Recently, some article mentioned that some economists recommend replacing the income tax with a progressive consumption tax. They didn’t elaborate on that, and indeed, it was just a side sentence in a longer recommendation.
It made me stop, though, because if that actually existed—or rather, if a feasibly collected, progressive consumption tax would exist—it might solve a lot of problems in economics. Let me explain.
Income Tax vs. Consumption Tax
While nations often charge a wide range of taxes, the bulk of income usually comes from only two: The income and the consumption taxes. I’m using the plural here because I use them as categories, while the exact terms might actually refer to more specific taxes in various countries.
Income taxes charge a tax on the increase of the wealth of (natural or legal) persons. The exact forms of income affected can vary, but the basic idea is the same. This is a very well understood tax that has defined applications. It does have a number of drawbacks, though. Taxes are added cost, and added cost disincentivize whatever they add to. And generally, we do not want to disincentivize work which leads to income, neither providing work nor doing work.
Consumption taxes charge a tax on consumption. Typical examples are sales taxes and especially the VAT, hence why I use sales tax and consumption tax interchangeably here. While disincentivizing consumption is not great, the alternative to consumption is investment, and investment is even better than consumption.
Consumption taxes have a number of other advantages. For example, they do not prefer imports as both imports and local products are affected equally by the tax. On the other hand, if the sales tax means the income tax is lower, this actually prefers locally produced goods, as imports need to deal with the income tax in the originating country, too. And as exports do have to deal with lower local income taxes, a sales tax actually benefits exports, too.
Finally, sales taxes are arguably also the most transparent tax. When a business has to pay income tax, this tax addition will obviously influence the price. In a multi-stage production process, the resulting price will have accumulated quite a portion attributed to taxes, but the consumer has no way of knowing how much that is. Using a sales tax (especially a VAT) makes this very explicit.
The only problem with consumption taxes is that they are inherently unfair.
Regressive, Proportional and Progressive Taxes
Taxes can be categorized in three groups depending on how they distribute the burden of taxation.
A tax where everyone pays the same percentage of their money regardless of how rich they are is called a proportional tax. This is often seen as the fairest kind, but that is not necessarily the case as I will explain later.
A tax where poorer people pay a larger percentage of their money than richer people is called regressive tax, and is usually seen as clearly unfair. An extreme example would be a tax where everyone pays the same fixed amount of money (lump-sum tax).
Finally, a tax where richer people pay a larger percentage of their money than poorer people is called a progressive tax. This has nothing to do with it being more developed, but with the tax percentage “progressing” further the more money there is. This tax can also arguable be called unfair.
Finally, to analyze taxes, we need to realize that an abstract human has basically three kinds of expenses.
First, there are the basic necessities. Food, housing, clothing, etc. all are necessary for a humane life. It is important to note that these cost the exact same for everyone, no matter how much money they have.
Once there is more money available, people can improve on this using luxury consumption. For example, if someone owns a large house, the amount of money he would need to spend at least to have any kind of humanely decent housing would be basic necessities for housing, everything else he spends on the house would be luxury consumption.
Finally, any money that is left after basic necessities are met and any luxury consumption can be invested in anything from normal savings accounts to stocks. Usually, once basic necessities are met, the luxury consumption and investment both grow at the same time, not alternately.
The fact that basic necessities are the same for everyone has important effects on taxation fairness.
Income tax is basically a tax on wealth, restricted to the increase in wealth to avoid double taxation.
Let’s assume we have a poor person with a yearly income of 10,000 EUR and a rich person with a yearly income of 50,000 EUR. The basic necessities cost about 5,000 EUR.
Without taxes, the poor person can spend 5,000 EUR or 50% of his income (10,000 - 5,000 EUR) as per his own choices on luxury and investment. The rich person can spend 45,000 EUR or 90% of his income on luxury and investment.
If we go for a proportional (flat) income tax of 25%, the poor person ends up with 10,000 × 0.75 - 5,000 = 2,500 EUR for luxury or investment. That is, from the 5,000 EUR of money he had at his free disposal before the tax, he was charged 50% of taxes. The rich person will end up with 50,000 × 0.75 - 5,000 = 32,500 EUR, that is, he was charged only 28% of his formerly freely available capital as taxes. Even though both have paid the same tax rate, they end up with vastly different amounts of capital they can use according to their own choice.
A standard solution to this problem is to include a tax-free amount roughly at the level of the basic necessities. This removes this odd effect off the income tax.
The next thing to realize is that investment is strange. It does not give the investor instant gratification, but it increases their wealth. While this wealth increase will also be taxed by the income tax, it’s still a self-reinforcing system. And it is one of the important factors behind the gap between rich and poor increasing.
If this is seen as a problem, the income tax can again be adjusted to charge those with higher income more money to compensate somewhat for this self-reinforcing cycle. This turns the tax into a progressive tax.
(It’s also possible to do so without creating income levels where a wage increase means you end up with less money. No idea why this idiocy is still present in some tax systems.)
As you can see, the income tax is a highly flexible instrument. It works so well because it taxes wealth (increase) directly. This makes it apply directly to what we consider affecting “fairness.”
A sales tax is usually charged on any sale. This would be equivalent to an income tax if all of our uses for money were consumption, but that only applies to basic necessities and luxury consumption. Investment money is completely exempt from the consumption tax.
Excluding investment, a consumption tax has the same problem with being regressive just because of the basic necessities. Similarly to the tax-free amount for the income tax, a consumption tax can use lower or no tax on goods considered part of the basic necessities. This is not quite as accurate as with the income tax, as some goods can be purchased just the same for luxury consumption, but it’s close.
The exclusion of investment makes this tax totally different, though. As noted initially, this can actually be considered an advantage, as it incentivizes investment which is good for the economy, but it also means that the more money you use for investment, the less taxes (percent) you pay. This makes a consumption inherently regressive.
And there is no simple way to charge higher taxes from richer people to compensate even partly for the self-reinforcing effect of investment. Quite to the contrary, a consumption tax reinforces this problem, incentivizes it, and the state does not even get money out of it.
This is a serious problem.
The Progressive Consumption Tax
Which brings us back to the beginning of this post. The consumption tax is absolutely stellar compared to the income tax in pretty much every respect, except when it comes to fairness.
One of the biggest problems of modern economies is that the “richer become richer and the poorer become poorer,” and while that is inherent in the system of investment, the sales tax reinforces exactly that effect tremendously. An income tax at least does not give tax advantages to just this effect, and even provides a small way to counteract it.
Now, if a consumption tax would exist that would be effectively progressive, that would not reinforce this cycle, and as simple to collect as an income tax, that would solve a whole lot of problems. I just don’t see it.
Is there a feasible, progressive consumption tax?
This is the important question.
Slate suggested a tax that takes annual income and a record of all savings, and pays money on the difference. This is basically an income tax from the way it is collected, except there is no steady stream of money to the tax office, and you get a huge paycheck at the end of the year. But all I can see that doing is simply an incentive to keep cash at home or outside of the country, and I don’t think that’s a smart thing. At least this idea would need a lot of elaboration.
It might also be possible to combine a consumption tax with a financial transaction tax. If the thoughts in this article on the differences are exhaustive, this should turn the consumption tax into the equivalent of an income tax effect-wise while retaining most of the advantages of the consumption tax. This requires a longer look at the economic effects of a transaction tax.