Is a “Consumption Tax” Fair?

Is a “Consumption Tax” Fair?

I have argued here and elsewhere (e.g., in newspaper letters to the editor and guest columns) that income tax is the only fair tax because it’s the only tax based solely on ability to pay. (I might include “luxury tax” also.)

In recent years a vocal minority have been calling for a universal “consumption tax” to replace income taxes. I tended to dismiss them as unthinking (to use a nicer word than what I really think) people. Now, however, I read a column in the newspaper by a leading investment advisor, obviously an educated person capable of critical thought, advocating that policy.

So what is a universal consumption tax? The “universal” means across the board, not local, and to replace incomes tax if not all taxes. “Consumption” means what most people call “sales.” In other words, the plan being promoted is to replace federal and (I assume) state income taxes (where those exist) with sales tax.

I consider this one of the dumbest and most regressive social policies ever.

One of the arguments used for it is all the “loopholes” in our complicated federal and state income tax laws. Allegedly, too many people (about 47%) pay no income tax and many affluent who do, like those who live off investments, pay a smaller percentage than middle class wage earners. Without doubt our income tax codes are too complicated and filled with loopholes.

I argue that those are reasons to fix income tax codes (federal and state) and not to discard them.

Let’s examine the idea of replacing income taxes with a universal consumption tax. For now I’ll focus only on the idea of replacing the federal income tax with a national sales or consumption tax.

First, has any government, anywhere in the world, done this? That is, has any nation replaced income tax with a universal consumption tax? If so, how has that worked in terms of raising revenue? What percentage of tax on sales/consumption was necessary to replace the income tax?

Personally, I’m not aware of any country that has tried this. Do people really want to rush into something that’s never been tried? Perhaps so. But I would think they would at least want to know in advance how it will work. So far the plans for it are so wildly diverse that I’m convinced nobody really knows how it would work.

Second, and closely related to “first,” what percentage would the tax have to be to replace income tax? That’s where the proposals fall apart—into wildly diverse estimates. I have heard everything from 25% to 35%. I suspect it would have to be higher because, immediately upon its institution, sales/consumption would drop dramatically. People would immediately delay or cancel plans to make unnecessary purchases.

Third, and closely related to “second,” I believe such a tax change, however gradually implemented, would result in a massive recession that would make 2008-2009 look tame. Many people, perhaps most, would immediately begin looking for ways to “purchase” items that would avoid the tax. How could laws be crafted to tax bartering, for example? I am old enough to remember when bartering became a huge practice. National networks of bartering were set up during the late 1970s. Eventually the government stepped in and passed laws to dampen the practice. I suspect people would find ways to barter to avoid paying a 30% consumption tax.

Fourth, one of the arguments for replacing income tax with sales tax is to do away with the IRS and the huge government bureaucracy related to income tax. I think it would simply have to be replaced with a huge government bureaucracy to oversee and regulate the new tax (e.g., to keep people from avoiding it through bartering, etc.).

Fifth, one of the arguments for replacing income tax with a consumption tax is that “income” is too difficult to define. Imagine trying to define “consumption.” What would be taxed? Your visit to the doctor’s office? What part of your related expense? Your co-pay or the whole amount charged? Your college tuition? Your day care expense for your child(ren)? In my opinion, that is one of the dumbest arguments for replacing income tax with sales/consumption tax. Income is much easier to define than “consumption.” Just because governments haven’t been doing it well doesn’t mean it’s really difficult.

Sixth, one of the often unstated reasons for replacing income tax with sales/consumption tax is to spread the burden of raising revenue to run the government around more evenly. In other words, the wealthy are envious of the poor and middle classes’ escape from paying income tax. So let’s look at what would inevitably be the case. A young woman works for minimum wage and pays no income tax. With the full implementation of the consumption/sales tax she now pays 25% to 35% on everything she buys—on top of its price. Oh, and all the prices for the few necessities she buys just went up to offset the sales/consumption tax on the businesses’ purchases of materials (and, presumably, services).

Seventh, whenever I have raised the sixth objection immediately above advocates of a sales/consumption tax start proposing exclusions and adjustments that would keep the working poor from falling further into poverty. “Okay,” they say, “under this new plan basic food stuffs wouldn’t be subject to the consumption tax.” But what about basic clothes? What about transportation to get to work? What about…? Soon the working poor person isn’t paying any sales/consumption tax which defeats a major purpose of it stated in “sixth” above.

In other words, in order to make the plan work so that it does not devastate the poor, so many loopholes would have to be instituted that it would be just like the present income tax (in that regard).

Eighth, suppose I am a millionaire when the new tax replaces the old and I get my joy out of saving, not spending (at least not here!). My goal in my financial life is to build up a huge fortune and then go to a country nearby (and believe me, it wouldn’t be far!) that has no or a smaller consumption tax and live it up there! Here I live in near penury because I don’t like paying taxes. Now I pay very little tax because I simply refuse to buy non-necessities—yet. Soon, however, I have enough money stashed away from untaxed income to buy a home and car in a nearby country and travel there often and live like a monarch.

I guarantee that would be the common practice of the rich and especially the super rich. Sure, they might not live as if they were poor here, but they would spend as little as possible here to avoid the consumption tax and buy their luxuries elsewhere. Imagine the harm that would do to the economy!

My point is that the proposal I’m criticizing here is radically regressive. It would hurt the poor (to say nothing of the economy as a whole) and help the rich. That’s so obvious to me that I cannot help but conclude that people who advocate it either simply have not thought it through or want to hurt the poor and help the rich.

Ninth, one of the arguments for abolishing income tax and replacing it with a sales/consumption tax is that, allegedly, income taxes keep rising unchecked and it’s easier to detect tax increases in sales taxes. That’s utterly bogus, of course. Income tax rates have lowered dramatically in recent decades. And sales taxes have increased without most people noticing it. How? Because politicians simply spread the sales tax to cover more and more goods and services. They boast that they have not increased taxes when they actually have. A few years ago, when I had to have a repair person come out to the house to fix something, there was no sales tax on that service. Now there is. How is that not a tax increase? And yet the politicians who did this loudly proclaim that they have never raised taxes. And the sheep listen and believe.

Tenth, I am not opposed to a “value added tax” on true luxuries like limousines, speedboats, designer suits and dresses, etc., etc. However, when it comes to universal taxes (across the board) the only fair tax is income tax because it is the only tax based solely on ability to pay. People in government seem to recognize this when they don’t tax food. (Most states charge no sales tax on real food in grocery stores) and cap property taxes for senior citizens. However, that intuition hasn’t sunk in deeply enough. Property tax is bad because it forces a new widow (for example) to pay the same amount after her husband, who was the family’s primary source of income, dies. Often she has to sell the homestead and go live in an apartment. Think about it—income tax is the only tax based solely on ability to pay.

Governments have gradually abolished many regressive taxes (ones not based on ability to pay). For example, when I was a kid growing up in a Midwestern city in the 1950s, my parents had to fill out a form annually stating all their personal property—furniture, car, jewelry (they had none), appliances, etc. That even included savings accounts. Then the county or state (it doesn’t matter to my point and I don’t remember which) levied a tax on their personal property. This was a huge financial burden on them and us (their children). We were lower middle class if not poor. My parents never had savings or disposable income (money to spend on non-necessities). I recall that one year the taxing government did not believe their report and sent an agent to our house to inspect it. I was home when that happened. He went through drawers and cabinets and closets looking for unclaimed items such as jewelry, expensive clothes, etc. Of course, he found none and concluded that my parents had stated their personal property correctly. Sometime later, I don’t remember when, the government abolished that tax. It was extremely regressive. For example, suppose you were poor but inherited a piece of jewelry with sentimental value (such as your grandmother’s wedding ring set). You had to declare it and pay “personal property tax” on it annually. That tax had nothing whatever to do with ability to pay. That’s why it was abolished. But the same principle applies to real estate property tax (on homesteads) and, I argue, sales tax on clothes, services such as plumbing repair, etc. Those should also be abolished because they are regressive. The only progressive taxes are income tax and luxury tax.

  • Tom Shelton

    I suggest you read some of the actual proposals before making the unfounded accusation that supporters of a consumption tax are “unthinking” people out to hurt the poor. Go to http://www.fairtax.org for the whole story or you can see their white paper of fundamentals and facts at http://www.fairtax.org/PDF/FairTax-Fundamentals_and_facts-070122.pdf

    • rogereolson

      I have studied such proposals and find them ridiculous.

      • Aaron Hedlund

        Professor Olson,
        I can tell you as an economist that there is wide support among economists for taxing consumption rather than income. It is important to note that some of the most famous proposals– the flat tax and the FairTax– combine a switch in the basis of taxation AND the rate schedule that is applied. What you seem to have the biggest problem with isn’t consumption taxes, but really flat taxes. There are proposals out there supported by more liberal-minded economists, such as the X Tax, that tax consumption on a progressive basis and therefore would satisfy your “ability to pay” criteria.

        The reason that consumption taxes are seen by many economists as preferable to income taxes is because income taxes have a depressing effect on savings and investment, thus hurting long-term skill building, capital accumulation, and growth. The other complaint I here, which is more in line with your thinking, is that because wealthy people spend a smaller fraction of their income, any consumption tax disproportionately affects lower income people who spend their entire paychecks.

        This line of reasoning is false a) because you can implement a progressive consumption tax, and b) because at the end of the day, somebody’s living standard is determined by their spending, not their income. If there is a rich man and a poor man who both live in a small apartment, eat cheap food, and take the bus to work, what is the necessity in taxing the rich man much more, especially given that all of his unused income is doing society a favor by being available to entrepreneurs who want to borrow it.

        • Aaron Hedlund

          Don’t mind the early morning typos…

          • rogereolson

            I won’t if you won’t. :)

        • rogereolson

          What does “wide support among economists” mean? And what does it have to do with ethics?

          • Aaron Hedlund

            By “wide support,” I mean that if you talk to most macroeconomists, they would support, at least in theory (their final answer would depend on final legislation), a switch toward taxing consumption instead of income. Libertarian-minded economists might prefer something like a national sales tax or VAT, while more progressive economists might prefer a progressive consumption tax like the X-tax.

            Undoubtedly, any debate about taxes depends on determining the effects of possible tax changes and then making an ethical determination about whether those effects are desirable. We can have philosophical debates about whether “ability to pay” is the right principle to consider for taxation, but *even if we take that as given,* there is nothing incompatible between taxing consumption and adhering to the ability to pay principle. Progressivity + improved economic efficiency is the reason for its support even among progressive economists.

          • rogereolson

            I think we are disagreeing (in part) about ethics. I am not primarily a consequentialist, although I think consequences must be considered. But there are absolutes of fairness/justice that are independent of consequences. I follow John Rawls’ approach to public policy in A Theory of Justice. Even if a consumption tax would have utilitarianly good consequences for the economy as a whole I would oppose it.

          • Aaron Hedlund

            Although I could certainly get into a debate over using Rawl’s Theory of Justice as the criterion for judging the ethics of public policies, what I am saying is that there is nothing about consumption taxes that makes them incompatible with the ability to pay principle. A progressive income tax– that is, one that taxes higher amounts of consumption at a higher rate– satisfies the ability to pay principle just as well as an income tax does. The only difference is that savings would be exempted. People who spend lots of money would be taxed at higher rates while people who spend little money would be taxed at lower rates. What you’re really arguing against is the notion of flatness in taxes, and I’m saying that consumption taxes need not be flat.

          • rogereolson

            Okay, but all the consumption tax proposals I’ve read seem to imply a flat rate–usually around 25% to 35% on everything. Some proposals exempt food and possibly clothes. Still, even with a progressive consumption tax (which is what I understand you meant) would require money “up front” to pay it. Tax on income is on what is already received. Besides, I simply cannot conceive that a consumption tax to replace income tax would not result in less purchasing which would in turn hurt the economy. That’s a utilitarian argument, of course, so it isn’t my main reason for being against a consumption tax to replace income tax.

        • Holly

          With a consumption tax, all of the existing federal taxes will be eliminated. The poor, along with the rest of the population, will be subject to the federal consumption tax (FCT) on most of what they spend. However, the FCT rebate, which applies to purchases up to the poverty level, will essentially “un-tax” the poor under Sensible Tax Reform (STR)

          All flat taxes, whether flat income or flat sales tax, are regressive–the tax burden falls disproportionately heavily on the poor and middle-income groups. This is because the poor and middle classes spend all or most of their income, and pay the FCT on most of it. The rich, on the other hand, spend only a small part of their income and therefore only pay the federal consumption tax on a small part of their income.

          However, the removal under Sensible Tax Reform of Social Security and Medicare taxes, which are very regressive, benefits the poor and middle classes much more than the rich. Also, a rebate of the federal consumption tax on essentially all of the purchases of the poor and much of the purchases of the lower middle class, will also help to reduce the regressiveness.

          In order to protect the poor under Sensible Tax Reform, the amount of FCT taxes that the poor will pay will be rebated to them. For example, a married couple with two children and annual income of $20,000 is considered to be below the poverty level in the United States. At that income level, most families would spend all of their income. The 30% FCT on that amount of purchases would be $6,000. An annual rebate of that amount will be paid to the family. Payment will be made monthly ($6000 ÷ 12 = $500) to families at the beginning of each month.

          Thus, the poor would have the necessary funds to pay their FCT each month without suffering any decline in real income or in their standard of living. Indeed, since their Social Security and Medicare taxes will have been eliminated and prices have fallen, the poor will be much better off under STR.

          • Roger Olson

            I’ve heard this before, but where are the poor supposed to get the money to the pay the 30% tax on purchases in the first place? What good is a rebate if you can’t afford to pay what the rebate returns?

  • Tim Reisdorf

    You want, by means of taxation, to discourage production via the income tax and encourage sloth. At the same time, you reject the consumption tax – which would encourage thrift rather than “gluttony of stuff”. I cannot find anything in the Biblical witness where such encouragements are promoted. There are many (and long) passages where such is condemned.

    btw, I don’t favor the consumption tax either. I don’t want to hurt the poor or the rich. You are correct in identifying that governments are in the business of hurting people via taxation.

    • rogereolson

      Some taxes hurt people (especially the poor) more than others.

      • Tim Reisdorf

        … then take that next “love-your-neighbor” step and reduce taxes for all. Stop the pain, Roger! Stop the hurt. On this blog, announce that you care so much for your fellow human beings that you want to reduce the suffering inflicted upon them as much as possible by reducing taxation on everyone as much as is possible. This is the loving way – and as you have often said here, “God is love”. This is the way of peace; this is the way of kindness (as it relates to taxation). Why would any who have been born again in Christ’s love wish or vote for increasing hurt on their neighbors (especially the poor)? May it never be!

        • rogereolson

          Where and when have I ever advocated increasing taxes on the poor?

          • Tim Reisdorf

            Excellent, I’ll take that as a vote for “I love all my neighbors (including the poor)”. Well done.

        • Joshua

          Tim,
          I think you know as well as I do that that’s a straw-man argument and is simply unfair. You sounds like certain radio talk show hosts, taking people you disagree with to the bottom of an imaginary slippery slope and accusing your opponents of things that don’t actually makes sense of what they have said.

          • rogereolson

            Caution, please. Maybe Tim doesn’t know that.

        • John I.

          Reducing taxes for all usually results in reducing services for all, which leaves the poor worse off because then cannot pay to replace the reduced services, though the rich can. Moreover, a tax rate reduction benefits the rich much more in absolute value than a poor person (the rich get to keep a bigger sum of money).

  • J.E. Edwards

    Hey bro, your first comment:
    “First, has any government, anywhere in the world, done this? That is, has any nation replaced income tax with a universal consumption tax? If so, how has that worked in terms of raising revenue? What percentage of tax on sales/consumption was necessary to replace the income tax?”
    If you want to see how this is working out on a smaller scale, go no further than the 7 states that have no state income tax. I live in one of them (Tennessee). We do have a relatively high sales tax, around 9.25% most of the time. There are items (food and other things), due to poverty, that aren’t taxed. This argument is way deeper than defending poor people, though. You can have your say for sure, but to use that as the main crux of the argument isn’t very convincing, and I would say isn’t very well thought out. Especially with all the tax credits they can and do receive that help them. My tax preparer just saw a man receive an $11,000 refund without paying a single dollar into the income tax system. I’m sure this is not the norm, but there are government incentives that help poor people in this country regarding taxation.
    I’m not sure how the economies of the other 6 states are doing in relation to no income tax, but Tennessee is doing well. I don’t see how you think people aren’t thinking if they want to see this happen (flat/consumption tax). Even with a flat tax, rich people will pay significantly more taxes because they spend more. It doesn’t mean people dislike poor people and want them to suffer, either. This whole idea of “people paying their fair share” isn’t very biblical either. In fact, it’s always wrong to rob anyone unduly and against their wills. I thought you loved the idea of free-will, libertarianism? Forcing people to pay more than is fair, seems to go against that philosophy. Allowing them to spend as they will would fit it better. Interesting that we see it this way economically and the other way around, if you will, theologically:) Peace out.

    • rogereolson

      Where did you get the idea that I “love” free will? Where have I said anything even close to that? You’ve been coming here for a long time and I have often strenuously denied that I “love” free will. What’s up with that? Are you reading me with any understanding or do you just suspect I’m not truthful?

      • J.E. Edwards

        That wasn’t my point. Respectfully, Roger, you need to read what I said more carefully. I never said you loved free-will. I said you loved the idea of free-will. To me, that is leaving it open to whatever your perception of the concept of free-will might be. I wasn’t trying to nail you with it. I have been reading you for a while and I know that you’re not a straight up free-will lover or worshipper. That aside, you yourself live in one of the states that doesn’t pay income tax. Are you lobbying for it? What is the state of the economy in Texas these days? Another thing a consumption tax does, is that it makes politicians do their work. It causes them to be creative and find ways to help people. Shaking down people who make lots of money (of which I am not one) isn’t very creative and it’s lazy. We need to hold these leaders a little more accountable.

        • rogereolson

          Yes, I have “lobbied” for a state income tax to replace other taxes. What makes you think I wouldn’t? I have written letters to the editor and columns making my argument and the usual response is “We don’t want a state income tax because once you have an income tax it just keeps rising and rising.” What those people don’t understand (and I consider their lack of understanding almost a form of ignorance) is that present taxes keep rising and rising as well. How? Well, one way of raising taxes without doing it directly (and this has happened dramatically in the years I’ve lived here) is to cut back services without cutting back taxes. Then there is the constant extending of sales tax to cover more and more services. To say that I love the “idea of free will” is hardly different from saying I love free will. It’s a distinction without a difference.

          • J.E. Edwards

            It seems things are working well in Tennessee without one. We had a government surplus this last year. It’s also true that the 7 states without an income tax, are in the top 10 states that have the lowest tax burden. When you allow people to keep more of their money they are happier and they spend more and revenue is created. I’m not saying all taxes are unnecessary. Less is usually more when it comes to taxes though. Our politicians need to work harder themselves. Instead they take the easy route and look around for “free” money. This problem needs to lie at their feet, not at the feet of the people who are paying the taxes. Sorry for the “free will” quip, it wasn’t clear enough. I’ll make myself clearer from now on.

          • rogereolson

            I live in a state without an income tax and the resulting gap in services to the poor is obvious.

        • John I.

          The province of Alberta in Canada had no sales tax until the federal government introduced the GST (goods and services tax), though it also had revenue from oil and gas. However, recent overspending has the current government now considering the implementation of a provincial sales tax (either separate from the federal GST, or combined with it as an HST – hamonized sales tax).

          One aspect of income taxes often not commented on is “income bracket creep” resulting from inflation. Inflation results in increased wages, increased wages move many people into the next tax bracket, even though their purchasing power has not increased (because the cost of goods and services also inflates). Consequently, the wage earners pay more of their income in taxes (because they have moved up in tax bracket), even though their purchasing power remains the same, resulting in an actual decrease in their real income and standard of living–unless they are fortunate to have wage increases that outpace the increased price of goods.

  • John Mitchell

    I think your use of the word ‘fair’ hear is a problem. Nothing in this world is completely fair. I think a better word to use is ‘just’. We should strive to live in a just world not a fair world. ( I guess that is why it is called the ‘Criminal Justice’ system not the ‘Criminal Fairness’ system.)
    I believe that a consumption tax is the only way that everyone will realize how much our government spends. As long as there are revenue streams to the governors that are hidden from many of the governed, there will be ‘fairness’ for no one. However, a consumption tax will be ‘just’ to everyone. Every human would pay the same for the services that that particular human received from the government.

    • rogereolson

      When I say “fair” in this context I mean John Rawls’ definition of “justice as fairness.” Please read John Rawls.

  • Joe Canner

    Roger Olson for President!

  • hevangel

    Economically speaking, someone’s sales is another person’s income (more or less)
    Maybe we should have tax base on transaction instead.

  • blaze

    We need a bank account where we’re allowed to put all our money income tax free. If we withdraw from that bank account, the first 12K or so should also be income tax free. After that, people should have to pay more and more taxes, similar to the brackets we get with regular income tax.

    It’s pretty simple. We need to punish people who consume (pointlessly if you ask me) over what’s required. Obviously families should have a higher amount because their expenses are greater.

    This will super charge our economy. Taxing people for working more is the dumbest thing we can possibly do.

    • rogereolson

      That would play right into the hands of a rich person who only wants to save money and not spend it. I have known lots of miserly rich people who love having money more than spending it.

      • will f.

        “That would play right into the hands of a rich person who only wants to save money and not spend it. I have known lots of miserly rich people who love having money more than spending it.”

        It sounds like you are talking about me. This is something that really bothers me. When does ‘saving’ become ‘hoarding’ and I’m grateful for the tfsa since I think it’s a good way for the government to help people like me better themselves but maybe it’s all obfuscation for ignoring my sin of scrooge-ness. I wonder what to do… I am grateful to you for what you do.

        • holly

          Not spending (saving) puts money into the banks and stock market so that it can be lent to others. Thse people are making it sound like it is dead. It is not. We must increase savings.

    • John I.

      Canada now has Tax Free Savings Accounts that are protected from federal gains taxes (limited to $5,000 deposit per year, IIRC). One puts in after tax income into the TFSA, but all increases in value are protected from capital gains taxes, and one can remove the money at any time without paying any tax on the money. It seems to be working in a small way to encourage and increase savings.

  • Damien

    Professor Olson, this is one of the few posts of yours that I disagree with. I apologize for the length of this post, but this is a complex matter…

    It seems that you rightly criticize a bad version of a consumption tax, but mistakenly reject all such taxes when you argue that only the income tax is fair. Yes, there are many bad proposals, such as the FairTax. What they have in common is that they’re meant to appeal to a conservative constituency, as some of the bad arguments that you criticize show (e.g. making the poor “pay their fair share”). But the superiority of consumption taxes to income taxes is one of the most consensual ideas in contemporary economics. Support for a sensible consumption tax is found among economists of all stripes (typically in the form of either a progressive payroll tax or unlimited exemptions for savings and investments).

    I agree that the a good tax system requires the rich to pay more, not only in absolute terms but also as a percentage of whatever is taxed. That is, there should be progressivity. But this is only one aspect of “fairness”, namely vertical equity. When designing a tax system, we’re also interested in treating similar situations in the same way, or in horizontal equity, which you don’t address in your post. This is the main reason why a consumption tax is a good idea.

    Allow to me explain: Consider two indiduals, A and B, who each earn $100,000 from their labor. A enjoys fast cars and wants to live it up. B is thrifty and prudent. There are no taxes and A thus spends $100,000 the year he earns it, while B spends $30,000 and saves $70,000 at a 3% real annual interest rate. In 40 years, B has about $230,000. The counter-intuitive idea, for a non-economist at least, is that there is no inequality in this world. The $230,000 are exactly the same as the $70,000, only measured at a different point in time. If B spends this money 40 years from now, the present value of this consumption is still $70,000.

    Now let’s introduce an income tax of 40% (I use flat-rate tax because it is easier, but of course it would have to be progressive). A thus has $60,000 to spend now. B now spends $18,000 and saves $42,000. 40 years from now, he has $137,000 (which still has a present value of $42,000). The government considers the capital gains as income and taxes them (40/100*95,000 = 38,000). B now has $99,000 to spend. This seems fair (B has more money than A), but only because we are comparing apples and oranges by measuring income and consumption at two different points in time. We need to standardize our measures by measuring it all at the same time. The horizontal inequity then becomes clear:
    - A spends $60,000 and pays $40,000 in taxes in present value terms.
    - B spends $18,000 and pays $40,000 in taxes now. Additionally, 40 years from now, B spends $99,000 and pays $38,000 in taxes. In present value terms, B has spend $18,000 + $30,000 and paid $40,000 + $12,000 in taxes.

    This is unfair because A and B had the same amount of money to begin with. Why should B, who deferred consumption, have a lower present value for consumption and a higher one for taxes? He has delayed gratification, which is what we teach our children to do, and, in the process, improved everyone’s living standards by providing valuable capital, which is one of the main determinants of long-run prosperity. I note that you condemn “misers” but, in fact, they do a lot of good in this world by not consuming more than they need and building the capital that improves our living standards. Money in the bank or directly invested is not idle! If you tax that money away, the rich person is not any worse off since, by hypothesis, they don’t have any consumption to reduce in the first place. What you have just accomplished is taking money from people who would have gotten loans, bought a car, or built a factory.

    So, if an income tax is not really “fair”, why would a consumption tax be better? Well, consider a 40% payroll tax.
    - A still spends $60,000 and pays $40,000 in taxes in present value terms.
    - B spends $18,000 and pays $40,000 in taxes now. 40 years from now, he pays no taxes and enjoys the $137,000 that has accrued. That is, in present value term, his consumption is $18,000 + $42,000 = $60,000. In other words, A and B are treated equally and it doesn’t matter whether they’d rather consume their income now or later.

    You might object that we’re taxing labor income, not consumption. But another counter-intuitive fact is that this is all equivalent! Consider how a 40% VAT would work:
    - A earns $100,000. He spends it all and thus consumes $60,000 and pays $40,000 in tax. Same as above.
    - B also earns $100,000. He still spends $30,000 and saves $70,000. He pays 40/100*$30,000 = $12,000 in taxes and consumes $18,000 (same as above). 40 years from now, he spends the $230,000 that he now has. Of that amount, he consumes $138,000 and has to pay $92,000 in tax. So, in present value terms, he has consumed $18,000 + $42,000 = $60,000 and paid $12,000 + $28,000 = $40,000 on taxes.

    The two scenarios are therefore equivalent and a payroll tax is the same as a consumption tax, but much easier to administer.

    Note that this means that most of your objections are answered:

    1) This is in fact quite close to what most governments do, including the US government. Labor income taxes accounted for about 70% of tax receipts in the 2000-2009 period. Other countries have already tried reducing taxes on capital gains and dividends so we are not walking blindly.
    2) Not necessarily. People spend their after-tax income and there would be virtually no changes for most taxpayers, except that saving would not be penalized. A person who wants to spend X% of their income would pay the same amount of taxes whether we use a payroll tax or a sales tax, so we wouldn’t expect a great fall in consumption. And even if people decided to spend less on non-essentials, this would be a good thing in the long run as it would build our capital stock and increase our productivity.
    3) It is impossible to avoid a payroll tax, as the government already knows of much you’re making thanks to your W-2. It is only self-employed people that would be able to avoid taxation, just as they can try to do so now. This is in fact why the payroll tax is vastly superior to an equivalent sales tax!
    4) Fair point.
    5) Consumption is relatively easy to define for an economist. The questions here are the same as whether something is a business expense or not, or should be deductible or not. The political process and the bureaucracy can handle this and determine of much of education is investment in human capital and how much is current consumption. Or we can decide that all of education is investment. Or that education should be funded out of the public purse and thus not factor into anyone’s budget at all. Same for medical expenses.
    6 & 7) That’s a conservative talking point and indeed a bad idea. We want to keep the poor out of the tax system.
    8) With the payroll tax version, there is no incentive to do this since the tax has been prepaid when the money was earned. Another reason why it is superior to the equivalent sales tax. We might need to have a one-off tax on the current assets of millionaires to ensure a smooth transition, but that’s about it. In fact, with no taxes on capital gains and dividends, the US suddenly looks very attractive to foreign millionaires who might invest and consume here.

    • rogereolson

      Too many points to respond to individually. One thing stuck out at me, though. “Consumption is relatively easy to define for an economist.” I have not found that economists agree on much of anything which is why economics is historically called “the dismal science.” I return to my main point which is broad enough that it cannot be countered by specific economic arguments: income tax is the only fair (just) tax because it is the only tax based solely on ability to pay. Finally, can you name any country in the world that has no income tax but only a sales tax? Every state that lacks an income tax taxes property. Sales or consumption tax is never the sole tax. As I understand most proposals regarding consumption tax, they are to replace the federal income tax with that.

      • Damien

        As far as I can tell, there are no countries that have such a simple tax mix. But no country derived any substantial revenue from an income tax before last century either. Of course, in the real world, concessions will be made and we’ll never get such a clean, simple system. Yet, we can still estimate what would happen if we did because of the equivalence between taxing consumption and only taxing wage income. In 2005, taxes on dividend and capital gains accounted for less than $138.9 billion, or 6.4% of federal receipts. We might need to have higher top marginal rates to make up for that shortfall, but it would in fact be good because it would discourage conspicuous consumption. Robert Frank has made the same argument.

        - Ability to pay is only one side of the coin. What the money is used on is also important. The tax systems in European countries are very regressive, with non-progressive consumption taxes accounting for close to 30% of tax receipts. But the money is used on an extensive welfare state that greatly benefit the poor. So, while the tax system is unjust, the tax and benefits system as a whole is just. Regressive taxes can be justified if the revenue is used in a pro-poor fashion, such as a carbon tax with rebates or “sin taxes” on goods that are very harmful and are unfortunately primarily purchased by the poor.

        Additionally, income is not a very good measure of ability to pay. Who has the greatest ability to pay? Someone with no income but 10 gold bars in a vault, or a family with $50,000 in income but no assets?

        Anyway, I don’t want to bother you too much… I enjoy your posts and I hope you keep blogging for a long time :-)

    • Luis Augusto Fretes Cuevas

      “But the superiority of consumption taxes to income taxes is one of the most consensual ideas in contemporary economics. Support for a sensible consumption tax is found among economists of all stripes (typically in the form of either a progressive payroll tax or unlimited exemptions for savings and investments).”

      In general… consensus in economics are bad news, see Washington Consensus for an example, they mostly depend on ideological talk and not reality.

      ” In 40 years, B has about $230,000. The counter-intuitive idea, for a non-economist at least, is that there is no inequality in this world. The $230,000 are exactly the same as the $70,000, only measured at a different point in time. If B spends this money 40 years from now, the present value of this consumption is still $70,000.”

      This is bananas and absolutely wrong, not because I don’t think like economist, but rather because it’s economically wrong, it would be true that is the same amount measured at different times if you were just increasing the nominal amount at the same rate of inflation, a 3% *real* interest rate means it *really* increased.

      I’m too lazy to discuss the rest, but you’re wrong in everything.

  • E.G.

    Canada has gone a short part of the way with a small (5%) national consumption tax. The burden on the poor is removed by an ongoing supplement returned to those with low incomes. In other words, if you don’t make much, you still pay the tax, but you also receive regular reate checks that are tuned to your specific income level.

    No reason that couldn’t be implemented for a higher tax rate too.

    In other words, the way it’s painted in this post is regressive, but it doesn’t have to be that way.

    • rogereolson

      One of the main arguments I have read for consumption tax is to do away with bureaucracy. This would not do that. Also, how is a poor person to pay a 30% consumption tax if they don’t have the money “up front” even if they will receive a rebate check some time in the future?

  • E.G.

    One other note. I’d also argue that a consumption tax will act to reduce consumption. Since profligate consumption/consumerism is a major part of the various environmental issues that beset our world today, from a Christian creation stewardship point of view, some form of consumption tax might actually be a good thing. But, as I also said in a previous comment, care would have to be taken to reimburse those of lower means so as to keep it non-regressive.

    Fact of the matter, though… the more money you have, the more you spend. And vice versa. So with the correct measures, a consumption tax could mirror income taxes with the added benefit of reducing general consumerist materialism.

    • rogereolson

      You don’t address my argument that the rich would simply establish residences outside the US where they buy their luxuries nearly tax free and enjoy them. Without income tax to pay they would have much more money to spend to do this.

      • E.G.

        Don’t they already do this without a consumption tax?

        • rogereolson

          Yes, but not to the extent they would if consumption tax replaced income tax.

  • L. Lee

    I noted today on the Huffington Post That James Hansen of Global warming fame endorses the idea of a carbon (or fossil fuels) tax the proceeds of which would be distributed to the public at large. If global warming is real and severe, it might be a good approach (and could be a consumption tax at the pump).

  • Kevin McKee

    Canada has a national sales tax, but we also have a progressive tax system, with far fewer deductions than that in the U.S. We have some difficulties with poverty, especially among the aboriginal peoples (caused by a failure to support and encourage them in the past), but we have far fewer people homeless and all people receive their basic health needs without overtaxing the hospital system. We spend approx. 9% of GDP on health, while you spend 18%. Our wealthy overall pay about 22% to government, while your upper 1% pay about 5% (including capital gains deductions), that is why you have such a massive deficit issue. We are 1 tenth your size. Our deficit is about 50 billion, multiply by 10 it is 500 billion, compared to your 4 trillion in the past year. Regressive taxes disproportinately harm the poor, so we exempt food and shelter from sales tax. Simplifying your tax code, removing deductions for capital gains (income not earned by labour), and deductions for oil and gas companies and you could remove your deficit over 20 years. As Christians we are principally called by Jesus, to care for the poor, consumption taxes do the opposite.

    • rogereolson

      Exactly. Thank you.

    • E.G.

      Kevin wrote: “As Christians we are principally called by Jesus, to care for the poor, consumption taxes do the opposite.”

      Not sure that it actually does. As you noted, Canada has a consumption tax. You left out the fact that there are rebates on that tax that are set to different income levels. I don’t see why this couldn’t be put in place for a higher consumption tax (higher tax, higher rebates for those in need) as well. Other than moving offshore (as Roger noted… but the rich already do that), there are way less loopholes available if you pay the tax at the point of purchase.

      • rogereolson

        Again, that would require a huge bureaucracy to carry it out and how would a poor person be able buy a product with a 30% consumption tax just because she will someday get a rebate check? The issue is money “up front.”

  • J.E. Edwards

    How about the voluntary “tax” that 43 states already have in place (including Tennessee)? The lottery? Statistically, poor people are more likely to play the lottery. That is really a voluntary tax. Duke Policy News reports this: “Some studies show that the amount increases somewhat with income, while other studies indicate that the amount declines with income. But in virtually every case we have examined, one conclusion is constant: lower-income individuals spend a higher percentage of their income than those in middle and upper income brackets. This fact does not by itself make lotteries a good thing or a bad thing. It only means that lotteries tend to have a particular pattern of consumption, which is unlike, for example, the pattern of expenditures for brie or Chablis, commodities the expenditures for which tend to increase as a percentage of income in upper income brackets. Instead, the relationship of lottery purchases to income looks more like those of chicken wings or barbeque, items for which lower income households tend to spend a larger share of their income than those who are more affluent.”
    This is really the root: (1) Politicians have too much power and (2) Sometimes people just want a handout. All poor people are not the same, many need assistance. There is a nuance to this line of argument, that if you cross over it, you hate poor people. Somehow, people who do not want to pay more taxes don’t like poor people. Truthfully, I was surprised to see my earnings go down this year due to the tax increase. My wife and I aren’t even near the middle of the middle class in earnings.

  • John I.

    Commentors should note that Olson is talking about proposals to replace income tax with consumption tax, not about multiple / combined tax regimes.

    Multiple tax regimes, which have income taxes, sales taxes, capital gains taxes, royalties, etc., are arguably better because of their distributed base for taxation. Like investing, it is never wise to have all of one’s eggs in one basket.

    Sales taxes of some kind, at some level, are important because rich people buy more and buy more expensive items and so generally pay a greater substantive amount / proportionately higher amount in taxes than a poor person. It is not impossible to exempt certain goods from a sales tax (such as food) or to provide rebates, both of which are done by Canada. Similar regimes exist in Europe.

    Rich people have many reasons to stay in the US aside from tax avoidance issues, such a family, lifestyle, access to goods and services, residency requirements, desireability of US citizenship, politics, safety & crime, climate, location, corruption, personal roots, networking, etc. Rich people tend not to move unless sales or other taxes become (in their mind) unreasonably high. Typically only the uber rich move, and even then it is rare enough to be news – such as the two recent moves to Russia by movie stars. OK, they might pay less taxes, but honestly, how many people want to live in one of the murder and mugging and corruption capitals of the world?

    • rogereolson

      My wife and I watch HGTV and especially “House Hunters International.” We see a lot of super wealthy Americans (and others) moving to places with lower costs of living to live more luxurious lives.

      • John I.

        The number of people presented on HHI is small relative to the population of rich in America, consequently the implication of moving is anecdotal and because only a few couples are presented over a short period of time, the viewers perception of what is happening in society at large is skewed. Furthermore, program does not often comment on how long the couple intends to move, whether they will give up American citizenship (to avoid income taxes), what the sales tax rate is in the prospective country, etc. More importantly, the reasons given for moving have to do primarily with job relocation, weather, geography, lifestyle, etc. and taxation is never mentioned as a reason for moving (my wife watches the show from time to time, and drags me into it, knowing that I like exotic scenery and different kinds of architecture).

  • http://postmodernprodigal.wordpress.com/ AJG

    The simplest and fairest tax is a graduated income tax with no deductions. If you make $100,000 you pay X. If you make $150,000 you pay X + Y and so on. The top bracket should be around 90% as it was in the boom years after WWII. Politics aside, Ronald Reagan did more to saddle this country with crushing debt while creating the dangerous idea that “taxes are evil” than anyone else in history.

    • rogereolson

      I agree completely. And the reason this is fair is it is what most people (all reasonable people?) would choose under the veil of ignorance in the original condition (Rawls).

  • Joshua Douglas

    The Nation of Chile has a 20% concumption tax on all goods purchased except food. There is no income tax, only companies, businesses, etcare taxed on their earnings. I have lived in Chile for 5 years and they didn´t blink an eye in the 2008-2009 recession. Also, though not the largest economy, they are one of, if not the fastest growing economies in Latin America. So, yes, there are nations that have implemented this system and it works.

    • rogereolson

      What work does it do? It punishes people for spending–especially the poor.


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