Consumption vs Income Tax: Which has a Larger Impact?
Prior to the passage of the 16th to the , the primarily raised using consumption . It took the passage of the 16th Amendment in 1913 to to create because the Founding Fathers believed income taxes could be abused by persons in .
A true consumption tax is nearly impossible to increase to excessive or punitive levels. These taxes are naturally limited because they will ultimately discourage when they become too . Excessive consumption taxes affect the in three ways:
- by discouraging ,
- by decreasing revenues and
- by lowering the of tax that can be collected when economic activity decreases.
Ideally, a consumption tax would only tax goods or services when consumed while leaving alone. Income tax, however, does tax savings because revenues are raised not only from labor ( or ), but also from capital ( , , ). So which is superior?
Consumption vs. Income
Consumption TaxPure tax argue that a consumption tax is superior because it comes closest to attaining “temporal neutrality”. Although impossible to attain in reality, a tax would be considered to have attained temporal neutrality if it did not alter spending habits, change , or affect the natural . Because a consumption tax only taxes consumption, the good or being consumed is largely irrelevant in reference to the of .
Income TaxAn income tax, however, creates a barrier between the of a person’s labor (how much they earn from working) and what they actually receive ( ). This is a negative on the economy because it to less and pursue more leisure than would otherwise be the case if income taxes did not exist. In other , if there were no income taxes people would immediately see a increase in for each additional of time they spent working, and thus would be theoretically be more inclined to work.
The barrier created by income taxes also produces
- less savings (because capital is taxed),
- reduces ,
- discourages , and
- ultimately contributes to a lower when compared to a pure consumption tax.
A well designed consumption tax is more and does not affect the allocation of resources as dramatically as an income tax. Taxes are only assessed on any income that is consumed (spent on goods, services, etc.) while not taxing savings. This eliminates any barrier to savings and actually would encourage people to save more, increase available capital, and ultimately a more solid, economy.
Examples Comparing Income Tax vs. Consumption TaxTo better understand the true each tax system has upon the and economy at large, consider someone who has $20,000 and must income tax. For the example, that the is 20% and that the on an investment is 5%. After paying income taxes, the would be left with $16,000 that could be consumed. Assuming the individual put all $16,000 into savings, they would earn $800 in interest after one year. However, the would to pay $160 in taxes on the ($800 x 20%) leaving him with $16,640, or a of 4%, over the previous year.
Under a consumption-based tax system, the on consumption is the same 20% as in the income-based system. If the consumes every dime, they would pay $4,000 in taxes ($20,000 x 20%) and could have consumed the remaining $16,000 — just like the previous example with the income taxes. However, if the money were saved, then no tax would be due and the investor would earn 5%, or $1000, on the $20,000. All are taxed in this system, so if the investor wanted to consume all $21,000, they would $4200 and still be to consume $16,800. This end amount represents a gain of 5%, and is larger than the 4% gain under the income tax system. This system encourages more investment while not creating any tax between present and future consumption.
The Argument against Consumption TaxThe main against a consumption tax is that it would less than an income tax if the two were the same. This is certainly true because capital is not taxed in the consumption-based system. While true, the long term effects of a consumption tax would be a greater of savings, more capital to , and an economy that is fundamentally stronger than one using an income tax system.
Several European have used a derivation of a consumption tax, the Value-Added-Tax (VAT), and actually raised more revenue while not appearing to have caused economic . However, when the true tax burden is compared between and European taxpayers, the total burden has increased significantly for Europeans since the adoption of VAT’s while remaining relatively the same in the United . The reality is that unless the VAT is substituted for the income tax, the overall tax burden actually increases for the .