Income Tax vs. Consumption Tax

Background

Policymakers must choose how much to rely on taxing the income people receive versus taxing only the income that they spend (i.e., consumption). In many countries, a combination of taxes on income and consumption form the backbone of revenue systems. The U.S. is an exception in not having a federal-level consumption tax, although most states do tax consumption through sales taxes. The possibility of a new broad federal consumption tax, such as a value-added tax (commonly known as VAT), has been on policymakers’ agendas for decades as an alternative to merely increasing the income tax.

Supporters of consumption taxes point to several advantages relative to an income tax. First, consumption taxes can encourage saving since 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. Finally, compared with income taxes, a consumption tax can produce a more stable stream of revenue and is relatively easy to administer.

One concern with consumption taxes is that they tend to be regressive, absorbing a larger share of the earnings of people with low incomes. This occurs because people with lower incomes use a larger share of their income for consumption than do those with higher incomes. Limited mechanisms exist to increase the progressivity of consumption taxes.

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

INCOME TAX VS. CONSUMPTION TAX: Policy

Preference for income tax

In this policy: FederalState

A progressive income tax is the preferred method of raising revenue at the federal and state levels but other sources, such as a consumption taxes, may be needed.

States that do not have a broad-based personal income tax should enact one to increase equity, improve balance among revenue sources, and promote economic and budgetary stability.