Ted Cruz has a tax plan with a bad name.
The senator from Texas and Republican presidential candidate has proposed a roundly conservative system. It would substantially reduce taxes in the United States, especially for wealthy Americans, while making it more profitable to invest. Republican wonks have been calling for a similar approach for decades.
Unfortunately for Cruz, however, he has proposed what economists and experts on taxation call a "value-added tax," or a VAT. The acronym is no better than a slur in conservative circles, partly because the system is popular in European countries.
"Bad! Europe! France! Greece! Ebola virus!" Those, said Daniel Mitchell, an economist at the libertarian Cato Institute, are a few of the words that conservatives associate with the letters V, A and T. The obscene syllable they form has been on the lips of rival Sen. Marco Rubio (R-Fla.) for months as he's criticized Cruz's plan in debates and on the stump.
Cruz denies that he has proposed a value-added tax. He prefers to describe it as a "business flat tax." As a result, the candidates haven't really been able to debate the merits of Cruz's plan, because they can't agree on what to call it. A controversy over the meanings of words has gotten in the way of a serious discussion about tax policy.
"The business flat tax that is in my tax plan is not a VAT," Cruz said, once again, in Saturday's Republican debate.
Cruz calls for reducing the individual income tax to a proportional rate of 10 percent for all taxpayers and eliminating the estate tax. He'd combine the existing payroll tax and corporate income tax into his "business flat tax."
Businesses would be responsible for paying this tax on a quarterly basis. They'd file a quarterly return with the federal government -- though not the Internal Revenue Service, which Cruz has pledged to abolish -- listing their revenues along with their total purchases (excluding wages and salaries). They'd have to pay the difference between their total revenues and their total purchases, multiplied by a flat rate of 16 percent.
Many conservative economists argue this kind of tax would be fairer and would stimulate the economy. All of a firm's output -- and, by extension, the total output of the economy -- would be taxed in a neutral way, they argue. Under the existing corporate income tax, a firm cannot immediately deduct any new investments in equipment and technology from its tax bill. As a result, the money the firm uses to make those purchases is arguably taxed twice -- first, when the firm pays its income tax, and second, when the supplier pays income tax on the money it receives from the first firm.
Under Cruz's plan, that redundant taxation would be eliminated, giving firms another reason to invest. They would simply pay tax on the difference between their output and their inputs. That difference is the amount by which the firm is increasing the size of the real economy -- what you might call the value added by its investors and employees.
This is a compelling argument for a value-added tax, and it's one of the reasons that these taxes are popular all over the world. The United States is the only developed country without one.
Cruz's plan is a "textbook" example of a value-added tax, said Len Burman, director of the nonpartisan Tax Policy Center. Blow the dust off your copy of Fundamental Issues in Consumption Taxation, the primer that economist David Bradford published with the conservative American Enterprise Institute in 1996. You'll find a description of "what is called in the jargon of the tax trade a subtraction-method value-added tax of the consumption type," with a description of the kind of tax that Cruz has proposed:
The tax base of a business consists of the difference between the payments it receives for sales of goods and services of any kind (including sales of assets, such as a building) and the purchases of goods and services from other firms. This total is then taxed at some predetermined fixed rate. That is it.
Compare that with Cruz's own description of his "business flat tax," in The Wall Street Journal. "This would tax companies' gross receipts from sales of goods and services, less purchases from other businesses, including capital investment," he wrote. "Simple, efficient, fair."
Burman is flummoxed about the controversy over whether Cruz's system is a value-added tax. "The fact that it's a debate is really just bizarre," he said.
Cruz and his supporters, though, point out that most value-added taxes around the world are collected using a different system. In that system, for example, a manufacturer would pay a sales tax on products supplied to a retailer, and the retailer would pay a sales tax on each transaction at the cash register. The retailer, though, could demand an invoice from the manufacturer showing what the manufacturer paid in sales tax, and receive a credit from the government for that amount.
Again, no firm's income is taxed twice in this system. Yet those defending Cruz argue that because the system of invoices and credits facilitates firms in passing the tax on to their customers, it is ultimately only the customer at the cash register -- who isn't eligible for any kind of credit -- who pays the tax. Under a plan like Cruz's, they argue, the incidence of the tax is broadly shared across the economy -- among shareholders and workers as well as consumers.
"The only 'real' taxpayer under the VAT-type sales tax is the retail consumer — the last one in the chain and the one who receives no tax credit," Ernest Christian, a conservative tax expert and a veteran of the Reagan and Ford administrations, wrote in Investor's Business Daily.
"A VAT in Europe is a sales tax. The business flat tax is not a sales tax," Cruz said Saturday.
In general, though, economists don't buy this argument. The math is straightforward. If you own a business, receiving a credit for a tax your supplier paid on a purchase at a certain rate is exactly the same as deducting the entire purchase from income on which you owe tax at the same rate in terms of your bottom line. As a result, there should be no difference between the two systems in terms of who pays.
"The equivalence between the two forms of VAT is not a matter of opinion," the Tax Policy Center's Burman noted. "It's simple arithmetic."
"It shouldn’t matter in the long term," said Alan Cole, an economist at the nonpartisan Tax Foundation. "This is definitely still a value-added tax."
The only clear difference is in how the rate is calculated. Cruz's rate of 16 percent would be imposed after the fact on total sales, so a business with $100 in value added would pay $16. A firm making identical transactions in Europe would charge customers $84 and then pay $16 in tax -- a rate of 19 percent. In other words, the rate in Cruz's plan is the equivalent of a 19 percent in other countries, close to the average for the rest of the developed world.
Some conservatives oppose a value-added tax on the grounds that its burden on voters is indirect. Businesses file the returns, which ordinary people pay in the form of reduced wages or increased prices at the cash register. As a result, Cato's Mitchell argued, there is less public opposition to a value-added tax, and such a tax is more likely to increase over time -- even if Cruz's immediate plan is to reduce overall taxes.
"Call it a polka-dot tax. It doesn't matter. It's a new source of revenue that would be nontransparent and easy to raise," Mitchell said. "The downside risk is you become France."
Cruz's response to this argument has been that, in imposing one new, indirect, invisible tax, he would eliminate two -- the corporate income tax and the payroll tax, which voters only know about if they read their paychecks carefully.
That hasn't mollified some observers, who dislike Cruz's use of the phrase "business flat tax." Conservative tax activist Ryan Ellis called it a "euphemism" that misleadingly suggests workers and consumers wouldn't be affected as well.
"I don't think there's any factual dispute that it's a VAT," he said. "They only want to talk about the positive elements of their plan. They deny the downsides of their plan."
Correction: In an earlier version of this story, Len Burman's group was incorrectly identified on first reference. It is the Tax Policy Center, not the Tax Policy Institute. We regret the error.