Designing a national consumption tax

By Felix Salmon
August 17, 2011

The US government, when it taxes individuals, taxes only what they earn, and not what they spend; this is one big reason why we have a gaping budget deficit. Every other developed country in the world has some kind of consumption tax, as indeed do many US cities and states. If the US is serious about getting its fiscal house in order, a consumption tax of some description is likely to be necessary.

Bloomberg has come out in favor of a value-added tax of the kind familiar to those of us from Europe. It’s a tried-and-tested solution, and it’s superior in just about every way imaginable to the flat sales taxes that Americans are used to right now. It’s spread along the supply chain instead of being back-loaded at retailers; it is much more adaptable to an economy based on services rather than goods; and it easily captures online activity from places like Amazon.com which current sales tax regimes find hard to deal with.

There would also be a reduction of tax-collecting bureaucracy: rather than having to operate their own sales-tax regimes, states and cities could simply use the national one instead.

Any sales tax, of course, is regressive, and would therefore need to be combined with some kind of income-tax credit. But if you take that as a given, then there are real advantages to consumption taxes: for one thing, they provide an incentive to save and invest rather than to spend. That might be bad for the economy in the short term, but it’s good in the long term: we need to get our national savings rate up. And there could even be a short-term benefit, as Bloomberg points out:

The time needed to implement a VAT — as much as two years — could even provide a much-needed economic stimulus. If people knew the tax was coming, they would probably make big purchases now.

Count me in with the idea of a national consumption tax, then. But there are other ways of implementing such a thing, and it’s also worth resuscitating the progressive consumption tax idea that Robert Frank laid out very clearly in 2007.

Under such a tax, people would report not only their income but also their annual savings, as many already do under 401(k) plans and other retirement accounts. A family’s annual consumption is simply the difference between its income and its annual savings. That amount, minus a standard deduction — say, $30,000 for a family of four — would be the family’s taxable consumption. Rates would start low, like 10 percent. A family that earned $50,000 and saved $5,000 would thus have taxable consumption of $15,000. It would pay only $1,500 in tax. Under the current system of federal income taxes, this family would pay about $3,000 a year.

As taxable consumption rises, the tax rate on additional consumption would also rise. With a progressive income tax, marginal tax rates cannot rise beyond a certain threshold without threatening incentives to save and invest. Under a progressive consumption tax, however, higher marginal tax rates actually strengthen those incentives.

Frank laid out his tax as an alternative to the income tax; my feeling is that given how-do-we-get-there-from-here problems and also diversification benefits, it’s worth keeping them both at some level. We should keep the income tax, at a lower level than it is now, and increase Frank’s standard deduction to say $40,000 a year. Anybody spending less than that pays no consumption tax at all, while consumption of hundreds of thousands of dollars a year could be taxed at say 20% and consumption in the millions could be taxed at a higher rate still.

All of this could conceivably be done in a revenue-neutral way, with income taxes falling to make up for the new consumption taxes. But that would defeat a large part of the purpose, which is to get US incomes and expenditures roughly in line with each other. Up until now, the federal government has essentially been taxing with one arm tied behind its back. If we want to get serious about the deficit, then it’s time to free up as many new sources of tax revenue as we can find — including such things as a carbon tax, a wealth tax, a financial-transactions tax, and, yes, a consumption tax.

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