Why Volcker is Right About Raising Taxes -- And So Are His Critics

Last Updated Apr 13, 2010 10:52 AM EDT

Paul Volcker was right when he told a New York audience, "If at the end of the day we need to raise taxes, we should raise taxes."

Volcker was right to say that something has to give. The U.S. government is running a deficit of almost 10% of GDP - a figure unprecedented in peacetime.

He was right that a value-added tax (VAT) needs to be on the table. Essentially a national sales tax, even a modest VAT of, say, 5% would raise trillions.

Finally, Volcker was right that taxes need a broader base. The U.S. already has one of the world's highest corporate tax rates, so there is not much wiggle room there. And for all the fun associated with class warfare, the fact is, the rich and near-rich already pay the vast majority of income taxes.

Here's the numbers from the IRS for 2007 (the latest year available).

  • Top 1% of earners paid 40.42% of all U.S. income taxes
  • Top 5% - paid 60.63%
  • Top 10% - paid 71.22%
  • Top 25% - paid 86.59%
And the bottom half of the income distribution? They paid just 2.89% of all U.S. income taxes. So even if the top 10% paid ALL our income taxes, the fiscal gap still looms large -- very large.

Now, as for the critics, they are right that history shows that a VAT inexorably goes up. They are right that it feeds the government spending beast without addressing the other side of the ledger. And they are right that imposing a VAT would make U.S. economy look more like Europe's.
Not, of course, that there's anything wrong with that. Putting aside things like warm beer, and the tendency of European men to wear bikinis to the beach, Europe has a lot to offer. It's just that tax policy is not one of them, say the VAT critics.

Niles Gardner, who is with the right-of-center Heritage Foundation, put it this way:

There is a direct correlation between levels of economic freedom and economic prosperity. By going down the well-worn route practiced by major European economies such as France and Germany, the Obama administration will only undermine both. The introduction of a further layer of national taxation would be a huge leap forward for the United States towards a continental European vision of economic management.
The problem with the VAT, say the skeptics, is that if taxes rise to near European levels, that would hurt U.S. competitiveness. In 2009, the U.S. ranked first in global competitiveness, according to the Swiss-based IMD Business School annual rankings. Of the major European economies, the Netherlands ranked highest (10th), while Germany was 13th, the UK 21st and France 28th. And America's conspicuously lower tax take has to be part of the reason for this performance.

Christina and David Romer, for example, concluded in a 2007 paper that evaluated every major federal tax change since World War II:

Tax changes have very large effects: an exogenous tax increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent. These output effects are highly persistent. [And] ... investment falls sharply in response to exogenous tax increases. Indeed, the strong response of investment helps to explain why the output consequences of tax changes are so large.
That evaluation does not come from a Tea Partier. Rather the opposite: Christina Romer is chair of President Obama's Council of Economic Advisers.

So if everyone is right, do we just declare stalemate and go on to trash the next doomed idea? To be honest, that is probably the most likely scenario. There was a thundering silence from the White House and Democratic leaders after Paul Volcker's comments hit the press, even though he is chairman of the President's Economic Recovery Advisory Board. And while the Republican Party was quick to denounce the idea of a VAT, neither is it offering cogent ideas on the option it says it prefers -- to cut or slow spending.

But because elements of both critiques -- that the U.S. debt needs to be addressed, and that kneecapping the economy is not the way to do it -- have merit, there is actually some common ground to work with. A deal could be something like this: For every dollar raised by a VAT, another dollar would have to be taken out in spending. Both sides would gain a little, and lose a little. And the the U.S. would show that it was serious about dealing with its fiscal circumstances.

Of course, such a simple, elegant and useful solution would require the members of Congress to play in the same sandbox, which they aren't doing very well these days.

But you heard it here first. This is where the U.S. is going to go, eventually, for the most persuasive of all reasons: There is no other choice.