The Consumption-Based Income Tax

By Anderson, Kenneth E. | Journal of Accountancy, June 1994 | Go to article overview

The Consumption-Based Income Tax


Anderson, Kenneth E., Journal of Accountancy


Many tax-simplification advocates say just amending current laws doesn't go far enough and call instead for a major overhaul of the tax system. One reform many policy experts advocate is introducing a consumption-based tax system. Such a tax could be imposed indirectly through a value-added tax (see "The Value-Added Tax," by Charles E. Price and Thomas M. Porcano, JofA, Oct.92, page 44) or a national sales tax. It also could be imposed directly (as an income tax is), except savings and investment would be exempt. This article reviews the conceptual and administrative aspects of a consumption-based tax, presents the major arguments for and against it and discusses some implementation problems.

A consumption tax has been under consideration for a number of years. In 1977, the Treasury Department published Blueprints for Basic Tax Reform. In 1992, the Center for Strategic and International Studies (CSIS) in Washington, D.C., published the first report of the CSIS Strengthening of America Commission cochaired by Senators Sam Nunn (D-Ga.) and Pete Domenici (R-N.M.). Senators Nunn and Domenici expect to propose a bill in Congress providing for hearings on a new consumption-based tax system and setting a deadline for a vote in 1996 or 1997. In addition, Senators David Boren (D-Okla.) and John Danforth (R-Mo.) established a study group to develop a legislative proposal for a consumption tax.

WHAT IS A CONSUMPTION TAX?

When discussing a consumption-based income tax, theorists usually begin with a comprehensive income tax. The most common definition of income is Haig-Simons's--consumption plus accretions in wealth--which implies an individual's income can be either spent or saved. The Haig-Simons definition is typical of a comprehensive income tax base because it includes all income regardless of source and limits deductions.

Mathematically, Haig-Simons income can be represented as C + S = I, where C is consumption, S is savings and I is income. From this formula, a consumption base can be derived as C = I - S, which essentially is an income base with savings deducted.

In its 1977 study, the Treasury Department expanded this simple formula and defined consumption as: Consumption = Income receipts (cash and noncash)

            +  Gifts and inheritances received (?)
            -  Gifts and bequests given (?)
            -  Cost of earnings
            -  Other outlays
            -  Savings

Income receipts include wages, employee benefits, interest, dividends and asset sale proceeds. Gifts, inheritances and bequests are followed by question marks because their inclusion or deductibility is controversial (as discussed below). Cost of earnings includes business expenses and certain employment-related expenses. Other outlays include medical expenses, charitable contributions, state and local taxes and other expenditures that, for policy reasons, are not viewed as consumption. Savings include, among other things, net deposits to savings accounts and the cost of assets purchased.

NUTS AND BOLTS OF A CONSUMPTION TAX

A consumption tax differs from an income tax in that savings are exempt until spent. The Treasury Department study, the CSIS commission and others recommended implementing a consumption tax using a cash flow model because of the relative ease of administering it. The cash flow model would use two methods to exempt savings--the cash flow method and the prepayment method.

Cash flow method. If this method was adopted, "qualified accounts" could be established and managed by financial institutions in much the same way individual retirement accounts are handled. However, qualified account contributions would be deductible from the consumption base without limit, and withdrawals could be made at any time without penalty. Withdrawals would be included in the consumption base unless reinvested. This approach is particularly well suited to financial investments, such as stocks and bonds, and for savings accounts. …

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