A distributional analysis of substituting a value-added tax for the current federal tax system

The growing public dissatisfaction with the current federal tax system and the ongoing national debt crisis are generating serious consideration of alternative consumption tax systems, especially the value-added tax (VAT hereafter). The purpose of this study is to objectively evaluate the distributional effects of both the current federal tax system and the alternative value-added tax system it is intended to (partially) replace. This study finds some evidence that the current federal tax system becomes significantly more progressive over the period of 2005 and 2009 under the annual income approach, which is contrary to the prior research findings that the current federal tax system became less progressive from 1960 to 2004 (Piketty and Saez, 2007). A potential explanation for this result is the American Recovery and Reinvestment Act of 2009 (ARRA, Public Law 111-5). This Act made several changes that lowered individual income taxes in 2009. Also, when only considering households who pay payroll taxes (defined as working families in the paper), the current federal tax system is significantly less progressive, even regressive for year 2005, under the annual income approach. However, there is no significant difference about the progressivity level under the lifetime income approach for both full sample and subsample with only working families. The broad-based value-added tax system is regressive under both the annual and lifetime income approaches; nonetheless, it is significantly less regressive under the lifetime income approach. The narrow-based value-added tax systems (such as zero ratings and universal rebate) significantly alleviate the regressivity of the VAT under both the annual and lifetime income approaches. The narrow-based value-added tax system becomes progressive under the lifetime income approach, but it is still significantly less progressive than the current federal tax system. And the partial substitution of the current federal tax system with the VAT (such as the combination of narrow-based VAT and federal personal income tax system) is proportional under annual income approach and progressive under the lifetime income approach. The current study also analyzes the distributional effects of both systems based on age groups and locations (urban vs. rural). The results show that the progressivity levels among different age groups and locations are significantly different for both the current federal tax system and the alternative value-added tax system. Specifically, the current federal tax system for households with heads between 35 and 55 is proportional, instead of progressive, under the annual income approach