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A consumption tax is a tax on spending on goods and services. The term refers to a system with a tax base of consumption. It usually takes the form of an indirect tax, such as a sales tax or value added tax. However it can also be structured as a form of direct, personal taxation: as an income tax that excludes investments and savings.[1] A direct consumption tax is sometimes called an expenditure tax, a cash-flow tax, or a consumed-income tax, to name a few. Expenditure taxes of this kind have been briefly implemented in the past in India and Sri Lanka.[2]

Since consumption taxes are inherently regressive on income, some current proposals make adjustments to decrease these effects. Using exemptions, graduated rates, deductions or rebates, a consumption tax can be made less regressive or progressive, while allowing savings to accumulate tax-free.[3][4]

Contents

Origins

Throughout most of American history, taxes were levied principally on consumption. Alexander Hamilton, one of the two chief authors of the anonymous Federalist Papers, favored consumption taxes in part because they are harder to raise to confiscatory levels than incomes taxes.[5] In the Federalist Papers (No. 21), Hamilton wrote:

It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess. They prescribe their own limit, which cannot be exceeded without defeating the end proposed—that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty that, "in political arithmetic, two and two do not always make four." If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them.[6]

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Example

One of the first detailed analyses of a consumption tax was developed in 1974 by William Andrews.[7] Under this proposal, people would only be taxed on what they consume, while their savings would be left untouched by taxation. In his article, Andrews also explains the power of deferral, and how the current income tax method taxes both income and savings. For example, Andrews offers the treatment of retirement income under the current tax system. If, in the absence of taxes, $1 of savings is put aside for retirement at 9% compound interest, this will grow into $8 after 24 years. Under our current system, assuming a 33% tax rate, a person who earns $1 will only have $0.67 to invest after taxes. This person can only invest at an effective rate of 6%, since the rest of the yield is paid in taxes. After 24 years, this person is left with $2.67. But if, like in an Individual Retirement Account (IRA), this person can defer taxation on these savings, he will have $8 after 24 years, taxed only once at 33%, leaving $5.33 to spend on her retirement. It is also mathematically irrelevant when the tax is imposed, for if this same person is taxed on the dollar he earns, but is never taxed again, the $0.67 he invests will grow to $5.33 in 24 years. Timing the taxation in this way is much like a Roth IRA. This is the primary concept of the consumption tax- the power of deferral. Even though the person in the above example is taxed at 33%, just like his colleagues, deferring that tax left him with twice the amount of money to spend in retirement. Had he not saved that dollar, he would have been taxed, leaving $0.67 to spend immediately on whatever he wanted. Harnessing the power of deferral is the most important concept behind a consumption tax.

Concerns

In the above example, the equation for the government is the opposite as it is for the taxpayer. Without the IRA tax benefits, the government collects $5.33 from the $1 saved over 24 years, but if the government gives the tax benefits, the government collects only $2.67 over the same period of time. The system is not free. Regardless of political philosophy, the fact remains that a government needs money to operate, and will have to get it from another source. The upside of the consumption tax is that, because it promotes savings, the tax will encourage capital formation, which will increase productivity and economic activity.[3][4] Secondly, the tax base will be larger because all consumption will be taxed.

Some critics argue that sales and consumption taxes can shift the tax burden to the less well off. The ratio of tax obligation shrinks as wealth grows because the wealthy spend proportionally less of their income on consumables.[8] Setting aside the question of rebates, a working class individual who must spend all income, will find his expenditures and therefore his income base taxable at 100%, whereas wealthy individuals who save or invest a portion of their income will only be taxed on the remaining income. This argument assumes that savings or investment is never taxed at a later point when consumed (tax-deferred).

Further, average citizens cannot take advantage of tax-avoidance avenues, such as offshore purchases. A working class individual cannot realistically purchase, say, a Mercedes or Lexus offshore, thereby avoiding domestic tax. However, when purchases are made offshore, the buyer is subject to the tax laws in that country, using the example of Mercedes or Lexus - buyers would be subject to the VAT tax (the VAT is removed on exports and would not be charged if purchased domestically) and buyers may be additionally subjected to import taxes at customs. Moreover, the argument that consumption taxes can be avoided by offshore purchases implicitly assumes that the consumption tax is levied at the point of sale. There are methods of implementing the tax (such as the Hall-Rabushka model) that would tax a citizen's consumption regardless of where the consumption occurs. This also ignores the fact that many consumption tax regimes (such as the GST in Australia) levy the tax against imports over a certain value, and that many jurisdictions impose a use tax when automobiles purchased elsewhere are registered in the jurisdiction.

Practical considerations

Many proposed consumption taxes share some features with the current income tax systems. Under these proposals, taxpayers would be given exemptions and a standard deduction in order to ensure that the poor do not pay any tax. In a completely pure consumption tax, other deductions would not be permitted, because all savings would be deductible.[3]

A withholding system might also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.

A consumption tax could also eliminate the concept of basis when computing the value of investments. All income that is put in investments (such as property, stocks, savings accounts) is tax-free. As the asset grows in value, it is not taxed. Only when the proceeds from the asset are spent is any tax imposed. This is in contrast with the current system where, if you buy land for $10,000 and sell it for $15,000, you have a taxable gain of $5,000. A consumption tax only taxes consumption, so if you sell one investment to buy another investment, no tax is imposed.

In Andrews' article, he notes the inherent problem with housing. Renters necessarily "consume" housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset). The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent his or her home to others in exchange for money, but instead, the homeowner chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home. A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) and would not tax the increase in the value of the asset (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States, home ownership is subsidized by the federal government by permitting a deduction for mortgage interest expense, and by exempting a significant increase in value from the capital gains tax. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible in the United States.

Lastly, a consumption tax could utilize progressive rates in order to maintain "fairness." The more someone spends on consumption, the more they will be taxed. The rate structure could look like the current bracket system, or a new bracket system could be implemented.

Economics

Former senior editor of Fortune Magazine Al Ehrbar notes that proponents of a consumption tax argue its superiority to the income tax based on an economic principle called "temporal neutrality".[9] He observes that a tax is "neutral" if it does not "alter spending habits or behavior patterns and thus does not distort the allocation of resources." In other words, taxing apples but not oranges will cause apple consumption to decrease and orange consumption to increase. The temporal neutrality of a consumption tax, however, is that consumption itself is taxed, so it is irrelevant what good or service is being consumed in terms of allocation of resources. The only possible effect on neutrality is between consumption and savings. Taxing only consumption should, in theory, cause an increase in savings.[3] William Gale, Co-director of the Urban-Brookings Tax Policy Center, offers a simplified way to understand a consumption tax: Assume that our current tax system remains the same, but remove limitations to contributing to and removing funds from a traditional Individual Retirement Account (IRA). Thus, a person would essentially have a bank account where they could place tax-free earnings at any time, but unsaved (or consumed) withdrawals would be subject to taxation. Having an unrestricted IRA under the current system would approximate a consumption tax at the federal level.

Many economists and tax experts favor consumption taxes over income taxes for economic growth.[10][11][12] Consumption taxes are neutral with respect to investment.[3][11] Depending on implementation (such as treatment of depreciation) and circumstances, income taxes either favor or disfavor investment. (On the whole, the US system is thought to disfavor investment.[3]) By not disfavoring investment, a consumption tax might increase the capital stock, productivity, and therefore increase the size of the economy.[3][4] Consumption more closely tracks long run average income.[4] An individual or family's income often varies dramatically from year to year. The sale of a home, a one time job bonus, and various other events can lead to temporary high income that will push a low or middle income person into a high tax bracket. On the other hand, a wealthy individual may be temporarily unemployed and will pay no taxes.

See also

Notes

  1. ^ The Flat Tax, By Robert E. Hall and Alvin Rabushka, Hoover Institution
  2. ^ Encyclopedia Britannica: Taxation
  3. ^ a b c d e f g Andrews, Edmund L. (2005-03-04). "Fed's Chief Gives Consumption Tax Cautious Backing" (HTML). The New York Times. http://www.nytimes.com/2005/03/04/politics/04tax.html. Retrieved 2008-02-05.  
  4. ^ a b c d Auerbach, Alan J (2005-08-25). "A Consumption Tax". The Wall Street Journal. http://online.wsj.com/article/SB112492381500022421.html. Retrieved 2008-02-05.  
  5. ^ Bartlett, Bruce (2002-04-05). "The Founders and the consumption tax". Townhall.com. http://www.townhall.com/columnists/BruceBartlett/2002/04/05/the_founders_and_the_consumption_tax. Retrieved 2007-08-09.  
  6. ^ Federalist Paper No. 21
  7. ^ Andrews, William D. A Consumption-Type or Cash Flow Personal Income Tax, 87 Harv. L. Rev. 1113 (1974)
  8. ^ Gilbert E. Metcalf. "The National Sales Tax: Who Bears the Burden?"
  9. ^ Ehrbar, Al. Consumption Tax, The Concise Encyclopedia of Economics
  10. ^ Regnier, Pat (2005-09-07). "Just how fair is the FairTax?". Money Magazine. http://money.cnn.com/2005/09/06/pf/taxes/consumptiontax_0510/. Retrieved 2006-07-20.  
  11. ^ a b "Greenspan: Consumption Tax Could Help Economy". Fox News. 2005-03-03. http://www.foxnews.com/story/0,2933,149298,00.html. Retrieved 2008-08-09.  
  12. ^ "America the Uncompetitive". Wall Street Journal. 2008-08-15. http://online.wsj.com/article/SB121875570585042551.html. Retrieved 2008-09-03.  

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