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.

27 comments

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“Any sales tax, of course, is regressive, and would therefore need to be combined with some kind of income-tax credit.”

Don’t we have enough income-tax credits already? If you leave the Bush tax cuts in place, a small VAT might be a wave to move forward from here.

Posted by TFF | Report as abusive

“there are real advantages to consumption taxes: for one thing, they provide an incentive to save and invest rather than to spend”

I agree completely, though I am a little surprised you think this given your comment yesterday that savers and investors are “just living parasitically on the labor of others”. http://reut.rs/oYz0yo

Posted by markmthomson | Report as abusive

If we have an output gap then why would we want to encourage more savings/investing/working while discourage consumption.

The world right now has a lack of consumption not a lack of savings. Granted a lot of that savings is foreign, but if we join that group then who is doing the consuming? Consumption isn’t a bad thing but the purpose of economic life. It may put us in a better relative position, but globally the world needs to encourage more consumption not less.

Also the progressivity of it would be awful as we depend on upper-income consumption for a great deal of the demand in the economy. If we instituted this the rich would just save more when we probably need them to spend more. Personally I would hugely cut back on consumption if it increased my taxes. Instead I would save more today and perhaps end up spending more later outside of the country where it wouldn’t be taxed.

Posted by sditulli | Report as abusive

The questions unaddressed here are many, but to start:

Does all spending count as consumption? What about housing — are mortgage payments and rent treated the same? What about tuition (i.e. investing in your own or your child’s human capital)? Healthcare expenses?

And if you take away those categories (or even if you leave them in) what proportion of households consumes more than $40,000 per year?

You would also have an enormous amount of pushback from states and localities that rely on sales tax for much of their funding. They are generally reluctant (for mostly good reasons) to rely on federal money so we could see a rise in property taxes or other revenue raisers.

Finally, you don’t quite clearly acknowledge here that a VAT and a Frank-style progressive consumption tax are not compatible ideas, as the VAT would be paid at each step of the supply chain without regard for the wealth of the end consumer.

All that said, I believe a time has come for a straight-up VAT in the US but don’t see the political path forward until, say, Romney is in his second term.

Posted by right | Report as abusive

“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.”

This only makes sense if you think that the US economy is not growing as quickly as it should be because of a lack of capital.

I think you are confusing two separate issues: individual households have problems with both income and capital which could be mitigated, as against the national balance between savings and investment.

Just because one way for any given US household to address this issue is to save more, it does not mean that all US households should be doing so, as a whole. It could well be that a better way to address the issue is for some households to have more savings, and some less, for an aggregate fall in savings.

Posted by DrFuManchu | Report as abusive

The consumption tax is essentially a retread of the Economist’s idea from the 80s. It’s a good idea too.

But in trying to keep the income tax as well you’re missing part of the point. We don’t want to tax income at all. We only want to tax consumption. Because taxing consumption has fewer deadweight costs than taxing incomes.

As to a VAT, yes, I see the attractions. However, my worry would be that it would be an additional tax not a replacement one. And having another 5-10% of US GDP channelled through Washington DC just doesn’t strike me as a good thing to be proposing.

Posted by TimWorstall | Report as abusive

It’s European. 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 helped solve Canada’s deficit problems too.

In other words, it’s DOA.

Posted by MaggiesFarmboy | Report as abusive

How would that work with paying off student loans? Would that count as consumption?

Posted by NMiller | Report as abusive

“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.”

No one is ever going to vote for something like that. It’s the kind of proposal that fuels the Tea Party and broadens its appeal. A VAT or national sales tax is one thing, and it could be implemented in conjunction with income tax reform to balance everything out. But what you have proposed as a “progressive” consumption tax is way too intrusive to appeal to the American people. It is as tone deaf as the idea during the Clinton administration of extending the income tax to include “imputed rent” (i.e., the difference between a family’s mortgage payment and the amount it cost to rent the same house at current market rates). That did not go anywhere, and it cost Clinton a lot of support. Your “progressive” consumption tax proposal is that kind of thing. It reminds me of the joke about a new simplified Form 1040 proposal: How much did you make? How much did you spend? Send in the difference.

If you’re going to disseminate ideas like this, you should disclose whether you’re being paid by anti-government, no-tax extremists to drum up support for their cause by making tax reform proposals seem absurdly intrusive.

Posted by Bob9999 | Report as abusive

VAT is the worst possible way to tax consumption because every company in the food chain has to do the accounting and submit documentation to pay vs. only the final sale. VAT has but one purpose, hide the cost of the tax from the consumer. This is not the way to do this. Adding more different varied taxes creates more costly compliance and more room for loopholes. Please let’s not complicate tax code with more varied taxes let’s use this time of tax debate to simplify the tax code.

Posted by Byanyothername | Report as abusive

I cannot think of a better way to completely stop contributions to “tax deferred” retirement accounts in the USA. The most horrible would be Roth IRAs. Pay tax, put the money in, take it out and pay a huge consumption tax when you spend it, and probably other taxes too. Bam Bam! The Treasury keeps 75%, you get 25%. What a deal!

People need to stop falling for these crooked, fraudulent “retirement” schemes (note the word) the Federal Government keeps cooking up. They are all cheats. They will never be trustworthy. Get your money out now and buy physical gold and bury it. Do not “register” it. You might get to keep your savings. Play the Government game and you are a fool.

Posted by txgadfly | Report as abusive

What none of these tax schemes deals with is the concept of a percentage take for the State, no matter at what “level”. They all seek to keep pushing the tax burden down the income ladder while simultaneously guaranteeing income aristocrats a monopoly on political power. We will end up where the Soviets did, with workers figuring out: “We pretend to work, and they pretend to pay us.”

Will we collapse into an aristocrat / slave society? We are already perilously close. The kind of misery being doled out to the lower half of our population has never been done in a prosperous society. It never will be. It is our future. Welcome to North Guatemala. We already have their “democracy” now the economy is coming. Learn to grow food yourself or starve.

Posted by txgadfly | Report as abusive

I had to stop reading when the author started in on a family of 4 having a $5000 savings. Both my and I are highly educated and have careers in our chosen field. We have two kids, a dog, and a mortgage. Pretty normal, typical Amercians. However, the savings I used to have has completely vanished and will probably never be what it was. The credit card bills I was once able to pay off monthly have become astronomical, and we live pretty much month to month. Extravagant lifestyle? Living over our menas? No, and maybe. The maybe comes from paying exorbitant prices for basic living necessitites- food, gas, home. To say I am able to save anything in any given month is a joke, and together, our household income is way over the $50k example the author uses.

Perhaps I’m whining too much and should forebear to read the rest of the article. But it seems to me that the author of this article has sketchy information at best, and doesn’t know what he’s talking about at all.

Posted by allotta | Report as abusive

I ran a company in Europe and VAT is the worst accounting nightmare a corporation might have. It also drains liquidity imposing to pay it at source on stock unsold merchandise. If we put up a federal VAT we will lose agility and the economy will suffer. Perhaps a unified federal sale tax with adequate distribution between fed and state, it will take away that portion of intrastate business by consumers that now escapes local sales tax.

Posted by robb1 | Report as abusive

At first glance, I like the idea of a consumption tax. Then I wonder which European governments use it and what kind of system does Greece use?

Posted by breezinthru | Report as abusive

” If the US is serious about getting its fiscal house in order, a consumption tax of some description is likely to be necessary.”

A consumption tax is a great way to slow the economy and reduce employment. Whereas a land value tax would not discourage any kind of production, actually encourages it where land is held idle in hopes of price increase.

Wikipedia’s current article about land value tax is a decent introduction to the advantages of this approach.

Posted by rentpayer | Report as abusive

Felix:

I passed your consumption tax column around to a few of my friends who care about such things. One, who ran for US Senate and who shall remain anonymous had this to say (and I agree with him):

I’m with Felix on a national consumption tax but vehemently against several of his suggestions which would produce a European style social democracy, just the thing the Europeans are trying to reverse.

Here is my list of objections to Felix’s other suggestions:

VAT? HELL NO! The VAT is a bureaucrat’s dream, a hidden tax down the supply chain through every level from source to end customer with the end customer having no idea of what’s embedded in the end price and generally no way to get at how to reduce the tax. A simple end user retail sales tax is the way to go instead.

A progressive consumption tax? Double HELL NO. This is even worse than #1 as it would encourage tax dodging and suppress consumption as if a steady consumption tax rate wouldn’t already do that. And tax systems are not supposed to be social engineering instruments. All that you spend isn’t at the license of the government to dip its beak into for ever increasing percentages. And, why create yet another system that punishes the productive with ever high tax rates based on success? Isn’t say 17% of $200,000 spent in a year by an affluent taxpayer enough more than 17% of $20,000 spent in the same year by a different, less affluent taxpayer? Why should the former pay say 30% on the higher number? A progressive VAT is Marxism plain and simple.

A VAT + the income tax? Triple HELL NO. The whole idea of a consumption tax is to simplify the way government gets needed revenue, make it transparent to the end user, and get federal bureaucrats out of our hair. The combined scheme does none of the above.

Like states, we should be aiming for an end use retail sales tax made high enough to eliminate the IRS and its vicious bureaucrats. An end use sales tax would be recognizable to most Americans (as 46 states now have one) and simple unlike the nightmare of a VAT, much less a progressive VAT.

Posted by netvet | Report as abusive

How come everybody is in favor of a consumption tax – as if consumption is somehow bad and needs to be discouraged!

How about an asset tax – see:-

http://bright-life.us/blog/2011-08-15.as set-tax.htm

This would make a perfect complement to a balanced budget amendment – the tax would go into effect when money was needed, and the threat of the tax would ensure that extreme pressure was brought to bear on politicians before a crisis occurred!

Posted by brightlife | Report as abusive

Felix,

While we definitely need tax reform, especially closing loopholes and ending tax expenditures to increase revenue, a VAT is regressive, complex, burdensome to retailers as Robb1 mentions. Anyone who’s been to Europe knows the VAT is a very unpopular hassle. And it would burden our already sluggish economy, especially the crucial retail sector.

How about a smart tax? Cut global warming while generating revenue. Endorsed by economists right (Greg Mankiw, Doug Holtz-Eakin, Arthur Laffer), center (Adele Morris) and left (Alan Blinder, Paul Krugman), a gradually rising carbon tax would encourage low carbon energy and efficiency creating jobs in those sectors while efficiently phasing out fossil fuels, dirtiest and most wasteful first.

Using carbon revenue to reduce the deficit would cut future tax burdens, while using it to cut taxes on workers now would increase effective wages, a stimulus to jobs.

Either way, a carbon tax is a two-fer! A VAT is just a downer.

- James Handley
Carbon Tax Center

Posted by Handley | Report as abusive

Felix, I say this with all due respect as a fan of yours: You ought to collect your thoughts before you write any more on tax policy. In your last couple of posts, you wrote: (1) dividends should be taxed at a higher rate than earned income “because we want to encourage people to create value by working, rather than just living parasitically on the labor of others;” (2) a consumption task would be good in the startup period because it would increase consumption; and (3) a consumption task would be good in the long run because it would encourage savings. You’re simply not making any sense.

Posted by RogerNegotiator | Report as abusive

No VAT… it is regressive.

How about these instead:

Progressive income tax to 1950s rates
Taxing capital gains as ordinary income
Tobin tax on financial transactions
Carbon Tax

Posted by upstater | Report as abusive

“Extravagant lifestyle? Living over our menas? No, and maybe. The maybe comes from paying exorbitant prices for basic living necessitites- food, gas, home.”

Your housing cost is wholly under your control (or at least it was when you purchased). If you have an above-average income, you almost certainly are not living in the cheapest available accomodations. Trade down and your savings will reappear.

Our lifestyle — with the exception of private school tuition — costs less than $40k “all in”, and that is in one of the more expensive areas of the country. Before the kids were of school age, we were saving $30k+ per year on $90k of income.

Don’t tell me you CAN’T save money on a $50k income. Be honest and admit that you don’t choose to do so.

Posted by TFF | Report as abusive

Great.

So Warren Buffett would still never pay any taxes on his billions, we’d punish consumers as if they drank too much sugar soda, and we’d push more of the tax burden to low and middle income taxpayers? And Europe is our model for all of this?

Posted by comment1 | Report as abusive

I just read this and I see two things happening. One is a massive amount of reconsilidation driving up the unemployment rate as to avoid the tax. Businesses would buy each other than pay the tax. The other issue is we pay an imbedded tax when we buy goods and services we don’t see it. The VAT tax has the same accountability issue how much of what I am paying for a transfer of a tax, and how much is the price of the good relative to that overall tax rate. I support the Fair Tax in part because the actual money for the tax appears on the bill. In an ideal world I would have the retailer have the consumer write two checks one for the tax and one for the product so the person sees how much is going for the tax. this is verbatim from mytime2vote on facebook

Posted by eschichl | Report as abusive

Without the elimination of the income tax, this is a terrible idea. Actually a VAT is still a terrible idea because it hides the actual cost from the consumer. A better solution is a straight consumption tax that happens at the Business to Consumer level and not the Business to Business level. A VAT is a politicians best friend because tax rates can be raised without the consumer knowing, a consumption tax doesn’t allow that.

Posted by Jebus | Report as abusive

People would still spend their money if we had a consumption tax. If they saved it to buy stuff in a foreign country, think about the hassle in all that. It would not be worth it because you would be taxed when you brought it back in the country. Just think how great it would be not for everyone in this country to not have to fill out income tax forms ever again. Think of all the people not reporting their income that don’t pay any taxes and all the tourists that would help us to pay down our taxes. I want to make things simple, don’t everyone want their lives simple or do we still want to live life bonded to the IRS? This in my opinion is the only way to go if we want to pull our country out of recession. As far as the other post asking what about student loans. We want to encourage paying off our debts, so students loans would not have the consumption tax. Housing should have a consumption tax because you can choose how luxurous you want to live up the American dream.

Posted by batmanjames | Report as abusive

It saddens me that Americans seem to have completely forgotten Henry George. That said I think I know why, see this, http://homepage.ntlworld.com/janusg/coe/  !index.htm (Mason Gaffney – Corruption of Economics).

Maybe the consumption tax, at least in theory, has advantages over an income tax, however it suffers from most of the same problems of definition (what is and isn’t consumption, what are and are not savings etc – a lawyers and tax accountants charter just like the present system). It also suffers from continuing to be an attempt to tax mobile individuals and ephemeral companies(unless companies are exempt in which case there is a gaping loophole). The system will be just as complex and just as big a drain on our human resource (all those tax lawyers and accountants that might otherwise do something useful) as the present one. It may provide marginally better incentives than the present system but only to the extent that it can be effectively implemented, and, as I say, I doubt that.

Americans need to remember Henry George.

As for a VAT, well if Henry is right, maybe we don’t need sales taxes at all.

Posted by androo235 | Report as abusive