Eli Dourado

The VAT vs. sovereign default

One of the great joys (or frustrations, depending on your personality) of being a libertarian is the opportunity to participate in the infighting. Tyler Cowen’s recent post, in which he muses about a VAT in an uncommitted fashion, has generated some of it, e.g. from Fred Sautet and Dan Mitchell. Tyler responds here.

My favorite argument comes from Mario Rizzo, in a comment on Sautet’s post:

I would prefer the harms of the collapsing welfare state due to the unwillingness to compromise rather than the maintenance of (even a semblance of) the present system through any increase in the tax-take of government. We do not have to get the advocates of the welfare state to agree to reductions explicitly. Crisis will force it. I realize this may sound crazy to some people. But I am just being candid about my preferences.

I like Rizzo’s comment because it is characteristically honest and it addresses the real question: given that a sovereign debt crisis is coming without big fiscal changes, and that cutting spending is unlikely for political reasons, would you prefer a debt crisis and all that it entails or a more efficient tax system that will give the government more money?

We can think about the issue in terms of positive liberty and negative liberty. Here is my crude model: positive liberty is positively correlated with C + I + X, and negative liberty is negatively correlated with G. We can classify libertarians as those who want more negative liberty, other things equal; that is, you are a libertarian if MUG is negative.

In the state of the world in which a VAT is enacted and a debt crisis is avoided, C + I + X is higher, but so is G. In the state of the world in which a debt crisis occurs, G is lower, but so is C + I + X. The problem can be boiled down to two issues: what is the expected magnitude of these changes, and what is your marginal rate of substitution between negative and positive liberty?

No one knows for certain what effect a debt crisis would have on GDP or its components. My suspicion is that it would be quite large. Most countries that experience debt crises have deep and painful recessions that last many years. However, we have no experience with a default by a government like the US, because the modern US is unique. The world is so exposed to US Treasuries that a US default could destroy most of the banks and bank-like institutions in the world and cause a truly global recession. It would probably be much worse than a default by, say, Argentina, which mostly hurt the Argentines.

You can acknowledge the possibility of these consequences and still oppose a VAT if you are sufficiently libertarian. The question is then how negative is your MUG/MUC + I + X? If it approaches negative infinity, then you should still oppose a VAT. If it is close to zero, then you should support a VAT.

For now, I am (like Tyler) in the anti-VAT camp. However, as the probability of a debt crisis increases, due to failed attempts to decrease spending or simply the passage of time, at some point I would prefer a VAT. If a debt crisis were a week away, I would push the VAT button. Wouldn’t you?