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6th March 2010

Following yesterday's dire assessment of the future for our country and the likelihood that there will be a US debt crisis, I received a few comments reflecting a more positive tone. Today, I will pass on one of these comments(more next week):

"The deficit is already becoming center stage. Its a major issue and will gain focus heading into the mid-term election. As the problem grows the government will address it - There are lot of actions the US can take:

  • Impose a VAT tax. The VAT tax in Greece is 17%.
  • Slowly reduce defense expenditures
  • Means test Social Security
  • Increase the Retirement age
  • Uncap the Medicare tax withholding amount
  • Increase Estate taxes and capital gains taxes

But doing any of these now is probably the wrong answer. Why? Watch what happens in Greece and Ireland, and ultimately Spain and Italy. The EU has a fundamental competitiveness problem. Germany has a trade surplus with each of these nations. Increased austerity measures will further slow the Greek economy. A slower economy will mean less than projected tax revenues which will ultimately mean that they will never achieve the target budget position.

If you look at IMF led bail-outs there are generally two components - a set of austerity measures (spending cuts and tax increases) coupled with a reduction in the currency value. The currency devaluation restores competitive balance while the austerity measures give the foreign creditors confidence that they won't be devalued again. Austerity measures alone will never solve the problem and may force the economy into depression. I do not think the EU will solve their problems until all the debt of the EU is jointly guaranteed and they have unified taxing power (and that's just not going to happen).

Now think about the US. We have a much lower tax burden than Europe. We don't even have a VAT tax, but we have much higher defense expenditures, and substantially better demographics. We also have a much higher degree of Labor mobility and capital. We have a structural trade deficit that stems mostly from two items 1) Our need to import oil (the US is the 4th largest producer but #1 in usage) and 2) mercantilist trade policies of of China, Japan and Korea." (end of reader's comment).

The crux of this readers comment is that the US is in a better position to increase taxes, relative to Europe. To that I would argue that raising taxes works up to a point. I agree that the Bush tax cuts favoring the rich enacted 8 years ago did very little to boost the economy, so that repealing them should do little to hurt the economy. But that only buys you so much revenue. Enacting a VAT in the order of 17% would crush the economy in my opinion, and since a VAT tax is added to the cost of goods at all stages of production, this would amount to a sudden jump in CPI. In turn, cost of living adjustments (COLA) in social security and other COLA driven benefits would wind up costing the government a good part of the increased revenues from a VAT. And lastly, let me suggest that if all prices rose 10% due to a VAT, then it is likely that this will reduce our consumer led (70%) GDP, by some portion of a new VAT. In turn, this will reduce the revenues resulting from the enactment of a VAT.

I do agree that it is inevitable that we lower the benefits of Social Security, Medicare and Medicaid to the aging boomer population. The sooner we get on with this, the better. It is coming. Why wait for a crisis, at which point the medicine and pain would be much worse?

On the issue of defense expenditures, it is fine to think that we will withdraw from Iraq and Afghanistan, and manage to bring our defense budget down. Unfortunately, the realities of the geo-political landscape from Egypt to Pakistan, suggests that our involvement in that part of the world will continue for some time to come. Even if we manage to extricate ourselves from Iraq and Afghanistan, there is a decent chance that other world issues will arise which will require a US response, and demands to spend money will come about despite our best intentions to bring down our defense budget.

As for the comparison to Europe, the reader did not mention that the average cost of state provided health care in France is 9%, versus consuming 16% for the US. Unless something is done about tort reform, and other factors which make the US the highest cost nation in the world for health care, it will be difficult to bring this aspect of our budget under control.

The reader makes another interesting comment about Greece, and the idea that austerity measures without a currency devaluation will only go so far. It is the currency devaluation which enables a country to become competitive with respect to export driven industries, making the country more affordable/attractive to tourists, and the like. Since Greece is part of the EMU (European Monetary Union), there is no way to extricate Greece's currency from the EMU without taking Greece out of the EMU. And did you catch the headline earlier this week, that Greece is going to seek aid from the IMF. Somehow they think that they can work their way out of this mess, and still remain part of the EMU. Even today, protests about austerity measures being passed in Greece continue. Taxi drivers went on strike because the government was proposing to tax their earnings. This sounds very similar to an environment where the Greeks feel entitled, and do not want to pay for the services they enjoy. Clearly, something needs to be done. I want to repeat a comment from a reader (see Feb 12th blog for the complete dialogue) who lives in Greece:

"The problem in Greece is severe tax evasion. Not from salaried people (who can't evade) but from those who self-report (doctors, lawyers, plumbers etc) and the mega rich who have all their huge villas in off shore companies, amongst other things. This has been the case for years. The new tax measures adopted by the government are attempting to fight tax evasion. Just to give you some stats: there are about 250bn Euros of deposits at Greek banks (not counting the deposits Greeks have abroad), 11 million citizens in the country and only 2% report income above 70,000 Euros; 2 Greeks reported income above 1 million Euros last year and I think 49 above 500,000 Euros - a veritable joke - just look at the country's fleet size. (End of readers comment)

This leaves me trying to compare the situation in Europe with that in the US. The US consists of constituents who feel entitled. This recent Newsweek article, which a reader sent in, highlights this point:

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The list of the article is that the political process just reflects the mood of the US population which wants more and more without having to pay for the added benefits. Sacrifices need to be made before a crisis forces the sacrifices on us, in an involuntary way.

And I will repeat the comment made by a reader a few weeks ago, which was a rebuttal to a comment by a younger reader, who is just starting his family.:

"your reader (yesterday) says that the older generation (presumably the Boomers) DEMANDS social security benefits. Those benefits came out of our paychecks for 30-40 years. If he was so worried about that, why wouldn't he have spoken out when we were putting the two wars on the credit card and dipping into the Social Security trust fund for just about everything the past 30 years. So the benefits that the Boomers are supposedly demanding are their own money and the money of their employers." (end of readers comment)

Here is my comment: the Boomers did not invent Social Security and Medicare/Medicaid, but we/they have sure managed to come to expect our/their just returns. The Social Security scheme worked fine when the Boomers are working and able to support our/their parents. But the boomers have been less prolific about making babies as fast as their parents, and now there are not enough people in the workforce to support the aging Boomers.

Last night I caught the tail end of the CNBC special by Tom Brokaw, entitled "Boomers", which talked about the generation of post WWII baby boomers. Towards the end of the show, President Bill Clinton, himself a boomer, concluded that the boomer generation needs to shift gears and re-size their demands on society, otherwise their legacy will be a generation of debt. I agree. Will we have the self-less insight to forsake the faulty promises of a soft retirement, courtesy of Social Security promises made by the generation which won World War 2 and took the country out of the great depression?

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