Consumption taxes: a view of future tax reform in America.by Fellows, James A.
Income taxes don't encourage savings; consumption taxes do. A discussion of the merits of consumption taxes and how they might be computed shows there are more possibilities than may be expected.
Judging from the political rhetoric, it is highly probable that some form of Federal tax on consumer expenditures, i.e., consumption, is not far from legislative enactment. President Clinton has broached the idea more than once, and several members of Congress have suggested a consumption tax should become law. The discussion of these taxes has progressed from the academic arena, where these issues were first suggested, to the political area, where the issues may be debated as a matter of national policy.
Unfortunately, the general public is not well educated on the concept of consumption taxes at the Federal level. Most Americans pay some form of local or state sales tax on retail purchases, but their only contact with direct taxation from the Federal government is principally through income taxation.
Moreover, there is more than one type of consumption tax, and they often take on obscure names such as VAT (value-added tax).
The Income Tax and Taxation of Savings
Regardless of the consumption tax employed, economists generally agree it is preferable to an income tax in one important context. An income tax imposes a tax on savings when earned. A consumption tax taxes income when spent. Therefore, if a consumption tax replaces in whole or in part an income tax, more savings in the economy would be encouraged.
As an example of how the current income tax is biased against savings, consider two individuals, X and Y, and a two-year period in which any income not spent in Year one is saved and then spent in Year two. Both individuals earn the same amount of yearly income, $10,000, all of which is taxable. Individual X, however, manages to save $2,000 per year of her after-tax income, placing it in a savings account, which cams a before-tax interest rate of five percent. Individual Y does not save any of his after-tax income, spending all of it on consumer purchases.
Assuming a flat tax rate of 20%, both X and Y pay an income tax in Year one of $2,000, leaving them both with after-tax incomes of $8,000. Of this amount, X places $2,000 in her savings account to earn five percent before tax. This savings, plus the accrued interest of $100, will be spent by X in Year two. Individual Y does not save anything, but rather spends the entire after-tax amount of $8,000.
Table 1 depicts this two-year process. In Year two, X has taxable income of $10,100, after adding the accrued interest. Her income taxes are $2,020, yielding an after-tax amount of $8,080. Y has the same situation as in Year one.
On the surface, the higher tax to X might seem fair. Some would argue X is being unfairly taxed just because she made the decision to be more thrifty than Y. This second conclusion receives additional support when the present value of the tax liabilities of X and Y are considered. Assuming a discount factor of five percent, the present value of the two tax liabilities for X and Y are as follows:
X: $2,000 + $2,020/(1.05) = $3924 Y: $2,000 + $2,000/(1.05) = $3905
Thus, even in present value terms. X is suffering higher taxes simply because she chose to allocate some of her present disposable income from consumption to savings. It is the "distortion" between present and future spending that causes many economists to argue the present method of income taxation of interest and dividends discourages savings, and therefore reduces the nation's future capital stock. This reduction in our capital stock then causes our growth rate of national income to be smaller than otherwise.
There is certainly no question that the U.S., compared to other industrial democracies, has a relatively low savings rate. For example, during the 1980s, savings in the U.S., including those of households and businesses, were less than 15% of GNP, while that for Japan was over 30%. Moreover, there may be more than a coincidence between this relative low savings rate and the fact the U.S. also relies more heavily than other nations on the income tax relative to consumption taxes.
The Advantages of the Consumption Tax
A consumption tax that yields equal revenue would be superior to the income tax, at least as far as encouraging national savings. Refer to the scenario in Table 1 again, but now assume the flat rate income tax of 20% is replaced with a flat-rate consumption tax of 20%. Individual X still saves $2,000 in Year one, but this amount comes from pre-tax income, since income per se is no longer taxed. More to the point, income escapes taxation until it is spent. As shown in Table 2, X would pay a tax of only $1,600 in Year one, while Y would pay a tax of $2,000. The tax liability- for X in Year two is $2,420, while that for Y remains at $2,000. Total taxes paid over the two years, and thus after-tax income, are the same for both X and Y, as in Table One, i.e., $4,020 and $16,080 respectively for X and $4,000 and $16,000 respectively for Y.
Although X pays more of a total tax, as was the case depicted in Table 1, in terms of the present value of her tax liability, it is the same as that of Y, as shown below.
Present Value of Tax for X: $1,600 + $2,420/(1.05) = $3,905
Present Value of Tax for Y: $2,000 + $2,000/(1.05) = $3,905
By taxing income only when it is spent, a consumption tax is more economically efficient than an income tax. Regardless of the choice made between current spending and saving, the present value of the tax liability should be the same. Since there is no bias against savings, theory would predict the national savings rate should increase.
Arguments Against Consumption Taxes: The Problem of Regressivity
Those who criticize consumption-based taxation usually do so on the theory these taxes are regressive in nature, i.e., consumption-based taxes are felt to be more burdensome on the poor than on any other economic group. The reasoning is the poor spend most all of their income. In many instances, through borrowing or drawing down past savings, they may even spend more than their current income. A consumption-based tax would unfairly penalize the poor because their entire income, and perhaps even more, would be subject to the tax. On the other hand, higher income groups would not have all of their income taxed under a consumption-based tax. This tax would not reach the income of these latter groups that is saved or invested.
As a result, people with higher levels of income would pay a lower percentage of their income in taxes. This lower percentage is what is generally viewed as the regressivity in the tax structure of consumption-based taxes. Consumption taxes do not include "vertical equity," which mandates that those with larger incomes pay a larger portion of their incomes in taxes than those in lower income groups. Because of this regressivity, consumption-based taxes on the national level will be hard to implement for political reasons.
Meeting the Critics: A Progressive Consumption Tax
If the period of analysis is restricted to a single year rather than a person's lifetime, this criticism of consumption-based taxes is mathematically correct. Economic studies have confirmed that as income rises, the percentage that is saved increases. A flat-rate consumption tax would indeed be mathematically regressive, but this is because government agencies have chosen to collect these taxes from the seller of the commodity being taxed. Since there is literally no way for the seller to know the income of the buyer, there is no way for the seller to collect a different rate of tax on one buyer as opposed to another. In other words, the regressivity of existing consumption taxes, both the sales tax at state levels, and the VAT in Canada and Europe, are due to the manner of its enforcement.
The regressivity in the tax can be easily eliminated by altering the means of its enforcement. Instead of collecting the tax from the seller of a commodity, it can be collected from individuals, who would file a "consumption tax return." There are many ways this could be done, but a start could be adjusted gross income (AGI) from the taxpayer's 1040, with a deduction from AGI for the net amount of funds placed in savings or invested in stocks and bonds for the year. The difference would be the consumption-tax base and could be subject to progressive rates. Furthermore, there could be an allowance, i.e., a standard deduction. This amount would allow those too poor to save to have some deduction from the consumption tax base to allow certain essentials such as food and clothing to escape the tax. Table 3 depicts a hypothetically progressive consumption tax, that conceivably could replace an income tax.
As shown in Table 3, it is not a foregone conclusion that any consumption-based tax will be mathematically regressive and thus impose an undue burden on the lower economic groups. By changing the manner of its collection, so that it becomes payable in a manner similar to income taxes, progressive rates can be instituted to bring the tax into the realm of political acceptability.
Types of Consumption Taxes
The following is a discussion of the specific types of consumption taxes.
The Expenditure Tax. There are two very broad types of consumption-based taxes. One kind, with which Americans are most familiar, is "transaction taxes," whereby a flat-rate percent is usually assessed against the value of a purchase. These types of consumption-taxes are usually collected by the seller after being added to the amount of the price charged the buyer. They are exemplified by the traditional sales taxes at the state and local level.
The second broad type of consumption-based tax is not seen in the U.S. Conceptually, it was described in Table 3. This type of consumption tax is called an "expenditure tax." It is certainly the most radical of the two types of consumption taxes, because as envisaged, it would be enacted as a replacement for the personal income tax.
The Transaction Tax. There are two broad types of transaction taxes now being debated. One is a national sales tax virtually identical to the ones levied by state and local governments. The other is a national sales tax on "value added" by a firm to the production process. Both taxes are similar in that they are assessed against the seller of a product, either at the point of sale, or at another point of production or distribution.
Transaction taxes could be implemented instead of, or in addition to, an expenditure tax. If both are implemented, they could replace the present income tax system. Rates could be set so the same amount of revenue now being collected could be maintained. As a suggestion, the expenditure tax could be a replacement of the tax on personal income, while the national sales tax, or VAT could replace the tax on corporate profits.
National Sales Tax. The implementation of a national sales tax would be the easiest of the two transaction taxes to institute. Retailers who now collect on behalf of states also could collect on behalf of the Federal government, with appropriate commissions paid the retailer. Moreover, to protect lower economic groups, and guard against regressivity, certain items like food and medicine could be exempt. In addition, to further eliminate the impact on lower economic groups, a tax credit, similar in philosophy to the earned income credit, could be granted.
The Value-Added Tax. The tax on value added by firms during the production process (known by its acronym, VAT) could take one of many different forms. Conceptually, value added is the difference between a firm's sales revenue and its purchases from other firms. The difference is equal to the market value to the product the firm adds. The value added by a firm should equal the amount the firm pays for salaries, wages, interest, rent, materials, and retained profits. Mathematically, value added should, at the end of the production and distribution process, equal the retail value of the product. Therefore, a VAT with a tax rate equal to a national retail sales tax rate should collect roughly the same amount of revenue. However, in doing so, it requires more collection points, since each firm in the production process must pay a tax, rather than just the final retailer.
There is one further difference between the VAT and a traditional sales tax. Under the latter, the tax was assessed on and collected by the seller, though in essence it is paid by consumers, who are well aware of its amount, due to its separate listing on any sales invoice. Under a VAT, as it has developed in Europe, there would be no formal listing of the VAT on the final sales invoice to retail customers as is done with the current sales tax. The seller passes along the VAT in the form of a higher price. Indeed, this is one criticism of the VAT as it is employed in Europe, i. e., because there is no separate listing of the tax on the sales invoice, the tax is "hidden" from consumers. This probably rely resents the political reality of trying to win acceptance for the VAT from the public.
Computations for the VAT
In adopting a VAT system, the Federal government would be looking at two general types, though the specifics of each type can be altered to meet the political realities that might be faced. The two systems differ in one major respect. One VAT system allows the firm to deduct from sales revenue all intermediate purchases from other firms, including capital purchases of equipment and buildings, in arriving at the VAT base.
The other method, called the invoice method, is the one most widely used Europe, and is the one that will be discussed further. It is identical to the former method, except the firm cannot deduct from sales revenue any purchases of capital equipment or buildings. All other purchases from other firms would be deducted in arriving at the VAT base. The firm simply has to maintain invoices of sales and purchases from other firms. The VAT is calculated by applying the tax rate to the total amount of sales revenue from the invoices. The firm is then allowed a credit for the VAT paid by its suppliers, which would be indicated as a separate item on the purchase invoices. A calculation of a VAT by a retailer under the invoice method is shown under the following scenario, in which there is a flat VAT rate of five percent.
Assume a retailer pays $105 for an item from a supplier. This $105 includes a $5 VAT. The retailer then imposes a 100% markup on her costs, yielding a final price of $210 to the retail customer. This $210 includes a five percent VAT, or $10. The retailer will face an initial payment of VAT to the government of $10, but will be allowed a $5 tax credit for the VAT paid by previous supplier. Thus the net VAT liability of the retailer is $5, which is five percent of the value she added to the product. Exclusive of the VAT, the retailer paid $100 for the goods from the supplier, and "added value" of $100, yielding a final retail price, net of tax, of $200.
The actual implementation of a VAT system in America could take on different variants of the invoice system. There will always be questions about which items are exempt from VAT, so as not to be too burdensome on the poor. There is also the question of what the tax rate will be. Currently in the European community, the VAT rate averages 15%. Moreover, there are different rates on different products, in an obvious effort to pass more of the burden on to higher income groups. For example, luxury items are usually taxed at a higher rate than food or clothing. Needless to say, the VAT system in Europe has not been administered without political problems. The same can be expected in the U.S.
Computing the Expenditure Tax Base
In computing an expenditure tax, a taxpayer would still have to compute gross income and subtract business deductions and add net capital gains and losses to arrive at a new concept of adjusted gross income. Thus, all the tax rules surrounding what is and what is not gross income, or what is or is not a qualifying business expense, or a capital asset, will be retained, though many may be revisited in light of a radical new approach to taxation. From this concept of AGI, the taxpayer could then deduct the net amount saved during the year, or the increase in holdings of stocks, bonds, and other investment assets during the year.
There would still be room for tax preference of certain items by simply not including them in gross income to begin with. For example, an expenditure tax could still give preference to such items as interest income on municipal bonds.
One unique feature of an expenditure tax is the treatment of capital gains. Under an expenditure tax, capital gains would not be taxed upon their sale, but only when the gains are spent. If capital gains are reinvested, they are not subject to taxation since this reinvestment would represent another form of savings.
The mere mention of capital gains brings up the whole question of whether or not capital gains should receive preferential tax treatment. There is no reason why capital gains that are spent could not be taxed at lower rates than ordinary income.
Once a taxpayer withdraws savings, or otherwise shows a net reduction in his or her financial net worth for the year, perhaps through bond or stock sales, the amount of this "dissaving" will be taxed at capital gain rates to the extent the taxpayer had "unrecaptured" capital gains in prior years. Unrecaptured means the taxpayer had capital gains in prior years that were shielded from current taxation through positive savings in those years.
A Comprehensive Example
At this point, it would be helpful to look at a more comprehensive example of an expenditure tax over a two-year period. Keep in mind differences of opinion will naturally exist as to what constitutes "saving," or whether or not certain assets are capital assets, or whether capital gains should receive preferential treatment at all. The following example is not given to present all the ramifications of what a national expenditure tax would look like. It is only done for expository reasons.
In this example, assume the taxpayer in question is single, and named Mary. She has never owned any capital assets until 1994, the first year in question. Her salary is $50,000 per year, and each year she earns taxable dividends of $10,000, and $5,000 of interest on municipal bonds. The latter is not included in gross income in arriving at the expenditure tax base.
Assume Mary acquires a capital asset in 1994 for $5,000 which is an act of saving under expenditure tax rules. She also deposits $10,000 in a bank savings account. In addition, during 1994 Mary operated a small business on the weekends as a sole proprietor, and this business generated a net loss of $2,000. Based on these facts, Mary's tax base and tax liability under the expenditure tax are as shown In Table 4.
Assume in 1995 Mary's business generates net income of $7,000. Mary also sells the capital asset for $8,000, and it qualifies for preferential long-term capital treatment. The preference for capital gains is that one-third of any capital gain is excluded from income. In this manner, only $2,000 of the $3,000 represents taxable capital gain. Moreover, assume Mary again deposits $10,000 in her savings account. In reality, it is irrelevant whether the stock sale proceeds of $8,000 are spent on consumer goods and services or used to help finance the savings deposit. Money is a fungible commodity, so all that is essential in computing the deduction for savings is to recognize $10,000 has gone into savings. The taxable amount from the stock sale of course will be two-thirds of the capital gain, or $2,000, plus the stock basis of $5,000. Remember this $5,000 was counted as a deduction in 1994. Now that the stock sale has occurred, this basis is "released" for taxation. Table 5 describes the calculation of the tax base and the tax liability for 1995.
The underlying idea behind the expenditure tax is that consumption expenditures, from whatever source, should be discouraged, thereby raising the nation's rate of savings. If certain items of income or enhancements of new worth, e.g., municipal bond interest, gifts, inheritances, life insurance proceeds, are excluded from gross income, receipts from these resources can be spent on consumption with no tax penalty. It may be necessary to broaden the tax base by including these current items of tax preference. The tax rates could thus be lowered since a broader tax base existed. This reduction in tax rates could have positive effects on economic growth as well, since individuals would be facing lower marginal rates.
There is little doubt that some form of national consumption tax is on the horizon. In all probability, we should probably expect some form of national sales tax, or VAT, before the end of this century. Its enactment will become more necessary as Federal government activity expands into the financing of national health care. The VAT has proven to be a great revenue-raiser in Europe, and the U.S. government will certainly be looking for more ways to raise revenue, not only to finance its expanding activity, but also to help lower the annual government deficit.
An expenditure tax holds much promise, not so much as a revenue raiser, but as an idea whose time has come to raise the national savings rate and foster economic growth. Its implementation could be gradual and popular, as tax legislation would be enacted that would allow more and more savings, other than traditional IRAs, 401(k), or Keogh contributions to be deducted from gross income.
James A. Fellows, PhD, CPA, is Professor of Taxation at the University of South Florida.
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