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 taxing only income that is spent. This is known as a consumption tax. The U.S. is an exception in not having a federal consumption tax. Most states do, however, tax consumption through sales taxes. The possibility of a new broad federal consumption tax, such as a value-added tax (commonly known as VAT), is an alternative to merely increasing the income tax. 

Supporters of consumption taxes point to several advantages relative to an income tax. Consumption taxes can encourage saving. Any money someone saves is not taxed. In addition, a broad-based consumption tax can generate a significant amount of revenue at a relatively low tax rate. Compared with income taxes, a consumption tax can produce a more stable stream of revenue, and it is relatively easy to administer. 

One concern with consumption taxes is that they tend to be regressive. Regressive taxes absorb a larger share of the earnings of people with lower incomes than of people 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. 

Transitioning to a pure consumption tax at the federal level in the U.S. would pose challenges. Among them is the downside of taxing accumulated wealth. Generally, it has already been taxed under the income tax. That would burden older people who disproportionately own assets accrued during their working years.