Gruber Chapter Consumption tax and flat tax Changing from mostly taxing income to mostly taxing consumption would be a radical reform, favored

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1 Gruber Chapter Consumption tax and flat tax Changing from mostly taxing income to mostly taxing consumption would be a radical reform, favored by many economists. According to Hobbes in Leviathan, It is fairer to tax people on what they extract from the economy, as roughly measured by their consumption, than to tax them on what they produce for the economy, as roughly measured by their income. Consumption is taxed more in the rest of the world than in the United States. All types of governments get a lower share of tax revenue from consumption taxes in the United States than in any other country. There is some taxation of consumption here through local sales and excise taxes and some federal excise taxes (on gasoline, telephone services, alcohol, tobacco). Consider a retail sales tax, the way it is levied in most states, but at a higher level - say a federal tax of 35% on all purchases. Advantages of changing to such a tax. Many opportunities for tax evasion would disappear. Most of tax evasion come from shifting income from one form to another in which it is less taxed. For example, shifting income from one year to another or shifting income to fringe benefits, like getting direct consumption such as concerts or baseball games. Income paid in the form of fringe benefits doesn t get taxed at all without enforcement, is usually undeclared. It should be treated as income but isn t. When the firm pays for education of an employee, it is legally not taxed. Such a shifting would be impossible with a 35% tax on all consumption, as long as it included expenditures like employer-provided health insurance. A source of inefficiency in the current system is that some forms of saving are taxed more than others. Saving in the form of real-estate is favored through a tax exemption of rents on owner-occupied housing and the exemption of house owners from paying capital gains taxes on properties with value up to $500,000 for a principal residence (married couple). Saving in the form of equity in a corporation is penalized if the return to saving paid out as dividends. This is because dividends are taxed under the income tax. Dividends have a lower tax rate than earned income, but if the corporation paid income tax already on the income in the dividends, then the income tax paid by the individual is added on to that. So the dividend is double-taxed. This differences in the tax treatment of kinds of savings distort people s savings decisions, causing there to be too much savings in real estate and not enough in dividend-paying corporations relative to the efficiency-maximizing levels. A consumption tax would not favor one form of saving over another. It would tax money only when spent on consumption, thus not taxing savings at all. A disadvantage of the current tax system is that it penalizes those who save relative to those who spend, leading to less savings. A consumption tax system 1

2 would end this bias. Consider two individuals Homer and Ned who are similar except for their preferences for saving. Both live for two periods, earn $100 in the first period and nothing in the second period. Homer consumes his income in the first period and consumes nothing in the second period. Ned wants to consume in both periods. Initially they both face an income tax which taxes labor earnings and interest income at 50%. The interest rate is 10%. Homer saves nothing; he pays a tax of $50 on his income and consumes the remaining $50 in the first period, consuming nothing in the second period. The present discounted value of taxes he pays is $50. Ned pays a tax of $50 on his income. He wants to spread his remaining income over the two periods so that consumption expenditures are the same in both. Thus he saves of his $50 in the first period, earns $2.44 in interest on that and pays 1.22 of that in taxes in period 2. So his consumption in period 1 is and consumption in period 2 is The present discounted value of taxes he pays is = 51.1, more than Homer s payment. This is an example of horizontal inequity. Just because Ned chose to save more of his income, he had to pay more in taxes. Now consider a switch to a consumption tax system with a tax rate of 100%. So for each $1 of consumption you pay $1 in tax. Homer continues to consume $50 in the first period and nothing in the second period, paying $50 in tax. The higher rate of return to savings leads Ned to save slightly more (this is just an assumption. He consumes only 25 in period 1, pays 25 in consumption tax and saves 50. He earns a return of 5 on that 50 in period 2, giving him 55 in period 2. He thus can consume 27.5 and pay a tax of 27.5 in period 2. The present discounted value of his tax payments is = 50. Thus Homer and Ned have paid the same amount of PDV of taxes. The horizontal inequity has gone. When one considers models with more periods the argument against taxing capital income becomes stronger, as the difference between what one can get from interest with and without taxation becomes larger. If a consumer earns $100 and wants to consume $50 today and save the rest for ten years at a 10% interest rate, they get = 130 with no capital income tax. If capital income is taxed at 50%, then in ten years the consumer gets = 81. Another advantage of the consumption tax is that it is simpler. But even so there are ambiguities, for example should you be taxed on the purchase price of your home or on the flow of housing purchases as you consume them? Problems with having a consumption tax system. 2

3 1. Vertical equity. The poor consume a greater proportion of their income than the rich. This is because of the necessities of life. The rich save more than the poor throughout their lives. Dynan et al. found that the bottom fifth of the income distribution save 3% of their lifetime income, the highest fifth of the income distribution save 25% of their lifetime income. The top 1% of the income distribution save almost 1/2. So consumption taxes are regressive - the poor pay a larger share of their income in consumption taxes than the rich. To eventually tax the saved income by the rich, the government could tax bequests as consumption income. Then all individuals would end up being taxed on their lifetime resources. But large estate taxes are not politically popular. Taxing bequests as consumption may reduce the incentives to save for one s children, thus undoing some of the savings incentives created by the switch to a consumption tax. No developed nation that relies on a consumption tax includes bequests in the definition of consumption. One way to reduce the regressivity of a consumption tax would be to have a progressive expenditure tax (discussed later). Or one could tax more heavily goods that tend to be demanded by richer consumers, and less heavily staple foods, for example. But this would introduce more complication into the tax code. Also it creates more deadweight loss to tax goods with more elastic demand. 2. A reason for taxing capital income is that highest-ability individuals are likely to save the most. If the government wants to redistribute money from high-ability to low-ability individuals then savings is a good targeting device. Thus, when there are differences across individuals the prediction that zero capital tax is optimal does not hold any more. 3. Transition issues - if there was a switch from an income tax to a consumption tax system now, people who are now of college age should be roughly indifferent, as they have not yet earned much income or paid much in taxes. Later generations should benefit from the switch through a larger capital stock, a higher marginal product of labor and higher standard of living. But the current middle-aged and elderly would lose. They have presumably saved some of their after tax income to finance consumption after retirement. If this consumption is taxed at a higher rate, they will effectively be taxed twice on the same income. Also, if they will be consuming more relative to saving in retirement, they may lose more money in taxes than they would have if the income tax system had been continued. It would be politically infeasible to introduce a policy so detrimental to the elderly. They would have to compensated in some way, and the compensation could undo the efficiency gain of having an income tax. 3

4 4. Compliance would be more difficult to ensure with a consumption tax system than with the income tax system. According to Gale (1999) replacing the income tax with a consumption tax would require a consumption tax of 35% to make the same amount of revenue. With such a large tax compliance would be reduced. There could develop a black market for undeclared and untaxed goods, or buyers would conspire with sellers not to ring up the sale. Sales take place much more often than income is paid, so many more transactions would have to be tracked. For income taxes, withholding the tax from paychecks solves the compliance problem for much of the population. 5. Would there be cascading taxation of business inputs? Sales tax is paid only on retail sales, not on sales of business inputs. But many businesses buy their inputs at the retail level. So these businesses would be paying tax on their inputs and paying tax again when they sell the finished product. This cascading will tend to distort production away from ways that require multiple stages of inputs. Designing a consumption tax To address the concerns raised with the sales tax approach, one could implement a value-added tax (VAT). A VAT taxes a good at each stage of production on the value added to the good at that stage. For a kitchen table with retail sales value of $100 and VAT rate of 20%, the VAT works in the following way. At each stage of production, the difference between the value of what is produced an the price paid for inputs from other firms is computed and tax is paid on it. The first stage of production is the logger, who sells lumber for $25 to a manufacturer. The logger has transformed trees with an initial value of zero into lumber with a value of $25, thus value added is $25 and VAT on the lumber is $5. The manufacturer turns the lumber into a table and sells it to the retailer for $75. The value added is $50, so VAT is $10. The retailer sells the table to the consumer for $100. The value added is $25, so the VAT paid by the retailer is $5. The total VAT payments are $20, the same as if there was a 20% tax on the finished product. But with the VAT, each participant has an incentive to make sure that the previous seller does not underreport the sale value. If the previous seller underreports the value of the good sold, the buyer has to pay more VAT. Also, the cascading problem is accounted for as firms only pay tax on the value they add to the product, not on the whole value of the product. Firms that use retail inputs are thus not double-taxed. But in practice the VAT has become incredible complicated in most developed countries. There are multiple rates and exemptions. Expenditure tax 4

5 It is hard to have a progressive sales tax or VAT. An expenditure tax would be a tax on yearly consumption. It would be like an income tax, but the tax base would be expenditure not income. It could be designed to be progressive by making the marginal tax rates increasing. But too much information would be required to track everyone s expenditures. Experiments in an expenditure tax in India and Sri Lanka failed and the attempt was abandoned. Cash-flow taxation Taxing consumption at production leads to progressivity concerns. Trying to tax expenditure is administratively infeasible. But since consumption equals income minus savings, one could let people deduct savings from income in computing taxable income. This should give the same outcome as taxing consumption, and is called cash-flow taxation. This approach would require least change to the current tax system of the changes considered. Need to verify how much people save during a year, but this could be done if they save through officially recorded channels, like bank accounts and stock purchases. The flat tax Consider the plan introduced by economists Hall and Rabushka: 1. Corporations pay a flat-rate VAT on their sales, but also get to deduct wage payments to workers from VAT tax base. There is no corporate income tax. 2. Individuals pay tax on labor income only, not capital income at the same flat rate as the VAT. 3. Employer-provided health insurance would be treated as a wage payment, charitable contributions and home mortgage interest would not be deductible, etc. There would be just one single family-level exemption. By taxing wage income at the individual level we could make the system progressive without actually taxing expenditure. They proposed a flat tax rate of 19% and an exemption level of $25,000. This exempts lowest earners from paying a tax, allowing more vertical equity than VAT or sales tax. 5