Scott Sumner  

A consumption tax is a wealth tax

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When I advocate a (progressive) consumption tax to replace our current income tax system, some commenters reply that wealth provides benefits beyond consumption, such as peace of mind and security. I think that's true, but to me it seems to be an argument for making the consumption tax progressive, not switching to a tax on capital income or wealth.

It's important to keep in mind that (correctly measured) wealth is the present value of all future consumption by you, your heirs, and anyone you donate money to. If you tax all consumption at a 50% rate, then you've essentially put a one time 50% tax on wealth. Actual real world proposals for wealth taxes have something else in mind, an annual levy that implicitly taxes people at a higher rate when they spend their wealth in the future, as compared to spending their wealth today.

Here's another way of thinking about this point. Two people with identical wage income can allocate consumption over their lives in different ways (including deferring some consumption to their heirs.) When you decide to defer consumption to the future, there are both benefits and costs. The benefit is the option value of deferred consumption; it allows you to change your mind if an emergency comes up, requiring an unexpected change in plans. That's an advantage. On the other hand most of us prefer a bird in the hand to two in the bush. We are impatient. That's one reason why savers have traditionally been rewarded with interest; it's a form of compensation for saving. All of those things get factored into the market interest rate, which reflects the relative price of current and future consumption.

Now assume a 50% consumption tax. Anytime you save $100, you don't really have $100 available for emergencies, you have $50 available for after tax purchases. You are able to buy $50 worth of goods when you decide to spend the $100. That means the 50% consumption tax has cut your economic security in half, as compared to the no tax case. So it's not really correct to say that consumption taxes don't address the security and peace of mind conferred by great wealth.

On closer inspection, I find that almost all the arguments against consumption taxes are actually arguments in favor of progressive taxes. It is extremely hard for most people to think about taxes without getting drawn into the progressivity debate, even though there are many other issues such as efficiency and horizontal equity. (Horizontal equity means that two people with equal lifetime resources should pay an equal tax rate.)

For any income tax regime, there is a consumption tax regime of equal progressivity. Unfortunately that equally progressive regime will look much less progressive. This is one of the biggest barriers to tax reform. Democrats don't want a reform that looks more regressive, and to make the system look as progressive as our current system the top rates on the consumption tax would have to be too high for the GOP to stomach. Hence we don't do win-win tax reform, which would benefit both Democrats and Republicans, mostly because of cognitive illusions. Coincidently that's why we don't have sound monetary policy---cognitive illusions.

And let's not even talk about trade.

PS. This post is a sort of reply to Frances Woolley.


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CATEGORIES: Tax Reform , Taxation




COMMENTS (34 to date)
Conor writes:

I wasn't sure about this until I thought about it this way. I'm reasonably confident that it's right.

Allen earns less than Barry. They both spend all of their money as they earn it, so neither has a personal safety net benefit from wealth. Allen pays consumption tax rate 'a' and Barry pays consumption tax rate 'b.' Assume you agree a/b is a fair ratio given Barry's larger consumption.

Now bring Carl in. Carl earns as much money as Barry, but saves it for future consumption. When he consumes it, he pays tax rate 'c.' If you agree that Barry and Carl should pay the same taxes because the present value of their consumption is equal, then b = c, and a/b = a/c. Therefore, no extra tax on Carl's wealth safety net.

Jonathan writes:
Now assume a 50% consumption tax. Anytime you save $100, you don't really have $100 available for emergencies, you have $50 available for after tax purchases. You are able to buy $50 worth of goods when you decide to spend the $100. That means the 50% consumption tax has cut your economic security in half, as compared to the no tax case. So it's not really correct to say that consumption taxes don't address the security and peace of mind conferred by great wealth.

This doesn't change the argument much, but wouldn't a 50% tax on $100 mean that you have $66 2/3 available? Or do consumption taxes follow different rules?

Scott Sumner writes:

Conor, That sounds right to me.

Jonathan, It depends how taxes are defined, there is no consistent method. It varies from one tax to another.

Rajat writes:

I don't follow what you mean when you say:

...to make the system look as progressive as our current system the top rates on the consumption tax would have to be too high...
Do you mean the consumption tax would tax you on your aggregate annual consumption? If so, how would this be measured?

I have an observation and a question on your frequently-used 'two brothers' example against income tax as a form of double-taxation on income saved.

The observation is that I suspect many people have trouble with the idea that the rate of return on savings/investment is the rate at which one must discount future wealth to make it comparable to present spending. People might think that rates of return on investment (particularly certain types of investment, such as Australian residential property!) have been high in recent decades and as such represent a kind of windfall gain for savers. Obviously, this wasn't known ex ante, but I think it's why many people find the idea of not taxing returns on savings so difficult to accept.

My question is more specific. If we have a progressive payroll tax instead of an income tax as you propose, and this leads to more saving and more investment, will the rate of return fall such that it is closer to the current post-tax return on saving people currently receive? I'm guessing the decline in the rate of return would be a second-round effect and so wouldn't drag the rate down to the current post-tax rate, but I would be keen on your thoughts.

Trevor Adcock writes:

When I commented that her points were more arguments for a progressive consumption tax she responded that I was denying her assumptions, not that I have any idea what assumptions those were. I am not sure if any micro theory papers have been done on this issue, but surely there must be something that at least brushes on this issue.

Philo writes:

The security offered by great wealth is much less significant in a Social Democracy or Welfare State than it would be in Rugged Capitalism (with few charitable organizations).

And is this feeling of security something we ought to discourage, by taxing what makes it possible (i.e., individual wealth)? That would be anti-savings.

MG writes:

The argument that accumulated wealth should be taxed because it confers the holder peace of mind/flexibility, would need to account for all the stress/deprivation that it took to accumulate it.

acarraro writes:

I personally don't agree that it's fair to tax people on the total lifetime consumption. Are you saying the someone who earns 2m $ in one year and then retires should pay the same tax as someone working 40 years at 50k a year?

That doesn't sound fair to me at all... He is implicitly consuming a lot of leisure which is simply not calculated... I think the rate at which you earn should enter the calculation.

It's true that variability is penalized in most tax systems and that is unfair, but it seems less unfair than the above example to me...

I agree with the commenter above that a large part of capital income is just disguised labour income. I would have some sympathy for a hurdle rate on capital income (maybe target nominal growth or some percentage of that). But earning above that is likely the result of extra labour input or plain luck...

Philo writes:

Frances Woolley's title, "Consuming wealth without spending a dime," is wrong. Feeling good about being rich isn't *consuming* anything: the wealth just sits there undisturbed, undiminished. She should have called her piece, "*Enjoying* wealth without spending a dime (i.e., without consuming *anything*)."

John B writes:

'Consumption tax is a wealth tax.'

And...

'Actual real world proposals for wealth taxes have something else in mind, an annual levy that implicitly taxes people at a higher rate when they spend their wealth in the future, as compared to spending their wealth today.'

Not as understood here in the Old World, Europe. Wealth tax actually means asset tax. That is, as happens in France, an annual levy on Worldwide asset value above 1,3€ million. In France even the value of home and contents is taken into account, for example.

That means the $100 is wealth taxed even if not spent.

Europe has a distinct consumption tax... Value Added Tax, an end user tax not a cascade tax, typically 20%. Some items like fresh food and children's clothes are zero or lower rated.

Wealth then is taxed at a higher rate whenever consumed than if stored.

Philo writes:

Granted, it makes one feel good to know that he has "money in the bank"--that he has wealth that he can consume whenever he likes. This makes him better off than those with less wealth, so *fairness* requires that he be *taxed* in proportion to his wealth.

But the same is true of *having friends*: it is enjoyable to interact with friends, and friends provide security, in that one could call on them for help in an emergency. Fairness requires that people be taxed in proportion to their number of friends. (As a loner, I am deeply aggrieved that such a tax has not been instituted.)

Then there is good health, which makes for a much better life than does bad health. Ditto for strength, energy, intelligence, knowledge, beauty, and (no doubt) other personal characteristics. Where is the *fairness* in our system of taxation, that these things are not taxed?

Finally, there is political privilege. This probably should be abolished, but so long as it exists it should be taxed. American citizenship has historically been a notable political privilege, which ought to have been heavily taxed, with the proceeds being distributed globally.

Tax Fairness: let's all get with the program!

Nathan W writes:

When the government was considering to lower the sales tax in Canada it came into vogue for the right wing to decry the costs to lower class, who must also pay these sales taxes out of their smaller income. Imagine that argument, even in a tax system which pays back sales tax rebates up to about $40,000. People refused to admit that cutting sales tax most affects the people who pay it, all because of a refusal to admit that it wasn't a very smart place to cut taxes (it was a campaign promise which aimed to capitalize on distaste for the previous government implementing the GST, a largely misinformed campaign which ignored the fact that the sales tax replaced a manufacturing tax which was a really stupid tax to have in an era of global trade).

Mike W writes:

It seems to me that the only difference between a progressive income tax and a progressive consumption tax...ignoring capital gains taxes...is that the former accelerates tax collections from high income taxpayers. Why expend political capital for so small a benefit?

myb6 writes:

Thanks for addressing this critique.

Unfortunately, I'm sure it's no surprise, but I don't find the argument persuasive. You only addressed the "security" non-consumptive uses of wealth, and left out others (eg power, status, self-actualization, influence, probably more). Furthermore, I find the argument about security unpersuasive because you're assuming a known future where the consumption tax will always be 50%. You're also assuming that "security" depends on future economic transactions that will be classified as "consumption", which just brought us in a circle.

The other problem is taxation of option value. Let's say someone actually buys an option- that option's value already has the consumption tax on future purchases baked in, yet that option still has value that is being untaxed in your consumption regime. Just because taxation on some related asset affected the option's price doesn't mean that option doesn't still have utility that justifies taxation yet isn't caught in the consumption net. As I attempted to illustrate in my water example the other day, there is value in control/choice that doesn't necessarily get reflected in consumption as traditionally understood, no matter how long the time-frame.

This doesn't even get into the practical difficulties of recognizing "consumption" in the real world and taxing it in a fashion not avoided by the sophisticated.

Considering that you consider the issue complex enough to write so many posts, and that even sophisticated individuals like Woolley disagree with you, why do you imply that those who disagree with you must be ignorant or malevolent, as you did in "Low hanging fruit"?

myb6 writes:

Apologies for the double-post, but I'd like to add that I believe consumption-tax discussions turn into progressivity discussions because I don't believe I'm alone in intuiting that "consumption" as a category is a reasonable proxy for utility for most individuals. However, clearly some people, myself included, intuit that the gap between consumption and utility starts to yawn as you move up the economic ladder, and that income becomes a superior (though admittedly still quite imperfect!) proxy.

Ed Hanson writes:

Scott

In my opinion, you gave short shrift to the value of saving when you wrote, "The benefit is the option value of deferred consumption; it allows you to change your mind if an emergency comes up, requiring an unexpected change in plans. That's an advantage".

That certainly is the bulk of the value to the individual saver, but it ignores the greater value to society. Saving is one component of growth, and I contend a society that saves more will have a higher growth rate than a society that saves less. And since this post is about taxation which benefits accrue to the society on the whole more than to the individual, the emphasis for a consumer tax should be placed on benefit of encouraged savings.

Ed

Floccina writes:
wealth provides benefits beyond consumption, such as peace of mind and security.

Isn't that what Social Security supporters (most USA citizens) say SS is for and yet normally when they calculate wealth they do not include SS. In fact they exclude most of the assets that the bottom 20% of earners own.

BTW I wonder what value USA citizenship would be worth if it could be sold (which maybe should be allowed).

Floccina writes:

A consumption tax is also preferable because the goal is to move some consumption to Government purposes. If a tax results in less investment people consume less in the future. If you tax Warren Buffet and he does not consume less either someone else consumes less now or there is less investment. (This is assuming that their is not massive unemployment of resources.)

Floccina writes:

Addendum:

So if you are a politician, why tax Buffet and Gates, and income in general, rather than consumption? To fool the voters.
BTW: I consider matching FICA an ingenious scheme to fool the voters.

Thomas writes:

I have not heard of any Democrats that oppose progressive consumption taxes. Republican politicians seem to oppose progressive taxation period.
I do not see republicans supporting taxes that would raise most of its revenues from the top 30% of the consumption distribution.

Floccina writes:

@myb6
2 people earn the same but one is confident and fearless and saves nothing, the other in fearful under-confident and so saves most of his income, until he has enough to be as fearless about running out of many as the other and he then starts to spend.

(I resemble the latter. I am amazed that I earn what I do, and so I keep expecting it to end but I am now prepared and can sleep well at last).

Nick Anyos writes:

I am still learning about the idea of a consumption tax so I apologize if this question has an obvious answer, but if the US replaced all taxes with a consumption tax, would anything stop them from consuming very little for 10 years, and then moving to another country and spending all their savings on tax free consumption?

Scott Sumner writes:

Rajat, Here's an example. A rich guy makes $10 million per year and pays $3 million income taxes. His consumption is $1 million. How large must the alternative consumption tax be so that the system "looks" equally progressive to an income tax?

Some people earn higher returns than others, but investments with higher returns are riskier on average, so people are being compensated for risk. Again, the basic question here is not about progressivity, it's whether future consumption should be taxed at a higher rate than current consumption.

acarraro, Yes, consumption taxes are flawed by excluding leisure. But so are income taxes. I'd add that the rich tend to work as much if not more than the poor.

I'm all for taxing disguised capital income as labor income. If the income comes from a hedge fund they manage, or a property they renovate and sell, it should be treated as labor income. But would you agree that those with full time jobs who put savings into mutual funds should not be paying taxes on the capital income earned by those funds?

Philo, Good point.

John, In your example wealth is taxed at a higher rate when consumed later than when consumed earlier. Wealth is always consumed eventually.

Mike, There are huge advantages:

1. Encourages saving and investment.

2. Promotes more efficient economic policy (smaller government)

3. Fairness

4. Simplifies the tax system

myb6, You said:

"Considering that you consider the issue complex enough to write so many posts, and that even sophisticated individuals like Woolley disagree with you, why do you imply that those who disagree with you must be ignorant or malevolent, as you did in "Low hanging fruit"?"

I'm not sure "low hanging" fruit implies ignorance, but let's say it does. If I did not assume ignorance, there'd never be any reason for me to write any blog posts. If people were not ignorant of my views, then they'd already know my views, in which case why bother explaining my views? So of course I assume ignorance, all bloggers do. Today the term ignorant sometimes implies "stupid" rather than the original "uninformed". I do not assume stupidity on the other side, taxes are a very difficult topic, which I do not fully understand.

Scott Sumner writes:

myb6, Those other intangible benefits to wealth are also taxed when you tax consumption, at least if you treat things like donations to political candidates as consumption.

When in doubt as to whether something is a consumer or investment good, I'd treat it as a consumption good (the business lunch, for instance, or corporate jet travel.)

Ed, I agree.

Floccina. Good point about Social Security wealth.

Thomas, I don't know of any Democrats who support switching to a progressive consumption tax regime. Many used to, but they seem to have changed their minds.

Nick, Good question and I don't know all the answers there. But the 401k plan is the closest thing we currently have to a consumption tax, and I believe people who emigrate must first pay taxes on the accumulated funds in the 401k. Can someone confirm that?

Dave writes:

I'm also a fan of consumption taxes. You can't dodge consumption, and if you could implement progressive consumption tax, it would be far better than income tax. You could even think about it for corporations in jurisidctions with corporate income/profit taxes.

But... How do you practically implement it? The options I can think of a pretty big-brother'esque'.

Do you scrap cash transactions and move to uniquely identifable bank accounts, which monitor the level of your consumption/spending over any given period?

Where is the point that can track individual consumption and how could it be monitored?

Income tax is easy from a practical perspective as there are many employees, few employers.

Consumption is really hard, ins't it? - many sellers, many buyers, none of the sellers (traditional custodians of consumption tax collection) with information on the buyers. Would people have to carry rich guy cards, poor guy cards, middling class cards?

I'm not sure if you've written about the practicalities anywhere, but if you have, or know of any I'd be grateful for a steer.

fralupo writes:

Sounds like you're describing the outlines fo the Unlimted Savings Allowance proposal (USA Tax) from the 1990s which would have done exactly this. It didn't get too far in Congress, alas.

Thomas B writes:

When I first encountered consumption taxes it was immediately obvious to me that they are wealth taxes.

Here's the thing: a substantial portion of my life savings is money that was already taxed as income. So now it would get taxed a second time. Would I get a tax credit of some sort for the tax I already paid on that money?

Or just get taken to the cleaners a second time?

Scott Sumner writes:

Dave, All taxes have practical difficulties. One idea to to have a flat VAT, and rebate taxes on poverty level spending to everyone. Then the poor pay no VAT, but it doesn't make for much progressivity between the middle class and rich.

A consumption tax is equivalent to a payroll tax, so you could have a progressive consumption tax.

You could keep the progressive income tax, but allow unlimited contributions to 401K plans, and allow withdrawals at any time.

Fralupo, That's one option.

Thomas, It depends how it's done, see my answer to David. It could also be phased in gradually.

Floccina writes:

@Nick Anyos and Dave you could remove the cap on IRA's and tax earnings not contributed to the IRA and withdrawals from the IRA. You would then in effect be taxing consumption. If people moved out of the country to consume there withdrawals from the IRA would still be taxed.

Dave writes:

Thanks Scott,

I find the argument for consumption taxes compelling. To my mind, it is 'the' efficient model. Income effects for the disadvantaged could be dealt with through the rebate.

I'll look into the 401k plans a little. We don't have them where I am from.

Assuming they're a tax advantaged savings account, you would tax the *withdrawal* at a progressive rate and assume it's all for consumption?

Lifetime consumption tax equivalence would make this hard, but you could roll forward the tax to make it the average marginal rate over time period from year 0, to year spend/withdrawal.

So it would require:
1 - flat VAT on all goods and services
2 - poverty spending VAT rebate (to all)
3 - monitorable savings accounts where withdrawals attract taxation at some progressive rate (rolling average consumption tax rates forward year on year, so long-term frugality [time 0 to time spend - 1] does not get penalised by final large withdrawal [time spend])


myb6 writes:

Floccina,

-SS isn't marketable, nor is it a contract (eg gov't bonds) so I'm not convinced it should be included.

-There is no general investment shortage.

-I actually agree with you on FICA. There's little disagreement that employees bear the vast majority of the tax burden, so "the employers pay half" is a mirage. Can you provide a similar justification for income vs consumption taxes? If not, I believe it's unproductive to use loaded language like "fool the voters".

-I infer that you disagree, but in your example I see no reason the 2nd guy should get a tax break. That cash as an asset which you enjoy holding. Why should it be taxed differently than your car? I too am a saver/investor and dislike double-taxation; my disagreement is over never-taxation.


Scott,

"whatever is done to address inequality will either have a hidden agenda (high speed rail, education, etc.), or be mostly ineffective due to economic illiteracy"

Intelligent disagreement is not the same thing as illiteracy nor hidden agenda.

"other intangible benefits to wealth are also taxed when you tax consumption"

You haven't supported this. You're assuming that the intangible benefits are tied to eventual consumption. Why? Wealth grants those intangible benefits even if your plan is to live like a monk and have your body cremated over a large pile of 500-euro notes.

Worse, even if I agreed with the above point, there's still the problems of *additional* option-value (untaxed), and known-future assumptions.

I don't accept your hand-waving of the classification problem.

myb6 writes:

Floccina,

I meant "there is no general investment *capital* shortage".

Doug writes:

A progressive consumption tax is the way to go, but it's important that it be "post-paid," not "pre-paid." A payroll tax is pre-paid; a post-paid tax looks like a 401(k)—no tax upon earning, only tax upon consumption. See Ed McCaffery's work, especially his article titled "A New Understanding of Tax."

There have actually been very well thought-out proposals for a real world progressive consumption tax (I.e., not just theoretical arguments about fairness). See in particular the report by David Bradfird and the U.S. Treasury "Blueprints for Tax Reform." http://www.treasury.gov/resource-center/tax-policy/Pages/blueprints-index.aspx

Dean writes:

'One idea to to have a flat VAT, and rebate taxes on poverty level spending to everyone. Then the poor pay no VAT, but it doesn't make for much progressivity between the middle class and rich.'

Scott,
How about VAT on everything (including food, etc.) along with an Income Tax. Then rebate not only the VAT amount on poverty level spending but an amount for healthcare premiums, minimum wage supplement, offset of income/payroll tax until some income level, etc. - i.e., 'Income Redistribution' to those not benefiting from 'free trade' agreements, etc. That certainly would help small businesses ... along with any other retail establishments.

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