Consumption tax
Encyclopedia
A consumption tax is a tax
on spending on goods and services. The tax base of such a tax is the money spent on consumption
. Consumption taxes are usually indirect, such as a sales tax
or a value added tax
. However, a consumption tax can also be structured as a form of direct, personal taxation, such as an expenditure tax.
(VAT) applies to the market value added to a product or material at each stage of its manufacture or distribution. If a retailer buys a shirt for $20 and sells it for $30, this tax would apply to the $10 difference between the two amounts. A simple VAT would be proportional
on consumption but also be regressive
on income at higher income levels (as consumption falls as a percentage of income). Savings and investment are tax-deferred until they become consumption. A VAT may exclude certain goods, intent being creating progressive
effects. The tax is used in countries within the European Union
.
In Australia
, Canada
, New Zealand
, and Singapore
this form of national tax is called a Goods and Services Tax
(GST). In Canada it is also called Harmonized Sales Tax
(HST) when combined with a provincial sales tax.
typically applies to the sale of goods, less often to the sales of services. The tax is applied at the point of sale. Like a VAT, simple sales taxes hit lower-income consumers harder than others, leading to exemptions for basic items such as food.
that deducts savings and investment
s. A direct consumption tax may be called an expenditure tax, a cash-flow tax, or a consumed-income tax and can be flat
or progressive
. Expenditure taxes have been briefly implemented in the past in India
and Sri Lanka
.
This form of tax applies to the difference between an individual's income and increase/decrease savings. Like the other consumption taxes, simple personal consumption taxes are regressive with respect to income. However, because this tax applies on an individual basis, it can be made as progressive as a progressive personal income tax. Just as income tax rates increase with personal income, consumption tax rates increase with personal consumption.
, and whisky taxes
produced revolts, the first two against the British government
and the latter against the nascent American Republic. In India, an excise tax on salt
led to Gandhi's famous Salt Satyagraha
, a seminal moment in his struggle to win independence from the U.K.
, one of the two chief authors of the anonymous Federalist Papers
, favored consumption taxes in part because they are harder to raise to "confiscatory
" levels than incomes taxes. In the Federalist Papers
(No. 21
), Hamilton wrote:
Although personal and corporate income taxes provide the bulk of revenue to the federal government, consumption taxes continue to be a primary source of income for state and local governments. One of the first detailed proposals of a personal consumption tax was developed in 1974 by William Andrews.
After 24 years, the balance increases only to $2.64. The cumulative taxes in the latter case are $0.96. The missing $4.26 is not lost by the economy in any sense, as the $4.26 is what the government would make in interest, if they invested their tax revenue. If the initial investment amount is not taxed when earned, but the earnings are taxed thereafter, the cumulative taxes paid are about the same, but are spread more evenly across the period and the asset grows to more than $4. These results are primarily sensitive to the rate of return. With a 3% return, most of the tax receipts come from the tax on the initial $1.00.
To the extent that taxing something results in less of it (whether income or consumption), taxing consumption instead of income should encourage both work and capital formation, which will increase economic growth, while discouraging consumption. Secondly, the tax base will be larger because all consumption will be taxed.
Some critics argue that sales and consumption taxes can shift the tax burden to the less well-off. The ratio of tax obligation shrinks as wealth grows because the wealthy spend proportionally less of their income on consumables. An individual unable to save will pay taxes on 100%, but individuals who save or invest a portion of their income will be taxed only on the remaining income.
systems. Under these proposals, taxpayers would be given exemptions and a standard deduction in order to ensure that the poor do not pay any tax. In a pure consumption tax, other deductions would not be permitted, because all savings would be deductible.
A withholding system might also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.
A consumption tax could also eliminate the concept of basis when computing the value of investments. All income that is put in investments (such as property, stocks, savings accounts) is tax-free. As the asset grows in value, it is not taxed. Only when the proceeds from the asset are spent is any tax imposed. This is in contrast with the current system where if one buys land for $10,000 and sells it for $15,000, one has a taxable gain of $5,000. A consumption tax taxes only consumption, so if one sells an investment to buy another investment, no tax is imposed.
Andrews notes the inherent problem with housing. Renters necessarily "consume" housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset).
The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent the home to others in exchange for money but instead chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home.
A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) and would not tax the increase in the value of the asset (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States
, home ownership is subsidized by the federal government by permitting a deduction for mortgage interest expense and exempting a significant increase in value from the capital gains tax. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible in there.
Also, a consumption tax could utilize progressive rates in order to maintain "fairness." The more that someone spends on consumption, the more that the person will be taxed. The rate structure could look like the current bracket system, or a new bracket system could be implemented.
The temporal neutrality of a consumption tax, however, is that consumption itself is taxed, so it is irrelevant what good or service is being consumed in terms of allocation of resources. The only possible effect on neutrality is between consumption and savings. Taxing only consumption should, in theory, cause an increase in savings. William Gale, Co-director of the Urban-Brookings Tax Policy Center, offers a simplified way to understand a consumption tax: Assume that our current tax system remains the same but remove limitations to contributing to and removing funds from a traditional Individual Retirement Account
(IRA).
Thus, a person would essentially have a bank account where they could place tax-free earnings at any time, but unsaved (or consumed) withdrawals would be subject to taxation. Having an unrestricted IRA under the current system would approximate a consumption tax at the federal level.
Many economists and tax experts favor consumption taxes over income taxes for economic growth
. Consumption taxes are neutral with respect to investment.
Depending on implementation (such as treatment of depreciation) and circumstances, income taxes either favor or disfavor investment.(On the whole, the US system is thought to disfavor investment.) By not disfavoring investment, a consumption tax might increase the capital stock, productivity, and therefore increase the size of the economy. Consumption more closely tracks long run average income. An individual or a family's income often varies dramatically from year to year. The sale of a home, a one-time job bonus, and various other events can lead to temporary high income that will push a low or middle income person into a high tax bracket. On the other hand, a wealthy individual may be temporarily unemployed and will pay no taxes.
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
on spending on goods and services. The tax base of such a tax is the money spent on consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
. Consumption taxes are usually indirect, such as a sales tax
Sales tax
A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
or a value added tax
Value added tax
A value added tax or value-added tax is a form of consumption tax. From the perspective of the buyer, it is a tax on the purchase price. From that of the seller, it is a tax only on the "value added" to a product, material or service, from an accounting point of view, by this stage of its...
. However, a consumption tax can also be structured as a form of direct, personal taxation, such as an expenditure tax.
Value-added tax
A value added taxValue added tax
A value added tax or value-added tax is a form of consumption tax. From the perspective of the buyer, it is a tax on the purchase price. From that of the seller, it is a tax only on the "value added" to a product, material or service, from an accounting point of view, by this stage of its...
(VAT) applies to the market value added to a product or material at each stage of its manufacture or distribution. If a retailer buys a shirt for $20 and sells it for $30, this tax would apply to the $10 difference between the two amounts. A simple VAT would be proportional
Proportional tax
A proportional tax is a tax imposed so that the tax rate is fixed. The amount of the tax is in proportion to the amount subject to taxation. "Proportional" describes a distribution effect on income or expenditure, referring to the way the rate remains consistent , where the marginal tax rate is...
on consumption but also be regressive
Regressive tax
A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, where the average tax rate exceeds the...
on income at higher income levels (as consumption falls as a percentage of income). Savings and investment are tax-deferred until they become consumption. A VAT may exclude certain goods, intent being creating progressive
Progressive tax
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate...
effects. The tax is used in countries within the European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
.
In Australia
Goods and Services Tax (Australia)
The GST is a broad sales tax of 10% on most goods and services transactions in Australia. It is a value added tax, not a sales tax, in that it is refunded to all parties in the chain of production other than the final consumer....
, Canada
Goods and Services Tax (Canada)
The Goods and Services Tax is a multi-level value added tax introduced in Canada on January 1, 1991, by then Prime Minister Brian Mulroney and his finance minister Michael Wilson. The GST replaced a hidden 13.5% Manufacturers' Sales Tax ; Mulroney claimed the GST was implemented because the MST...
, New Zealand
Goods and Services Tax (New Zealand)
Goods and Services Tax is a value added tax introduced in New Zealand on 1 October 1986 at 10%. It later increased to 12.5% on 1 July 1989 and was further increased to 15% on 1 October 2010....
, and Singapore
Goods and Services Tax (Singapore)
Goods and Services Tax in Singapore is a broad-based value added tax levied on import of goods, as well as nearly all supplies of goods and services. The only exemptions are for the sales and leases of residential properties and most financial services...
this form of national tax is called a Goods and Services Tax
Goods and Services Tax
A goods and services tax or value added tax is a tax on exchanges.By country:*Goods and Services Tax *Goods and Services Tax *Goods and Services Tax *Goods and Services Tax...
(GST). In Canada it is also called Harmonized Sales Tax
Harmonized Sales Tax
The Harmonized Sales Tax is the name used in Canada to describe the combination of the federal Goods and Services Tax and the regional Provincial Sales Tax into a single value added sales tax in five of the ten Canadian provinces: Ontario, New Brunswick, Newfoundland and Labrador, British...
(HST) when combined with a provincial sales tax.
Sales tax
A sales taxSales tax
A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
typically applies to the sale of goods, less often to the sales of services. The tax is applied at the point of sale. Like a VAT, simple sales taxes hit lower-income consumers harder than others, leading to exemptions for basic items such as food.
Excise tax
An excise tax is a sales tax that applies to a specific class of goods, typically alcohol, gasoline (petrol), or tourism. The tax rate varies according to the type of good and quantity purchased and is typically unaffected by the person who purchases it.Expenditure tax
A direct, personal consumption tax may take the form of an expenditure tax or an income taxIncome tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
that deducts savings and investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
s. A direct consumption tax may be called an expenditure tax, a cash-flow tax, or a consumed-income tax and can be flat
Flat tax
A flat tax is a tax system with a constant marginal tax rate. Typically the term flat tax is applied in the context of an individual or corporate income that will be taxed at one marginal rate...
or progressive
Progressive tax
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate...
. Expenditure taxes have been briefly implemented in the past in India
India
India , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...
and Sri Lanka
Sri Lanka
Sri Lanka, officially the Democratic Socialist Republic of Sri Lanka is a country off the southern coast of the Indian subcontinent. Known until 1972 as Ceylon , Sri Lanka is an island surrounded by the Indian Ocean, the Gulf of Mannar and the Palk Strait, and lies in the vicinity of India and the...
.
This form of tax applies to the difference between an individual's income and increase/decrease savings. Like the other consumption taxes, simple personal consumption taxes are regressive with respect to income. However, because this tax applies on an individual basis, it can be made as progressive as a progressive personal income tax. Just as income tax rates increase with personal income, consumption tax rates increase with personal consumption.
History
Consumption taxes, specifically excise taxes, have featured in several notable historic events. In the U.S., the Stamp tax, the tax on teaBoston Tea Party
The Boston Tea Party was a direct action by colonists in Boston, a town in the British colony of Massachusetts, against the British government and the monopolistic East India Company that controlled all the tea imported into the colonies...
, and whisky taxes
Whiskey Rebellion
The Whiskey Rebellion, or Whiskey Insurrection, was a tax protest in the United States in the 1790s, during the presidency of George Washington. Farmers who sold their corn in the form of whiskey had to pay a new tax which they strongly resented...
produced revolts, the first two against the British government
Great Britain
Great Britain or Britain is an island situated to the northwest of Continental Europe. It is the ninth largest island in the world, and the largest European island, as well as the largest of the British Isles...
and the latter against the nascent American Republic. In India, an excise tax on salt
History of the British salt tax in India
Taxation of salt has occurred in India since the earliest times. However, this tax was greatly increased when the British East India Company began to establish its rule over provinces in India. In 1835, special taxes were imposed on Indian salt to facilitate its import. This paid huge dividends for...
led to Gandhi's famous Salt Satyagraha
Salt Satyagraha
The Salt March, also known as the Salt Satyagrahah began with the Dandi March on March 12, 1930, and was an important part of the Indian independence movement. It was a campaign of tax resistance and nonviolent protest against the British salt monopoly in colonial India, and triggered the wider...
, a seminal moment in his struggle to win independence from the U.K.
United States
In the early U.S., taxes were levied principally on consumption. Alexander HamiltonAlexander Hamilton
Alexander Hamilton was a Founding Father, soldier, economist, political philosopher, one of America's first constitutional lawyers and the first United States Secretary of the Treasury...
, one of the two chief authors of the anonymous Federalist Papers
Federalist Papers
The Federalist Papers are a series of 85 articles or essays promoting the ratification of the United States Constitution. Seventy-seven of the essays were published serially in The Independent Journal and The New York Packet between October 1787 and August 1788...
, favored consumption taxes in part because they are harder to raise to "confiscatory
Confiscation
Confiscation, from the Latin confiscatio 'joining to the fiscus, i.e. transfer to the treasury' is a legal seizure without compensation by a government or other public authority...
" levels than incomes taxes. In the Federalist Papers
Federalist Papers
The Federalist Papers are a series of 85 articles or essays promoting the ratification of the United States Constitution. Seventy-seven of the essays were published serially in The Independent Journal and The New York Packet between October 1787 and August 1788...
(No. 21
Federalist No. 21
Federalist No. 21 is an essay by Alexander Hamilton, the twenty-first of the Federalist Papers. It was published on December 12, 1787 under the pseudonym Publius, the name under which all the Federalist Papers were published. It is titled, "Other Defects of the Present Confederation."In Federalist No...
), Hamilton wrote:
Although personal and corporate income taxes provide the bulk of revenue to the federal government, consumption taxes continue to be a primary source of income for state and local governments. One of the first detailed proposals of a personal consumption tax was developed in 1974 by William Andrews.
Savings effect
Consumption taxes do not tax savings, which allows invested assets to grow more quickly. If, in the absence of taxes, $1 of savings is put aside for retirement at 9% compound interest, savings will grow to $7.86 after 24 years. Alternatively, by assuming a 33% tax rate, the same $1 is reduced to about $0.67 after taxes when earned. The effective interest rate, thereafter, is reduced to 6%, since the rest of the yield is paid in taxes.After 24 years, the balance increases only to $2.64. The cumulative taxes in the latter case are $0.96. The missing $4.26 is not lost by the economy in any sense, as the $4.26 is what the government would make in interest, if they invested their tax revenue. If the initial investment amount is not taxed when earned, but the earnings are taxed thereafter, the cumulative taxes paid are about the same, but are spread more evenly across the period and the asset grows to more than $4. These results are primarily sensitive to the rate of return. With a 3% return, most of the tax receipts come from the tax on the initial $1.00.
To the extent that taxing something results in less of it (whether income or consumption), taxing consumption instead of income should encourage both work and capital formation, which will increase economic growth, while discouraging consumption. Secondly, the tax base will be larger because all consumption will be taxed.
Some critics argue that sales and consumption taxes can shift the tax burden to the less well-off. The ratio of tax obligation shrinks as wealth grows because the wealthy spend proportionally less of their income on consumables. An individual unable to save will pay taxes on 100%, but individuals who save or invest a portion of their income will be taxed only on the remaining income.
Practical considerations
Many proposed consumption taxes share some features with the current income taxIncome tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
systems. Under these proposals, taxpayers would be given exemptions and a standard deduction in order to ensure that the poor do not pay any tax. In a pure consumption tax, other deductions would not be permitted, because all savings would be deductible.
A withholding system might also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.
A consumption tax could also eliminate the concept of basis when computing the value of investments. All income that is put in investments (such as property, stocks, savings accounts) is tax-free. As the asset grows in value, it is not taxed. Only when the proceeds from the asset are spent is any tax imposed. This is in contrast with the current system where if one buys land for $10,000 and sells it for $15,000, one has a taxable gain of $5,000. A consumption tax taxes only consumption, so if one sells an investment to buy another investment, no tax is imposed.
Andrews notes the inherent problem with housing. Renters necessarily "consume" housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset).
The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent the home to others in exchange for money but instead chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home.
A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) and would not tax the increase in the value of the asset (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, home ownership is subsidized by the federal government by permitting a deduction for mortgage interest expense and exempting a significant increase in value from the capital gains tax. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible in there.
Also, a consumption tax could utilize progressive rates in order to maintain "fairness." The more that someone spends on consumption, the more that the person will be taxed. The rate structure could look like the current bracket system, or a new bracket system could be implemented.
Economic impact
Former senior editor of Fortune Magazine Al Ehrbar notes that proponents of a consumption tax argue its superiority to the income tax based on an economic principle called "temporal neutrality". He observes that a tax is "neutral" if it does not "alter spending habits or behavior patterns and thus does not distort the allocation of resources." In other words, taxing apples but not oranges will cause apple consumption to decrease and orange consumption to increase.The temporal neutrality of a consumption tax, however, is that consumption itself is taxed, so it is irrelevant what good or service is being consumed in terms of allocation of resources. The only possible effect on neutrality is between consumption and savings. Taxing only consumption should, in theory, cause an increase in savings. William Gale, Co-director of the Urban-Brookings Tax Policy Center, offers a simplified way to understand a consumption tax: Assume that our current tax system remains the same but remove limitations to contributing to and removing funds from a traditional Individual Retirement Account
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
(IRA).
Thus, a person would essentially have a bank account where they could place tax-free earnings at any time, but unsaved (or consumed) withdrawals would be subject to taxation. Having an unrestricted IRA under the current system would approximate a consumption tax at the federal level.
Many economists and tax experts favor consumption taxes over income taxes for economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
. Consumption taxes are neutral with respect to investment.
Depending on implementation (such as treatment of depreciation) and circumstances, income taxes either favor or disfavor investment.(On the whole, the US system is thought to disfavor investment.) By not disfavoring investment, a consumption tax might increase the capital stock, productivity, and therefore increase the size of the economy. Consumption more closely tracks long run average income. An individual or a family's income often varies dramatically from year to year. The sale of a home, a one-time job bonus, and various other events can lead to temporary high income that will push a low or middle income person into a high tax bracket. On the other hand, a wealthy individual may be temporarily unemployed and will pay no taxes.