Learning to love consumption taxes

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06/05/2004

Learning to love consumption taxes

[Updated -- see below]

A few years ago, I worked with someone who viewed his mission in life as being to bring the enlightenment of a European-style Value-Added-Tax (VAT) to these shores. Every time he would launch into an explanation of just how rational and efficient it would be for the retailer to rebate the tax to the wholesaler and the wholesaler would rebate back to the distributor and the distributor back to the manufacturer, and then the consumer would collect a rebate based on income so the system could be made progressive, blah blah -- I would wince. It just seemed utterly technocratic and unrealistic, something only a management consultant could love. And taxing consumption always seemed inherently regressive, since poorer people need to consume more, if not all, of their income.

I've always been interested in large-scale tax reform, but with an old-fashioned moderate purism: my ideal would be a reasonably progressive tax on all income -- because income is the best measure of ability to pay -- on the broadest base (that is, all income included), with relatively low marginal and average rates. And I've been particularly wary of certain kinds of limited consumption taxes, like cigarette taxes or the "capuccino tax" that people I know sought to pass in Seattle last year. I understand the aphorism that "if you want more of something, tax it less and if you want less of something, tax it more," but I worry about making revenues and services dependent on things we want less of. For example, I have no doubt that the heavy taxation of tobacco, in combination with other policies and a general cultural shift, will mean that within five years, cigarettes will be virtually nonexistent in the U.S, outside of high school parking lots. Which will be a good thing, except it will cause a severe fiscal crisis in states that are either heavily dependent on tobacco taxes or have already borrowed against the revenues they expect to receive from the tobacco settlement. In the meantime, the burden of government will fall more and more on a shrinking number of deeply addicted individuals.

But I've started to rethink my attitude.

This op-ed by Ted Halstead and Maya MacGuineas of the New America Foundation makes a good case that the payroll tax, at least, should be replaced by a progressive tax on consumption, calculated not through the complex transaction-by-transaction method of a VAT, but simply by taking income, subtracting the first $25,000, subtracting total savings, and taxing the rest.

In the only comment I've seen on this,Matthew Yglesias commented that, before one could evaluate such a proposal, you would have to know what the rates were. The rates are certainly not irrelevant details, but in this case, Halstead and MacGuineas are talking about a replacement for the payroll tax. You really don't need much more information in order to compare it to the payroll tax. With the exception of tax rates that are explicitly and steeply regressive, just about any system would be fairer than a flat tax on the first dollar of income through $88,000, applied only to income from labor. Whatever the rate, if the first $25,000 of income, plus any savings, were tax-free, it would result in a gain worth $4,000-$4,500 to a worker earning in that $25,000-$30,000 range, exactly the group that has gained almost nothing over the last 25 years. (I'm assuming that the employers' share of the tax would be passed on to the worker in some form of wages or benefits.) That's not trivial; in fact, $4,500 makes all the innovations of the last decade, such as the child tax credit, look trivial. For a full time worker, $4,500 would be the equivalent of a $2 an hour raise!.

[UPDATE: I must not have been paying attention the last week of May. Everyone I reliably read commented on this proposal: Kevin Drum, Max Sawicky, and also some good comments at Paperwight. Max also pointed to a very thorough academic paper by Daniel Shaviro, which I should have read before posting. I don't understand Max's claim that the payroll tax is progressive. There are more regressive taxes, I suppose, but one with no zero bracket at the bottom, a flat rate, a ceiling, and applied only to labor doesn't seem to merit being called progressive. I'll conced that, inclusive of benefits, the payroll tax-Medicare/Social Security package is slightly progressive, but as I'll discuss below, it's not all that redistributive and that may be the key to its political staying power. Kevin Drum's comment is that the whole idea is politically unrealistic. I've got more to say on that below, but in short, there are times when the smartest political tactic of all is to put forward the most complete alternative, rather than to fight around the margins of the current debate, and I'm convinced this is such a time.)

(Incidentally, MacGuineas's lengthier statement of the case for replacing the payroll tax with a consumption tax in the book The Real State of the Union does give some rates, purely as an example: 10% on all non-saved income between $25,000 and $100,000, and 15% above $100,000. I don't know whether these numbers have been run through the appropriate models to estimate whether they would raise enough revenue to replace the payroll tax, or even if models used by, for example, the Tax Policy Center are able to estimate all the impacts, including the likely shift from consumption to savings.)

Of course, we still need the revenues for Medicare and Social Security -- and more than the payroll tax was bringing in, to put them on better financial footing -- so lifting the payroll tax burden from the working near-poor would have to mean a shift to the better-off. I have argued against proposals to remove the ceiling on the payroll tax entirely, because it would undermine one of the political strengths of Social Security, which is that it is basically a good deal for everyone, and create for the first time a class of people who would pay much more into Social Security than they get out. This would be the case with a consumption tax as well. But, in general, the political calculus around consumption taxes might be easier to manage, because the tax is in a sense, optional and unpredictable. It can be avoided by saving and investing. And since consumption presumably levels off at higher incomes anyway, there is an inherent limiting effect, which there would not be if the ceiling on income were lifted entirely.

But there are three other reasons that a consumption tax is suddenly more appealing to me:

1. It could capture income from investments. The payroll tax is regressive not just because it is flat and then drops off at higher incomes, but because it applies only to income from labor. Simultaneously, the trend in the tax system under Bush is to get more and more income from investment out of the tax code entirely. That's the effect of Health Savings Accounts, or Roth IRAs (which some House Republicans are pushing to expand), of the special rates on dividend and capital gains, and of the "Opportunity Society" savings vehicles that Bush intended to push this year but has held back. These tax breaks don't so much create incentives to invest as simply make income from existing investment tax-free. It's as a result of these special provisions that Warren Buffett could find himself in the 15% tax bracket, while his secretary pays twice that rate.

Under a consumption tax, income that people took from investment and did not add back to savings would be taxed just like income from work. That would be a huge breakthrough. And at the same time, there would be an incentive to save and invest -- probably a much greater incentive than through gimmicks like Roth IRAs and tax-free dividends, because it would actually be an incentive to invest, not just an incentive to collect income from investments.

2. A consumption tax for Social Security and Medicare might act as a subtle means test on those programs. Presumably seniors who earn enough to consume more than $25,000 a year would also pay some tax. This would help recapture some of the benefits for those who don't really need them, without an elaborate means-testing structure.

3. The more radical the change the better, as far as I'm concerned. Even if the consumption tax offered no advantages compared to the current tax code, it would at least restart the debate on a totally fresh basis. If we spend the next four years fighting about income tax rates and how much of the Bush tax cuts to repeal and how much to keep, the victories will be modest and compromised, if there are any victories at all. That's the debate the nihilistic Right wants to have; the only way to restore the revenues needed to make government work is to sidestep that debate entirely.

Once such a consumption tax is in place, it could be scaled up or down as needed. It could replace part of the income tax, or it could be expanded to provide additional funding for a system of private accounts that would match savings, scaled to income, as an addition to Social Security rather than a replacement.

There are plenty of details about such a tax that do need answers, though:

-- How would housing costs be treated? The home is the principal savings and investment vehicle for most families. Would mortgage payments be treated as savings? Or just the principal portion? How much revenue would be left behind if they were? How much further would that skew the burden against renters, especially if the income tax and the mortgage interest deduction remained?

-- What about borrowing for current consumption? Would the proceeds of a second mortgage be treated as non-saved income?

-- And finally, I just need an economics lesson: What would be the economic impact of so heavily taxing consumption? I know that the savings rate is too low, and that we are financing current consumption by borrowing from abroad, but isn't current consumption helping to drive the economy also? Wasn't excess savings the problem Keynes was trying to solve? Isn't it easy to swing too far in the other direction?

Posted by Mark Schmitt on 06/05/2004 at 09:06 AM in Decembrist archives | Permalink

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Max Sawicky, a lefty economist with the Economic Policy Institute, has a blog post on this subject you might find interesting:

http://maxspeak.org/mt/archives/000506.html

Posted by: Ed Viguerie | 06/08/2004 at 02:42 PM

To me, it seems this consumption tax is really just the income tax, with IRA status granted to all savings account.

So I say: drop the payroll tax entirely. Scale up the income tax to compensate (if you wish, raise the bottom tax rate, but not all the way up to 15.3%). Then, if you want to convert the income tax to a consumption tax, do that by granting IRA status to more and more kinds of investments. In other words, no need to create a whole bunch of new law for this, we already have what we need.

Or, if you're worried that dissolving the payroll tax will eliminate the social security trust fund, and if you don't want that to happen, then do this: redefine payroll tax as a constant multiple of income tax.

Posted by: Josh Yelon | 06/08/2004 at 02:55 PM

Actually, though I'm not much read, I commented on this as well, some actually in line with what you write. My thoughts are here:

http://fairshot.typepad.com/fairshot/2004/05/useful_conversa.html

Posted by: paperwight | 06/08/2004 at 04:08 PM

So did Drum, BTW:

http://www.washingtonmonthly.com/archives/individual/2004_05/004002.php

Posted by: paperwight | 06/08/2004 at 04:09 PM

I welcome the new ideas on taxes because they open up discussions that simply can't be had in the present tax cut debacle. How much do we care about fairness and progressivity? To what extent are we poorly served because the current tax system is too easy to demonize and discredits democratic government? Why do different behaviors and sources of income get treated differently? I know that this is the bread and butter of tax specialists, but it would be useful to have a broader discussion of some of these issues.

Posted by: Michael Lipsky | 06/08/2004 at 07:37 PM

Josh Yelon is right that a consumption tax is quite similar to an income tax with tax-exempt saving, with one key exception. When a consumption tax is instituted, retirees are hit hard- they paid tax on returns to saving all along, and then they have to pay again when they consume in retirement. That hit to the elderly is actually where most of the "supply side" effect of moving to a consumption tax comes from- the elderly reduce consumption because they have no other choice (except for those who can reduce bequests), and therefore national saving and investment increase. Understandably, advocates of a consumption tax don't tend to make a big deal of this fact.

Posted by: Ben Page | 06/08/2004 at 10:15 PM

Ben - tricky.. hmm.

Probably the thing to do is to let people record which, of their investments, they already had at the time the new tax was implemented. All of those investments would be subject to capital gains tax on withdrawal. Any new money they invest from that day forward would be tax-deferred, which would mean that it would be taxed as income on withdrawal.

Posted by: Josh Yelon | 06/09/2004 at 12:19 AM

Josh nailed it. If you can make current savings go away (which he explains how to do) the increased incentive to save takes care of seniors once they begin to live off retirement income. The only problem I see is that the amount of money you need to save to maintain the same standard of living as before the consumption tax has suddenly jumped and not everyone might appreciate that...

Posted by: samiam | 06/09/2004 at 11:22 PM

I not sure I understand why income is seen as the best indicator of ability to pay. Isn't net worth a better indicator? Surely someone like Bush, who inhereted or was given so much money has a greater ability to pay than someone who started from nothing but now has a seven figure income.

Posted by: Paul C | 06/11/2004 at 01:36 PM

Nice try, but a reform like this wouldn’t work for the simple reason that it is not simple enough – no one would have any idea what it’s actually about, least of all the people it is meant to benefit.

More to the point, this is exactly the kind of opacity that here in Europe leads to such rampant and gleeful non-compliance across the income spectrum, cheating that makes everyone co-conspirators in a system that inevitably disenfranchises those at or near the bottom.

Posted by: Erik D | 06/16/2004 at 04:45 AM

right Eric, how to tax the informal earners, which is large in the US.

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06/05/2004