Business, Legal & Accounting Glossary
A consumption tax is a tax on the purchase of a good or service. The term “consumption tax” refers to a system whose tax base is consumption (as opposed to income or labour). While this can be structured like a pure sales tax, many proposals for a consumption tax make adjustments to decrease regressive effects. Using exemptions, graduated rates, deductions or rebates, a consumption tax can be made less regressive or progressive, while allowing savings to accumulate tax-free.
A consumption tax is a charge levied on spending on goods and services. Often a consumption tax will be a percentage of the total price of the purchased goods or services. A consumption tax is distinct from an income tax in that the latter is a percentage charge imposed on an entity’s earnings. Many local and state governments derive revenue from a combination of property taxes and various forms of consumption tax. Some municipalities and most states also collect income tax. The federal government collects most of its revenue from income taxes and the consumption tax. At the local and state level, a consumption tax may take the form of taxes on retail sales and excise taxes on gasoline, tobacco, and alcohol. At the federal level, the consumption tax is also imposed in the form of excise taxes, but there is no federal sales tax.
Political advocates of the consumption tax as a partial or full replacement for federal income taxes argue a consumption tax would have several advantages. A consumption tax would promote resource conservation by discouraging consumption, encourage saving and investing, simplify the current tax system, and collect more revenue from those who illegally generate income. Opponents of a federal consumption tax raise a number of objections. For one, a consumption tax is regressive. That is to say, low-income individuals would pay a proportionately higher share of their income in taxes relative to high-income earners. Also, a consumption tax would eliminate certain deductions/incentives available under the current income tax system (e.g. deduction for mortgage interest rate and eduction expenses, etc.).
Throughout most of American history, taxes were levied principally on consumption. Alexander Hamilton, one of the two chief authors of the anonymous Federalist Papers, favoured consumption taxes in part because they are harder to raise to confiscatory levels than incomes taxes. In the Federalist Papers (No. 21), Hamilton wrote:
It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess. They prescribe their own limit, which cannot be exceeded without defeating the end proposed—that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty that, “in political arithmetic, two and two do not always make four.” If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them.
One of the first detailed analyses of a consumption tax was developed in 1974 by William Andrews. Under this proposal, people would only be taxed on what they consume, while their savings would be left untouched by taxation. For this reason, the tax can be called a consumption tax, a cash-flow tax, an expenditure tax, or a consumed-income tax, to name a few. Former senior editor of Fortune magazine Al Ehrbar notes that proponents of a consumption tax argue its superiority to the income tax based on an economic principle called “temporal neutrality”. He observes that a tax is “neutral” if it does not “alter spending habits or behaviour patterns and thus does not distort the allocation of resources.” In other words, taxing apples but not oranges will cause apple consumption to decrease and orange consumption to increase. The temporal neutrality of a consumption tax, however, is that consumption itself is taxed, so it is irrelevant what good or service is being consumed in terms of allocation of resources. The only possible effect on neutrality is between consumption and savings. Taxing only consumption should, in theory, cause an increase in savings. William Gale, co-director of the Urban-Brookings Tax Policy Center, offers a simplified way to understand a consumption tax: Assume that our current tax system remains the same, but remove limitations to contributing to and removing funds from a traditional IRA. Thus, a person would essentially have a bank account where they could place tax-free earnings at any time, but unsaved (or consumed) withdrawals would be subject to taxation. Having an unrestricted IRA under the current system would approximate a consumption tax at the federal level.
In his article, Andrews also explains the power of deferral, and how the current income tax method taxes both income and savings. For example, Andrews offers the treatment of retirement income under the current tax system. If in the absence of taxes, $1 of savings is put aside for retirement at 9% compound interest, this will grow into $8 after 24 years. Under our current system, assuming a 33% tax rate, a person who earns $1 will only have $0.67 to invest after taxes. This person can only invest at an effective rate of 6% since the rest of the yield is paid in taxes. After 24 years, this person is left with $2.67. But if like in an IRA, this person can defer taxation on these savings, she will have $8 after 24 years, taxed only once at 33%, leaving $5.33 to spend on her retirement. It is also mathematically irrelevant when the tax is imposed, for if this same person is taxed on the dollar she earns, but is never taxed again, the $0.67 she invests will grow to $5.33 in 24 years. Timing the taxation in this way is much like a Roth IRA. This is the primary concept of the consumption tax- the power of deferral. Even though the person in the above example is taxed at 33%, just like her colleagues, deferring that tax left her with twice the amount of money to spend in retirement. Had she not saved that dollar, she would have been taxed, leaving $0.67 to spend immediately on whatever she wanted. Harnessing the power of deferral is the most important concept behind a consumption tax.
In the above example, the equation for the government is the opposite as it is for the taxpayer. Without the IRA tax benefits, the government collects $5.33 from the $1 saved over 24 years, but if the government gives the tax benefits, the government collects only $2.67 over the same period of time. The system is not free. Regardless of political philosophy, the fact remains that a government needs money to operate, and will have to get it from another source. The upside of the consumption tax is that, because it promotes savings, the tax will encourage capital formation, which will increase productivity and economic activity. Secondly, the tax base will be larger because all consumption will be taxed.
Some critics argue that sales and consumption taxes can shift the tax burden to the lower to middle class. The ratio of tax obligation shrinks as wealth grows because the wealthy spend proportionally less on consumables. Setting aside the question of rebates, a working-class individual who must spend all income, will find his expenditures and therefore his income base taxable at 100%, whereas wealthy individuals who save or invest a portion of their income will only be taxed on the remaining income. This argument assumes that savings or investment is never taxed at a later point when consumed (tax-deferred).
Further, average citizens cannot take advantage of tax-avoidance avenues, such as offshore purchases. A working-class individual cannot realistically purchase, say, a Mercedes or Lexus offshore, thereby avoiding US tax. These concerns cannot be easily dismissed by the disingenuous mantra, “The wealthy don’t pay taxes anyway.” When purchases are made offshore, the buyer is subject the tax laws in that country, using the example of Mercedes or Lexus – buyers would be subject to the VAT tax (the VAT is removed on exports and would not be charged if purchased domestically).
Many proposed consumption taxes share some features with the current income tax systems. Under these proposals, taxpayers would be given exemptions and a standard deduction in order to ensure that the poor do not pay any tax. In a completely pure consumption tax, other deductions would not be permitted, because all savings would be deductible.
A withholding system might also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.
A consumption tax could also eliminate the concept of basis when computing the value of investments. All income that is put in investments (such as property, stocks, savings accounts) is tax-free. As the asset grows in value, it is not taxed. Only when the proceeds from the asset are spent is any tax imposed. This is in contrast with the current system where, if you buy land for $10,000 and sell it for $15,000, you have a taxable gain of $5,000. A consumption tax only taxes consumption, so if you sell one investment to buy another investment, no tax is imposed.
In Andrews’ article, he notes the inherent problem with housing. Renters necessarily “consume” housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset). The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent his or her home to others in exchange for money, but instead, the homeowner chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home. A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) and would not tax the increase in the value of the asset (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States, homeownership is subsidized by the federal government by permitting a deduction for mortgage interest expense, and by exempting a significant increase in value from the capital gains tax. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible in the United States.
Lastly, a consumption tax could utilize progressive rates in order to maintain “fairness.” The more someone spends on consumption, the more they will be taxed. The rate structure could look like the current bracket system, or a new bracket system could be implemented.
Depending on implementation (such as treatment of depreciation) and circumstances, income taxes either favour or disfavour investment. (On the whole, the US system is thought to disfavour investment.) By not disfavoring investment, a consumption tax might increase the capital stock, productivity, and therefore increase the size of the economy.
An individual or family’s income often varies dramatically from year to year. The sale of a home, a one-time job bonus, and various other events can lead to temporary high income that will push a low or middle-income person into a high tax bracket. On the other hand, a wealthy individual may be temporarily unemployed and will pay no taxes.
Designed by economists at the Hoover Institution, Hall-Rabushka is a fully developed flat tax on consumption. Loosely speaking, Hall-Rabushka accomplishes this by taxing income and then excluding investment. An individual could file a Hall-Rabushka tax return on a postcard.
In the United States, extensive tax reform has not taken place since the Tax Reform Act of 1986, and like other tax reform, the flat tax has not advanced far in the U.S. political process. However, Eastern Europe has enthusiastically embraced the flat tax after the fall of the iron curtain. Robert Hall and Alvin Rabushka have consulted extensively in designing these flat taxes.
Since the 1990s, the idea of replacing the income tax with a national sales tax has been floated in the United States; many of the actual proposals would include giving each household an annual rebate, paid in monthly instalments, equivalent to the percentage of the tax (which varies from 15% to 23% to 30% in most cases) multiplied by the poverty level based on the number of persons in the household, in an effort to reduce the sales tax’s inherent regressivity. While some political observers consider the chances remote for such a change, the Fair Tax Act has attracted more cosponsors than any other fundamental tax reform bill introduced in the U.S. House of Representatives.
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This glossary post was last updated: 18th April, 2020 | 2 Views.