Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Consumption Taxes: Macroeconomic Effects and Policy Issues

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Consumption Taxes: Macroeconomic Effects and Policy Issues

Article excerpt

Proposals for fundamental reform of the federal rax code are receiving increased attention in the business press and among economic analysts and policy-makers. President Bush has identified tax reform as a top priority, calling for a tax system that is "pro-growth, easy to understand, and fair to all." Moreover, the President has appointed a commission to consider different approaches to tax reform. One approach might be to improve the current income-based federal tax code, perhaps by broadening the tax base and lowering income-tax rates. However, another approach might be to replace current income taxes altogether with a consumption tax.

Switching the federal tax system from an income tax to a consumption tax could have important macroeconomic effects. Most economists believe that switching to a consumption tax could increase saving and real output per person over the long run, although studies differ on the size of these effects. However, switching to a consumption tax might also require sizable short-run economic adjustments and create challenges for monetary policymakers.

This article analyzes the macroeconomic effects of replacing the current federal tax system with a consumption tax. The first section provides some background on the goals of tax reform and the basic difference between an income tax and a consumption tax. The second section describes three widely discussed versions of a consumption tax: a national retail sales tax, a value-added tax, and a consumption-type flat tax. The third section examines the macroeconomic effects of adopting a consumption tax. All three proposals could raise U.S. output over the long run, but adopting a consumption tax could have sizable transition effects as well. These transition effects could vary depending on which consumption tax was adopted and how monetary policy responded to the reforms.

I. BACKGROUND ON TAX REFORM

When considering tax reform options, fiscal policymakers are likely to weigh several important goals of tax policy. This section briefly discusses these goals because tradeoffs among them have a major influence on tax policy in practice. The section also considers the basic economic difference between an income tax and a consumption tax, the treatment of saving.

Goals of tax reform

Fiscal policymakers usually consider various goals for tax policy. Five possible goals are: simplicity, stability, fairness, adequate revenue, and economic efficiency. The macroeconomic effects emphasized in this article fall primarily under the heading of economic efficiency. However, the other policy goals also play an important role in motivating the recent interest in tax reform. Fiscal policymakers often must make tradeoffs between these goals. For example, research described later in this article illustrates some key tradeoffs between economic efficiency and fairness.

Simplicity. Tax experts do not dispute that the current federal tax code is extremely complex, although some might argue that complexity is unavoidable. In 2000, the Internal Revenue Code and related regulations contained 9.4 million words, up from about 1 million words in 1940 (Graetz). This complexity requires extensive recordkeeping, large amounts of time devoted to preparing tax returns, and the hiring of expert tax advisors. In 2002, individuals, businesses, and nonprofit organizations spent 5.8 billion hours and over $194 billion complying with the federal tax code (Moody). Simplifying the tax code could reduce taxpayer frustration and free up resources for more productive uses.

Stability. Greater stability of the tax code is another possible goal for tax reformers. Besides being complex, the federal tax code has been modified frequently as fiscal policymakers responded to changing economic circumstances and political pressures. An example is changes in the marginal tax rate, the percent of an additional dollar of income that must be paid in taxes. The federal government's highest marginal tax rate for individuals was 50 percent in 1986. …

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