VAT: The Next Big Tax Increase?

The Senate voted 85 to 13 late Thursday to oppose the idea of a value-added tax (VAT). The resolution sponsored by Sen. John McCain, R-Ariz., isn’t binding, but it is a sign that many lawmakers are worried about what's coming.

“The value added tax is becoming a hot topic because people are realizing that the deficit is so big that if politicians aren’t willing to cut spending, the regular ways of raising taxes,” such as raising tax rates on the rich “won’t provide enough, ” says Brian Riedl of the Heritage Foundation.

In fact, the U.S. is spending so much money it doesn’t have, some say the VAT is the only real alternative if large amounts of new revenues are needed.

“If we really want to cut the deficit in the next five, 10 years we need to take a look at tax options,” said William G. Gale is vice president and director of the Economic Studies Program at the Brookings Institution. “If you are talking about a really significant chunk of revenue, value-added tax is really the only option.”

Former Federal Reserve Chairman Paul Volcker, one of President Obama's outside advisers, recently said a VAT is "not as toxic an idea" as it used to be, and may be necessary. Volcker is back at the White House Friday, where the president and others have not embraced the idea, at least not yet.

A VAT, used in 100 countries around the world, is essentially a sales tax but one collected at every stage of production.

Take bread, for instance.

“When the farmer grows the wheat, sells it to the baker, there's value-added tax on that. When the baker makes something and sells it to the grocery store, there's value-added tax. When the grocery store sells it to the individual, there's value-added tax,” said Gale.

But a VAT is regressive, meaning the poor and the wealthy pay the same tax on every product, which is why liberal analysts say a VAT would have to be on top of the current income tax.

“You would not want the value-added tax to replace the income tax. If you did that you would have huge tax increases on middle income people and on the working poor and massive tax cuts for the richest people in the country, ” said Robert Greenstein, executive director of the liberal Center on Budget and Policy Priorities.

But others say adding VAT on top of the income tax, rather than replacing the income tax with it would make the total tax burden far too great and put a dent in economic growth.

“You don’t want a value added tax on top of the income tax otherwise the total tax bite of the government is huge. You'll have individuals who are paying tax rates on their income of 25 and 28 and 30 percent and then going to the grocery store and paying a 20 percent tax on whatever money's left over,” said Brian Reidl, lead budget analyst at the conservative Heritage Foundation.

Some argue a portion of VAT revenues could be used to smooth out the impact -- either to offset some existing taxes such the corporate tax or to help offset the burden of the VAT for low-income households.

A VAT can be implemented many ways. Some nations exempt some products, such as food, but Gale said that would only invite massive politicking and ultimately undermine the purpose of the tax.

“What's crucial to understand in implementing the VAT here in the U.S. is that if we want to use it to raise revenue, we need to try to make it as immune from political considerations, as immune from targeted subsidies and carve-outs as possible. So, we don't want to exempt food, we don't want to exempt housing, we don't want to exempt healthcare. If we exempt all of those things, we've cut into about half of the tax base of the VAT,” said Gale.

Advocates for the poor are uneasy about a VAT, but even more concerned about a debt crisis that could lead to devastating cuts in everything from education to veterans benefits to Social Security and Medicare. Under that scenario, a VAT, as regressive as it is, looks more attractive even to liberal analysts.

“I worry because it is a regressive tax. But, we are going to need more revenue, so it's gotta be something that's on the table at least,” said Michael Linden, associate director for Tax and Budget Policy at the Center for American Progress.

“I think that when people look at the alternatives, how much they would have to cut education or Veterans payments or Medicare benefits or Social Security or how much they would have to raise tax cuts across the board, when they look at the alternatives they may conclude that a modest value-added tax in conjunction with other reforms in taxes and spending is actually a better approach and less painful to the average person than a lot of the alternatives would be,” added Greenstein.

In any case, he thinks a VAT is not likely soon. “We're not there yet. We might not be there for five or 10 or 15 years, but sooner or later I think there's a reasonable possibility that we will find like other countries have that that's where we'll need to go,” he said.

Greenstein and others say many analysts may be warming to the idea of a VAT, but don’t see politicians moving that direction.

“I think right now you would find that a majority of analysts, people like myself that don’t have to run for office, think it's a good idea and a majority of people in both parties who do have to run for office oppose it. I think they're afraid of the voters' wrath,” he said.

VAT would clearly be a tough move for Obama, who promised not to raise taxes on anyone making less than $200,000.

A VAT would raise taxes on everyone.

Watch more on this topic on Friday's Special Report with Bret Baier at 6pm ET.

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