A Room with a Viewpoint

“The time has come,” the Walrus said, “To talk of many things: Of shoes—and ships—and sealing wax— Of cabbages—and kings— And why the sea is boiling hot— And whether pigs have wings.” (Lewis Carroll)

Monday, December 26, 2005

Consumption Tax v. Income Tax

Okay, I’m ready to admit that a consumption tax might be better than an income tax, or at least is no worse. The clearest definition I have found for a consumption tax is that it equals income minus savings. Thus, it rewards saving, which is a desirable goal.

It also allows you to control, to some extent, the timing of paying taxes. However, eventually, most or all of your income will be taxed (either by you or your heirs), because your savings will be taxed when you use it. The exception would be the very rich who may have quite a bit of money that will be used to create more money, but may never be spent.

Possibly one of the biggest arguments for the consumption tax is philosophical. An underlying premise of the income tax is that, if the government can take a portion of your income, it can take all of it. In the case of a consumption tax, at least theoretically, your income is yours and you choose through your decisions--not so much whether to pay it (you have to pay rent, buy food, etc.) but how much you will pay at any given time (by putting money into savings, or buying as many used goods as you can--though the original tax will eventually be embedded into the resale value).

Another objection to the income tax is tax withholding. The government takes your money before you've even had your hands on it, and if it took too much, you have to file a return to get it back. This, again, to me anyway, is philosophical. The government is going to get your money one way or another and withholding is easier to pay than a lump sum.

Yet another problem with the income tax is that it is incredibly intrusive. You have to give all kinds of information to the government, your income, your investments, your donations to charity, your medical expenses, work expenses, etc.

The biggest problems with a consumption tax, however, are progressivity and transition. It is easier to make an income tax progressive, either through exemptions or graduated rates, or both (our current system uses both). A consumption tax can be made more progressive by exempting things like food, medicine, etc. However, most proposals for a consumption tax would exempt almost nothing.

Other than exemptions, making a consumption tax progressive is difficult because of the way it would most likely be administered: through a tax on purchases, either as an add-on tax or an embedded tax. Two types of embedded consumption taxes would be:

• The Value Added Tax (VAT), where products are taxed at each level of production (and at the next level, the taxes previously paid on the product are subtracted, so each part of the product is taxed only once).

• The embedded sales tax proposed in the Fair Tax Act, whereby the retailer would add 30% of the retail value of the item before pricing, so that the tax is computed at the register as 23% of the total cost of the item.

The add-on tax would operate the same as state sales taxes; a percent would be added to the cost of the item at the register.

The following are some ways in which to make consumption taxes progressive:

• One method would be to require each household to file for a rebate based on family size or income or both.

• Another way, proposed in the Fair Tax Act, would be to give each household a monthly “prebate” based on family size alone, though an income component could be added.

• Another way to administer a consumption tax would be to use some of the progressivity already in the income tax (personal exemption and dependent exemptions) but to also exempt all savings from the income tax. Period. It is then assumed that anything not saved will be spent. We already exempt capital gains from the income tax, which is halfway to a consumption tax. However, this does not benefit low-income taxpayers at all, who probably don’t have money to invest; and it would probably hit middle-income taxpayers irregularly. Exempting all savings would give every level of income earner the opportunity to exempt some of their income from taxation through savings, or at least control the timing of when the tax is paid.

But as with everything, the devil is in the details and in upcoming posts, I will discuss the details of the Fair Tax Act, including some of the claims made by its authors and some of the problems I see in transition.

An article I found interesting (though I probably disagree with most of it) is called Bleeding-Heart Libertarianism.