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Random Thoughts on a Consumption Tax

I haven't thought about a consumption tax comprehensively. But I have some things that are worth saying even if they're incomplete and ill-organized. (You see, I was thinking about it in the shower, and if I don't write it down, I'll forget…)

I don't like any taxes. But from an economic standpoint, I have to prefer taxes on consumption over taxes on income. Income taxes reduce the incentive to work, and taxes on investment income reduce the incentive to invest. Both of these are powerful brakes on economic growth. A consumption tax also reduces economic growth, but primarily because the government wastes money, not by damaging incentives.

I haven't read anything approaching a specific proposal for how the tax system of the United States might be replaced with a consumption tax. But I worry about how many ways it could be done badly. I'm normally not a better-the-devil-you-know kind of person, but it would be very easy to screw up the implementation and make it a terrible mess. (Even worse than the income tax? You've got me there. Even a botched consumption tax could wind up better than what we're living with today.)

Economically, a consumption tax means a tax on consumption expenditures — all purchases that are not made for the purpose of making money. If you buy nails to hang a painting in your home, that is a consumption expenditure. If a business buys nails for use in constructing a boat it will subsequently sell, that is not a consumption expenditure.

I worry that the consumption tax has been floated as a national sales tax -- sales tax ≠ consumption tax. The nails purchased by the boat-building company are productively consumed, consumed for the purpose of making money, so they are a productive expenditure and should not be subject to a consumption tax. If a national sales tax were used, would it have exemptions for productive expenditures? How would it be administered — would purchasers be required to prove how the purchase will be used?

If a sales tax doesn't have an exemption for productive expenditures, it will create an economic incentive for potentially wasteful vertical integration of companies as a way to avoid the need to buy basic supplies at retail (where they would be taxed).

Investments should also be exempt from a consumption tax. But here the line becomes unclear. A gold bar is clearly an investment and shouldn't be taxed. But what about jewelry? Numismatic coins? Expensive paintings? When do these things become more consumption goods and less investments? And who decides?

What about goods that go through many hands, such as a used car? Would its sale be taxed only when it was sold as new, or would it be taxed again when it as sold as used? It should be taxed only once, because the tax is supposed to cover the entire consumptive value of the good. Taxing it multiple times would be distortionary by making later transactions more expensive, and would also double-tax the (remaining) consumptive value of the good. However, a car rental company's used fleet vehicle should be taxed if it is ever sold to the public. But not if it's sold to a business. Does a system that tries to incorporate all this sound complicated, yet?

There will be enormous political pressure for exemptions that shouldn't exist. Food, medical expenses, and real estate are either so important or so expensive that politicians will be heavily pressured to make them tax-exempt. A true consumption tax should cover these things. Owner-occupied housing is, economically speaking, a consumption good -- because it's purchased for purposes other than making money. Housing is particularly interesting, because investment properties should not be taxed (I can hear the screams of unfairness already!) and because its character can change over time: If rents are too low, the owner might decide to live there instead of renting it, changing what had originally been a productive expenditure into a consumption expenditure. How would that be taxed? One obvious idea is to adjust the tax for depreciation. But what of the reverse situation, where a home becomes an investment property when the owner moves out but doesn't sell? They've paid too much tax; do they get a rebate?

Again, I haven't read any specific proposals. But there are a lot of ways to screw it up. Let's be cautious.

Tiny Island