As promised: An assessment of the case for changing from an income to a consumption tax base. Be warned, this is going to take a while. I’m trying to present the cases even-handedly here.
Just to begin, as noted by various people there are two different sorts of consumption taxes:[ul][li]Sales taxation (like the European Value Added Tax – also known as a Goods and Services Tax after New Zealand’s coinage –- which is multistage tax, and single stage Retail Sales Taxes which are more common in US states)[/li][li]Direct taxation on a consumption base. I give some details below, but the most important difference here is that these taxes can be made progressive, whereas it is not really possible to do this with a sales tax whilst maintaining significant revenue and administrative feasibility.[/ul][/li]There are three main traditions in looking at what constitutes a “good” tax (I’m mainly using the third):[ul][li]benefit taxation[]optimal taxation[]“ability to pay” or equitable taxation [/ul]Benefit taxation looks at tax burdens and expenditure benefits together and comes from the Swedish tradition pioneered by Wicksell and Lindahl. In this way of looking at things, a system of “just taxation” is where each taxpayer faces a tax rate equal to their marginal benefit of government expenditure. Whilst this is a pretty appealing way to look at the issue in principal the impossibility of reliably gathering the information required to make it work in a large numbers situation means that it isn’t really a practical option for running a tax system.[/li]
The optimal taxation tradition –- pioneered by Ramsey – starts by recognising that all feasible tax systems distort economic decisions because some things (notably leisure) are untaxable. In the light of this the theoretically best tax system (from the standpoint of efficiency) is a complex system of taxes with different rates for different commodities and activities. A pure Ramsey system would tax commodities at a rate inversely proportional to the price-responsiveness of individual markets. Equity objectives modify the conclusion a bit, but the general theoretical result is for lots of different tax rates.
Once again, whilst this is an important strand of thinking it has pretty severe limitations. Once again informational and administrative considerations make this not really a practical option for the bulk of taxes. In addition the imperfect nature of governments would means that giving them the power to try to do this would be a recipe for disaster. Generally speaking most economists would agree that taxing some broad economic aggregate like income, consumption, wages or wealth at standard rates is the only serious policy option for most revenue-raising. Optimal tax considerations enter into the debate, but mainly for questions like: [ul][li]Can we better achieve our equity objectives with income tax rates or by exempting food from the tax base? []Should we be more concerned about work incentives for high income earners facing high tax rates or average income women facing middling rates?[/ul]This leaves us with equitable taxation, a tradition which basically proceeds along the lines of taxing a broad aggregate at a standard rate scale. The standard tax policy objectives in this tradition are:[ul][]Revenue adequacy[]Efficiency (which in this context means neutrality – the tax system should change agents’ decisions about what to consume, how much to work, save, invest etc. as little as possible)[]Equity, both horizontal (the equal taxation of individuals or households in the same economic position) and vertical equity (the unequal treatment of people in different positions). Obviously there is no agreement on how unequal tax burdens should be. Note in passing that even quite steeply regressive taxes result in the rich paying more tax than the poor.[]Simplicity[]various others such as federalism, international efficiency, stabilisation and growth which are less important here.[/ul]The basic result in this tradition is that to a fair degree these objectives can be simultaneously pursued with an income or consumption tax levied at an equal rate on all activities on a progressive rate scale for a personal or direct tax possibly supplemented by a broad-based uniform rate indirect sales tax.[/li]
As an aside, note that this conclusion is weakened (but not really overturned) if you are worried that the government is a revenue-grabbing monster rather than an entity which comes to the appropriate amount of government expenditure by some process of balance which reflects what people want in some way.
So the choice is between consumption and income as the direct tax base. Many people have argued over the centuries that consumption is the better base for both equity and efficiency reasons.
Both consumption and income are going to be pretty crude proxies for economic position. Measured income or consumption will never be a perfect measure of how well off a person is. An example: suppose you are taxing households and you observe that two couples have the same market income (and if you assume they undertake no saving they would have the same market consumption as well). Suppose for one couple both individuals are earning a market wage of $50 000 and for the other couple one individual is performing unpaid tasks around the house and the other is earning $100 000. The benefits of the household production can’t be counted for tax purposes, yet clearly --since the person could have received a wage but decided not to – the second couple is in a better economic position than the first. No tax system is really going to be able to pick up on that effectively.
One reason consumption can be viewed as a superior proxy is that it is a better measure of lifetime economic position than year to year income. Consumption is much less volatile than income. The typical response of income tax proponents is that they have always (well since the 1930s anyway) advocated allowing income to be averaged over time for tax purposes for precisely this reason. This is just an argument for doing income tax right, not abolishing it.
The big argument in favour of expenditure tax has always been about savings (and the economic growth consequences of savings’ tax treatment). The line has always been that income tax taxes the activity of saving at a higher rate than anything else. If economic agents undertake saving for the purpose of future consumption this argument is true: an income tax unfairly overtaxes people who like to save and biases the economy against saving [I’ll provide a numerical example if anyone wants]. A tax on consumption or a wages tax is neutral in this respect. The conclusion of the expenditure tax proponents is that consumption is therefore a better base for tax than income on both efficiency and (horizontal) equity grounds. The connection between savings and economic growth is also obviously pretty important. The fact that the tax can be made progressive means that vertical equity concerns can be dealt with by an expenditure tax.
The second big point put by expenditure tax people is the simplicity argument. There are three ways to get from an income tax to a consumption tax:[ul][li]exempt the initial saving required to finance investments: C=Y-S, (‘Y’ is income)[]allow 100% deprecation allowance on investments: C=Y-I (‘I’ is investment)[]or exempt income derived from capital from tax C=Y[sub]L[/sub]=Y-Y[sub]K[/sub] (‘L’ is labour, ‘K’ capital)[/ul]In the very long run these approaches will give pretty much the same result although the transitional differences are substantial.[/li]
If you look at these approaches something stands out. If you use the cash-flow or Fisher method I mentioned in an earlier post or use a wages tax, many of the things that make doing income tax well difficult disappear. Looking at the first crude little equation, accrued pension rights (superannuation) are hard to tax fairly and efficiently. In the second equation, depreciation of investment is hard to allow for in a simple and non-distorting way and debt is complex to treat under income tax. In the third equation, capital gains are a nightmare to tax effectively. Under a cash-flow consumption tax you don’t have to worry about any of them, the problems simply disappear. Administrative and compliance issues become much smaller. (Practically this would be done under the Meade Committee’s system of asset registration. I recommend reading the full report if you suffer from insomnia.)
Ok, that’s the case for switching to a consumption expenditure base. You can have as progressive a tax as you like which is fairer, simpler and more efficient than income tax.
Now, as the remark I linked to in an earlier post alluded to, these were arguments that had gathered a fair bit of steam by the 1970s, but enthusiasm has since dissipated a fair bit.
The first reason is simple enough. In the 1970s people were pretty concerned about economic growth because there wasn’t much. A major reason for this was thought to be a lack of available savings for capital accumulation. Much of the political impetuous for action therefore has disappeared since most Western economies have grown strongly during the last decade. Anyone trying to hang this tax change on the supposedly stultifying effects of income tax on growth these days is probably going to get a funny look. In addition, economists’ views on growth have been changing, with the growth and development literature de-emphasising capital accumulation and re-emphasising human capital (education), institutions and innovation. Also capital mobility has hugely increased since the 1970s with the abolition of capital and currency controls. It is no longer true that domestic investment is strongly constrained by domestic saving.
The second reason is that both the savings and simplicity arguments are weaker than first thought.
The savings argument can be attacked theoretically by denying that all saving is undertaken for the purposes of future consumption (even taking bequests as future consumption). Saving can also be motivated by the desire to accumulate. Having an existing pool of savings gives you advantages in terms of security and (for large holdings) power. These “extra benefits” of saving are current benefits of saving and would be entirely untaxed under expenditure tax. So whilst it might be said that saving would be overtaxed by income tax it could equally be said that it would be undertaxed under consumption tax.
The response to this by mainstream expenditure tax advocates (ie those who are not pushing the idea because they think it will line the pockets of the rich) is to say this: “First, we still win because an ideal consumption tax would tax the current benefits of saving and therefore in theory it is still better than income tax, nyah. Secondly, this in practice can be dealt with by a small wealth tax.”
But this is a big problem: all those complicated things that you need to measure for income tax you need to measure for wealth tax. Indeed serious wealth taxes are probably even more complex than income taxes. So the either the efficiency and equity arguments are greatly undermined (if you don’t have a supplementary wealth tax) or the simplicity baby goes out with the bathwater.
Finally there is a lack of empirical evidence for the importance of the savings argument. In order to justify the sort of upheaval this sort of a change would entail it needs to be shown that the savings argument is a big deal. What you need in order to do this is to show that the supply elasticity of aggregate saving is a biggish number – say 3 :). In other words you need to show that if you reduced taxes on saving you’d get more saving (preferably lots more saving). If you can’t do that the efficiency argument just doesn’t fly (although the horizontal equity argument is still there). Now there is ample evidence that different types of saving and investment are highly sensitive to after tax returns. Initial fairly high aggregate savings elasticity estimates were however subject to severe criticism in the literature. Later studies – many by expenditure tax advocates – failed to show anything (ie failed to reject it being 0). At least as at the last time I looked at this stuff no-one could confidently say that aggregate savings behaviour responds at all. Now as an economist I am confident that savings behaviour does respond, but the point is that it if we can’t see any response then the response must be pretty small even if it’s there.
A quick word on the transitional problems – a change of this magnitude would involve large windfall gains and losses, which either means it has no hope of getting up politically (unless the potential losers don’t wake up to the fact) or complex compensation arrangements. Add to this the fact that the capital market has to revalue every asset in the economy in the face of considerable uncertainty about the effects of existing taxes and the great political will required to follow the announced programme.
Switching to a wages tax tomorrow would give holders of existing assets large, tax-free, wholly unearned gains. In effect this would be a massive transfer of wealth to the (mostly) already wealthy. A more gradual and orderly transition (via an asset registration process) would greatly reduce these windfall gains (and the losses which other taxpayers would effectively face as a consequence) but would be a long process which would delay the emergence of any benefits from the change.
Lastly anyone who had accumulated savings under income tax would effectively taxed a third time on their savings as they faced higher prices for current consumer goods. This would be mainly the elderly and politically they would have to be compensated. An expensive and complex business.
To wrap up: whilst there is no question that an expenditure tax could work and is a viable –- and maybe even a superior – alternative to income tax, the case is far from overwhelming and the transitional period looks tricky. Other types of tax reform (reform within the capital income area to equalise the tax treatment of different types of assets for example) look easier and promise more reward for effort. I doubt we’ll see an expenditure tax in an advanced economy in the next twenty years.
Little too much paradox for me, thanks. ha