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The Folly of the National Sales Tax

Mises Daily: Wednesday, June 17, 2009 by

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Facing a historic national debt that President Obama correctly characterized as "unsustainable," yet still desiring to implement some sort of national health-care package, US policymakers, notably Budget Committee Chairman Kent Conrad and former Federal Reserve Chairman Paul Volcker, have recently hinted at the possibility of a national sales tax. More specifically, they hint at possible implementation of a national value-added tax (VAT) which would tax at a certain rate the difference between the cost of inputs and the price of the output along each individual step of production.

Beyond the factual objection that a national tax on consumption would fall disproportionately on low-income consumers who spend a greater percentage of their income on consumption goods and save at a lower rate than do higher-income consumers, the VAT is a particularly odious proposal for all consumers because of its effect on overall economic activity.

Because it places an extra cost onto every step of the productive process, the VAT necessarily decreases the marginal productivity of both capital and labor in literally their every possible application. Without affecting the actual scarcity of the basic physical resources available for use in an economy, a value-added tax simply makes each step of each productive process less efficient, with a certain fraction of output being destroyed by government. The final result of this economywide loss in efficiency is a real increase in the scarcity of both capital goods and final consumer goods on the marketplace.

The VAT is a rare and heinous type of government policy that attacks not the ratios of exchange between certain goods, but rather the availability of every single good produced within a national economy. Put another way, a VAT has the ability to increase in real terms the prices of every good legally produced and sold within a country's borders. By decreasing the real output derived from national resources in this manner, the VAT necessarily decreases the material standard of living for all of a nation's consumers.

Furthermore, these effects are not mere theoretical points but real effects that are certain to be felt by the everyday consumer. Any VAT that would be able to raise a sufficient amount of money to fund new health-care initiatives would necessarily place a significant burden on each step of the productive process, resulting in a noticeable decrease in the standard of living of every consumer.

The burden of a value-added tax would fall disproportionately onto those goods that require long productive cycles involving several processes and that result in a final good valued much more highly by society than the raw inputs they require — for example, automobiles and personal computers. Such goods are the end products of the types of long-term processes into which businesses tend to heavily invest capital and labor during the boom portion of a credit-expansion cycle, as Mises explained in his theory of the trade cycle.Download MP3

During the beginning of a recession, as the insufficiency of real demand for these products becomes apparent to entrepreneurs, they must, in an attempt to return to profitability, decrease or halt the production of these long-processed goods, or reduce their price to market-clearing levels. However, by more harshly increasing the costs of long productive processes, a value-added tax would make that second option, a price reduction, impossible — or at least highly unprofitable and ultimately loss-inducing for makers of goods such as cars and computers. Therefore, the only alternative left to such firms facing a VAT in the event of a recession is to even more intensely halt their production of those goods, exacerbating the rise in unemployment of laborers within those industries.

Even if we were to ignore all other consequences of the value-added tax, this economic reality ought to dissuade President Obama from considering a VAT, as it will especially harm the already-ailing domestic automakers. The introduction of a VAT would require more direct subsidies to the American automakers, though perhaps that is no deterrent for President Obama.

As if this weren't enough, not only do all consumers face higher prices for everything, but the introduction of a VAT would tend to distort market signals of consumers' preferences between certain categories of goods. In the form of higher prices for highly-processed goods, a VAT sends entrepreneurs a phony signal that consumers prefer goods of high processing over those of low processing more strongly than they actually do. This is similar to Mises's teaching that a central bank's credit expansion, when not supported by real savings, falsely distorts the picture of consumer preferences between current and future goods. And, as was central to Mises's teachings, no economy can efficiently allocate resources without an unhindered and market-determined price system.

Unfortunately, because the general Keynesian theories of capital and interest and of consumer choice do not accurately describe the phenomena of resource allocation and of consumer choice, President Obama will not be offered any valuable advice about the potential catastrophe that would result from the introduction of a VAT.

The most striking irony of the fact that the president's economic team is considering the VAT is that it stands in stark contrast to their economic policy paradigm thus far. As neo-Keynesians, top figures from Bernanke to Obama himself have blamed the recession on insufficient aggregate consumer spending by the private sector. It is curious, then, that these top-ranking left-liberal politicians and economists would even consider the implementation of a tax policy that would, as its explicit goal, increase the real price of literally every consumer good and thereby depress the overall efficiency and activity of the American private sector.