The Congressional Research Service Reports on Consumption Taxes
January 2014A recent report by the Congressional Research Service examines the potential consequences of the United States adopting a consumption tax as part of comprehensive tax reform legislation. The report is of interest because it describes some economic benefits of adopting such a proposal. It also discusses the groups of taxpayers that would benefit or be disadvantaged if a consumption tax were to be adopted.
The United States does not have a national consumption tax, although all but five states have a sales tax. In this regard, the United States is an outlier compared to the rest of the world. At least 120 countries do have a consumption tax, and the United States is the only OECD-member country that does not have a national consumption tax. Worldwide, the revenue collected from such taxes is substantial. In 2012, OECD-member countries collected 20 percent of their total tax revenue using a value-added tax (“VAT”). In contrast, 25 percent of total tax revenue was collected with an income tax in OECD-member countries.
Overview of Consumption Taxes
There are three fundamental types of consumption taxes: a VAT, a national sales tax and a consumed-income tax. A VAT is a tax levied at each stage of production on a business’s net value-added. The most popular method of computing the VAT is the credit-invoice method. Under this method, a firm first calculates the VAT on its sales and subtracts from that its VAT payments on inputs. The difference is remitted to the government.
A national sales tax is collected by vendors on retail sales. It is determined as a fixed percentage of taxable goods and services. A consumed-income tax is implemented by using a savings account similar to an individual retirement account (or IRA). A taxpayer’s income is first determined and then reduced by net contributions to the savings account. This net amount of income is subject to tax. Thus, savings remain untaxed until they are withdrawn from the account. Unlike a VAT, which is determined based on a fixed rate, a consumed-income tax may be imposed at progressive rates.
Consequences of a Consumption Tax
Impact on hours worked
The report discusses in some detail the impact of a consumption tax on the work-leisure choice and on savings. The report notes that, with respect to the work-leisure choice, a consumption tax has both a substitution effect and income effect. As a consumption tax reduces after-tax wages, the tax reduces a taxpayer’s purchasing power which leads some taxpayers to work longer hours. This is the income effect. Offsetting that is a substitution effect. A consumption tax reduces the relative value of work compared to leisure, which will lead some taxpayers to work fewer hours. The report cites empirical data that the substitution effect is greater than the income effect, with the net result that hours worked decrease.
Impact on Savings
An income tax affects savings by reducing the after-tax return to savings. For example, if a taxpayer places $1,000 in a savings account earning 10% interest, the taxpayer will earn $100 of taxable income during the year. In contrast, a consumption tax does not tax savings so the $100 of interest is not taxed currently. The income effect of a consumption tax implies that taxpayers will save less because their after-tax return is higher, and a taxpayer can achieve the same targeted savings by saving less. The substitution effect implies that taxpayers will save more by raising the price of current consumption as compared to future consumption. Economic research suggests that the substitution effect tends to outweigh the income effect. The report goes on to state, however, that “the economic literature has not reached a clear consensus on the savings response . . . with many researchers finding a wide range of estimates including no response at all.”
Impact on the Economy
Moving from an income tax to a consumption tax is expected to have a positive impact on the economy for several reasons. First, savings accumulated prior to the introduction of a consumption tax have already been subject to the income tax. Those “old” savings will be taxed again when consumed. As the stock of old savings is large, it permits a lower rate of consumption tax compared to the situation in which there is no stock of savings at the outset.
As discussed above, a consumption tax also is expected to increase savings. This, in turn, leads to increased investment, which tends to stimulate economic growth. The report cites economic studies suggesting that in the long term, under a consumption tax, economic output could increase by 5 to 10 percent when compared with an income tax.
The report also notes that as the stock of old savings is owned by the elderly, there may be political pressure to tax consumption out of old savings at a lower tax rate. This, in turn, will offset the benefit of a lower tax rate on consumption as the general consumption tax rate will have to be increased to raise the same revenue.
Winners and losers
A consumption tax is often thought to be regressive, i.e., the tax rate is higher on taxpayers with lower income. For example, some lower income taxpayers have negative savings rates leading to a high effective rate of tax on consumption. On the other hand, wealthier individuals have positive savings rates leading to a lower effective rate of tax.
The report states that when using lifetime income, as opposed to annual income, the burden of the consumption tax is more equitably distributed. Over an individual’s lifetime, consumptions tends to approximate income. Thus, although wealthier individuals may pay a lower consumption tax in earlier years, in later years they will pay higher tax when they consume more.
The report also notes that under an income tax, an individual’s tax burden is independent of his age. However, the burden of a consumption tax varies with age. Middle-aged individuals typically are saving for retirement, which reduces the effective tax rate of a consumption tax. Retired individuals, however, pay a higher effective tax rate because they spend out of savings.
Consumption taxes have been the favorite of conservatives for hundreds of years. However, the tax has not had much political support as of late. Republicans generally oppose it as a tax increase, and Democrats generally oppose it as regressive. There is also some evidence from other countries that politicians who support a consumption tax suffer political setbacks in elections following the year the tax is introduced.
Nevertheless, there are various scenarios under which a consumption tax may become part of U.S. law. First, Congress will eventually resolve the growing deficit in the Social Security and Medicare programs. This probably will be done through a mix of reductions in benefits and tax increases. A consumption tax may very well be part of that bargain.
A consumption tax also may be a part of comprehensive income tax reform. For example, the income tax could be eliminated for lower and middle income taxpayers and replaced with a consumption tax. A well-known law professor and tax policy expert, Michael J. Graetz, has written a book considering this possibility. Finally, some have discussed a consumption tax as part of a bargain to lower the corporate income tax rate and move the United States to a territorial system of corporate income tax.
 Marples and Stupak, Consumption Taxes: An Overview, Congressional Research Service (January 14, 2016). Bruce Bartlett, The Conservative Case for a VAT, Tax Notes, March 17, 2015. The economist Larry Summers has commented that the United States will have a VAT when Republicans realize it is regressive and Democrats realize it’s a money machine. Jan M. Rosen, “Tax Watch, the Likely Form of New Taxes,” New York Times, December 19, 1988. See note 2. See Michael J. Graetz, 100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States (Yale University Press, 2008).
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