Taxing consumption only: identifying the issues

Editor's Note: The signs are unmistakable that substantial attention will be devoted in the coming months and years to whether the federal tax system in the United States should be fundamentally restructured. In the January-february 1994 issue of The Tax Executive, former Commissioner of Internal Revenue Shirley D. Peterson set forth the case for such a fundamental review in "Restructuring the Tax System." (Mrs. Peterson, who now serves on the National Commission on Economic Growth and Tax Reform -- the so-called Kemp Commission -- also presented her views at Tax Executives Institute's 1995 Annual Conference in Nashville.) In the following article, Professor Paul McDaniel identifies the major issues that need to be considered as the United States contemplates whether to move from an income tax system to a tax regime that taxes consumption only. In the coming months, The Tax Executive will publish articles on various alternatives to the current system, and invites TEI members and other readers to submit their views for publication.

For a number of years, the issue whether the United States should adopt some form of consumption tax has been analyzed by academics, including those serving in the Office of Tax Policy in the U.S. Treasury Department. Until recently, however, the issue was not one with which politicians were prepared to deal. That situation has now changed and various proposals have been put forth in Congress to replace the current income tax (sometimes the personal income tax only; sometimes the corporate income tax, too) with some variant of a consumption tax.

Let me state my position at the outset: I oppose replacing our income tax with a tax on consumption only. Nonetheless, I think it is healthy for our country that the supporters of the two positions engage each other in debate on the merits of each system of taxation. Ultimately, either a pure consumption tax or a pure income tax rests on value judgments that we make as a society. The present debate requires that we reexamine the values that caused us to choose an income tax in 1916 and continue to use it to the present. But for the debate to be fully engaged, it is equally necessary that the values underlying a tax on consumption only also be identified clearly so that the electorate can assess which set of values it subscribes to.

We should be clear what the debate is not about. It is not about taxing something -- consumption -- that we do not tax currently. We already tax consumption in our income tax system. This fact can be demonstrated by reference to the Haig-Simons definition of income: personal income equals a taxpayer's increase in net worth plus consumption, each measured between two points in time. The middle income taxpayer can see the point just by looking at his or her tax returns. The tax paid is based largely on the cost of personal consumption during the year and, if the individual has savings, on the income derived from that saving. Using simple algebra, the Haig-simons income definition can be converted to a consumption definition: consumption equals personal income minus any increase in net worth.

Thus, the income tax-consumption tax debate is not about whether to tax consumption; consumption is and would be taxed under either system. The debate is about whether to tax consumption only -- whether to exempt from tax all income from savings and investments, including capital gains, until that income is used for personal consumption.

It is asserted frequently that income is what an individual produces in the economy and consumption is what the individual takes away from the economy. And this statement causes some to prefer consumption only as the tax base. But, given the above discussion, the statement really leads nowhere except to a predetermined conclusion that it is better not to tax income from savings and investment. Income tax proponents agree that consumption should be included in the tax base.

Another question posed is which tax base better reflects an individual's ability to pay the taxes Congress decides are necessary to fund our government. "Ability to pay' is not a phrase loaded with precision. But it generally points people toward an income tax. I suggest that the power to consume is as important as actual consumption. An income tax captures this factor; a consumption-only tax does not. There are some common sense supports for this view. For example, the news media publish the annual incomes of corporate executives, university presidents, and heads of charitable organizations; they do not publish the amount of annual consumption by such individuals. Rightly, I suspect, the power to consume is seen as equally (or more) important to actual consumption.

Tax experts can point up the importance of recognizing and making clear the value judgments that must be made in choosing between an income and a consumption-only tax. But, in the end, each voter must make that judgment by bringing to bear all the decision-making resources -- history, religion, common sense, psychology -- that he or she brings to bear in making value judgments on any public policy issue.

That said, there are some specific issues that can be identified and clarified in reaching that decision.

Effect on Savings. One of the complaints about the income tax is that it adversely affects the level of savings in the United States. Implicitly or explicitly, it is asserted that removing the tax on returns from savings would increase national savings. But it is less than clear that this would be the result. Economic studies have never been able to demonstrate conclusively that reducing taxes on savings increases savings. The reasons this result cannot be demonstrated can be simply stated. First, if taxes on savings are reduced, a benefited taxpayer either can increase savings or increase consumption. There is no way deductively or otherwise to predict which course will be taken. Second, if a taxpayer has already achieved his or her desired level of savings, or is on a path to achieve that result, the reduced tax is unlikely to increase savings. Third, the effect on savings from adoption of a consumption tax in the first place may not be the same as the effect of a change to a consumption tax from an income tax in which tax preferences are granted for certain types of savings.(1)

Thus, for many people, the biggest source of savings is their tax preferred employment retirement plan. Under some of the current proposals, an employer would no longer receive a deduction for its share of contributions to an employee retirement plan. In short, moving from a tax system in which incentives are created for some types of savings to a system in which no type of savings is preferred over the other could result in decreased rather than increased saving. This issue needs to be carefully studied to give us a better sense than we have now on the direction in our savings level that proposed changes may take us.

Simplicity. Many of the objections to the current income tax system focus on its complexity. For the majority of people whose income is derived only from wages and some interest or dividend income, however, the system is not complex at all. Nor will a consumption tax be any more simple since, for many of these taxpayers, as much as 90 percent of their income is expended through consumption.

For people with complex business and investment affairs, there is no reason to expect the tax system to be simple. If taxpayers develop complex financial instruments based on time-value-of-money precepts, or debt-equity distinctions or tax arbitrage, complex rules are required in an income tax. Tax simplicity does result for such taxpayers under a consumption-only regime, of course, because no tax is always more simple than some tax. So the simplicity argument is not a primary argument for a consumption-only tax; it is merely a derivative result from a decision made on other grounds. And, if the Unlimited Savings Allowance (USA)-type of consumption tax is employed (as it is in the Nunn-Domenici proposal), increased complexity will result for everyone who incurs debt -- that is to say, most of US.(2)

Tax Expenditures. One of the causes of complexity in the current income tax is the more than 100 different government spending programs that are embedded in the Internal Revenue Code. (These tax expenditures range from incentives for home ownership to encouraging employers to provide health insurance for employers to providing incentives for certain types of investments.) Under a pure consumption-only tax, all these programs would disappear. Two questions must be faced:

(1) Will a consumption tax really be kept free of tax expenditures?

(2) What are the economic and social effects of effectively repealing in excess of $400 billion in annual government spending?

As to the first question, the European experience is illuminating. In every country with a value-added tax, tax preferences are provided for food (via lower-than-standard rates), for agriculture, and (usually) for small businesses. One study identified more than 100 tax expenditures in the United Kingdom's VAT system in 1985, about the same number as in the U.S. income tax system. There simply is no reason to believe that advocates of tax expenditures for consumption items such as housing, health care, employee fringe benefits, charitable contributions, and child care costs will retreat from the tax legislative scene simply because a consumption-only tax is enacted. These subsidies are just as important in that tax as in an income tax.

On the second question, we need more evidence than we have now on the effect of repealing, for example, tax subsidies for owner-occupied housing or eliminating tax incentives to make charitable contribution.

International Aspects. There has been a distressing absence in the political debate on the effects a change to a consumption-only tax (including repeal of the corporate income tax) would have on our multinational corporations, international portfolio investments, and our tax treaty relationships with other countries.(3) Much depends on the system for applying the tax to cross-border transactions.

But, to take what is presumably an extreme case, if the United States adopted a consumption tax with no border adjustment, goods leaving the United States would be encumbered by a, say, 20-percent tax and would enter our European trading partners only to face an additional 20- to 25-percent VAT. That is not a prescription for increasing U.S. competitiveness in foreign markets. (Of course, if the U.S. corporate income tax is to some extent embedded in current U.S. exports, the effect of such a change would be mitigated.) In addition, such a change would throw into question all U.S. income tax treaties which, by definition, do not cover consumption taxes. Working out new bilateral tax relationships in a world in which no major country has ever relied exclusively on a consumption tax would be a major undertaking for the United States and its treaty partners.

Revenue Neutrality. Presumably a shift from an income tax to a consumption-only tax should be revenue neutral. (There appears to be no case that adoption of a consumption tax should be accompanied by an increase in our deficit.) But trying to replicate existing revenues would involve revenue estimating problems of enormous and maybe unsolvable difficulty. In my opinion, the revenue estimating process is being asked to perform far more than it is capable of producing under the current system; it could buckle under the pressure of a proposed substitution of a whole new tax system. Yet the economic effects of a major deviation in actual results from the estimates could be significantly adverse to our economic goals.

Distributional Effects. I have saved this issue for (nearly) the end because it brings us around to many of the value issues with which I began. Under any of the major consumption tax proposals, the single positive tax rate on consumption ranges from 17 percent (surely not revenue neutral) to 27 percent (if items like food, medical care, and housing are exempted) and, of course, a zero rate on income from savings. This structure means that upper-income people would realize very large tax reductions, low-income people might incur a tax increase (depending on the magnitude of the exemption level and whether the earned income tax credit is retained), and middle-income taxpayers would experience a tax increase. If the economic benefits to be realized by a switch to a consumption-only tax are speculative at best, then a powerful case on some other ground will have to -- and is yet to -- be made to justify the redistribution of income from lower to upper income taxpayers that would take place.

Moreover, a consumption-only tax creates new distributional pressures of its own. The ratio of consumption relative to income over a lifetime is high in young taxpayers (as they borrow to fund needed consumer durables and housing), low on middle aged taxpayers, and high again on elderly taxpayers (as they disinvest for consumption). Thus, the question of intergenerational equity is raised in a consumption-only tax. Again, the matter calls for a value judgment, but I suspect a tax system that imposes its highest relative burdens on our youngest and oldest taxpayers does not have strong intuitive appeal.

Transition. How would we go from the current income tax to a consumption tax? Economist James W. Wetzler has demonstrated that introducing a VAT is the same as imposing a one-time tax on all existing capital and a tax on all future wage income (only).(4) So one transition rule would simply impose a tax on all existing capital (perhaps paid in installments) and then move to the equivalent of a tax that is in effect on wages only. This approach seems unlikely. But taxing again the capital that retired persons have built up with after-tax income as they consume that capital seems equally unattractive, practically and ethically- And trying to phase in a consumption-only tax while phasing out an income tax could create unmanageable levels of complexity, depending on the type of consumption tax selected.

In the end, the transition issue poses squarely the question whether we believe that both our current capital stock and wage income have been undertaxed and whether it is appropriate, therefore, to increase taxes on both. If one believes that proposition, then a consumption-only tax is the right policy prescription. But, clearly given that choice, my guess is that more Americans will find that the income tax system is not so bad after all.

(1) See William F. Gale, Building a Better Tax System: Can a Consumption Tax Deliver the Goods?, Tax Notes, Nov. 6, 1995, at 781, 785. (2) See Martin D. Ginsburg, Life Under a Personal Consumption Tax, The Office of Tax Policy Research, Working Paper No. 95-1 (Univ. of Michigan) (to be published in the December 1995 issue of the National Tax Journal). (3) An initial inquiry into such matters is set forth in Harry Grubert & T. Scott Newman, The International Implications of Consumption Tax Proposals, The Office of Tax Policy Research (Univ. of Michigan), Working Paper No. 95-3 (to be published in the December 1995 issue of the National Tax Journal). (4) James W. Wetzler, The Role of a Value-added Tax in Financing Social Security, XXXIII Nat'l Tax Journal 334 (1979).

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