Essay on Taxing Consumption

Submitted By Ashleyhardy1
Words: 917
Pages: 4

Taxing consumption – taxing individuals based upon what they consume not what they earn. This theory can be traced back as far as the seventeenth-century philosopher Thomas Hobbes, who stated “It is fairer to tax people on what they extract from the economy, as roughly measured by their consumption, than to tax them on what they produce for the economy, as roughly measured by their income.” (754 Gruber)

Consumption is already taxed to some extent through state and local sales and excise taxes as well as some federal excise taxes but compared to the rest of the world, the United States national and subnational governments receive a lower percentage of tax revenue from consumption taxation than in any other OECD nation. The average rate sits at 29.6% while the US has a 14% rate. (754)

Why might consumption make a better tax base?
Improved Efficiency: A single rate sale tax could reduce many of the inefficiencies associated with the current tax system.
One source of inefficiency in our current tax system is the lack of a “level playing field” across investment choices. Through our current tax system, certain types of savings are favored while others are penalized. Real estate is an example of saving that is favored. People can earn a tax exemption of imputed rent on owner-occupied houses and a capital gains exemption on housing. One type of savings that is penalized is equity from a corporation is it is paid out as dividends. These differences in tax burdens can distort savings decisions just like tax wedges can cause people to make inefficient decisions. People who own homes will earn much more back in savings than those in dividend paying corporations. If an individual prefers to save rather than consume, the amount saved should not be taxed no matter what form their savings take. (755)

Fairer Treatment of savers and less distortion to savings decision:
One major complaint about our current tax system is that it penalizes those who save relative to those who spend. The reduced savings could lead to lower productivity for the US economy. For example, consider the following two individuals, Heather and Sara, in a two period economy; Both earn $100 in the first period and nothing in the second. Sara decides to save some of her income so she can consume in both periods, while Heather prefers to consume her entire income in the first period. Each individual is subject to a 50% income tax and the interest rate earned on savings in 10%. Each person pays $50 in income taxes. Heather spends $50 the first period while Sara spends $25.61. By saving $24.39, Sara can earn interest on the money she saves which comes to the amount of $2.44. Since there is a tax on interest earned, Sara pays $1.22 on her interest of $2.44. Because Heather decided to consume her entire income in period one, she only paid $50 in taxes, but since Sara consumed her income in both periods, she ends up paying $51.11 in taxes. In the long run, Sara is penalized for saving. The tax treatment of savings is both horizontally inequitable and inefficient because it may reduce the incentive to save. The outcomes under a consumption tax system would turn out much different. For instance, a consumption tax system that has a tax rate 100% so that for each $1 of consumption you pay $1 in tax. This system doesn’t have any effect over Heather who consumes $50 in the first period and pays $50 in taxes. Sara, on the other hand, will only consume $26.19 in the first period, pay