VATs -- Even Cash Cows Have Their Limits

July 25, 2011

Tomorrow, Tuesday, July 26th, the House Ways and Means Committee will hold a hearing on Value Added Taxes (VATs). Some have suggested recently that the U.S. adopt a VAT as a source of revenues to either reduce the federal deficit or to cover the growing cost of federal entitlements such as Medicare and Medicaid.    

To many Americans, VATs are "cash cows" that generate huge amounts of tax revenues to fund Europe's generous social welfare programs. Indeed, a high-ranking European tax official once told me that the VAT is the "perfect tool to fund big government because it is largely hidden from view and you can always dial up the rate if you need more revenue."

As the nearby chart indicates, according to OECD data, VAT rates have averaged around 18 percent for the largest industrialized nations since the mid-1980s. Japan and Canada currently have the lowest VAT rates at 5 percent while Iceland has the highest at 25.5 percent, followed by Denmark and Sweden at 25 percent.    

However, rather than consume an increased amount of GDP as tax collections, VATs have been somewhat declining in importance in OECD countries, both as a share of the economy and as a share of overall tax collections.

For the past 20 years or so, VAT collections have averaged roughly 11 percent of GDP across the OECD. Overall, VAT collections peaked in 2000 at an average of 11.5 percent of GDP, but have decreased slightly since then. Denmark's VAT takes the greatest share of GDP at 15.6 percent, followed by Hungary (14.9 percent) and Iceland (13.6 percent). Japan's VAT consumes the least amount of GDP at 5.1 percent, followed by Switzerland at 6.3 percent and Canada at 7.9 percent.

As a share of total tax collections, VATs have averaged roughly one-third of total collections for OECD nations for the past three decades. Once again, Japan has the lowest VAT collections as a share of overall revenues at 18 percent, followed by Switzerland at 21.7 percent, and Italy at 24.5 percent. By contrast, Mexico gets a whopping 59.2 percent of collections from its VAT. Next is Chile at 50.6 percent of overall revenues and Turkey at 45.5 percent of revenues.

VATs may have a reputation as cash cows, but there does seem to be a limit on how much they can collect. But this should not be a surprise since consumption tax revenues are limited by the growth in private consumption. This should be a warning to those in this country who see VATs as a funding solution to programs such as Medicare that are growing three-times as fast as the economy.

The bottom line is that even a so-called cash cow can be insufficient to fund big government if that government is growing faster than the private economy.  

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