduction leads to 
an increase in social welfare for a wider range of welfare functions. 
However, the proportional rate reduction may lead to the larger effi- 
ciency gain. 
The paper  contains some sensitivity analyses with respect to the 
specification of consumer demands and to saving elasticity. While the 
numbers obviously change, the qualitative implications of the intro- 
duction of a VAT  are unaltered. 
We  conclude that different tax measures impose significantly differ- 
ent efficiency costs on the economy. A flat VAT appears to be far more 
efficient at the margin than an income tax surcharge. However, rate 
differentiation is a costly and relatively ineffective way to affect the 
distribution of welfare in the economy. It would be more effective to 
change the progressive tax rates of the personal income tax directly 
(or to introduce a progressive expenditure tax) than to erode the po- 
tential efficiency of a value-added tax. This Page Intentionally Left Blank

Taxes and Capital Formation

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