Greenspan Sees the Value of Taxing Personal Consumption Over Income

Federal Reserve Chairman Alan Greenspan on Thursday nudged President Bush’s tax reform panel in the direction of relying more on taxing personal consumption and less on taxing income, saying it would encourage people to save and invest more of their money.

He argued that increased savings would create assets that could be used for investment in the nation’s economy.

“Many economists believe that a consumption tax would be best from the perspective of promoting economic growth, particularly if one were designing a tax system from scratch, because a consumption tax is likely to encourage saving and capital formation,” he told the panel.

Greenspan did not propose throwing out the income tax in favor of a consumption tax, nor did he oppose it.

But he seemed to lean toward a mixed system, favored by many European countries, in which income and consumption were taxed.

The advantage of a consumption tax -- a sales tax is one example -- is that it does not tax income that is saved and invested, Greenspan said.

“I believe that, as the baby boom generation begins to retire in a few years, it will become increasingly important for the nation to boost resources” by promoting savings and partici- pation in the labor force, he said.

“The tax system has the potential to contribute importantly to those goals, and, at a minimum, tax reform should not hinder the achievement of those objectives,” he said.

Greenspan was the leadoff witness in the second hearing of the President’s Advisory Panel on Federal Tax Reform. Bush has said that simplifying the tax code is his No. 2 domestic priority for his second term, after overhauling the Social Security system.

Bush has given his advisory panel until July 31 to offer multiple options to Treasury Secretary John W. Snow, and Snow has until the end of the year to send a recommendation to the president.

Following Greenspan was James A. Baker III, who was President Reagan’s Treasury secretary in 1986, when Congress last simplified the tax code. The 1986 revisions, Baker said, reduced the number of tax brackets from 14 to two, eliminated scores of tax breaks and slashed the top personal tax rate from 50% to 28%.

“Regrettably,” Baker said via closed-circuit television from his office at Rice University in Houston, “this sweeping reform proved transitory, as subsequent decades saw marginal rates raised and some deductions and loopholes restored.”

He warned that the same special interests responsible for coaxing Congress into reviving tax breaks after 1986 would “bedevil the process every step of the way” as the panel sought to simplify the tax code.

Greenspan noted with approval that the U.S. was already drifting toward a consumption tax by giving favorable tax treatment to money saved, as opposed to money spent. Capital gains and dividends are taxed at a maximum rate of 15%.

Responding to Democrats’ assertions that a consumption tax would more severely affect lower-income people, since a larger share of their income goes for such items as food, clothing and medication, Greenspan suggested that certain items “disproportionately consumed in the lower brackets” could be excluded from taxation, although he offered no specifics.

In most states with sales tax, food items and prescription drugs are exempt.

Under questioning by panelists, the Fed chairman conceded that switching to a consumption tax would have little effect on the U.S. trade deficit.

“The mere existence of savings doesn’t create the investment,” he said.

Greenspan praised the 1986 tax reform legislation, which he said was “widely regarded as having been the most successful in the postwar era.”

“A defining feature of the 1986 reform was the broadening of the tax base and the lowering of rates, and it is widely believed that these changes enhanced economic efficiency,” Greenspan said. “However, since that exemplary reform, the tax code has drifted back to be overly complicated and burdened by higher marginal rates and by many special provisions that have undesirably narrowed the tax base.”

The tax code has become so complicated, he said, that taxpayers have difficulty determining their marginal tax rate -- the rate paid on their last dollar of income earned.