Why the United States Should Adopt a National Tax on Consumption
The drumbeat for tax changes is getting louder. Democrats and Republicans, liberals and conservatives, all have come up with their favorite nominees for tax cuts--the poor, the middle class, manufacturers, savers, investors, producers of luxury goods and so forth. In any event, interest is growing once again in revising the Internal Revenue Code.
Under the circumstances, it seems appropriate to discuss a truly fundamental change rather than debate an inconsistent array of very specific modifications of the existing federal revenue structure. The proposal suggested here is the most basic: Abandon the emphasis on taxing income and shift to a consumption tax as the primary federal revenue source.
The governments of most industrialized nations, especially in the European Community, use consumption taxes far more than the United States. While 18% of government revenue comes from taxes on consumption in the United States, the comparable figures are 26% for Germany, 29% for France and 31% for the United Kingdom.
There are several basic arguments for shifting the primary base of taxation from income to consumption. It puts the fiscal burden on what people take from society--the goods and services they consume--rather than on what they contribute by working and saving. Thus, saving is encouraged at the expense of consumption. Unlike current consumption, saving makes possible investment in future economic growth.
There are two major types of consumption taxes. One is a value-added tax (VAT), such as is customary in Western Europe. The second approach is to change the current income tax to an expenditure tax by exempting savings.
The increasingly international nature of business competition requires updating the American tax system to global realities. A governmental revenue structure based on income penalizes economic success. A consumption-based tax will encourage saving and thus investment and yield a more productive and competitive economy. True, problems will arise in setting up a new tax, just as difficulties are encountered with the changes that Congress has been enacting yearly.
Unlike selective excises, a value-added tax is comprehensive. It is paid by each enterprise in the chain of production--manufacturer, wholesaler and retailer. Duplication is avoided by taxing only the added value that the firm contributes to the goods or services it produces. Essentially, value added is the difference between a business’ sales and its purchases from other companies.
A VAT is more economically neutral than an income tax. The allocation between labor and capital does not affect the tax burden, nor does the allocation of resources across products, markets and industries. Under the VAT, there is no justification for making a wasteful expenditure just because it is “tax deductible.” Expenses and earnings are both fully included as “value added.” The VAT is also neutral between corporate and unincorporated business and between public and private enterprises.
Proponents of the VAT contend that it would help reduce our trade deficit because it is rebated on exports and imposed on imports. Economists tend to dismiss this argument on the grounds that fluctuations in exchange rates would wash out any advantage. Nevertheless, the argument has substantial political appeal.
A disadvantage of the VAT is that it is regressive. There are several ways of dealing with this issue, although they all involve complication. One is to provide a partial offset on the income tax, including a “refundable” feature for low-income people who do not earn enough to pay income taxes. In Western Europe, the regressivity of the VAT is softened by exempting certain categories of expenses--such as food and medicine--or taxing those purchases at lower rates.
Like any sales tax, a VAT is inflationary in the period in which it is introduced because, unlike the income tax, it is included in product prices. A change in monetary policy can offset the inflationary effect, although such action could slow down the economy somewhat.
Introduction of a tax based on value added would require setting up a new tax-collection system and new business record keeping. Many states likely would object on grounds that the new federal tax invades a traditional state government revenue source. However, the imposition of the federal income tax did not inhibit states and localities from subsequently using that source of government income.
An expenditure tax, in contrast, employs a “top down” approach. Rather than taxing individual purchases, an annual expenditure tax return would be filled out by each taxpayer. The existing income tax schedule could be converted for the purpose, based on the fact that income equals consumption plus savings. Taxpayers would continue reporting their yearly income but, in addition, would have to list their saving for the year--and deduct it. That new schedule would include changes in bank balances and in holdings of bonds, stocks and similar investment assets.
A tax on expenditures could be made as progressive as any income tax by adjusting the rates. Like the income tax, it could be used as part of fiscal policy to fight inflation or recession. In the longer run, it might generate more revenue--or permit rate reductions--to the extent that the added savings stimulate economic growth.
Great disagreement exists as to whether a consumption tax should replace the income tax or supplement it. Clearly, a “top down” expenditure tax would supplant the income tax. But, the value-added tax provides a range of possibilities. A VAT could be an additional revenue source or it could be used to finance new expenditures or reduce the deficit. It also has been suggested that a VAT could permit a major reduction of the Social Security tax or the corporate income tax.
