Rethinking our Tax System: Consumption vs. Income

As I read through my usual blog-roll of economic websites today, I was struck by Simon Johnson's latest post at The Baseline Scenario. Johnson's post was mostly centered around what he describes as the three competing views on the necessity of raising the debt ceiling. However he ended (rather abruptly) with an interesting and little talked about idea for restructuring our tax system in the context of the debt and deficits debate - taxing consumption rather than income.

Johnson argues that if indeed we spend too much relative to revenues:

It would make sense, therefore, to find ways to tax consumption more and income less. This could be done in a way that is not regressive, that does not punish people at the lower end of the income scale. Some of the most progressive tax systems in the world are based in large part on consumption taxes.

This is, of course, the same rationale we use throughout the tax code. Tax those things which we desire less of, and reduce taxes for things we wish to encourage. These are the basic laws of incentives, something that both Democrats and Republicans alike agree drive the human decision making process. A couple of easy examples which illustrate this point include taxing carbon dioxide or reducing taxes for businesses performing research and development. Doesn't it make sense then, to tax consumption (spending) more heavily than income?

Its an interesting proposition, and one which does have some merit when carefully considered. When we think of taxing consumption, we typically think of the Value Added Tax or VAT that is common in the European Union. The VAT works as standard tax on the purchase price for the consumer. In the case of the manufacturer, they are taxed only on those items in the supply process they purchase to make the product beyond their own. For example, a refrigerator manufacturer would pay taxes only on the component parts of the refrigerator above and beyond those created at its own factory. Once the refrigerator is sold at a retail store, the consumer pays the VAT much the way he or she typically pays a sales tax at point of sale. The VAT differs however, by taxing each purchase in the arch of the supply chain. The end goal is to increase revenue whenever consumption occurs. For the consumer, theoretically, they could avoid all taxes by simply putting their paycheck directly in the bank and abstaining from any and all purchases. The French generate nearly 50% of all total revenue by way of a VAT.

So, if it follows that we spend too much relative to income and if both sides have historically structured the tax system in line with desirable behavioral incentives, the idea of a VAT, or any other tax which attempts to encourage savings and disincentivize spending, at least deserves broader discussion. While it is certainly not a short term budget fix, it does potentially address the long term structural problems which afflict the way America taxes and spends.

For a couple of differing takes on the Value Added Tax, see this piece by the Urban Institute's William Gale and another by the Cato Institute's Daniel Mitchell.