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First, let me wish you Merry Christmas, Happy Holidays or your favorite personal form of greetings for this time of year. I realize as you read this you are more focused on Christmas and the approaching New Year and family, so this will be a shorter letter than normal, but still a topic that is seminal in our discussions on taxes and debt.

But before we get into that, I want to respond to a few questions from readers. I have some readers who have evidently not been reading me for that long, and they are not very happy with me talking about raising taxes. They see my (very reluctant) willingness to consider raising taxes as just another tax and spend liberal/progressive, or a RINO. Whatever.

Longtime readers know that I have been dead against increasing taxes since the early 80s. Government spending and especially taxes distort the true economy. I viscerally understand, taking money from productive hands and putting it into the hands of government is not a pro-growth policy. It is not a free market policy. It is not something I was even willing to consider up until five, maybe seven, years ago.

The only reason I am willing to consider raising taxes is that we have painted ourselves into a corner on deficits and debt. Well over 20 years ago, I was writing that we would reach this point if we did not get a grip on spending. We didn’t.  Now here we are. The one thing that would be worse for the economy than raising taxes would be allowing the debt markets to overwhelm the economy and basically grind economic activity to a halt.

There are some hair shirt libertarians who would prefer everything collapse so we can rebuild with a “more principled approach,” assuming that they can come through the fire unscathed and not terribly concerned about those around them. I will admit to possibly, maybe, potentially, having lived in that dreamscape for a period of time in my life. Then kids and grandkids happened and I see the economy through their very challenged lives. We (you and me and our kids and families and friends) are all in this together.

The sad situation is that we can either watch our economic world crumble, or we can deal with reality and recognize that we are going to have to both cut spending and raise taxes. Hopefully, we can do it in a way that allows us to eventually dial back those taxes, or, as I am suggesting today, consider alternative tax revenue sources that are less destructive.

I've been writing this series on various cycle theories and lately have been writing on debt and deficits. I would suggest that you need to see my arguments in their totality, and not as an individual letter. At some point, I hope to put them all in one piece rather than a weekly series.

A number of readers have asked about why not propose a value added tax (VAT) like the rest of the world uses? I have been peripherally talking about VATs for some time now, and frankly think a VAT is probably our only real solution to raise the revenues needed along with some very serious and stringent spending restrictions/cuts.

For those who asked, I don't see military spending as a sacred cow. For that matter, I don't see Social Security or Medicare as they exist today as a sacred cow. Everything, and I mean everything, has to be on the table.

With that said, let's talk about value added taxes.

Taxing Consumption

As I said earlier, tax policy will always distort the economy, often for the worse. When you take money from productive people and then try to social engineer an outcome, it’s not always a good use of money. Think Solyndra and a hundred other examples. Welfare has unintended consequences. Doesn’t mean we shouldn’t do it but recognize that it will create behavioral distortions. It’s one of those areas where we should just try to minimize harm.

The consensus of economists is that consumption taxes produce the fewest side effects. I think this is one thing that progressive economists, even Paul Krugman, can agree on. Not that they wouldn't want to continue with income taxes and even raise them. That is where we part company. If we are going to raise taxes, we must reduce spending commensurately.

All that being said, the side effects of a VAT may actually be good if the tax encourages people to spend more carefully. And given how a VAT works, it would be good for our exported manufacturing sectors, creating new jobs. VATs are rebated at the border for exports, making US manufacturers more competitive versus the rest of the world. Seriously. Given that the US is generally at the forefront of technology revolutions, a VAT done right could enhance the US economy in marginal ways.

(Again, if the deficit was under the growth of nominal GDP, I would never even think about suggesting an increase in any tax, let alone a VAT. But, as us country boys would say, that horse is already out of the barn and well into the north 40.)

Americans are familiar with consumption taxes. Most states have a sales tax, sometimes with exemptions for necessities like food. Some have proposed national versions. The FAIR Tax is one idea that’s been floating around awhile. It would impose a 23% national sales tax on all new goods and services, combined with a monthly “prebate” to every household that prevents an unfair burden on low-income families.

Advocates say the FAIR tax would fully replace the current income tax and payroll tax systems. I would note that this was true at one time, but I suspect the current level of deficits and debt have taken that 23% and increased it substantially. Oh, well.

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