Income and Consumption

So here’s the exciting bit of information that lead me to finally decide to put my two cents on the web. Dave Neiwert reports that the 2003 Economic Report of the President contains language referring to plans to eliminate or reduce the income tax and replace it with a consumption (i.e., sales) tax. This is an astounding plan.

A general principle of Economics is that when the government wants the citizenry to do less of something, then the government should levy a tax on that activity. In this case, the ramifications seem twofold: (1) less taxes on income means more working (the principle acting in reverse) and (2) more taxes on consumption, which implies

less consumption for any given level of income. Of course the latter effect is confounded by the fact that if people work more, then they will have more income and thus tend to consume more. So the a priori effect of this policy proposal is ambiguous.

Here’s the frightening language from Chapter Five of the Economic Report of the President:

“The major objectives of tax reform are to reduce complexity, improve economic incentives, and address fairness. The central theme that brings these objectives together is that household and business decisions should depend on the tax code as little as possible. Taxing all income, but taxing it only once, is a key ingredient of many reform plans. This would involve broadening the tax base while lowering tax rates. Some efforts have also focused on a shift from taxing income to taxing consumption or consumed income [emphasis mine].”

First, much like the upper-income tax cuts disguised as an expanded savings plan in the current proposed budget, plans like these are never explicitly discussed by the current administration. In particular, they certainly did not make it into the State of the Union Speech. And with good reason: it’s a terrible idea, unless you consume a relatively small portion of your income.

Second, this abandons all pretense of progressivity in the tax code. If you are living paycheck to paycheck, as many do, then virtually all of your income is spent on consumption, and therefore will be subject to a “consumption tax”. Conversely, as your income reaches the top levels, a very small portion is devoted to consumption, with the balance going to savings and investment (admittedly, good things for the economy). Let’s hypothesize that the consumption tax is 25%. A family of four making $50,000 likely spends 90% of its income on consumption (food, shelter, leisure), making the tax burden $50000*.9*.25=$11,250, a tax rate of $1,250/50,000 = 22.5%. If the same family makes $200,000 per year, they would spend perhaps $150,000 of that on consumption, which would correspond to taxes of .25*$150,000 = $37,500, which is a tax rate of $37,500/200,000=18.75%. It’s regressive: as you make more, you pay a lower percentage of your income in taxes. (Extra credit: suppose your income is $1m and you spend $400,000 on consumption, what is your effective tax rate under a 25% consumption tax?)

There are a number of reasons, including social justice, why a regressive tax is not a good idea, but that’s a topic for a later post. Instead, the question is why a consumption tax is worse than an income tax. First, it will surely cost more than it is expected to. Why? Because naively setting the target consumption tax in a revenue-neutral fashion will actually lead to a decline in revenue. A consumption tax increases the cost of the final good to the consumer, meaning that for any price that stores charge, consumers buy less after the tax is imposed than before. Most states have sales taxes around 8%. To replace all income taxes with consumption taxes would require a federal consumption tax of at least 15% on top of the states’ 8%. So things will change from the scenario in which, when a store sells a DVD player for $100, the consumer pays $108 to a situation in which the consumer pays $123. Consumers care about price after tax, not before (question: can you buy a $100 DVD player with only a $100 bill?)! So what happens when the effective price to consumers goes up? They buy less DVD players! But the government can not collect sales (consumption) taxes on unsold DVD players. As an economic aside, some, but not all, of the impact of the tax would be borne by sellers. In the current example, the retail price might fall to $95 ($5 less for stores) and the after tax price to consumers would be $95*1.23=$116.85 (an $8.85 increase). Stores get less and consumers pay more, as a result the total volume of goods traded will fall. More generally, any move to a consumption tax that proposes a neutral tax rate, one such that

“(the value of all goods sold * proposed rate) = Income Tax Revenue”

will not generate the same revenue as under the income tax because it fails to account for the fact that the volume of commerce will fall (economists call this “dead weight loss”). If this tax is actually pursued, look for this factor to be ignored by Fleischer, Rove, et al.

But aren’t income taxes distortionary too? Yes they are, but two factors make them less so. First, corner solutions: at prevailing wages, many people are willing and able to work more hours, but employers do not hire them to work those additional hours. Second, a phenomenon that economists call the “backward bending supply curve”.

Stay tuned! AB

P.S. No, consumption taxes are not necessarily regressive–exemptions could make them progressive, but that invalidates the “simplicity” argument for such taxes.

P.P.S. Are there legitimate reasons for elimnating the dividend tax? Yes, there are. Dividend taxes are in fact distortionary, but all taxes are distortionary (no one is yet proposing a lump sum tax), so why choose to eliminate the one that is only paid by the wealthy? …”But over 1/2 of the population now has savings invested to some degree in stocks”….yes, but for most of those people, those investments are made through 401k’s or other tax-protected accounts, meaning that a dividend tax cut does almost nothing for them.