[A-List] Progressive Consumption Tax

[Bill Totten]

by Robert Frank

democracyjournal.org (Spring 2008)

Although voters like public services, they detest paying taxes. To cover
the resulting budget deficits, we borrow hundreds of billions of dollars
each year from other countries, loans that must be repaid in full with
interest. Deficits also erode savings, choking off investment that drives
economic growth. Except for the end of the Clinton years, this has been
the dynamic of our economy for the past four decades.

Things are poised to get worse. Rising Social Security and Medicare costs,
overdue infrastructure maintenance, and some form of universal health
insurance will all require substantial federal revenue. Even if the next
president and Congress are more successful at cutting wasteful spending
than any modern democratic government has ever been, they will still need
major sources of new revenue to put our fiscal house in order.

Replacing the current income tax with a progressive consumption tax is the
only way to cover our current revenue shortfall without demanding painful
sacrifices from voters. Such a tax, which has been proposed both by
conservative economists like Milton Friedman and liberal economists like
Edward Gramlich, would be simple to implement. Families would report their
incomes and their annual savings to the IRS, just as many now do with 401
(k) and other similar retirement savings accounts. Their taxable
consumption would then be calculated as income minus savings minus a large
standard deduction - say, $30,000 for a family of four. For example, a
family that earned $50,000 and saved $5,000 during a given tax year would
have taxable consumption of $50,000 minus $5,000 minus $30,000, or $15,000
total. Tax rates on taxable consumption would start off low - say, ten
percent for the first $30,000 of taxable consumption. Under the
consumption tax, this family would owe $1,500, about half of what it would
pay under the current income tax.

Because the progressive consumption tax exempts savings from tax, it
cannot generate even the same revenue as the current income tax unless
marginal rates on the highest consumption levels are significantly higher
than the highest current rates on income. But higher marginal rates would
be problematic under the current income tax, because they would undermine
people's incentives to save and invest. In contrast, higher marginal rates
on consumption, as opposed to income, would actually encourage savings and
investment.

Moreover, a steeply progressive consumption tax would raise additional
revenue without causing significant reductions in consumer welfare. For
families that already consume at a high absolute level, evidence suggests
that psychological well-being depends much more on relative consumption
than on absolute consumption. By encouraging an across-the-board reduction
in high-end consumption, a progressive consumption tax would thus have
little effect on the relative consumption levels that shape well-being.

Consider a wealthy man who wants to host a "special" coming-of-age party
for his daughter: Because the incomes of top earners have been soaring in
recent years, the required expenditure levels have increased in tandem. To
celebrate his daughter's birthday in 2005, David H Brooks, the chief
executive of a company that supplies body armor to the American military
in Iraq, invited 150 of her friends to the Rainbow Room atop Rockefeller
Center in Manhattan, where they were serenaded by Fifty Cent, Don Henley,
Stevie Nicks, and other luminaries in a celebration reported to have cost
$10 million. If all wealthy families spent a little less on such parties,
as high marginal consumption tax rates would encourage them to do,
everyone's daughter would feel just as special as before.

Although some people worry that tax incentives for reduced consumption
might throw the economy into recession, it is total spending, not just
consumption, that governs output and employment. Phased in gradually, a
progressive consumption tax would slowly shift spending from consumption
to investment, causing productivity and incomes to rise faster. In
addition, during recessions, a temporary cut in consumption taxes would
provide a much more powerful stimulus than the traditional temporary cut
in income taxes, because a temporary consumption tax cut would be
advantageous only if people spent more right away (in contrast, consumers
who fear losing their jobs in a recession are often reluctant to spend
temporary income tax refunds).

The Bush tax cuts for the nation's wealthiest families threaten American
economic prosperity, yet they have done little for their ostensible
beneficiaries. Higher spending on larger mansions serves only to raise the
bar that defines adequate housing for economic elites. Even in terms of
naked self-interest, everyone would have fared much better if the same
money had been spent to repair aging bridges and inspect the cargo
containers that enter the nation's ports. Realistically, the progressive
consumption tax is the only policy that can make this happen.

http://www.democracyjournal.org/8/6591.php


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