Income Tax Versus Consumption Tax

There are two main ways for governments to collect taxes. One is by taxing income directly. This is known as an income tax. The other is by taxing income that is spent. This is known as a consumption tax. Unlike most other countries, the U.S. does not have a stand-alone federal consumption tax. Most states, however, tax consumption through the sales tax.

Policymakers and experts have discussed a broad federal consumption tax, such as a value-added tax (commonly known as VAT), as an additional new major source of revenue or as a replacement for the income tax. Supporters of a consumption tax point to several advantages relative to an income tax. A consumption tax can produce a more stable stream of revenue. It can encourage saving since income not spent is not taxed. A consumption tax also is relatively easy to administer.

However, a federal consumption tax also has disadvantages. Consumption taxes tend to be regressive. They absorb a larger share of the earnings of people with lower incomes than those with higher incomes. This is because people with lower incomes use a larger portion of their income for consumption than do those with higher incomes. Limited mechanisms exist to increase the progressivity of consumption taxes. In contrast, income taxes can be more progressive because people pay a higher percentage of their income as their earnings increase.