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Is It Time to Try a Consumption-Based Tax System?

May 7, 2014 7 minute Read by Christopher Hanna

On February 26, 2014, House Ways and Means Committee Chairman Dave Camp (R-MI) released his 979-page comprehensive tax reform plan.  Chairman Camp’s goal was a broad-based, low-rate income tax system that was both revenue neutral and distributionally neutral.  He came very close to achieving his goal.  The plan was approximately revenue neutral over the 10-year budget window (raising $3 billion) and roughly distributionally neutral.  The income and corporate tax bases were substantially broadened.  The corporate tax rate was decreased from 35 percent to 25 percent.  However, the top individual tax rate was only decreased from 39.6 percent to 35 percent (25 percent top rate coupled with a ten percent surtax) -- short of the goal of a top individual tax rate of 25 percent.    

If a comprehensive tax reform plan is both revenue neutral and distributionally neutral, then a question arises as to why the United States should enact such a plan.  In evaluating a tax plan, generally three criteria are considered: fairness (equity), efficiency and simplicity.  Fairness has generally been determined under the concept of ability to pay.  Those with a greater ability to pay should pay more in taxes than those with a lesser ability to pay.   A plan that is both revenue and distributionally neutral removes, for the most part, fairness from the discussion.  More specifically, the fairness issue has already been decided at the outset.  As a result, the focus appears to be on efficiency and simplicity.

An alternative to a broad-based, low-rate income tax system is a broad-based, low-rate consumption tax system.  The key difference between an income tax and a consumption tax is the tax burden on income from capital.  An income tax includes income from capital in the tax base, while a consumption tax does not.  By including income from capital in the tax base, an income tax system is generally considered to be fairer than a consumption tax system.  A consumption tax system, however, is generally considered more efficient than an income tax system because income from capital is not included in the tax base.  Both systems can achieve some measure of simplicity depending on how they are structured.  If the focus of tax reform is efficiency, then maybe a shift to a consumption-based tax system is in order.

An income tax system is considered to be inefficient because of the penalty on savings that results by including income from capital in the tax base.  In an income tax system, an individual is taxed when she earns her wages.  She is also taxed on any return from investing the after-tax proceeds from her wages.  For example, assume an individual earns wages of $100, which can be either spent or saved.  If the individual saves the $100 at an annual yield of ten percent, she will have $110 at the end of one year.  The individual has ten percent more available for consumption by saving for one year.  She can either spend at that time or continue to save.  If a 40 percent income tax is introduced, then the individual has $60 to initially spend or save.  If the individual saves it for one year with an annual yield of ten percent, the individual will have $63.60 ($60 plus $6 of interest less tax of $2.40) at the end of that time.  The individual has only six percent rather than ten percent more available for consumption by saving for one year.  The income tax is viewed as discriminating against savings.  The individual is sometimes referred to as being double-taxed on her savings.  In other words, a taxpayer is penalized in saving for future consumption rather than engaging in immediate consumption. 

A consumption tax, however, does not penalize savings because income from capital is not taxed.  This can be demonstrated by returning to our simple example of an individual that earns wages of $100.  If the individual saves the $100 at an annual yield of ten percent, he will have $110 at the end of one year.  The individual has ten percent more available for consumption by saving for one year.  If a 40 percent tax is introduced on consumption (in reality, because consumption is smaller than income, a higher tax may be needed under a consumption tax system relative to an income tax system), then the individual has $60 to spend or can save the entire $100.  If the individual saves the $100 for one year with an annual yield of ten percent, the individual will have $110 at the end of that time.  If the individual decides to consume it at the end of one year, the individual will have $66 ($110 less tax of $44) available to consume.  The individual still has ten percent more available for consumption by saving for one year even with a 40 percent tax on consumption.  As a result, assuming constant tax rates, a consumption tax does not discriminate between consumption and savings.  In other words, a consumption tax is neutral as between immediate consumption and future consumption. 

An extensive body of literature has developed over the years in which economists have attempted to estimate the economic gains that result from the economic efficiency of a consumption-based tax system.  In sampling the literature on the potential economic growth from tax reform, one of the most often-cited studies is contained in a 2001 paper by David Altig, Alan J. Auerbach, Lawrence J. Kotlikoff, Kent A. Smetters and Jan Walliser.   The authors conduct a study simulating five different tax reform proposals, including four consumption tax proposals.  They estimate long-run output gains of 1.9 percent to 9.4 for the four consumption tax proposals.  In 2005, the President’s Advisory Panel on Tax Reform issued its report, which included discussion of a Progressive Consumption Tax Plan.  The Treasury Department, using three different models, suggested long-run output gains of two to six percent for the Progressive Consumption Tax Plan.  As the President’s Advisory Panel noted: “While the studies [of consumption tax plans] produce different estimates of how taxing consumption rather than income would affect economic growth, virtually all such studies suggest that the long-run level of national income would be higher.”


Image by Katie Harbath


Author

Christopher Hanna
Christopher Hanna

Christopher H. Hanna is a professor of law and a University Distinguished Teaching Professor at Southern Methodist University. Professor Hanna has been a visiting professor at the University of Texas School of Law, the University of Florida College of Law, the University of Tokyo School of Law and a visiting scholar at the Harvard Law School and the Japanese Ministry of Finance. In 1998, Professor Hanna served as a consultant in residence to the Organisation for Economic Co-operation and Development (OECD) in Paris. From June 2000 until April 2001, he assisted the U.S. Joint Committee on Taxation in its complexity study of the U.S. tax system and, from May 2002 until February 2003, he assisted the Joint Committee in its study of Enron, and upon completion of the study, continued to serve as a consultant to the Joint Committee on tax legislation.

Prior to coming to SMU, Professor Hanna was a tax attorney with the Washington, D.C. law firm of Steptoe & Johnson. His primary duties included tax planning for partnerships and corporations on both a domestic and international level and also tax controversy. He has received the Dr. Don M. Smart Teaching Award for excellence in teaching at SMU Dedman School of Law on eight separate occasions. In 1995, he was selected and featured in Barrister magazine, a publication of the ABA Young Lawyers' Division, as one of “21 Young Lawyers Leading Us Into the 21st Century” (Special Profile Issue 1995).

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