A Small Value-Added Tax Could Pay for Tariff Repeal

TariffTariffs are taxes imposed by one country on goods imported from another country. Tariffs are trade barriers that raise prices, reduce available quantities of goods and services for US businesses and consumers, and create an economic burden on foreign exporters. revenue has more than tripled as a share of GDP under the tariff increases imposed by President Donald Trump since 2018. The revenues have proven unstable, however, as many new tariffs were imposed under untested legal authorities and subsequently struck down by the Supreme Court in February 2026. While the administration crafts replacements, policymakers should devise their own alternative fiscal plan to address the twin problems of economic uncertainty and fiscal instability.

 

Even with the new tariff revenue, America’s fiscal trajectory is still poor. Annual budget deficits will exceed $2 trillion within a few years and $3 trillion by the end of the budget window in 2036. Interest payments on the debt will exceed $2 trillion by 2035, costing more than defense spending and almost as much as major spending programs like Medicare.

Our new book, Options for Reforming America’s TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Code 3.0: A Policymaker’s Guide to Tax Reform Trade-Offs, considers a reform that would remove all the new tariffs and return US tariff policy to its 2017 baseline. Removing the tariffs would ease the economic burden they create, but would add to the US’s already-high deficits.

Since publication of the book, additional tariffs have taken effect. We now estimate that removing all the new tariffs, including the levies dating back to Trump’s first term, would cost nearly $1.8 trillion in forgone revenue for the federal government from 2027 through 2036. Tariff repeal would reduce marginal tax rates on work and investment in the US, leading to higher output and hours worked.

To replace the lost revenue, lawmakers could consider a value-added tax (VAT).

A VAT is a consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or income taxes where all savings are tax-deductible. collected on the incremental value added at each stage of production of a good or service—it is similar to a retail sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding.  in that it only burdens final consumer goods, but it is administered along the way during production rather than only at the final sale.

VATs are most commonly administered through a credit-invoice system: businesses collect tax on their sales at every stage but receive credit for the tax paid on their inputs. This removes the tax burden on intermediate transactions and places it on the final sale.

The result is that a VAT is neutral between consumption and saving. Unlike the present income tax, which can discourage capital investment, a VAT, once fully transitioned to, imposes no burden on the normal return to investment (that is, the return required to just break even, as opposed to supernormal returns that exceed the normal return, arising from advantages such as market power, rent-seeking, investment risk, or innovation). VATs are also neutral with respect to trade and different types of capital investment. VATs still impose an economic burden by reducing returns to work, which shrinks hours worked and economic output.

Many think of tariffs as a consumption tax, but they depart from consumption tax design in an important respect: they apply to final consumer goods as well as intermediate transactions. In contrast with a VAT, which imposes no burden on the normal return to investment because intermediate transactions are effectively exempted, tariffs burden investment, in some cases by more than the income tax.

Tariffs can distort returns across sectors and types of investment, leading to capital misallocation. They also differ from other taxes because they carry geopolitical consequences: they invite retaliation, which compounds the economic cost without raising additional revenue for the Treasury, and may encourage countries to pursue trade pacts that exclude the tariff-imposing country. For these reasons, tariffs are a relatively distortive type of tax. Additionally, the new tariffs have been imposed under executive authority (including Section 122, Section 301, and Section 232 tariffs) and face ongoing legal challenges.

Accordingly, a VAT would cause fewer distortions than a tariff. We estimate that the revenue loss from eliminating the tariffs could be fully replaced with a broad-based VAT levied at a rate of 1 percent, while increasing economic output, the capital stock, and hours worked. Tax Foundation’s modeling does not capture the distortive effects tariffs have on the cost of capital, and so likely understates the gains from replacing them with a VAT.

Table 1. Replacing the Tariffs with a VAT Would Grow the US Economy

Source: Tax Foundation Tariff Model and General Equilibrium Model, September 2026.

The swap would be revenue neutral on a conventional basis, but after considering the increase in output, it would raise $130.1 billion over the budget window on a dynamic basis. The debt-to-GDP ratio would be virtually unchanged conventionally measured, but dynamically, it would be slightly lower, falling about 1.3 percentage points from 175.9 percent in 2056 to 174.7 percent. Distributionally, the revenue-neutral swap would not result in a significant change in who bears the burden of the tax. On a dynamic basis, all income groups would see gains because of the increase in economic output.

Table 2. A Revenue-Neutral, Pro-Growth Reform Creates Fiscal Benefits

Source: Tax Foundation Tariff Model and General Equilibrium Model, September 2026.

The nation is on track to run record-breaking deficits year after year, and businesses and workers are navigating an uncertain economic environment. Policymakers must navigate difficult trade-offs in designing policy solutions to these twin problems. Rather than continuing the administration’s tariff policy, policymakers should explore new solutions that can raise sustainable revenue with fewer distortions, like replacing the tariffs with a value-added tax.


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