Has a High Value Added Tax Harmed the European Economy

Abstract

The Value Added Tax (VAT) is widely used throughout Europe and is analogous to state and local sales taxes in the United States of America (U.S.) in that both are taxes on consumption. However, Europe's VAT rates are much higher than U.S. sales tax rates. The standard VAT rate ranges from 20% in Austria to 27% in Hungary. In contrast, U.S. state and local sales tax rates range from 0% in three states to 9.45% in Tennessee. Additionally, U.S. taxpayers can take a federal income tax deduction for sales taxes paid; thereby reducing their overall federal income tax bills. In part, the relatively low U.S. sales tax contributes to the difference in recent economic performance between the U.S. and Europe. Over the last year, Real Gross Domestic Product (RGDP) has increased by 2.4% in the United States compared with 1.4% in the Euro Area. The U.S. civilian unemployment rate is 5.0% compared with 10.2% in the Euro area.This paper examines whether European countries have been harmed by their high VAT rates. I collect revenue and expenditure data for 19 European countries, 17 of which are members of the European Union. For each country, I determine the effect of the VAT on GDP, on the unemployment rate, and on social welfare.The paper refers to the optimal tax theory, which defines an optimal tax regime as one in which social welfare is maximized. I introduce two additional criteria: GDP maximization and unemployment rate minimization. I compare the existing European tax regime to the current U.S. tax regime, and estimate the optimal VAT tax rate for 19 European countries.