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Research Desk explains: What would a progressive consumption tax look like?

By Dylan Matthews

Matt Lewis asks:

What would a truly progressive consumption tax look like?

Currently, the personal income tax applies, as its name suggests, to all income. Salaries, wages and so forth are taxed whether or not they are being used to buy goods and services or to save. Heavy consumption, financed largely by debt, helped fuel the economic bubble over the past decade, and more sustainable consumption patterns are probably needed. One way to produce those is to not tax income but only consumption, which would encourage savings and discourage spending.

Retail sales taxes and value-added taxes (VATs) are the most widely used consumption taxes currently. The latter has the virtue of being easier to enforce, though given how many exemptions and loopholes would probably be included in a passed version, that benefit may not be present in practice. Unfortunately, both of these are regressive, as they tax spending by the poor and rich equally, and the poor tend to spend more as a percentage of income than the rich do. Thus, proposals for progressive consumption taxes have arisen.

The most prominent of these comes from the economist Robert Frank. His proposal would work like the personal income tax, with taxpayers tallying up their income on a return, only Frank would exempt all savings from taxable income, leaving consumption as the base to be taxed. To generate the same amount of revenue as the personal income tax, much higher rates would be needed, but one of the main disadvantages of higher rates--that they discourage savings and investments among high earners--would not be relevant, so steeply progressive rates would be less economically harmful. Frank would also include a large standard deduction, so very basic consumption--food, non-luxury rent, etc.--would end up not being taxed.

The late economist David Bradford proposed an alternative model, called the "X tax" which has two parts. The first is a VAT, but with businesses deducting wage payments from their burden. The second is a personal income tax on wages. Combined, the two tax the same base as a full VAT, since the wages deducted at first are then subject to a tax paid by the workers who receive them; see the anecdote of "Patient and Impatient" here for a fuller explanation of why the income tax is effectively a consumption tax. The personal income tax can be bracketed, allowing much more progressivity than under a simple VAT. It also would not require taxpayers to track all of their savings, as Frank's proposal would.

Finally, law professor Edward McCaffery proposed a progressive consumption tax in his book, Fair Not Flat, that combines a VAT or national sales tax and a Frank-style tax. McCaffery would impose a VAT or national sales tax of 10%, but provide a rebate to taxpayers, such that the first $20,000 in consumption would be tax-free. Then, McCaffery would impose a progressive consumption tax along Frank's lines, which would work essentially like a personal income tax with an unlimited savings deduction, on consumption above $80,000, with rates varying from 10 to 50 percent. This would allow most taxpayers to avoid filing returns while ensuring that the tax is still progressive.

By Ezra Klein  |  August 5, 2010; 4:52 PM ET
Categories:  Taxes  
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Comments

What about the opposite where we tax individuals like we tax businesses? Write off all expenses, only tax what's leftover.

Basically, a consumption only tax would cripple our economy (by discouraging spending) and encourage big box stores only. Not only are you paying lower prices at Wal-Mart, but you're paying lower taxes, too.

A savings-only tax, however, would encourage spending, since the gov't would only get a share of what you didn't spend! Before commenting, I really don't think the solution is as simple as that. Tax code is simply too complex to discuss in 3000 characters.

Posted by: will12 | August 5, 2010 5:59 PM | Report abuse

How would the govt track consumption? Would everything not going into savings be considered consumption? If basic needs are tax free/deductible, would consumers need a receipt at tax time for every loaf of bread, gallon of milk?

I like the premise however, it seems like our economy went from making things to revolving around debt. Something that would lessen debt levels seems beneficial.

Posted by: rirondo | August 5, 2010 6:14 PM | Report abuse

Please also see Professor Frank's fantastic classic Washington Post op-ed on this at:

http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf

Posted by: RichardHSerlin | August 5, 2010 6:38 PM | Report abuse

Eliminating paper currency and tracking bank accounts (only track the balance, of course!) and mandating everyone have a US bank account would be a start. We'd also have to mandate all employers use direct deposit, too.

Of course, that means more gov't intervention into our personal lives. I think republicans only want that when it involves testing unemployment insurance recipients for drug use or keeping gays from marrying or adopting.

Posted by: will12 | August 5, 2010 7:06 PM | Report abuse

will12: There'd be absolutely no reason for the government to get that involved in things. If people choose to hide their savings from the government, that would INCREASE their tax liability under such a system. So government would benefit from people hiding their savings, and taxpayers would have incentive to report their savings. And government obviously has quite a few fingers in the world of savings to begin with.

Posted by: usergoogol | August 5, 2010 8:22 PM | Report abuse

Well, its not exactly true that "the personal income tax applies, as its name suggests, to all income" - at least, not all income equally. We get fully taxed on income produced by the sweat of our brow, but a big break if we passivly collect income from investments. That seems up-side-down to me, but taxing all income at the same rate would be a bold first step towards fairness.

Posted by: glenerian | August 6, 2010 9:24 AM | Report abuse

Frank's is a pretty good model. Here's a great tweak of it: peg the standardized deduction to cost of living.

Right now variances in cost of living are a huge barrier to labor mobility and, frankly, people realizing their talents and potential to contribute. Especially as long as health care is not portable and reliable.

Posted by: iraqvet231 | August 7, 2010 11:42 AM | Report abuse

I have two initial concerns about such a tax.
1) Is taxing consumption a good thing?
(I actually mean that as a question -- there is so much written about the importance of consumption to the economy that I'm not sure how decreasing it would be helpful.)

2) A consumption tax (of any kind) amplifies price differences.
That's fine as long as we are thinking in terms of buying luxury car instead of a used car, or of buying artworks instead of saving the money.
But this amplification of price means that policies that distort price, such as the corn subsidies, would produce an even greater distortion than they do already. Fresh fruits and vegetables are already more expensive than less healthy subsidized food, a consumption tax would make them more so.
Needless to say, this is not the only bad policy. Therefore, though the tax initially seems less distorting than the current income tax hodge-podge, it would in fact enhance every bad, market distorting, policy automatically. (To be fair, it would also enhance good policies -- but then again, good policies eventually become bad after they garner enough dependents to be immune to change).

Posted by: bill_who | August 7, 2010 3:37 PM | Report abuse

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