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Fix the Tax System By Taxing Consumption

This article was written by in Taxes. 17 comments.


An elegant answer to the over-complicated tax system is to shift the basis of the system from income to spending. There have been a variety of proposals to make this happen. It’s the core of the so-called Fair Tax and Herman Cain incorporated its concept into his 9-9-9 tax plan. Other proposals have called for a value-added tax similar to the system in the United Kingdom.

FerrariWorking to earn a living contributes to society, as does investing in businesses. Taxes on income, whether wages or dividends, could discourage this type of economically-beneficial activity. Consumer spending also benefits the economy, though, and if this tax system discourages spending, it might have a negative effect on the economy initially.

Also, lower-income households and those who live paycheck-to-paycheck would bear a higher burden. When almost all of a family’s income is spent, this family would be taxed on a high percentage of their income. On the other hand, a corporate executive earning more than a million dollars does not need to spend all of his money. His tax burden is more affordable. Under today’s tax environment, someone with the means might put money into real estate, invest in businesses, and shelter assets in offshore accounts. Under the new system, a wealthy individual might stay away from buying houses if those transactions are taxed, while bringing more offshore assets back to the United States.

Rather than adding a national sales tax to determine consumption, one solution is to report all income, as is currently done, as well as all contributions to savings, just like what is done for IRA and 401(k) accounts. The difference between income and savings would be the basis on which the government levies the consumption tax. There could be a high standard deduction applied to the difference, so that lower-income families who are struggling to save do not need to pay an unaffordable tax bill, and so that the system remains progressive.

Reforming the tax system away from income tax is a tall order. Thanks to deductions for tax-advantaged savings, the income tax system has already begun to shift towards a focus on spending, but if you believe that the system could be vastly improved by focusing solely on consumption, the system has a long way to go before workers and savers aren’t punished by a tax collection system.

Would you prefer a tax system based solely on consumption?

Photo: exfordy
New York Times, Slate

Published or updated January 23, 2012. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 17 comments… read them below or add one }

avatar JT

A consumption tax as you propose where the difference between savings and income is the only thing taxed? Absolutely.

Most proposals want a pure consumption tax as a VAT or national sales tax. This is just another way for the government to tax twice your savings. If you have $20,000 in savings that you earned at an average tax rate of 20%, then you’ve already paid $5,000 in taxes for the amount in savings. (You earn $25,000, pay $5,000 in taxes, and have only $20,000 remaining.) In this case, a sales tax would tax again post-tax savings. There’s nothing “fair” about that.

I personally think the current tax system is fine with multiple income brackets. However, the amount of exemptions, deductions, and tax credits are not only ridiculous, but they’re also inefficient. In most cases, these tax credits are nothing more than subsidies for a few chosen businesses and industries – automakers, window manufacturers (A/C, heating, and appliance companies), etc. The whole tax code should be gutted, every tax credit and deduction removed, and each bracket’s percentage lowered in order to create a more efficient and fair tax system that doesn’t create work for Americans to give favors to the politically connected.

As always – this is just my 2 cents.

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avatar Monica

I agree that the tax structure needs to be reformed, but I am completely against a VAT (value added tax) such as the one in England. I lived there for a while, and the VAT tax was an incredible burden for the consumer, and it kept prices on everything extremely high. Unfortunately, where the government is involved, nothing is ever simplified its just made more complicated!

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avatar SteveDH

A Tax on the difference between income and savings is surely mislabeled when called a “consumption” tax. How would the savings amount be determined? If it was just the difference between earnings and spending then we would just spend everything – where would that get us? I could envision a plethora of “spending account schemes” emerging as a way to spend your money without really spending it. Before we condemn all of those special tax code breaks for the chosen few, we should look back at history. It was one of those sleazy little tax code changes to “help” a couple of extremely rich businessmen that when incorporated into our tax laws was entered as rule 401(k). How many of us now enjoy that little gem?

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avatar Luke Landes ♦127,505 (Platinum)

The question, if one were to move towards a consumption-based tax, is how to measure consumption. One method is to take the VAT approach, where tax is collected at every step of the chain of the movement of capital. A simpler option would be at the individual level, an estimation of consumption assuming all that is earned but not saved or invested must have been spent. Banks and financial firms would be charged with reporting contributions to all accounts. Of course, hiding cash under a mattress wouldn’t be reported as savings, and since it’s not consumption, households that do not use the financial industry for savings are at a disadvantage. I’m not sure I’m a fan of any of these options, but that’s the logic behind calling that process a consumption tax.

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avatar shellye ♦107 (Cent)

On the surface, this tax looks like it could motivate low-income earners to save more money by spending less. I don’t know if this is true; I’m just asking the question. But if I’m not earning that much to begin with, and now I’m taxed on what I spend money on, I’m going to start looking harder for better deals on everything and thinking before I spend, rather than buy out of convenience or ignorance.

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avatar wylerassociate ♦162 (Cent)

i’m against a consumption tax because it’s going to make the cost of living for middle class & low income families even tougher as it is now.

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avatar Luke Landes ♦127,505 (Platinum)

But what if the consumption tax system included a rebate, prebate, or some sort of exception that decreased the tax liability for low and middle income households? Any tax code will need to include some kind of provision to ensure it’s progressive.

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avatar wylerassociate ♦162 (Cent)

Flexo,
I would be ok if a consumption tax system had a rebate/exception that decreased the tax liability for low income/middle class families but I don’t have faith in the government to do that.

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avatar SteveDH

I can’t conceive how a prebate or exception would/could work on purchases but the rebate or refund might ease the burden like it does on income taxes. The problem is that everyone would have to pay this tax on purchases and then wait for a refund, bringing on cash flow issues. A “poor card” (like a tax exemption card for businesses) wouldn’t survive this country’s bias.

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avatar lynn ♦155 (Cent)

I was under the impression (from the book, Fair Tax) that there would be rebates for low income families.

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avatar SteveDH

Aren’t we already paying Value Added Tax on goods from the EU, India, Mexico, China and other VAT countries? Sellers in those countries get their final VAT back when selling overseas even though it’s already built-in to the cost along the way. There was a bill in Congress titled “Border Tax Equity Act” to either negotiate this disadvantage out or charge a border tax equal to the amount refunded to the sellers. It died. All of this conversation talks about revamping the tax code to increase revenue get’s couched in terms of being progressive and fair, but without spending constraints, there’s not enough free flow cash out there to support a spendthrift government with such an enormous interest expense on its existing debt. I’m not usually a doomsayer but now that our debt has ballooned past our annual GDP I may have to start looking at my mattress as a financial institution. ;-O

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avatar crashdamage1957

Wont ever happen. too many vested interests in keeping the status quo. I agree with JT, makes sense, but that will never happen either. see reason above. I’m usually not this cynical, but history back me up.

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avatar Num8er5

Isn’t this effectively an income tax with a large standard deduction and a deduction for “savings”?? This solves nothing. The key problem with the income tax system is defining income. For a wage earner that just receives a W-2 at the end of the year, maybe it’s simple. But if you have your own business, or even basic investments, it get’s real complicated and subjective from there. (e.g. what is a legitimate business expense vs. a “write off”?, etc.) Thus, the current system is ripe for manipulation and cheating. Look at all the economic and intellectual resources wasted on compliance with the current system.

A sales tax isn’t perfect, but it’s magnitudes simpler and could be set up to reverse the burden on lower incomes (standard rebate).

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avatar Ceecee ♦53 (Newbie)

I would like to see the VAT exempt food and clothing( under a certain price,) so it is more of a luxury tax. NJ does this with their sales taxes, to a degree. I can’t imagine the politicians ever allowing a flat tax. I don’t believe that the tax system should favor one lifestyle over another, such as giving deductions for homeowners, but not renters. Just sayin’.

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avatar PK

If you actually tossed out the income tax? Fair trade, IMO. The problem comes when you have both taxation systems active at the same time at a federal level – a VAT is a prescription for tax creep.

The other issue? All those Roth earnings you’ve saved don’t matter, heh. Should have picked the other account type, I suppose!

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avatar David C

VAT taxes are great for politicians because 1) it is easier to pass an increase without the taxpayers noticing and 2) taxpayers won’t be able to easily tell without additional bookkeeping the amount of tax they are paying each year (this “feature” is also shared to a lesser extend with “regular” sales taxes). I’d like a simplified income tax code (fewer deductions, one progressive rate scale for all sources of income), but I still prefer an income tax over the alternatives.

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avatar qixx ♦1,895 (Half-Dollar)

No change in the tax system is worth the effort involved until government spend is controlled or capped. Sure any change in the tax system will benefit someone. But as long as spending is not controlled then changes to the tax system will not produce the outcomes people want.

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