Replacing the Income Tax with a Progressive Consumption Tax
First Fridays: Seminar Series in Economic Policy
About This Event

Shifting from an income tax to a consumption tax could offer major simplification advantages. But could a consumption tax achieve the same progressivity as an income tax? Many people think not, but recent economic and legal research suggests that it can. Daniel Shaviro, a professor at the New York University Law School and a visiting scholar at AEI, will argue that the X tax, a version of the Hall-Rabushka flat tax with a greater rate of graduation, does match the progressivity of an income tax. Former IRS commissioner Fred T. Goldberg and Diane Lim Rogers of the Joint Economic Committee will comment. AEI’s Eric M. Engen will serve as moderator.

Agenda
9:15 a.m.
Registration
9:30
Introduction:

Eric M. Engen, AEI

Presenter:

Daniel Shaviro, AEI and New York University Law School

Panelists:

Fred T. Goldberg, Skadden Arps LLP

Diane Lim Rogers, Joint Economic Committee

Moderator:

Eric M. Engen, AEI

11:30
Adjournment
Event Summary

Replacing the Income Tax with a Progressive Consumption Tax

Shifting from an income tax to a consumption tax could offer major simplification advantages, but could a consumption tax achieve the same progressivity as an income tax? Many people think not, but recent economic and legal research suggests that it can. Daniel Shaviro, a professor at the New York University Law School and a visiting scholar at AEI, argues that the X-tax, a version of the Hall-Rabushka flat tax with a greater rate of graduation, does match the progressivity of an income tax; and former IRS commissioner Fred T. Goldberg and Diane Lim Rogers of the Joint Economic Committee commented on his work at a December 5 AEI event.

Daniel Shaviro
AEI

There are two main ways to execute the Progressive Consumption Tax. The first is the Consumed Income Tax, which resembles the current income tax but with savings and investment expensed, and dissaving taxed. The other is the X-tax or Flat tax, which looks like the Value Added Tax (VAT) but allows payments to workers to be deducted to include graduation.

Simplification is an important feature of the new proposal: it eliminates issues of realization, debt versus equity, rules of corporate and partnership taxation, interest deduction rules, ordinary income versus capital gain, loss disallowance rules, Alternative Minimum Taxes, foreign tax credit limitations, and possibly transfer pricing. Issues that remain are those of personal versus business expense, household taxation, personal deduction, devices to encourage savings, bundling of real and financial transactions, and auditing to detect fraud. Although interest-group politics is unlikely to improve anytime soon, the main point is that complexity problems under the income tax are largely structural in character. Many of these problems exist at the business level, especially for individuals.

Why not consumption taxation? Many argue that the main reason-apart from transition and coordination with the rest of world-is progressivity. Income taxes appear more progressive than consumption taxes; however, the fact that wealthier individuals tend to save more relative to their earnings means that consumption tax should be more nominally graduated. The income tax has a higher rate for deferred consumption than it has for current consumption. The real concern by most critics of the consumption tax is that they simply fail to reach "capital income" or wealth--i.e., the Bill Gates problem.  There are three grounds for the belief that consumption taxes exempt wealth: the coupon clipper, Cary Brown, and the unspent wealth problems. The coupon clipper problem is really a mistake because people take home the business earnings which will themselves will be taxed.  The unspent wealth problem suggests that if rich people never spend most of their money, then they are benefiting from their deferral to spend money. The problem of whether consumption tax exempts Bill Gates is really a question about the effect of exemption on Microsoft, ostensibly exempted by expensing.

The consumption tax exempts the pure return to waiting while the income tax reaches it; however, evidence from the short-term treasuries suggest that the real risk-free rate is historically one percent and thus is insignificant. A properly designed consumption tax has no Bill Gates problem. The actual income tax does reach inflationary gain, while both offer involuntary insurance and similarly bear risk. Most importantly, both taxes similarly tax or fail to tax risk premia ex ante and actual risky outcomes ex post.  If the bet is scaled up, the "Bill Gates" population would be reached by neither of the two. Tax burdens, not current tax payments, are of interest, and unspent wealth bears the full burden. Consumption reaches wealth's intangible value via purchasing power.

Fred Goldberg
Skaden Arps, LLP

Simplification is an issue to be dealt with; the real issue, however, is progressivity. The incidence of the tax is how it affects people, but it really affects the taxpayer only in how big a check they have to write. Death taxes are something to think about. There also should be a closer examination into the impact on prices.

How does the tax get paid when one consumes? It is worth discussing the effect of the consumption tax on lower income individuals in addition to its effect on the genuinely wealthy. Whereas with the income tax, a lower income individual may receive an income tax credit, how does the consumption-based proposal get such individuals their money back? We need to consider the price effect that may arise as a result of the proposed tax. It is possible that can they be worse off than they were before given the price effect.

Diane Lim Rogers
Joint Economic Committee

The ideas that Daniel Shaviro proposed are validated on a theoretical perspective. For economists, issues in elasticity are what tend to matter. Although people are not as forward-looking as they appear to be, slight behavioral responses do exist. There is concern, however, about the feasibility of Mr. Shaviro's argument in the policy realm. Indeed, the consumption base is much preferred for its administrative ease. Wealth does have value even when unconsumed because it still makes people better off. It is true, in theory, that it is possible to design a system that is as progressive as the present system. This could be achieved by applying higher marginal rates at the top, but this method may not necessarily be worth it. Trade-offs exist with efficiency and equity. 

The consumption base provides a lot of distortions, including those with labor. There is also a lump sum tax from this transition on existing wealth. The fundamental tax reform seems like it could be economical but faces budgetary as well as political constraints, and as a result it may lead to distortions in other areas. The current push for fundamental tax reform is somewhat mistimed. Shaviro's tax proposal does not convince listeners it can attain the level of progressivity the present tax exhibits.

AEI intern Kimberly Kim prepared this summary.

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