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Consumption vs Income Tax: Which has a Larger Impact?

By: , dated January 25th, 2013

A consumption tax (also known as a cash-flow tax, expenditure tax, or consumed income tax) is levied on goods and services that are consumed. While an income tax is based upon income earned from labor or capital, a consumption tax is solely based upon consumption. This may sound similar to a sales tax, but in its purest form a consumption tax will not become regressive as is the case with a pure sales tax. A consumption tax can be designed to be progressive if it includes the following features:

  1. Exemptions
  2. Graduated
  3. Deductions
  4. Rebates

Prior to the passage of the 16th Amendment to the Constitution, the United States primarily raised government revenues using consumption taxes. It took the passage of the 16th Amendment in 1913 to permit Congress to create income taxes because the Founding Fathers believed income taxes could be abused by persons in power.

A true consumption tax is nearly impossible to increase to excessive or punitive levels. These taxes are naturally limited because they will ultimately discourage economic activity when they become too high. Excessive consumption taxes affect the economy in three ways:

  1. by discouraging consumer spending,
  2. by decreasing business revenues and
  3. by lowering the amount of tax that can be collected when economic activity decreases.

Ideally, a consumption tax would only tax goods or services when consumed while leaving savings alone. Income tax, however, does tax savings because revenues are raised not only from labor (wages or salaries), but also from capital (interest, dividends, capital gains). So which system is superior?

Consumption vs. Income

Consumption Tax

Pure tax economists 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 behavior patterns, or affect the natural allocation of resources. Because a consumption tax only taxes consumption, the good or service being consumed is largely irrelevant in reference to the allocation of resources.

Income Tax

An income tax, however, creates a barrier between the value of a person’s labor (how much they earn from working) and what they actually receive (money after taxes). This is a negative force on the economy because it causes people to work less and pursue more leisure activities than would otherwise be the case if income taxes did not exist. In other words, if there were no income taxes people would immediately see a real increase in purchasing power for each additional unit 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 investment,
  • discourages innovation, and
  • ultimately contributes to a lower standard of living when compared to a pure consumption tax.

To think of it another way, income taxes will actually cause greater consumption in the present while reducing future savings and future consumption.

A well designed consumption tax is more neutral 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 produce a more solid, robust economy.

Examples Comparing Income Tax vs. Consumption Tax

To better understand the true impact each tax system has upon the consumer and economy at large, consider someone who has $20,000 and must pay income tax. For the example, assume that the tax rate is 20% and that the pretax interest rate on an investment is 5%. After paying income taxes, the individual 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 investor would need to pay $160 in taxes on the interest income ($800 x 20%) leaving him with $16,640, or a gain of 4%, over the previous year.

Under a consumption-based tax system, the rate on consumption is the same 20% as in the income-based system. If the taxpayer 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 burden would be due and the investor would earn 5%, or $1000, on the full $20,000. All withdrawals are taxed in this system, so if the investor wanted to consume all $21,000, they would owe $4200 and still be able 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 distortion between present and future consumption.

The Argument against Consumption Tax

The main argument against a consumption tax is that it would raise less revenue than an income tax if the two rates 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 accumulation of savings, more capital to invest, and an economy that is fundamentally stronger than one using an income tax system.

Several European nations have used a derivation of a consumption tax, the Value-Added-Tax (VAT), and actually raised more revenue while not appearing to have caused long-term economic damage. However, when the true tax burden is compared between American 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 States. The reality is that unless the VAT is substituted for the income tax, the overall tax burden actually increases for the average citizen.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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4 Responses to “Consumption vs Income Tax: Which has a Larger Impact?”

  1. Aaron P Mullen says:

    You stated “This may sound similar to a sales tax, but in its purest form a consumption tax will not become regressive as is the case with a pure sales tax.” You give no foundation to tie this statement to in your article.I know sales tax is not what your article was about but could you expound more on the difference between a pure consumption tax and a pure sales tax, and how a sales tax is regressive and just what you meant by that. It was a little confusing.

  2. John B. Egan says:

    Before you start talking about the VAT not having much impact (as it’s supposed to be revenue neutral) , I’d like to say that I lived in Britain during the conversion to VAT and it most certainly did have an impact. I knew people that lived near me who were left to decide if they wanted heat or food. It may have been intended to be revenue neutral, but most certainly was not. VAT and flat taxes are shell games designed to move income from the poorest of our populations to the wealthier. Does anyone think the Koch Brothers or Steve Forbes would push flat tax if it did not benefit them?

  3. European VAT tax seems like an annoying tax system and over complicated tax system to deal with…

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