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Encyclopedia > Consumption tax

A consumption tax is a tax on the purchase of a good or service. Image File history File links Broom_icon. ... A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements). ...

Contents

Overview

The term "consumption tax" refers to a system whose tax base is consumption (as opposed to income or labour). While this can be structured like a sales tax, realistic proposals for a consumption tax recognize that regressivity is a problem with pure sales taxes. Using exemptions, graduated rates, deductions or rebates, a consumption tax can be made progressive, while allowing savings to accumulate tax-free. A sales tax is a consumption tax charged at the point of purchase for certain goods and services. ... A regressive tax is a tax imposed so that the tax rate decreases as the amount to which the rate is applied increases. ... A progressive tax is a tax imposed so that the tax rate increases as the amount to which the rate is applied increases. ...


Origins

One of the first detailed analyses of a consumption tax was developed in 1974 by William Andrews. See William D. Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 87 Harv. L. Rev. 1113 (1974). Under this proposal, people would only be taxed on what they consume, while their savings would be left untouched by taxation. For this reason, the tax can be called a consumption tax, a cash-flow tax, an expenditure tax, or a consumed-income tax, to name a few. Former senior editor of Fortune magazine Al Ehrbar notes that proponents of a consumption tax argue its superiority to the income tax based on an economic principle called "temporal neutrality." See Al Ehrbar, Consumption Tax, The Concise Encyclopedia of Economics.[1] He observes that a tax is "neutral" if it does not "alter spending habits or behavior patterns and thus does not distort the allocation of resources." In other words, taxing apples but not oranges will cause apple consumption to decrease and orange consumption to increase. The temporal neutrality of a consumption tax, however, is that consumption itself is taxed, so it is irrelevant what good or service is being consumed in terms of allocation of resources. The only possible effect on neutrality is between consumption and savings. Taxing only consumption should, in theory, cause an increase in savings. William Gale, Co-director of the Urban-Brookings Tax Policy Center, offers a simplified way to understand a consumption tax: Assume that our current tax system remains the same, but remove limitations to contributing to and removing funds from a traditional IRA. Thus, a person would essentially have a bank account where they could place tax-free earnings at any time, but unsaved (or consumed) withdrawals would be subject to taxation. Having an unrestricted IRA under the current system would approximate a consumption tax at the federal level. It has been suggested that 401k_ira_matrix be merged into this article or section. ... It has been suggested that 401k_ira_matrix be merged into this article or section. ...


Example

In his article, Andrews also explains the power of deferral, and how the current income tax method taxes both income and savings. For example, Andrews offers the treatment of retirement income under the current tax system. If, in the absence of taxes, $1 of savings is put aside for retirement at 9% compound interest, this will grow into $8 after 24 years. Under our current system, assuming a 33% tax rate, a person who earns $1 will only have $0.67 to invest after taxes. This person can only invest at an effective rate of 6%, since the rest of the yield is paid in taxes. After 24 years, this person is left with $2.67. But if, like in an IRA, this person can defer taxation on these savings, she will have $8 after 24 years, taxed only once at 33%, leaving $5.33 to spend on her retirement. It is also mathematically irrelevant when the tax is imposed, for if this same person is taxed on the dollar she earns, but is never taxed again, the $0.67 she invests will grow to $5.33 in 24 years. Timing the taxation in this way is much like a Roth IRA. This is the primary concept of the consumption tax- the power of deferral. Even though the person in the above example is taxed at 33%, just like her colleagues, deferring that tax left her with twice the amount of money to spend in retirement. Had she not saved that dollar, she would have been taxed, leaving $0.67 to spend immediately on whatever she wanted. Harnessing the power of deferral is the most important concept behind a consumption tax. It has been suggested that 401k_ira_matrix be merged into this article or section. ... A Roth IRA is an individual retirement account (IRA) allowed under the tax law of the United States. ...


Concerns

In the above example, the equation for the government is the opposite as it is for the taxpayer. Without the IRA tax benefits, the government collects $5.33 from the $1 saved over 24 years, but if the government gives the tax benefits, the government collects only $2.67 over the same period of time. The system is not free. Regardless of political philosophy, the fact remains that a government needs money to operate, and will have to get it from another source. The upside of the consumption tax is that, because it promotes savings, the tax will encourage capital formation, which will increase productivity and economic activity. Secondly, the tax base will be larger because all consumption will be taxed.


Practical considerations

A workable consumption tax would share some features with the current many income tax systems. Taxpayers would be given exemptions and a standard deduction in order to ensure that the poor do not pay any tax. In a completely pure consumption tax, other deductions would not be permitted, because all savings would be deductible. An income tax is a tax levied on the financial income of persons, corporations, or other legal entities. ...


A withholding system might also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.


A consumption tax would also eliminate the concept of basis when computing the value of investments. All income that is put in investments (such as property, stocks, savings accounts) is tax-free. As the asset grows in value, it is not taxed. Only when the proceeds from the asset are spent is any tax imposed. This is in contrast with the current system where, if you buy land for $10,000 and sell it for $15,000, you have a taxable gain of $5,000. A consumption tax only taxes consumption, so if you sell one investment to buy another investment, no tax is imposed.


In Andrews' article, he notes the inherent problem with housing. Renters necessarily "consume" housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset). The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent his or her home to others in exchange for money, but instead, the homeowner chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home. A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) and would not tax the increase in the value of the asset (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States, home ownership is subsidized by the federal government by permitting a deduction for mortgage interest expense, and by exempting a significant increase in value from the capital gains tax. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible in the United States.


Lastly, a consumption tax could utilize progressive rates in order to maintain fairness. The more someone spends on consumption, the more they will be taxed. The rate structure could look like the current bracket system, or a new bracket system could be implemented.


Economics

Economists generally favor consumption taxes over income taxes.

  • Consumption taxes are neutral with respect to investment

Depending on implementation (such as treatment of depreciation) and circumstances, income taxes either favor or disfavor investment. (On the whole, the US system is thought to disfavor investment.) By not disfavoring investment, a consumption tax might increase the capital stock, productivity, and therefore increase the size of the economy.

  • Consumption more closely tracks long run average income

An individual or family's income often varies dramatically from year to year. The sale of a home, a one time job bonus, and various other events can lead to temporary high income that will push a low or middle income person into a high tax bracket. On the other hand, a wealthy individual may be temporarily unemployed and will pay no taxes.


Consumption tax proposals in the United States

Stability of the Tax Base: A comparison of Personal Consumption Expenditures and Adjusted Gross Income.
Stability of the Tax Base: A comparison of Personal Consumption Expenditures and Adjusted Gross Income.

Image File history File links Size of this preview: 800 × 359 pixels Full resolution (828 × 372 pixel, file size: 22 KB, MIME type: image/png) I 14:52, 23 March 2007 (UTC) created this image based on a similar graph by the Americans for Fair Taxation. ... Image File history File links Size of this preview: 800 × 359 pixels Full resolution (828 × 372 pixel, file size: 22 KB, MIME type: image/png) I 14:52, 23 March 2007 (UTC) created this image based on a similar graph by the Americans for Fair Taxation. ... The Personal Consumption Expenditure (PCE) is a price index, like the Consumer Price Index. ... Adjusted gross income (AGI) is a financial term to describe the amount used in the calculation of an individuals income tax liability. ...

Hall-Rabushka

Designed by economists at the Hoover Institution, Hall-Rabushka is a fully developed flat tax on consumption.[2] Loosely speaking, Hall-Rabushka accomplishes this by taxing income and then excluding investment. An individual could file a Hall-Rabushka tax return on a postcard. Hoover Tower at the Hoover Institution The Hoover Institution on War, Revolution, and Peace is a public policy think tank and library founded by Herbert Hoover at Stanford University, his alma mater. ... A flat tax, also called a proportional tax, is a system that taxes all entities in a class (typically either citizens or corporations) at the same rate (as a proportion on income), as opposed to a graduated, or progressive, scheme. ...


In the United States, extensive tax reform has not taken place since the Tax Reform Act of 1986, and like other tax reform, the flat tax has not advanced far in the U.S. political process. However, Eastern Europe has enthusiastically embraced the flat tax after the fall of the iron curtain. Robert Hall and Alvin Rabushka have consulted extensively in designing these flat taxes. President Ronald Reagan signs the Tax Reform Act of 1986 on the South Lawn. ...


FairTax

Main article: FairTax

Since the 1990s, the idea of replacing the income tax with a national sales tax has been floated in the United States; many of the actual proposals would include giving each household an annual rebate, paid in monthly installments, equivalent to the percentage of the tax (which varies from 15% to 23% in most cases) multiplied by the poverty level based on the number of persons in the household, in an effort to reduce the sales tax's inherent regressivity. While some political observers consider the chances remote for such a change, the FairTax Act has attracted more cosponsors than any other fundamental tax reform bill introduced in the U.S. House of Representatives. The FairTax Book, co-authored by Neal Boortz and John Linder, was published on August 2, 2005, as a tool to increase public support for the FairTax Plan. ... For the band, see 1990s (band). ... An income tax is a tax levied on the financial income of persons, corporations, or other legal entities. ... The poverty line is the level of income below which one cannot afford to purchase all the resources one requires to live. ... The FairTax Book, co-authored by Neal Boortz and John Linder, was published on August 2, 2005, as a tool to increase public support for the FairTax Plan. ... The House of Representatives is the larger of two houses that make up the U.S. Congress, the other being the United States Senate. ...


See also

An income tax is a tax levied on the financial income of persons, corporations, or other legal entities. ... Value added tax (VAT) is tax on exchanges. ...

Notes

  1. ^ http://www.econlib.org/library/Enc/ConsumptionTax.html
  2. ^ http://www.hoover.org/publications/books/3602666.html

  Results from FactBites:
 
Consumption Tax, by Al Ehrbar: The Concise Encyclopedia of Economics: Library of Economics and Liberty (1630 words)
Proponents of a consumption tax argue that it is superior to an income tax because it achieves what tax economists call "temporal neutrality." A tax is "neutral" if it does not alter spending habits or behavior patterns and thus does not distort the allocation of resources.
Champions of a consumption tax argue that the income tax does enormous long-term damage to the economy because it penalizes thrift by taxing away part of the return to saving.
The one objection to a consumption tax that is based on pure economics is that it would require a higher tax rate in order to raise the same revenue as the income tax.
Consumption Tax Information (2542 words)
Thus, for a U.S. consumption tax to raise as much revenue as the current income tax, it would appear that the consumption tax rate would have to be higher than the current income tax rates.
Indications that a tax is a consumption tax—An indication that a tax is a consumption tax is that it exempts savings, and for businesses, it allows investment in capital (such as land, building, and equipment) to be deducted when acquired, rather than depreciated over a period of years.
Key benefits of a consumption tax—A commonly cited economic benefit of a consumption tax over an income tax is that a consumption tax does not penalize a taxpayer who earns and saves in early years and then consumes in later years, relative to a taxpayer who does not postpone consumption.
  More results at FactBites »

 
 

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