Thursday, September 29, 2005
Coming At You From The Econoverse (Maybe): The Consumption Tax
by Tom Bozzo
A consumption tax has been a darling of long standing for some economists. The main idea, as articulated by Alan Greenspan here, is that taxing consumption as opposed to income — thereby deferring tax on saved income until it's consumed — increases saving (by lowering the price of future consumption relative to present consumption) and, by extension, investment and economic growth.
The forms of consumption taxes can vary widely, from increases in energy taxes (not a bad idea, lest any impression to the contrary arise from the folowing discussion), to national sales taxes or Euro-style VATs. The IMF has actually been trying to press the U.S. to adopt some or all to straighten out the budget deficit mess. One idea with more than a little currency is to replace the income tax system entirely with a "progressive consumption tax." This is often presented as a simplification of the income tax system in that you just subtract (net) saving off of income to obtain "consumption," probably further subtract some personal exemptions, hit the result against a tax table, and voilà, a tax return in ten lines or less.
While some forms of consumption taxes are "regressive" in that they disproportionately fall on the not-rich who have little choice but to consume most or all of their income in order to live, the rates in a "progressive consumption tax" (as the name suggests) can be set to ensure that the rich pay their fair share to roughly the same extent as in a progressive income tax system. Moreover, the top tax rates would specifically discourage some of the conspicuous consumption the emulation of which drives portions of the non-rich classes to the poor house, making some forms of consumption taxation amenable even to left-of-center economists like Mark Thoma and Cornell's Robert Frank (author of Luxury Fever). (*)
You might ask, if this is such a damn great idea, why wasn't it implemented yesterday? There are a few candidate answers:
1. Just wait. The tax reform commission launched earlier this year is due to report its findings soon, notwithstanding the various preoccupations of the Bushist "policy" shop. Given that promoting savings and growth are explicitly listed elements of its remit, its quite conceivable that consumption taxation in some form will be among the recommendations.
2. There are big transition issues (also cited by Greenspan), particularly relating to the treatment of assets acquired under the income tax system. Really, any material tax reform will have some sort of transition problem, since even if the system were designed to be as distributionally neutral as possible, someone's oxen will be gored and the Flying Spaghetti Monster help the politicians who do it.
3. As a replacement for income taxation, consumption taxes aren't obviously so great after all.
---------------------------
I'll make some of the case for #3, if you'll bear with me. One problem is that the simplicity argument in favor of a consumption-tax replacement for the income tax can be a chimera: The simpler the consumption tax in the length-of-the-tax-form sense, the less clear it is that its economic distortions are smaller than those from a well-designed income tax. That leads to the more fundamental question: is a sea-change in the tax system really necessary?
That measuring net savings is potentially complex is well-enough known that it's mentioned in pro-consumption tax sources like this EconLib article. The solution proffered by the article's author — a sort of unlimited IRA, given the stunning success of accounting for retirement fund distributions — amounts to little more than a wave of a magic wand. Tax-deferred retirement accounts, after all, have relatively predictable patterns of contributions and distributions; moreover, most people only have so many of them. Under a consumption tax, it becomes necessary to track and net out all contributions and distributions from every possible savings vehicle. This doesn't bother me, but then again I can figure out my AMT on my own if I have to. I would predict a bonanza for tax preparers and tax software providers.
There also arises an issue of just where does consumption end and saving begin. It's not so simple. Traditional savings vehicles like bank accounts may be straightforward, but what about paying not-necessarily-rational market prices for various assets? Would it be necessary for the tax authorities to pre-qualify all savings vehicles to ensure that an "investment" in cousin-in-law Bernie's start-up company isn't a tax-avoidance scam? What part, if any, of a mortgage payment is saving?
Nor is it necessarily easy to measure economic consumption. "Non-durable goods" like the salad I ate yesterday are consumed in trivial fractions of a tax year. However, consumer "durable" goods like appliances, cars, and (in some respects) houses account for large shares of expenditures and are mostly consumed in tax periods other than the year of purchase.
If the consumption tax is essentially a cash-flow tax (i.e., simpler from an accounting perspective), then it will tend to overtax durables in the year(s) of purchase, and then undertax them once they're paid off, in the sense that the full tax would be due up front even though the economic consumption occurs over the entire life of the good. This could be seen variously as excessively discouraging durable goods acquisition, or encouraging the universal purchase of durables with long-term credit to minimize the bite from high consumption tax rates. Did I mention that for a given level of revenue, consumption tax rates would need to be much higher than income tax rates, other things equal, given that consumption represents a smaller tax base than income?
The more economically efficient alternative of gradually taxing durable goods consumption would itself be a colossal administrative undertaking, as it would be necessary to keep detailed records of durable-goods purchases over the long term, classify goods for the purposes of applying depreciation curves, calculate depreciation, and so on. Again, this is not necessarily so simple.
As for the necessity argument, since a consumption tax system eliminates tax distortions affecting savings returns at the cost of increasing them (via higher tax rates) in various goods markets, the net benefits would appear to be ambiguous. Reasonable assumptions in the matter would suggest that moderate tax rates don't materially discourage would-be investors and entrepreneurs from getting rich (see: 1990s); also many if not most people don't take full advantage of their existing opportunities for tax-deferred saving when arguably they should. I wonder how much saving really is discouraged by taxation as opposed to other factors — stagnant wages, less job security, etc.
So I'm not especially inclined to buy. I'd prefer a simplified progressive income tax that traded off some of the present mess of deductions, credits, and tax-preferenced forms of income for as low a set of rates, applied to a broad income base, as will approximately balance the federal budget along 'trend' growth. (That'll require a lot more revenue than is presently being raised, in the absence of a reversion to fiscal discipline among the ruling classes.) To be sold, I'd need convincing that any feasible consumption tax will outperform that counterfactual.
(*) What's perhaps most interesting about Frank's article is that he proposes an untraditional mechanism by which the consumption tax might promote savings. The progressive rate structure would tend to reduce consumption inequality which, Frank argues, pushes people to spend themselves into oblivion to try to keep up with higher-income, higher-consuming peers who ratchet up general expectations of what constitutes a reasonable lifestyle. Social acceptance of financially modest consumption is, then, a collective good that's under-provided by the "market."
Discussing Frank's article, Mark Thoma doesn't completely buy the collective good argument , and I'd certainly view the need for a tax remedy to the "problem" with extreme suspicion, but I'm not inclined to dismiss the relevance of the social context of consumption.
(Warning, long and possibly wonky economics post ahead. Feel free to skip to the baby pictures and snarky comments on car marketing below, if you are so inclined.)
A consumption tax has been a darling of long standing for some economists. The main idea, as articulated by Alan Greenspan here, is that taxing consumption as opposed to income — thereby deferring tax on saved income until it's consumed — increases saving (by lowering the price of future consumption relative to present consumption) and, by extension, investment and economic growth.
The forms of consumption taxes can vary widely, from increases in energy taxes (not a bad idea, lest any impression to the contrary arise from the folowing discussion), to national sales taxes or Euro-style VATs. The IMF has actually been trying to press the U.S. to adopt some or all to straighten out the budget deficit mess. One idea with more than a little currency is to replace the income tax system entirely with a "progressive consumption tax." This is often presented as a simplification of the income tax system in that you just subtract (net) saving off of income to obtain "consumption," probably further subtract some personal exemptions, hit the result against a tax table, and voilà, a tax return in ten lines or less.
While some forms of consumption taxes are "regressive" in that they disproportionately fall on the not-rich who have little choice but to consume most or all of their income in order to live, the rates in a "progressive consumption tax" (as the name suggests) can be set to ensure that the rich pay their fair share to roughly the same extent as in a progressive income tax system. Moreover, the top tax rates would specifically discourage some of the conspicuous consumption the emulation of which drives portions of the non-rich classes to the poor house, making some forms of consumption taxation amenable even to left-of-center economists like Mark Thoma and Cornell's Robert Frank (author of Luxury Fever). (*)
You might ask, if this is such a damn great idea, why wasn't it implemented yesterday? There are a few candidate answers:
1. Just wait. The tax reform commission launched earlier this year is due to report its findings soon, notwithstanding the various preoccupations of the Bushist "policy" shop. Given that promoting savings and growth are explicitly listed elements of its remit, its quite conceivable that consumption taxation in some form will be among the recommendations.
2. There are big transition issues (also cited by Greenspan), particularly relating to the treatment of assets acquired under the income tax system. Really, any material tax reform will have some sort of transition problem, since even if the system were designed to be as distributionally neutral as possible, someone's oxen will be gored and the Flying Spaghetti Monster help the politicians who do it.
3. As a replacement for income taxation, consumption taxes aren't obviously so great after all.
---------------------------
I'll make some of the case for #3, if you'll bear with me. One problem is that the simplicity argument in favor of a consumption-tax replacement for the income tax can be a chimera: The simpler the consumption tax in the length-of-the-tax-form sense, the less clear it is that its economic distortions are smaller than those from a well-designed income tax. That leads to the more fundamental question: is a sea-change in the tax system really necessary?
That measuring net savings is potentially complex is well-enough known that it's mentioned in pro-consumption tax sources like this EconLib article. The solution proffered by the article's author — a sort of unlimited IRA, given the stunning success of accounting for retirement fund distributions — amounts to little more than a wave of a magic wand. Tax-deferred retirement accounts, after all, have relatively predictable patterns of contributions and distributions; moreover, most people only have so many of them. Under a consumption tax, it becomes necessary to track and net out all contributions and distributions from every possible savings vehicle. This doesn't bother me, but then again I can figure out my AMT on my own if I have to. I would predict a bonanza for tax preparers and tax software providers.
There also arises an issue of just where does consumption end and saving begin. It's not so simple. Traditional savings vehicles like bank accounts may be straightforward, but what about paying not-necessarily-rational market prices for various assets? Would it be necessary for the tax authorities to pre-qualify all savings vehicles to ensure that an "investment" in cousin-in-law Bernie's start-up company isn't a tax-avoidance scam? What part, if any, of a mortgage payment is saving?
Nor is it necessarily easy to measure economic consumption. "Non-durable goods" like the salad I ate yesterday are consumed in trivial fractions of a tax year. However, consumer "durable" goods like appliances, cars, and (in some respects) houses account for large shares of expenditures and are mostly consumed in tax periods other than the year of purchase.
If the consumption tax is essentially a cash-flow tax (i.e., simpler from an accounting perspective), then it will tend to overtax durables in the year(s) of purchase, and then undertax them once they're paid off, in the sense that the full tax would be due up front even though the economic consumption occurs over the entire life of the good. This could be seen variously as excessively discouraging durable goods acquisition, or encouraging the universal purchase of durables with long-term credit to minimize the bite from high consumption tax rates. Did I mention that for a given level of revenue, consumption tax rates would need to be much higher than income tax rates, other things equal, given that consumption represents a smaller tax base than income?
The more economically efficient alternative of gradually taxing durable goods consumption would itself be a colossal administrative undertaking, as it would be necessary to keep detailed records of durable-goods purchases over the long term, classify goods for the purposes of applying depreciation curves, calculate depreciation, and so on. Again, this is not necessarily so simple.
As for the necessity argument, since a consumption tax system eliminates tax distortions affecting savings returns at the cost of increasing them (via higher tax rates) in various goods markets, the net benefits would appear to be ambiguous. Reasonable assumptions in the matter would suggest that moderate tax rates don't materially discourage would-be investors and entrepreneurs from getting rich (see: 1990s); also many if not most people don't take full advantage of their existing opportunities for tax-deferred saving when arguably they should. I wonder how much saving really is discouraged by taxation as opposed to other factors — stagnant wages, less job security, etc.
So I'm not especially inclined to buy. I'd prefer a simplified progressive income tax that traded off some of the present mess of deductions, credits, and tax-preferenced forms of income for as low a set of rates, applied to a broad income base, as will approximately balance the federal budget along 'trend' growth. (That'll require a lot more revenue than is presently being raised, in the absence of a reversion to fiscal discipline among the ruling classes.) To be sold, I'd need convincing that any feasible consumption tax will outperform that counterfactual.
(*) What's perhaps most interesting about Frank's article is that he proposes an untraditional mechanism by which the consumption tax might promote savings. The progressive rate structure would tend to reduce consumption inequality which, Frank argues, pushes people to spend themselves into oblivion to try to keep up with higher-income, higher-consuming peers who ratchet up general expectations of what constitutes a reasonable lifestyle. Social acceptance of financially modest consumption is, then, a collective good that's under-provided by the "market."
Discussing Frank's article, Mark Thoma doesn't completely buy the collective good argument , and I'd certainly view the need for a tax remedy to the "problem" with extreme suspicion, but I'm not inclined to dismiss the relevance of the social context of consumption.
Comments:
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Nice wonky post. I'm not an economist, but I am a lawyer, so I believe I'm qualified to speak on all subjects, and I happen to be one of those progressive consumption zealots, so let me offer a partial response from the viewpoint of someone who has done significant tax law work and research.
First, let me throw one argument you (understandibly, given the framework of your post) didn't address: a good number of people believe that a progressive consumption tax would be inherently more "fair" than an income tax since it would track the taxpayer's realized standard of living, rather than theoretically highest standard of living, as an income tax can be seen to do. People seem to just agree or disagree with that statement based on their normative framework. Either way, while it doesn't make such a transition "necessary," it is an argument in favor nonetheless.
Second, a good number of folks suggest that His Noodly Appendage could possibly be available to the politicians embracing such reform, allowing them to also reform the messy deductions/credits/source system along with it. Far be it from me to suggest the poisonous tree of the Bush Administration would allow a major policy proposal to pass by without an smorgasboard of special interest exceptions, but one day responsible grownups may occupy government again, and a move to progressive consumption tax could bring with it deduction/credit/source reform.
Third, addressing specifically the issue of taxing durable goods financed via loans: why not tax the interest payments themselves? That can be seen as the real consumption, as it is the income that is actually being directed to consumption. That knocks out two birds with one stone, deferring taxation of durable goods and doing such in an easy-to-administer manner which tracks the marketplace valuation of its durability. Maybe there's something horribly wrong with this idea, but I can't see it right now.
Fourth, there already exists an impressive body of law to determine what a savings are: securities regulation. The Securities Registration Act applies to "notes" and "investment contracts" and a host of other investment vehicles (aka "securities"), and there's 70+ years of case law defining precisely what is investment and what is consumption. Why not just apply that body of law to the new progressive consumption post?
Again, nice post, you have no idea how much we armchair wonks appreciate them.
First, let me throw one argument you (understandibly, given the framework of your post) didn't address: a good number of people believe that a progressive consumption tax would be inherently more "fair" than an income tax since it would track the taxpayer's realized standard of living, rather than theoretically highest standard of living, as an income tax can be seen to do. People seem to just agree or disagree with that statement based on their normative framework. Either way, while it doesn't make such a transition "necessary," it is an argument in favor nonetheless.
Second, a good number of folks suggest that His Noodly Appendage could possibly be available to the politicians embracing such reform, allowing them to also reform the messy deductions/credits/source system along with it. Far be it from me to suggest the poisonous tree of the Bush Administration would allow a major policy proposal to pass by without an smorgasboard of special interest exceptions, but one day responsible grownups may occupy government again, and a move to progressive consumption tax could bring with it deduction/credit/source reform.
Third, addressing specifically the issue of taxing durable goods financed via loans: why not tax the interest payments themselves? That can be seen as the real consumption, as it is the income that is actually being directed to consumption. That knocks out two birds with one stone, deferring taxation of durable goods and doing such in an easy-to-administer manner which tracks the marketplace valuation of its durability. Maybe there's something horribly wrong with this idea, but I can't see it right now.
Fourth, there already exists an impressive body of law to determine what a savings are: securities regulation. The Securities Registration Act applies to "notes" and "investment contracts" and a host of other investment vehicles (aka "securities"), and there's 70+ years of case law defining precisely what is investment and what is consumption. Why not just apply that body of law to the new progressive consumption post?
Again, nice post, you have no idea how much we armchair wonks appreciate them.
# posted by 
: Sat Oct 01, 04:45:00 PM
: Sat Oct 01, 04:45:00 PM
Thanks for the comment, Max, and welcome.
I agree that the fairness issue you raise is fundamentally a normative matter, though it's not independent from the main positive case for the consumption tax (as not taxing unrealized potential to consume is the savings incentive). I'll probably expand more in another post, but I partly agree. The big question is whether zero is the fairest tax rate for that unrealized potential standard of living.
On the second point, possibly true. I tend to see the main need for His Noodly Appendages being to keep the hands of the ruling kleptocracy out of the cookie jar.
For the third, the discussion in the post implies that a cash flow tax works better if durables are financed over long terms. I'm not sure whether encouraging people to borrow long for durables is good or bad on balance.
Last, it is useful to have securities law to provide a basis for identifying savings vehicles under a consumption tax code. It seems like there would still need to be some certification step.
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I agree that the fairness issue you raise is fundamentally a normative matter, though it's not independent from the main positive case for the consumption tax (as not taxing unrealized potential to consume is the savings incentive). I'll probably expand more in another post, but I partly agree. The big question is whether zero is the fairest tax rate for that unrealized potential standard of living.
On the second point, possibly true. I tend to see the main need for His Noodly Appendages being to keep the hands of the ruling kleptocracy out of the cookie jar.
For the third, the discussion in the post implies that a cash flow tax works better if durables are financed over long terms. I'm not sure whether encouraging people to borrow long for durables is good or bad on balance.
Last, it is useful to have securities law to provide a basis for identifying savings vehicles under a consumption tax code. It seems like there would still need to be some certification step.
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