VAT Trap: The inevitable fix for the deficit

NEW YORK (Fortune) -- The gigantic deficits the Administration is projecting are appalling, and they provide a chilling look at our future: America is hurtling towards a fiscal trap that is forcing us into the only option we'll have to restore budgetary sanity: A Value-Added Tax.

Unfortunately, no one really wants to address it. Nancy Pelosi has spoken admiringly of a VAT, and on the Right, former Arkansas governor Mike Huckabee wants a broadbased consumption tax to replace the income tax and payroll taxes.

But so far, it's mainly a favorite of a cadre of economists at universities and think tanks. White House budget chief Peter Orszag recently dismissed it as an idea that's "popular with academics but not seriously considered by policy makers."

It's not an option Americans understand, or ever hear debated much. In fact, most folks probably never heard of it. And if they had, they probably wouldn't want it, since it's the bulwark of an economic system alien to the American model -- the social democratic economies of Europe.

But the sheer scale of the expected numbers makes it practically inevitable that the U.S. will soon adopt a big VAT. It's the only vehicle capable of raising the money to cover the gigantic projected increases in spending and deficits.

Briefly, a VAT resembles a sales tax passed in the end onto the consumer at the register. But the government collects most of the money during the stages of a product's manufacture. Since manufacturers are writing the checks, it's an extremely efficient, virtually fraud-free way to collect money.

But it's never gotten much support in the U.S. for two reasons. First, it's a regressive tax: Low-earning families pay a bigger portion of their incomes than the wealthy. And second, the VAT -- first introduced by a French civil servant in 1954 -- has fueled the rapid growth of government in France, Germany, and even Japan. In fact, no other country spends the kind of money we're planning to spend without a VAT. The numbers tell the story.

In the President's 2011 budget report, the Office of Management and Budget forecasts that the deficit will decline from $1.6 trillion in 2010 to $1 trillion in 2020. But that $1 trillion is still an enormous 4.2% of Gross Domestic Product. And that's assuming 5% unemployment and decent growth rates.

No one argues that America can keep on that fiscal course. One dollar in seven will wind up paying interest on the debt, which will scare away overseas capital. "Foreign investors could dump our debt, causing a fiscal crisis and a disastrous rise in interest rates," says Brian Riedl, an economist at the conservative Heritage Foundation.

Here's the big problem: Government spending is projected at $5.7 trillion in 2020. Total tax receipts are expected to come in at $4.7 trillion, which creates the $1 trillion shortfall. But income tax receipts, by far the government's biggest source of revenue, are projected to reach just $2.3 trillion. Hence, erasing the deficit would require a 44% increase in income tax revenues to cover that $1 trillion deficit.

But even if tax rates rose 44%, tax receipts wouldn't increase nearly as much, since Americans would flee for tax shelters or retire early. "You can't get to rates high enough to increase receipts by almost half," says Riedl.

So how big would the new VAT need to be? The short answer is very. Raising the $1 trillion needed to cover the projected shortfall in 2020 would require a 7% tax on everything we consume.

But the VAT wouldn't be imposed on everything. It's inevitable that Congress would exempt staples such as food and clothing. As a result, the rate on everything else will need to start in double digits. And if the European experience is any guide, it will rise from there.

The VAT will also require that the federal government mail billions of dollars in checks every year to lower income Americans to compensate for their extra burden. Just who gets how much money will be just one of the thorny details we'll have to grapple with.

There are two options besides the VAT, though they're fading fast.

The first is achieving extremely high growth rates. That could hold future deficits far lower than those projected today. The rub is that big government spending tends to depress rather than boost economic expansion. The other option is to substantially lower spending. But as we've clearly seen, that option is conspicuously absent from President Obama's new budget.

The battle over whether America should adopt a VAT will be a bloodbath. The debate over how it will work will be wrenching. Most Americans may well hate the entire concept. Our leaders should have thought of that sooner. The smart money says the VAT is America's destiny, a destiny that comes closer with each passing budget.

--A previous version of this story incorrectly stated that Mike Huckabee would want a VAT to replace the income tax. Huckabee instead favors a broadbased consumption tax to replace the income tax and payroll taxes.