If you must raise taxes, raise VAT

The rich world’s states are getting bigger and less effective—and the forces that are the cause cannot easily be turned back. As governments look after ageing populations and fight wage inequality, they are doling out more in pensions and benefits. From 1980-2022, social spending in rich countries with available data rose from 14% to 21% of GDP.

Yet politicians have been loth to raise taxes to keep pace, and in many cases have cut them. Borrowing has therefore soared and, to pay the bills, public services have been squeezed. As a result, many government services are breaking down. In parts of Canada children spend as long on the waiting list for nursery as they would in nursery itself. Britain is releasing convicts early because it has not built enough prisons; fewer than two-thirds of Germany’s long-distance trains run on time.

The Economist has long argued that retirement ages should rise with life expectancy. Even with this policy, however, the ratio of pensioners to workers can still rise simply because the elderly are so numerous. In any case, the formidable voting power of the old makes it hard to stop their benefits from growing. Likewise, it is unavoidable that progressive taxation and income top-ups for low earners bring about more redistribution when pre-tax wage inequality rises. If they want to be elected, politicians will struggle to contain the welfare bill. If they are to avoid the implosion of public services—or fiscal crises—they will need instead to pay for bigger government by raising taxes. The option that is both feasible and not too economically damaging is to tax consumption by raising vat.

The good news is that more redistribution need not crush capitalism. Unlike, say, hiring civil servants or nationalising industries, removing cash from Peter to pay Paul is a relatively light-touch economic policy. If handouts make up half a government’s budget, for instance, it may find that it spends 40% of GDP but employs only 20% of workers as civil servants. In purely economic terms, the redistribution system is costly only in that it distorts incentives, in particular by taxing work and enterprise. Redistribution and free markets can happily co-exist if the system avoids trapping potential workers in welfare, and if it uses “efficient” taxes that are gentle on incentives.

Unfortunately, governments today are ignoring this rule. In its budget next month Britain’s new Labour government is expected to raise taxes on saving and investment, which is likely to harm growth. Canada has increased capital-gains taxes. France’s new government is reportedly considering fresh levies on business. In America, which is recklessly running an annual deficit of 7.3% of GDP, presidential candidates are in denial about the need to raise taxes or make them efficient. Instead, they are promising distorting gimmicks, such as exempting tips from income tax, and, in the case of Donald Trump, exempting overtime too. Mr Trump would also rebalance the tax system towards tariffs, which grossly twist incentives against international trade.

Politicians should try more efficient taxes instead. The best would be a land tax. Unfortunately, voters hate the idea, perhaps because property taxes require individuals to write big, regular cheques. Second-best for efficiency is value-added tax (VAT), a levy on consumption which distorts incentives only to the extent that certain goods and services are exempted.

Experience suggests that it is easier to raise VAT than other efficient taxes—so much so that America’s Republican Party has historically opposed the tax on the grounds that it makes it too easy to build a welfare state. (America, unusually, levies only state-level sales taxes.) In 2011 Britain raised its VAT rate from 17.5% to 20% and faced little public backlash. And high VAT has long helped Nordic countries pair big government with thriving market economies; they levy rates of 24% or 25%, among the highest in the rich world. Estonia is raising its tax to similar levels to pay for more defence.

An argument against VAT is that it is regressive, because the poor consume more of their incomes than the rich. But the poor also have the most to gain from better public services and faster economic growth. In any case, vat is less regressive when measured against lifetime, rather than annual, income; raising the tax would affect rich retirees who spend out of wealth and no longer pay labour taxes. Another argument against increasing VAT today is that doing so would raise prices and add to measured inflation. But inflation has fallen significantly. If increases were phased in gradually, the effects would be manageable.

Bills don’t pay themselves

The same cannot be said of the consequences of allowing public services to collapse and debt to explode. That would outrage voters and upend economies. VAT is not perfect, but few other taxes can preserve public services as populations age and fund Leviathan without throttling free enterprise. If a state is fat, it needs a VAT. ■