A better way to tax - consumed income tax

IN THE SUMMER OF 1992, Senators Pete Domenici (R-NM) and Sam Nunn (D-GA) decided to move beyond the short-term tinkering that usually dominates congressional debate over taxation. The senators reached onto the academic shelf and pulled down an idea that many economic thinkers have advocated: replacement of the personal income tax with a consumed income tax (CIT).(*)

The consumed income tax is not a new proposal. The distinguished economists Irving Fisher and Nicholas Kaldor, writing from different philosophical perspectives, each wrote treatises advocating a CIT, and many economists have long found the proposal attractive in theory. Prior to the 1970s, however, it was widely assumed that a CIT would be hard to implement. In the last two decades, however, tax experts have reexamined the consumed income tax and concluded that it might be easier to operate than the current income tax. Two major studies undertaken by tax specialists--the U.S. Treasury's Blueprints for Basic Tax Reform (1977) and the U.K. Institute for Fiscal Studies' The Structure and Reform of Direct Taxation (1978)--have concluded that converting the income tax to a CIT is both feasible and desirable.

Support for a CIT is in fact quite broad and ideologically diverse. Consider this list of prominent economists and other experts who have endorsed the idea in one form or another: David Bradford (Princeton), Martin Feldstein (Harvard), Lawrence Summers (Harvard), Lester Thurow (MIT), Michael Boskin (Stanford), John Shoven (Stanford), Henry Aaron (Brookings), Harvey Galper (Peat Marwick), and William Andrews (Harvard).

How would a consumed income tax work? Under a CIT, all household savings would be tax deductible. Meanwhile, all consumption would be taxed. Every April 15th, each household would determine its taxable consumed income by adding up its total cash inflow and subtracting savings and previous tax payments.

Why do it?

It is an inescapable fact that investment--in plant, equipment, and technology--must be financed by domestic saving or borrowing from abroad. When domestic saving falls, so does investment. Take a look at what happened in the 1980s: Between 1980 and 1990, the United States' gross national saving rate declined from 17 percent to 13 percent of gross domestic product (GDP). Of this 4 point drop, 3 points were due to a fall in private saving (the other 1 point was due to a rise in government dissaving). Not surprisingly, gross private investment fell nearly 3 points, from 17 percent to nearly 14 percent of GDP; only a 1 point increase in borrowing from abroad prevented the fall in investment from fully matching the 4 point drop in saving.

If the U.S. had begun the 1980s as a high saving nation, one bad decade might be shrugged off. But the pattern is long term. From 1960 to 1984, the U.S. gross saving rate averaged 19 percent. By contrast, in France it averaged 24 percent; West Germany, 25 percent; and Japan, 34 percent. It is no surprise that these high saving nations gained economic ground on the United States. In 1950, France's output per person was only 47 percent of ours; by 1980, it had risen to 84 percent. Over the same three decades, West Germany's output per person rose from 40 percent to 86 percent of ours, while Japan's rose from 17 percent to 72 percent.

Conversion to a CIT would raise national saving in three distinct ways. First, consider the incentive effect. Unlike the income tax, the CIT would let a household reduce its taxes by saving, thereby giving it a financial incentive to save. True, tax would be owed if the saving was eventually spent. But in the meantime, the household could earn interest. And if the saving was left as a gift or bequest, then it would escape tax until the recipient spent it.

Second, consider the horizontal redistribution effect ("horizontal" because the redistribution is between persons in the same income class). Under a CIT, above-average savers would pay less, and below-average savers would pay more; the result would be more saving, overall, from each income class. To see this most easily, suppose the $100,000 income class has only two people: S and C. They are each extremists. Person S saves everything and person C consumes everything. Under a 20 percent income tax, S and C each pay $20,000 in tax. Thus, total tax revenue is $40,000. S saves $80,000 and C, nothing, so total saving is $80,000. Under a CIT that raises the same $40,000 of tax revenue, C will pay $40,000 in tax and S, nothing; so S will save $100,000 and total saving will rise to $100,000. Conversion has caused a horizontal redistribution effect: $20,000 has been redistributed from C to S, and the result is an increase in total saving. Of course, if C surprises everyone by actually saving to take advantage of the new saving deduction, then total saving would rise by more than $20,000.

Third, consider the postponement effect. Conversion shifts some of the tax burden from the work stage of life (when money is saved) to the retirement stage (when money is spent). That enables workers to save more. In an economy with growing real wages and labor force, the higher saving of workers outweighs the higher dissaving of retirees, resulting in an increase in aggregate net saving. Thus, conversion would give workers a greater ability to save (by postponing some tax to retirement age) as well as a greater incentive to save. Is it fair?

A person's income reflects his contribution to economic output; hence, a tax on income is a tax on a person's contribution to the economic pie. By contrast, a tax on consumption is a tax on the slice of the pie a person enjoys. It can be argued that it is fairer to tax a person on the slice he enjoys than on his contribution to the pie. Under a sales tax, if person A consumes a slice twice as large as B consumes, he pays twice the tax. But under a household CIT, Congress can set the tax rates so that A pays more than twice the tax. Unlike a sales tax, a CIT can be made progressive if Congress desires. The most common reaction to a proposed CIT is: "It favors the affluent who can afford to save more." But that reaction is based on a fundamental misunderstanding. The misunderstanding is that tax rates would not change when a CIT was adopted. If that were true, then deductibility would indeed favor the affluent who can afford to save more. Also, if the rates were unchanged, less total revenue would be collected (due to the savings deduction), causing the budget deficit to grow even larger. Conversion, however, can and must be accompanied by a tax rate adjustment, to keep tax revenue at its target.

But what kind of an adjustment? If Congress wants each income class to continue to provide the same proportion of total revenue, then high-income households--which save most--would have their consumed income tax rate raised most; since low-income households save least, their consumed income tax rate would be raised least. True, some affluent households would end up with a tax cut. But if Congress sets CIT tax rates so that the affluent pay the same proportion of total revenue as under the income tax, then for every affluent household with a tax cut there will be another with a tax increase (recall our earlier example).

People disagree about how our tax burden should be distributed. But the fact is that the CIT is neutral on this matter. The matter of tax base--income vs. consumed income--is completely separate from the matter of distribution--where to set tax rates for each class. Thus, the CIT is supported by the wide swath of economists mentioned above--economists who disagree about distribution but agree on the need to raise our national saving rate.

Some critics have charged that a CIT is really a labor income tax--an income tax that exempts capital income (interest, dividends, capital gains). True, a CIT and a labor income tax both try to encourage saving. A CIT exempts saving in the year it occurs. A labor income tax exempts the income the saving yields. Both methods avoid the reduction in the after-tax return to saving that occurs under the income tax. But they are not the same. In fact, the two taxes differ fundamentally with respect to fairness. Consider a lazy heir who inherits a fortune in corporate stocks, earns high capital income but no labor income, and sells off stocks each year to finance high consumption. Under a labor income tax, the lazy heir would pay nothing. Under a CIT, the heir would pay a high tax each year on his high consumption.

Practical issues

Tax specialists have analyzed how to handle various practical problems that would arise under conversion to a CIT. This section gives some tentative solutions. The recommendations offered here are not necessarily those Senators Domenici and Nunn will offer in their legislation. Their staffs are continuing to weigh practical options.

If a family buys a house for $120,000 this year, it certainly does not consume $120,000 of housing this year. Instead, the $120,000 of consumption will be spread over many years and a CIT would recognize it. Here's how: Suppose the family borrows $100,000 to buy the house. Then $100,000 would be excluded this year from tax. In return, mortgage payments would not be deductible, so the house would be taxed gradually as the mortgage was paid. If the family sold the house, the revenue would be excluded from tax. If Congress wishes to encourage home ownership, it could enact a special housing tax credit targeted at families unable to afford a home.

Expenditure on higher education is part investment, part consumption. The part that is investment should be deductible, the part that is consumption should not. A reasonable rule might be to allow half of tuition to be deductible. Economists have shown that investment in human capital--education--is as important for economic growth as investment in physical capital. A CIT should recognize this important economic reality.

Consider also the treatment of gifts and bequests. The recipient should be taxed if he consumes. Analysts differ about the donor. Some recommend taxing the donor to keep a miser from escaping tax. Others recommend exempting the donor because he did not actually consume. Still others suggest a compromise: tax only affluent donors above a high cumulative lifetime threshold. Most analysts agree that charitable contributions should earn the donor either a deduction or credit.

Current retirees deserve some protection during the transition. Under the current income tax, most retirees have some savings they accumulated after paying income tax. They should not be double-taxed. One option would be to have each retiree list all assets, exclude the ones that have already been taxed, but include the ones that have not been taxed (such as an employer-financed pension). But this option is too complicated and would require too much record-keeping. A better option is simply to set a lower consumption tax rate for retirees. The rate should gradually be raised to normal over perhaps a decade.

If the entire population were converted to the CIT in the same year, there might be a sharp increase in saving rather than the gradual increase that the economy can safely absorb. It is therefore prudent to phase in the population subject to a CIT. Perhaps the best method would be age-phasing. In year one, households whose oldest member was twenty-five or younger would convert permanently to the CIT; in year two, thirty-five and younger would convert, and so on. Prior to conversion, an age cohort would remain subject to the current income tax. Phasing from young to old would permit middle-aged households to retain current income tax deductions (such as home mortgage interest) for several years and permit current retirees to pay low tax on their consumption for much of their retirement.

Abolish the corporate income tax

An important advantage of a CIT is that it would permit us to eliminate the corporate income tax (note that Nunn and Domenici may not endorse abolition). If the goal is to tax consumption instead of income, there is no longer a good reason for a corporate income tax. True, corporations do pay for some employee consumption. For example, a corporation might pay the cost of an employee's automobile or vacation. The integrity of the CIT requires that such corporate-financed consumption be added to an employee's taxable household consumed income.

Most analysts agree that the corporate income tax is a source of substantial inefficiency. Measuring true income requires measuring the true economic depreciation of each real asset (machinery, plant, and equipment). But that's difficult to do accurately, so arbitrary estimates must be used. And since these estimates are based on the historic cost of the asset, inflation leads to even more distortion. As a result, income is overtaxed in some corporations, undertaxed in others. Moreover, corporations spend a lot of money trying to minimize corporate taxes. Obviously, the termination of the corporate income tax would eliminate this waste.

There are two potential problems with terminating the corporate income tax and they have the same solution. The first is the revenue loss. The second is the gain that would accrue primarily to affluent corporate stockholders and managers. The solution to both problems is to raise the CIT tax rates of high-bracket households. This will recapture the revenue from those who would otherwise gain. The public wants corporate managers and stockholders who spend a lot of money to pay a correspondingly high rate of tax. These reforms would--fairly--give the public what it wants.

Do it now

The Domenici-Nunn proposal for a consumed income tax comes just in time. International economic competition is fierce and the U.S. must find a way to do better. With the U.S. investment rate lagging behind other leading nations', boosting saving should be a central goal of economic policy.

Although the importance of saving has often been grasped, the policy responses have been poor. Tinkering with the income tax has predominated: an individual retirement account (IRA) here, an investment tax credit there. Often the response has generated a divisive, deadlocked debate over fairness versus growth--witness the capital gains cut proposal.

It is time to recognize that a fundamental tax reform--conversion of the household tax from income to consumption--may be the proposal that is most politically practical as well as economically effective. The capital gains proposal has achieved nothing but deadlock because it seems to single out one kind of income for special treatment. Conversion to a CIT would break the deadlock: income from any source would not be taxed per se, and consumption, however financed, would always be taxed. Other, ad hoc plans to encourage saving tend to favor the tax-wise who know how to play the game of saving shuffling; such plans are also complex. Conversion to a CIT would make it simple: all saving would be tax deductible.

To encourage saving, we have tried complex tinkering, and it has not worked politically or economically. Let us at last try a fundamental, consistent reform: conversion of the household tax from income to consumed income.

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1A. Title of publication: The Public Interest. 1B. Publication no.: 00333557. 2. Date of filing: October 1, 1993. Frequency of issue: Quarterly. 3A. No. of issues published annually: Four. 3B. Annual subscription price: $21.00. 4. Complete mailing address of known office of publication: 1112 16th Street, NW, Suite 530, Washington, DC 20036. 5. Complete mailing address of the headquarters of general business offices of the publisher: The Public Interest, 1112 16th Street, NW, Suite 530, Washington, DC 20036. 6. Full names and complete mailing addresses of Publisher, Editors, and Managing Editor: Publisher, National Affairs, Inc., The Public Interest, 1112 16th Street, NW, Suite 530, Washington, DC 20036. Editors, Irving Kristol and Nathan Glazer, The Public Interest, 1112 16th Street, NW, Suite 530, Washington, DC 20036. Managing Editor, Joshua Abramowitz, The Public Interest, 1112 16th Street, NW, Suite 530, Washington, DC 20036. 7. Owner: National Affairs, Inc. (nonprofit), 1112 16th Street, NW, Suite 530, Washington, DC 20036. 8. Known bondholders, mortgagees, and other security holders owning or holding 1 percent or more of total bonds, mortgages or other securities: None. 9. The purpose, function, and nonprofit status of this organization and the exempt status for federal income tax purposes has not changed during the preceding twelve months.

                                                              Actual no.
copies                                         Average no. copies    of
single issue                                         each issue during
published nearest 10. Extent and nature of circulation:   preceding 12 months
  to filing date
A. Total no. copies:                         9,735                 9,651

B. Paid circulation:
1. Sales through dealers and careers:        1,071                 1,175
2. Mail subscriptions:                       5,235                 5,272

C. Total paid circulation:                   6,306                 6,447

D. Free distribution:                          547                   846

E. Total distribution:                       6,853                 7,293

F. Copies not distributed:
1. Office use, leftovers, etc.:              1,593                 1,173
2. Returns from news agents:                 1,289                 1,185
G. Total:                                    9,735                 9,651

11. I certify that the statements made by me above are correct and complete:
Joshua Abramowitz, Managing Editor.

* Nunn and Domenici are co-chairmen of the Strengthening of America Commission of the Center for Strategic and International Studies. The report of the commission was directed by Debra L. Miller, whose comments were helpful in preparing this article.

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