Consumption Tax, by Al Ehrbar: The Concise Encyclopedia of Economics: Library of Economics and Liberty

Consumption Tax,
by Al Ehrbar

For most of the twentieth century, the principal federal tax on individuals in the United States was on income, whether it is earned from labor (wages and salaries) or capital (interest, dividends, and capital gains). But a growing number of economists and politicians have concluded that the United States should replace the income tax—partially or entirely—with a tax on consumption....

Consumption Tax, by Al Ehrbar: The Concise Encyclopedia of Economics: Library of Economics and Liberty

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• Most of the political debate over a consumption tax has centered on whether the United States should adopt a value-added tax (VAT) similar to the ones that European countries have. While a VAT definitely is a tax on consumption, it is not the kind that most consumption-tax advocates prefer. What's more, the debate over whether to add a VAT to the U.S. tax code has obscured the more basic issue of whether to tax income or consumption.
• A consumption tax—also known as an expenditures tax, consumed-income tax, or cash-flow tax—is a tax on what people spend instead of what they earn. A VAT does that in the same way that a sales tax does. But a true consumption-tax system would entail something much different from simply layering a VAT on top of the current income tax. One way to think of a consumption-tax system is simply as an income tax that allows unlimited deductions for savings and that taxes all withdrawals from savings, much like independent retirement accounts (IRAs).
• Proponents of a consumption tax argue that it is superior to an income tax because it achieves what tax economists call "temporal neutrality." A tax is "neutral" if it does not alter spending habits or behavior patterns and thus does not distort the allocation of resources. ...
• ... In contrast, a properly constructed consumption tax can be neutral between consumption and saving. That is because taxes fall only on income that is consumed, not on income that is saved. The results are that the tax wedge on saving is zero and that total saving in the economy is much closer to the optimal amount
  
  (1) To see how this works, first consider what happens with the income tax to a person with $10,000 of pretax income. Assume for simplicity that the only tax bracket is 25 percent, that the market (pretax) interest rate on bonds is 5 percent, and that inflation is zero. Under the income tax, the individual pays $2,500 in taxes no matter what he does, and then can consume $7,500 of goods and services now. Or he can save $7,500, investing it in bonds paying 5 percent interest. In the first year the individual earns $375 interest (5 percent of $7,500), pays 25 percent of that ($93.75) in taxes, and is left with $281.25 of after-tax interest income. Added to his original $7,500, he now can consume $7,781.25 of goods and services, or 3.75 percent more than a year ago. Note that the market paid the individual 5 percent to postpone consumption. But the income tax reduced what he received to 3.75 percent.
  (2) Now look at what happens under a consumption tax. If the individual consumes all his income, he pays the same $2,500 in taxes and has the same $7,500 to spend on goods and services. But if he saves all his income, he can invest $10,000 because he gets a deduction for all income saved. In the first year he earns $500 interest (5 percent of $10,000), leaving him with $10,500. If he wants to spend all of that now, he must pay taxes equal to 25 percent of the full $10,500, or $2,625. That is because all withdrawals from savings are taxable. After paying his taxes, the individual can consume $7,875 of goods and services. That is 5 percent more than the $7,500 he could have consumed a year earlier. The individual receives the full 5 percent market interest rate, and there is no tax distortion between present and future consumption.
• opposition from some (mostly liberal) economists.
  (1) The one objection to a consumption tax that is based on pure economics is that it would require a higher tax rate in order to raise the same revenue as the income tax. That is because saved income is gone from the tax base. For this reason a consumption tax would be less neutral between work and leisure than an income tax. Advocates of a consumption tax maintain that the gains from additional saving and investment would outweigh the losses from less work effort. It is, however, impossible to know with certainty whether that is correct.
  (2) Another objection to a consumption tax is that it would be regressive (i.e., it would fall most heavily on those with the lowest incomes). The fear is that the tax burden would be shifted to labor because returns to saving and investments—which constitute a much larger share of income in the upper brackets—would not be taxed. That is partly true ...