Static and Dynamic Analysis of Consumption Taxes

This and one more post on Chapter 5 of the Economic Report of the president. The author(s) of this chapter clearly anticipated a “consumption taxes are regressive” line of attack and attempt to construct a defense, coming up short in my opinion. Here are two phrasings of their defense:

Conventional distributional analysis typically considers a snapshot of a taxpayers’ economic well-being at a particular point in time. Research has shown that [What research? How? Who?] when a longer view is taken, differences in well-being, whether measured by income or by consumption, tend to be not as great, because of the fluidity of household incomes over time.” [ERP, p. 177]

and

The substantial movement of taxpayers across rate brackets suggests that the tax burdens in a given year may tell a very different story of the distribution of the tax burden than do measures of tax burdens over longer horizons…Analyses that rely on annual snapshots of taxpayer incomes are likely to suggest that a small fraction of taxpayers benefit from rate cuts, when in fact a larger fraction of taxpayers are likely to benefit because of the substantial movement of taxpayers up and down the tax rate schedule over time.”[Box 5.4, p. 201]

Get it? It’s ok if the proposed consumption tax is regressive because later on you might make more money and be on the side of the income distribution that benefits from regressivity! Let’s just say it: relying on this argument is a tacit but telling stipulation that in a static sense (i.e., looking only at one year), consumption taxes are regressive. But is the argument right, even so? There are a number of things wrong with the line of reasoning in this chapter:

1. Their own stats (see Box 5.4) indicate that a large part of the population will continue to be subject to the regressive tax. They take families in 1987 and examine what tax brackets those same families are in circa 1996, finding “about 53 percent of taxpayers were in a different [not necessarily higher] tax bracket at the end of the period [1996] than at the beginning.” Of course 47% are still in the same bracket–regressively taxed in both 1987 and 1996 and presumably the intervining years as well. So it’s not at all clear clear that the mobility factor averages out in a way that makes lifetime taxes non-regressive, much less progressive.
2. Also comparing 87 to 96, they find that “about 28% of taxpayers had moved to a higher tax bracket at the end of the 10 years. About 66% of the taxpayers in the bottom (zero tax rate) bracket in year 1 had moved to a higher bracket after 10 years, the vast majority moving to either the 10 percent or the 15 percent bracket.” Fine. But being in the 10% or 15 % bracket does not make a family wealthy. In 2002, the 15% bracket topped out at $27,950 for single filers and $46,700 for joint filers. Remember, a consumption tax is less of a burden as less of your income is devoted to consumption. A married couple with children making a combined $46,700 is still going to spend nearly early all of their income on consumption. Sure, at that level, they likely do save via a 401(k) or similar vehicle, but the remainder after that is spent on consumption, not savings. So these families may move up from the “extremely regressive” bracket to the “somewhat regressive” bracket, but would still pay more of their income in taxes than would wealthier familes!
3. Nowhere do the authors deny that in a static snapshot, the consumption tax is in fact regressive. Instead they rely on the Panglossian notion that it’s fine because you’ll move up, devote a smaller portion of your income to consumption, and then benefit by paying less in taxes. Whether the movements in brackets are truly “substantial” is subjective, but let’s assume it is. The authors fail to note that implementing a regressive tax will reduce the very mobility they use to defend the proposed consumption tax. An old truism is that it takes money to make money. If we take more money from poor people now (via consumption taxes), it will be more difficult for them to become not poor later.
4. The economy goes up and down; it’s a fact of economic life. But the size of the swings in the post-war era pale in comparison to those of the late nineteenth and early twentieth centuries. Why have the swings become smaller? A variety of counter-cyclical mechanisms implemented since World War II, such as unemployment insurance. And the progressive income tax is innately counter-cyclical: when a recession moves families into a lower tax bracket, their after-tax income falls by less than does their pre-tax income (because they move into a lower bracket). Consumption taxes are intrinsically less counter-cyclical. A family’s spending can be divided into subsistence (food, clothing, shelter) and discretionary (new car instead of used, vacations, …). By definition, subsistence spending can’t be varied in concert with the business cycle, though discretionary can. The point: families whose income is devoted mostly to subsistence will not have an off-setting tax benefit in recessions. Here’s the shocker: which families devote the most to subsistence and the least to discretionary spending? Poor families.

AB

Next up: Social Security and why this may all be much ado about nothing.