One potential source of revenue at the federal level is a tax on “consumption.” By definition, “consumption” is income minus savings. Thus exempting savings is the fundamental economic distinction between consumption tax and “pure” income tax. Currently, there is no broad-based federal consumption tax, but there are state and local sales taxes.
In terms of their administration, broad consumption taxes may take many forms:
- Retail sales tax—the consumption tax most familiar to Americans is the retail sales tax. Retail establishments collect the tax on behalf of state and local governments but pass the tax burden directly along to consumers. There have been several proposals in Congress (such as the Fair Tax Act) that would substitute a national retail sales tax for the income tax, the payroll tax, or both. Retail sales taxes at the state level are discussed in greater detail below.
- Value-added tax—all industrialized nations except the US rely heavily on a value-added tax (VAT). This is a tax on businesses at each stage of production; it is levied on the difference between total sales and total purchases (including capital investment). Its effect is similar to that of a retail sales tax, but it is more effective at reducing multiple taxation of the components used in the production of goods. Proposals to implement a consumption tax have been debated in the US since at least World War II. Yet in the end policymakers have chosen not to impose such a tax. Some analysts believe, though, that the ongoing budget problems and increasing globalization of the economy may bring about a change in this area.
- Consumed-income (cash-flow) tax—a consumed-income, or cash-flow, tax (such as the “X tax”) measures consumption as income minus savings. This approach, like the income tax, requires filing annual returns. It can be progressive if exemptions, deductions, and graduated rates like those in the income tax are incorporated, something that neither the retail sales tax nor the VAT can accomplish as easily because they are based on individual transactions.
- Flat tax—because it does not tax income from savings and investments, the flat tax is in effect a consumption tax. It taxes only the labor income of individuals and the income—net of costs and investments—of businesses. Individuals do not pay tax on interest, dividends, or other investment income. Flat tax systems have one or two rates and few deductions. A flat tax eliminates most tax preferences, including the deductibility of mortgage interest, charitable contributions, and state and local taxes.
The fact that consumption taxes do not tax savings is the main argument in their favor. Only money spent on goods and services is taxed. This type of tax can therefore encourage saving and investment, which in turn help to support economic growth. Other positive characteristics of consumption taxes are their ability to raise significant amounts of revenue at low rates and their ease of administration.
A general criticism of consumption taxes, however, is that they are typically less progressive than the existing income tax. Lower-income people spend a larger share of their income on consumption than do higher-income people. There are ways to mitigate this, but there are limits to and concerns with the strategies. For example, a VAT can never be as progressive as an income tax because of the inability to deliver refundable tax credits without an external credit mechanism (such as filing requests for credits). Another common strategy for lowering the tax burden on low-income people involves exempting certain purchases, such as food, from the tax. This approach is poorly targeted toward low-income people, requires a higher tax rate to raise the same amount of revenue, and increases administrative complexity. Finally, establishing a consumption tax such as a VAT at the federal level would be challenging because of the need to coordinate the tax with retail sales taxes at the state and local levels.
The advantages of exempting savings under a consumption tax may be overstated, because the existing US individual income tax system is a hybrid between income and consumption tax. It features a number of provisions that benefit savings, so a large portion of savings escapes taxation anyway. Other ways of taxing consumption—excise taxes and gross receipts taxes—are discussed later in this chapter.