A Twist on the Consumption Tax Gains Traction

You’ve probably never heard of the X tax. Chances are, you will.

As President Bush’s tax reform commission moves toward a Nov. 1 deadline for recommending alternatives to the current tax system, it is considering a greater role for consumption taxes.

Consumption taxes are generally levied not on what people earn but on what they purchase or consume in other ways. In particular, they leave savings, or the money earned from savings, untaxed. Examples are sales taxes and excise taxes -- and the X tax, a proposal by a Princeton University economist that has not been enacted anywhere.

To the taxpayer, the proposed X tax might look a lot like an income tax with a blanket deduction for dividend and interest income, capital gains and other income from investments.

It is one of many options the commission is weighing.

The commission’s report could put consumption taxes at the center of a new national debate, as Bush is hoping that the panel will lay the groundwork for a major effort to change the tax code.

Bush has said a reconstructed tax code should be simple and progressive -- that is, wealthier people should pay higher tax rates than lowerincome people. Bush has also said that the tax system must promote economic growth.

And he has said the new system must raise as much money as the present system -- a particular challenge because most members of the panel seem to support abolishing the alternative minimum tax. That tax was initially aimed at the wealthiest taxpayers, but in recent years it has raised the annual bill for an increasing number of middle-class taxpayers. Eliminating it would cost the government $1.2 trillion over the next 10 years.

Some commission members say a consumption tax could be structured to meet all of Bush’s criteria. “We’re not pursuing a consumption tax to plug a revenue gap,” said former Republican Sen. Connie Mack of Florida, chairman of the commission, known formally as the President’s Advisory Panel on Federal Tax Reform. “We’re pursuing it because it arguably creates a superior economic climate.”

By shifting more heavily to taxes that people pay when they buy things, a consumption tax would encourage people to save, some economists say. And that, in turn, would spur investment and encourage economic growth, they say.

Not all panelists are convinced. Liz Ann Sonders, chief investment strategist for Charles Schwab Corp., said Congress had enacted 20 tax breaks for savings in the last 30 years -- and the public’s collective savings rate had fallen from 10% to close to zero.

In addition to predicting that a consumption tax would bolster economic growth, supporters say it could also meet the commission’s mandate that a new tax system be simple.

The simplest form of consumption tax is a sales tax, such as the 7.25% tax levied in California on all consumer purchases except food and drugs. Rep. John Linder (R-Ga.) has introduced legislation to replace the income tax with a national sales tax.

Many commission members, however, do not favor a national sales tax. Former Sen. John B. Breaux (D-La.), its vice chairman, said the tax would land disproportionately on the poor.

But consumption taxes come in other forms. One is the value-added tax -- known as VAT -- popular in Europe.

Like a sales tax, the VAT is a consumption tax on goods and services. The difference is that the tax is determined by calculating what each business involved in creating a product adds to its value. If a company buys raw material -- say, a piece of untreated wood -- for $20, and then turns it into a chair and sells it to a retailer for $30, it pays the VAT on its $10 contribution.

In the end, the consumer pays the accumulated VAT taxes when buying the product, reimbursing the businesses.

It is harder for businesses to cheat on a VAT than a sales tax. But the VAT has many of the same drawbacks, including the fact that it tends to hit lowerincome people harder than wealthier ones.

Unlike sales taxes and the VAT, the X tax could be imposed at escalating rates, making it more progressive. The concept is the work of Princeton University economist David Bradford, who died last year.

Bradford proposed two rates, one for income below an unspecified annual amount and a higher one for income above the cutoff. He wrote last year that an X tax could generate as much revenue as does the current income tax system, while keeping the maximum tax rate on individuals at less than 30%. Business profits would be taxed at a single rate, equal to the top rate on individuals.

Abolishing the income tax in favor of a consumption tax is a “political nonstarter,” John Podesta, president of the Center for American Progress and White House chief of staff in the Clinton administration, told the president’s tax reform panel.

It seems more likely that the panel, which intends to recommend several alternatives to the current system, will include the option of supplementing the income tax with a consumption tax.

The panel’s work will go first to Treasury Secretary John W. Snow, who in turn will make recommendations to the White House. The president would then decide whether to propose legislation to Congress.

“I hope there is a real opportunity to overhaul the tax code over the next year or two,” said panel member Elizabeth Garrett, a USC law professor. “The president has said it’s a high priority for him, and it is for Congress too. Every tax bill since the 1986 reform has made the system more complicated and less fair, and it’s time to turn that around.”

Leonard Burman, a tax specialist with the Urban Institute, said things might not happen that quickly. The 1986 tax reform, he said, grew out of a 1976 report.

“Even if the panel’s report doesn’t lead to speedy tax reform,” he said, “it could set the tone for tax reform down the road.”