Consumption Taxes: A View of Future Tax Reform in America
Fellows, James A., The CPA Journal
Judging from the political rhetoric, it is highly probable that some form of Federal tax on consumer expenditures, i.e., consumption, is not far from legislative enactment. President Clinton has broached the idea more than once, and several members of Congress have suggested a consumption tax should become law. The discussion of these taxes has progressed from the academic arena, where these issues were first suggested to the political area, where the issues may be debated as a matter of national policy.
Unfortunately, the general public is not well educated on the concept of consumption taxes at the Federal level. Most Americans pay some form of local or state sales tax on retail purchases, but their only contact with direct taxation from the Federal government is principally through income taxation.
Moreover, there is more than one type of consumption tax, and they often take on obscure names such as VAT (value-added tax).
THE INCOME TAX AND TAXATION OF SAVINGS
Regardless of the consumption tax employed, economists generally agree it is preferable to an income tax in one important context. An income tax imposes a tax on savings when earned. A consumption tax taxes income when spent. Therefore, if a consumption tax replaces in whole or in part an income tax, more savings in the economy would be encouraged.
As an example of how the current income tax is biased against savings, consider two individuals, X and Y, and a two-year period in which any income not spent in Year one is saved and then spent in Year two. Both individuals earn the same amount of yearly income, $10,000, all of which is taxable. Individual X, however, manes to save $2,000 per year of her after-tax income, placing it in a savings account, which earns a before-tax interest rate of five percent. Individual Y does not save any of his after-tax income, spending all of it on consumer purchases.
Assuming a flat tax rate of 20%, both X and Y pay an income tax in Year one of $2,000, leaving them both with after-tax incomes of $8,000. Of this amount, X places $2,000 in her savings account to earn five percent before tax. This savings, plus the accrued interest of $100, will be spent by X in Year two. Individual Y does not save anything, but rather spends the entire after-tax amount of $8,000.
Table 1 depicts this two-year process.(Table 1 omitted) In Year two, X has taxable income of $10,100, after adding the accrued interest. Her income taxes are $2,020, yielding an after-tax amount of $8,080. Y has the same situation as in Year one.
On the surface, the higher tax to X might seem fair. Some would argue X is being unfairly taxed just because she made the decision to be more thrifty than Y. This second conclusion receives additional support when the present value of the tax liabilities of X and Y are considered. Assuming a discount factor of five percent, the present value of the two tax liabilities for X and Y a as follows:
X: $2,000 + $2,020/(1.05) = $3924 Y: $2,000 + $2,000/(1.05) = $3905
Thus, even in present value terms, X is suffering higher taxes simply because she chose to allocate some of her present disposable income from consumption to savings. It is the "distortion" between present and future spending that causes many economists to argue the present method of income taxation of interest and dividends discourages savings, and therefore reduces the nation's future capital stock. This reduction in our capital stock then causes our growth rate of national income to be smaller than otherwise.
There is certainly no question that the U.S., compared to other industrial democracies, has a relatively low savings rate. For example, during the 1980s, savings in the U.S., including those of households and businesses, were less than 15% of GNP, while that for Japan was over 30%. Moreover, there may be more than a coincidence between this relative low savings rate and the fact the U. …