A Value-Added Tax: a Revenue-Neutral Alternative to the Corporate Income Tax

June 23, 2016

Republican presumptive presidential nominee Donald Trump has proposed lowering the corporate income tax rate from 35 percent – one of the highest rates in the world – to 15 percent. This proposal, much like any other tax cut, has been criticized heavily for reducing federal revenue. The critics have a point – the tax cut will lead to revenue loss even on a dynamic basis. Policymakers interested in cutting the corporate income tax but who are concerned about the federal deficit may be interested in finding an alternative source of revenue to make up for a lower corporate rate.

One common tax reform proposal is instituting a value-added tax (VAT) and eliminating the corporate income tax completely. VATs have a much broader base than the corporate income tax, and are a more economically efficient source of revenue. Under the current system, wages and salaries in a corporation are completely deductible, while capital investments are partially taxed. A value-added tax, on the other hand, would apply to corporations’ labor costs but would let corporations deduct all of their investments. Under a value-added tax, corporations would have an incentive to invest and expand more, leading to jobs creation and additional economic growth.

Our newly-released Options for Reforming America’s Tax Code book describes and models this proposal in detail on page 92. The Options book suggests that a 5% VAT in place of the existing corporate tax would increase GDP by 5.5% and raise $3.1 trillion in federal revenue on a dynamic basis. Therefore, even a VAT with a rate of less than 5% would be sufficient to eliminate the corporate income tax and stay revenue-neutral in the long run. In fact, our model estimates that a 1.46% value-added tax would provide enough revenue, on a dynamic basis, to replace the corporate income tax in full, increasing long-term GDP by 6.5% and not losing any federal revenue in the long run.

Corporate Tax Rate

VAT %

Static Revenue Change, $ Billion

Dynamic Revenue Change, $ Billion

GDP Growth

0

4

1,453.8

3,155.2

5.6%

0

3

177.9

1,936.6

6.0%

0

2

-1,122.6

687.3

6.3%

0

1

-2,446.6

-588.9

6.6%

For policymakers interested in a value-added tax that is revenue-neutral on a static basis, a 2.86% VAT would suffice to replace all of the revenue from the current corporate income tax, assuming no changes in the size of the economy.

Replacing the corporate income tax with a small VAT may be an efficient, revenue-neutral, and growth-maximizing solution to the problems caused by our system, which has fallen out of line with the rest of the world. There are many other proposals and ideas, of course – the most common ones are outlined in the new book that Tax Foundation released several weeks ago.


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