Economics

Why a Consumption Tax May not Make any Sense at All

The devil’s in the (accounting) details — and the economic effects

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By Steve Roth

You often hear calls out there — mostly from Right economists but also from some on the Left — for a consumption tax in the U.S. As presented, it’s a super-simple idea: tally your income, subtract your saving, and what’s left is your consumption. You pay taxes on that.

We want to encourage thrifty saving and discourage profligate consumption, so what’s not to like?

Lots. Before getting into the idea’s economic virtues and vices, consider the accounting. Whaddaya mean by “saving”? Economists are deeply confused about that word, so it’s worth sorting through a bit.

Start with a simple pared-down household. The only accounting complication is that they own a house:

How much did this household “save”? Should the interest payments count as consumption? The principal payments almost certainly should not (and could be treated that way under the rules of a consumption tax without a whole lot of work for homeowners and lenders…). But what about home maintenance? A new paint job increases your home’s asset value. Should you depreciate that asset value over some years? Or say you buy new appliances for your kitchen: You’re cash out of pocket, but your home is worth more. Are those purchases “consumption”?

This notion of some simple tally of your “saving” starts to look more complicated. We’re not talking “taxes on a 3-by-5 card” here. And this is not a complex household. There will have to be some complicated IRS rules for what counts as saving. (I won’t even touch here on various clever opportunities to game this system.)

An expanded tally raises some other tricky questions:

What if this family leases its car with an option to buy at the end of the lease, instead of buying? How do you account for that? And this doesn’t even touch the troublesome issue of health care: is it consumption? That’s how it’s tallied in the national accounts. But if Americans didn’t invest in maintaining their health, how prosperous would our country be? Should we tax health spending? If you get sick, your taxes go up. Hmmm.

I’ll leave it to my gentle readers to consider the details — what’s consumption, what’s saving, and what’s neither? Just to say: I can’t quite see how this family would do their taxes without a complete balance-sheet accounting every year, or some quite complicated rules for 1040 filing that result in essentially the same thing.

The rather childishly simplistic “just tally your income and subtract your saving” isn’t so simple when you think about the actual details.

The tuition line raises a particularly vexing question, and brings us back to the second question: what economic effects would we see from a consumption tax, under various accounting and taxation rules? Clearly, if you tax tuition, you discourage education. And consider more-prosperous families paying for private school. Are those families “consuming” more education than public-school families? Those households would be especially hard hit if tuition counts as taxable consumption — as would those private schools. Is that A Good Thing?

Much more broadly, though, the notion that saving is good and consumption is bad rests on some completely incoherent economic notions. For individual households and firms, sure: saving is prudential, and savings funds (at least some of) their investment. But that’s simply not true collectively. Individual saving, spending less than your income, has no effect on our collective wealth (that mythical stock of “loanable funds”). It just means you’re holding the assets in your account instead of somebody else holding them (if you spend instead of saving).

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So the theory of collectively virtuous household-saving-funding-investment doesn’t make sense. And the empirics over many decades bear that out: higher saving rates have pretty much nothing to do with investment rates.

When you tax consumption, you discourage consumption, including some forms of so-called “consumption” —tuition, home maintenance, health maintenance — that arguably should be tallied as investment, at least in part. (In the national accounts, they aren’t, at all; they’re all consumption.)

And that raises a key question that cuts to the crux of economic thinking: why do producers produce stuff?

Any entrepreneur will give you a simple answer: they produce stuff because people are buying it, and consuming it (either immediately or over time). So taxing hence discouraging consumption discourages production — of both short-term consumption and long-term investment goods. A consumption tax, compared to, say, a wealth tax or a land-value tax, is a direct assault on GDP and GDP growth.

Is that what Right economists had in mind?

2017 August 5


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  • These are all fair points, but questions of classification of income arise under the present tax system too– which is why they present income tax is so complex (especially when you include Treasury Regs, various precedents, etc.).

    The rationale for the consumption tax is that even the current income tax system attempts to tax consumption and why not do it more directly. That seems like a reasonable to pursue, even if it ultimately turns out not to be feasible.

    • Boonton

      Indeed but for *most* people income is not very complex even under IRS rules. For most people salary is clear cut. Add to that small business income or income from being a landlord. Those cases things get a bit more complex with depreciation and ‘business expenses’ becoming elements of confusion but you aren’t that far off from basic accounting concepts. I would say that covers easily 80% of the population who will never in their lifetimes touch the more complicated areas where income starts getting really complex under our tax code.

      In contrast 80%+ of Americans will be doing the simple things depicted above like paying tuition, buying a car, buying or improving a home, at some point in their lifetimes and either be confronted with ‘complex’ rules about what savings really is or be confronted with games that will crop up to take advantage of provisions that are created to accommodate people who will object to suddenly getting a huge tax bill because they did something very basic like buy a well maintained home one year.

      • I’m not sure 80% is right, but even if it is that simplicity comes at the cost of doing a poorer job of differentiating what should and should not be taxed. It is not an advantage that is inherent to an income tax. This is especially true if you believe (as many tax policy makers do) that the income tax is just a proxy for taxing consumption and that the rules for calculating income should take that into account.

        • Boonton

          Again for “80%+” it’s roughly right, especially if you consider that long term saving retirement or your kids’ college can be done in tax sheltered accounts. At that point income in is essentially consumption for most people except when they use income to pay off debt (i.e. past consumption). Money that is put into relatively liquid types of savings (“Holiday Clubs”, savings accounts, CD’s, non-IRA type investment accounts), is usually not a huge portion of income for most people (several financial shows I’ve listened too suggest the average person should be saving about 20% of their income…most people are nowhere near this and those that are would almost always be using a 401K or IRA of some sort).

          The logic of the consumption tax is that in theory you can be super rich but if you never spend the money you are never actually taking it out of the economy…..you’re ‘letting it ride’ in a sense. But couldn’t that more easily be accomplished with a VAT tax that offsets income tax rates? And also it isn’t clear ‘not spending money’ when you’re very rich is really not using it for your own benefit….consider Trump’s ‘charity’ that purchase 8 foot paintings of himself.

          • I’m not sure we really disagree. For example, a VAT is a consumption tax and arguably a quite efficient one. It is that very efficiency (combined with it being hidden) that lead those who fear increased government spending to eschew it.

            You describe one rationale for a consumption tax, but a related one is that you artificially discourage investment by taxing more than consumption. Ideally you would like the decision to invest or consume not to be affected by the tax system and you get that via a consumption tax.

          • Boonton

            I don’t think we disagree as well.

            The fear that a VAT will increase gov’t spending seems to me to be based on a faulty model of what determines gov’t spending. I call it the ATM theory. When I was younger I’d hit the ATM for $40. Wait, it says my balance is higher than I thought it was. Yay! Let’s take out $100 instead, time for some fun!
            But does this apply to gov’t? It doesn’t seem so. In the late 80’s/90’s Social Security was changed to run a surplus. Critics said the gov’t ‘spent’ the surplus but did they? What major spending would not have happened in those decades had SSI been balanced instead of running a surplus? Likewise after Bush cut taxes, what stopped him from spending $1T on the Iraq/Afghanistan/Generational War? Congress doesn’t look at how much money came in on Monday and then decides how to spend it all on Tuesday. Not at all that simple IMO.

            IMO what is more likely to happen is lobbies for additional spending tend to undercut each other. If someone is making a push for more farm subsidies, those who want more housing subsidies tend to resist least one side get ‘all the money’. How much happens to be coming into the Treasury is not the primary concern. I think something along those lines would be a more realistic model of how gov’t spending is determined as opposed to the ‘politicians buying votes’ model. If that model worked then all gov’t budgets would surge to infinity as each side would outbid each other in bringing goodies to their voters. In reality voters actually seem somewhat mean spirited and would be as happy or happier cutting someone they don’t like off of gov’t benefit rather than getting a second helping themselves.
            I’m not sure we really agree on the idea that consumption/investment decisions shouldn’t be affected by the tax system, but I suspect you might really agree with me. For example, are you annoyed with the idea of 401Ks/IRA’s? Clearly they encourage diverting income into long run investments and away from consumption. Left to their own devices, people probably would be inclined to under save. WE are full of internal biases that incline us away from rational planning for the far off future. Trying to get us to save more alleviates the pressure on entitlement programs in the future.

            Other dynamics come into play to make this story a lot more complex than it already appears. For one thing, the conflict between saving and consumption is not like the conflict between work and leisure. If I work a 50 hour week, I’m confronted with the question of whether I want to do a part time job for more hours or enjoy leisure time. Adding another 20 hours of work is a big imposition on me. Investment income, however, does not require this type of ‘work’. If I have $500K and invest it in some mutual funds and earn $20K in dividends and appreciation I would normally get taxed on it today (assuming I’m not using a vehicle like an IRA). But as much as that tax hurts, the fact is earning that $20K required nothing like the effort I would have to put out by using a part time job to earn an extra $20K per year.
            What then really is the incentive problem with the tax code? Do people with $500K really opt to splurge on a nice boat because the taxman will take a bite out of the $20K they can earn by forgoing consumption? Remember a year later they will still have the original $500K plus whatever is left of the $20K….if they opt for consumption they have a boat that is now a year old and not getting any newer. Given that consumption has rapidly diminishing returns as your income goes up, it actually becomes a bit of a full time job to *not* invest your money. Buffett and Gates, for example, have to turn to massive charity donations to even begin to turn their fortunes into consumption (and Bill Gates had to create a new charity from scratch to do it!). Less intelligent rich people end up investing in their quest to consume….start buying mansions and private jets and soon enough you’re actually investing in assets….Elvis’s estate, for example, is an asset that has earned more money than he ever was able to spend despite his best efforts towards hedonism.

          • For a better discussion of the notion that a consumption tax (in contrast to an income tax) doesn’t artificially depress investment see http://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=3035&context=journal_articles (p1419). I’m not sure you would disagree with this, but it’s an important point and one that is difficult to explain, hence the citation.

          • Boonton

            I think I get it. Using their example, MR Z can spend $100 he earned today or put it in a savings account and spend $105 a year from now. But if the tax rate he faces is 40% then he will only have $103 a year from now. Assuming his discount rate is 5% and is the interest rate, he is indifferent between consuming $100 today and $105 a year from now. Being only able to consume $103 a year from now implies he will rationally shift consumption up from next year to this year. The income tax is essentially a ‘sales tax on future consumption’ trying to shift consumption to the present.

            This is great in theory but misses key points. Ask yourself this, do you think you’d find evidence of dramatic consumption decreases among the upper class in the 1980’s? Why not? There was a cut to marginal rates on the top, in effect that would be lowering ‘future sales tax’ leaving ‘present sales tax’ relatively higher. The rich should then respond by dialing back consumption in order to reap the benefits of future consumption by increased savings.

            Two factors missing from the theory are the effort required to generate a marginal $100 in income and the marginal utility of $100 additional consumption. In terms of labor producing another $100 in income is hard. In terms of investment it simply means moving more funds into that 5% savings account. In terms of consumption, the value of actually consuming $1B for Bill Gates today is probably negative. If he really tried to do it, it might kill him. Hence most of his money is invested despite the imposing ‘future sales tax’. A third factor that we might add is finite lifespans. For many, the purpose of savings is not investment income but provisioning for old age. The point of putting $100 away today is not earning $5 in interest income tomorrow but having $100 in the account for when we are too tired and old to do work. That we happen to get an extra $5 as interest is icing on the cake, so to speak.

            Another way to think about it, this piece implies if we converted to a consumption tax we should see a big pull back in present consumption because massive amounts of funds would move into investment accounts because the ‘future sales tax’ has now been eliminated. Given interest rates near 0% and huge amounts of capital flowing back and forth and no sign of cost push inflation…the global ‘savings glut’ still seems to be around…does it seem reasonable that this world is consuming excessively? That we desperately need to pull out of present consumption so we can build up our capacity for additional future consumption?

            Again I think the model presented by libertarian and mainstream economists makes sense but there’s something missing from the equation, IMO.

  • Helen Murphy

    there should be no income tax for low income elderly and seniors aged 65 + in new York city

  • Which is why we should have a simple expenditure tax with full rebate on the value of
    assets/goods/services sold.

    Given that net income is what you have to spend, then whenever you spend it, whatever
    you spend it on, tax should be paid at the same percentage rate for everyone.

    To avoid double taxation, everyone needs to get a full tax rebate on the proceeds of any assets (including securities), goods or services sold. There would also need to be an adjustment for loans, to avoid double taxation.

    The whole system could be immensely simplified by managing it through the banks: deducting tax as you withdraw money to spend, and rebating tax when the proceeds of sale are deposited. This would allow us to eliminate all other taxes, as it would be possible to have different local and state tax rates depending on your place of residence.

    If you don’t spend, it just means that you have contributed value to society (by working or investing) equal to the money earned, but have not taken any value out. If you put in without taking, there is no reason why you should be taxed. But as you spend, so you should have to share the same proportion of your earnings as everyone else – to pay for common/public goods and services and to support those who are unable to support themselves (the young, old, incapacitated and their unpaid carers, as well as those who lack the knowledge and skills required by the market)… most of the population.

    Sharing is now done via family (less certain with family breakdown), charity
    and welfare (which creates second class citizens), and crime.

    Any sharing should reduce the pressure to commit crime just to live. It should also aim to avoid creating second class citizens and poverty traps.

    This is best done via an Expenditure Tax.

    Under this approach, if you earn little, you pay little, but proportionally the same as someone who earns a lot, who also pays a lot in tax.

    Some people object to a flat percentage tax, as people on lower incomes need their whole income just to live. Many see progressive income tax as fairer for this reason.

    The simplest way to turn a flat rate expenditure tax into a progressive income tax (while treating everyone the same) is to pay everyone a flat rebate of tax: a Universal Basic Income (perhaps with additional support for the old and incapacitated that is means tested).

    If everyone receives the same annual tax rebate as a ‘Universal Basic Income’ and also pays the same % of the income in tax as they spend it, those at the bottom get the greatest relative benefit. However the rich benefit too.

    Those at the top get the greatest absolute benefit as the UBI is spent. This is because money flows up and is concentrated into fewer hands the further up it goes. The UBI (paid to everyone) flows immediately into the businesses that supply our goods and services and from there into the hands of investors.

    With a combination UBI and flat % expenditure tax, the money goes round, as it needs to. It is pumped in at the bottom enabling people to meet their needs, circulates up through the different levels within business and government and back out again as tax (at each level) to be paid in again at the bottom. Everyone benefits from the flow.

  • Macrocompassion

    A consumption tax means that individuals have less money to spend on consumer goods, but also the government has more money to spend on its infrastructure and internal management. So the money is being circulated elsewhere, not lost or wasted, and the employees of infrastructural improvements and better government management now have more jobs and money to spend. This approach to the whole of the Big Picture suggests that by diverting money into taxation more people can be employed by the government. But since these people are also consumers, even if less consumer goods are bought by the rest of the employed householders, more will be purchased by the governmental employed ones and the overall effect is no change in consumption but a better kept country. In the long run it will make the country more efficient in its productive capacity. Hence taxes are good for you!

  • Harry Pollard

    The right want consumption taxes while the left want income taxes. There was a time, perhaps a long while ago, when a tax was intended for a specific purpose. The roads had potholes, everyone chipped in to fill them.

    Now it becomes ‘what can we tax to get revenue for the government to spend’. Take a look at your telephone bill, or your water and power bill. Added to your costs are a bunch of little taxes that often have little or nothing to do with the bill you are paying.

    The only economically satisfying tax is mentioned at the end of the article – the land-value tax. Land values are a creation of the community that attaches to your location. When you pay a land-value tax you are simply compensating the community for the value they are giving you. In fact, it’s more of a charge than the tax. You get something, you pay for it. Seems fair enough which is probably why it won’t be considered.

    • Ian Tompkins

      This, is an incredible idea related to what you stated. STOP valuing land + improvements, and just value the land itself, forcing people to invest in improvements collectively. Land value would increase as improvements in the region increased, instead of as the specific improvements on that particular plot increased.

  • Peter van den Engel

    First point is I don’t see the connection between consumption tax and as a result higher savings. When consumption costs you more, obviously there is less money to save/ unless you consider taxes saving (money collecting) for government. But we don’t consider investment as saving, so that’s the wrong word for the purpose if that’s the case. The article is somewhat confusing in retrorespect.

    Obviously higher consumption tax means less consumption, so the suggestion that the same amount would go to government employees spending more is a wrong equation. It will be less/ and commercial labor will be less, resulting in lower income tax revenues for government.
    Above all consumption tax would in comparison hit lower incomes harder than higher, because their margin is smaller.
    When there is, or you set an average consumption level, any incomes above that could be taxed higher without hurting the broader economy.

  • Derryl Hermanutz

    Exactly. Consumer money-spending “is” producer money-earning (sales revenues, rents, service fees). And business investment of money in the money costs of production “is” workers’ and suppliers’ money-earning (earned incomes, contract earnings, etc).

    On party’s money-spending becomes the other party’s money-earning. If consumer money-spending is reduced, producer money-earning is equally reduced. If producer money-investing is reduced, worker/supplier-cum-consumer money-earning is equally reduced.

    When businesses cannot sell the stuff they produce — because consumers are not spending money buying the stuff; producers stop investing their money paying workers and suppliers who contribute to producing more stuff the businesses can’t sell. Which reduces worker/supplier spendable earned incomes, which further reduces producer sales revenues, which further reduces producer investment, in the familiar downward spiral into financial-cum-economic Depression.

    Buy-sell, spend-earn, invest-earn — are binary (2 sided) money transactions. “Financial” transactions.

    Businesses do not produce stuff to “trade” with other producers. Businesses produce stuff to “sell” to consumers, for money.

    Producing stuff does not produce any money.

    The economic production system that produces all the stuff that is “for sale”; and the monetary system (almost exclusively commercial banks making “loans” of bank deposits) that creates all the money: are 2 separate and different “kinds” of systems.

    One system produces food and builds houses and manufactures iPads.

    The other system creates spendable numbers with a $ sign in front of them.

    Spending the $numbers puts the “real” productive economy to work, to earn the money that is being paid.

    The productive economy produces real economic wealth that is bought-sold for money in the financial economy. The financial economy is the monetary system that creates and allocates the money. Commercial banks create and allocate the money, by “making loans” with private sector debtors and by “purchasing bonds” from government debtors.

    The money-using people, businesses and governments issue interest-bearing debts and sell them to commercial banks, who create new bank deposits (spendable bank deposit account balances) to “pay for” the banks’ purchases of the debtors’ new interest-bearing debts, which are the banks’ new interest-earning assets.

    Mainstream (neoclassical) macroeconomics does not distinguish between the financial economy (the monetary system that creates the money; and the buy-sell, spend-earn, payer-payee financial economy that uses the money); and the productive economy.

    As productive enterprises, businesses add value to inputs and produce outputs that are “worth more” than the sum of the values of the inputs. Businesses are value-adding productive enterprises.

    As financial enterprises businesses invest money as their costs then earn money as their sales revenues (and rents, service fees). To earn money profit, businesses have to earn more money “out” of the economy’s spend-earn stream in sales revenues, than businesses added “into” the spend-earn stream as their costs. As for-profit financial enterprises, businesses have to subtract more money out of the economy, than they invest into the economy.

    Which means workers/suppliers — the earners of businesses’ cost money — have to spend more money buying stuff from businesses, than they earned by being paid by businesses for contributing to production.

    How can people as money-spending consumers, consistently spend more money than they earn as income-earning contributors to production?

    Debt.

    A constant, never-ending increase in total private sector loan account debt and government bond debt. Commercial banks create the new money (bank deposits) to buy the new debts. Debtors spend the additional new money into the economy’s spend-earn stream, which enables businesses to sell their outputs at money-profitable prices.

  • Patrick cardiff

    No, this one is missing the point entirely.
    If some forms of home maintenance are not being put in the right column, that’s not Economics; it’s Accounting. Economics is what happens stochastically, not what number is deterministically placed into which bin. The comparison of Economics with Accounting is a huge problem wrt interpretation – and Mr. Roth is correct in mentioning that the GDP is much more associated with the latter than it should be, respecting the science, testing, and error-filled aspects of human behavior.
    When you go to the IRS with your completed 1040, they do not expect “an estimate” of taxes you owe.

  • Overt

    Ugh, the whole beginning of this article seems to be one large straw man. No consumptive tax that I have seen out there assumes a family sitting down at the end of the year to calculate how much they have consumed. Instead they use some mechanism of a Sales Tax. And if sales taxes were so gosh darn hard to account, how in the world have 40+ states of the Union managed it for the better part of a century?

    The rest seems to be a bunch of unfounded speculation. For example, we may discourage Private Education by taxing tuition. Are we sure about that? What if a person’s take home pay is higher due to the elimination of their income taxes? And, for that matter, who says that a Consumptive Tax has to be flat across the board? Consumptive taxes have just the same opportunity for graft and carveouts to special interests (or more charitably, “critical needs”) as any other tax out there.

    Frankly, the article seems to be a lot of attempts at gotchas that any person familiar with consumptive taxes has heard and disposed of dozens of times before. Rather, it seems more of an article meant to give talking points to people who have done no real research on the subject but innately “feel” like consumptive taxes are a bad idea.

  • Brux

    I suppose there are some good points here, but the format of Evonomics is such that it does not energetically and enthusiastically hit on its major notes to education and activate people like is should due to speculative and confusing articles that provoke thought and argument, but detract from the main Evonomics points that I have heard and think are important. This is something the right-wing websites would never do.

  • Brux

    Stop treating everyone like a special case and treat everyone by class. That is when you make exceptions for black people, whether they are poverty stricken and live in the inner city or they are super-rich and successful entrepreneurs you provoke confusion, jealousy and racism. One law based on class to buoy up the desperate to help them stop dying – because that is what is happening now.

    The problem I think is that when you guarantee a life that is safe, then people reproduce to fit the perceived world, not the real world where for whatever reason and for good or bad people die when they do not have sufficient resources or freedom.

    I think what Liberal economics is missing is some way to modify people’s reproductive behavior because at the bottom of things the population is the point and it needs to be controlled.