Could Consumption Tax Affect Income Inequality?

tax chance cardThe tax filing deadline has come and gone (hopefully you made it). But there’s still a lot of tax talk going on.

That’s because the Senate voted down a bill based on what President Obama dubbed the “Buffet Rule.”

To make a long story short, the “Buffet Rule” rule came about after renowned investor Warren Buffett of Berkshire Hathaway pointed out he paid a tax rate of around 15% while his secretary paid a much higher tax rate of up to 35%. That’s because Buffett makes his money off of investments, which are subject to capital gains taxes, while his secretary pays mainly income tax.

Even though most are blowing off the so-called and now dead Paying a Fair Share Act of 2012 as an election year stunt, it still has people talking about how we pay taxes.

Could there be a better way?

If you want to learn more about the Buffett Rule, I highly suggest you check out a post on PT Money titled 5 Facts About the Buffett Rule. It’s what got me looking into taxes in the U.S. a little more.

As I was reading up on different journalists’ and economists’ opinions on raising taxes for the rich, I stumbled across a recent piece written by Eduardo Porter for the NY Times Economic Scene. Porter brought up the topic of a consumption tax as a possible solution to a bunch of problems.

If you’re like me, you may have heard of consumption tax before but could stand to learn a little more about the idea.  It’s sometimes referred to as a Federal sales tax or a value-added tax. To put it simply it is a tax on spending for goods and services. Depending on where you live, you might already pay a state sales tax.

tax on brick wall

Porter writes that the U.S. tax code is extremely flawed, bad at creating any sort of decent revenue and overly complicated.

He says this came about because Democrats wanted a tax system with higher rates for the rich so money could be spent on social programs for American citizens. In response, Republicans wanted tax deductions exclusions and exceptions to help Americans avoid over-taxation and keep government small.

“This compromise has left us with a loophole-riddled code that isn’t very good at raising money,” writes Porter.

Who Supports Consumption Tax?

Republican presidential candidate Ron Paul – known for having unconventional views – is a proponent of eliminating personal income tax and replacing it with a consumption tax. But a consumption tax isn’t exactly that controversial – or even very new.

Porter believes that most other developed nations – including Japan and all of Europe – have a better tax system than the U.S. He adds that while those systems vary, all of them “raise a lot of money taxing people’s consumption, at the point of sale.”

Historically, pre-Revolutionary War Americans had some issues with consumption tax when it was passed down from the British. Taxes on things like tea and whiskey led to revolts.

However, some of our founding fathers were major proponents of taxing consumption – including Alexander Hamilton.

Many economists support a consumption tax and say that it could help boost the economy, simplify the tax code and reduce the nation’s debt.

Pros and Cons of a Consumption Tax

Pro: Increased Incentive to Save

The biggest benefit of a consumption tax might be that it encourages more Americans to save instead of spend. Overspending has certainly become an issue in this country. If a consumption tax replaced income tax, there would be no taxes taken out of any income you stashed away, but every dollar you spent would be taxed.

Economist William Gale compares the hypothetical situation to having an IRA in which you could deposit money and withdraw it at any time for any reason.

There could also be a downside to this benefit. Economist Len Burman  points out that since all savings would be tax-free, it may not make as much sense for someone to invest in typical retirement savings – like a 401K. That raises the question would people be as likely to save for retirement using one of those traditional methods? And if they put retirement savings in a typical bank account, would they be as likely to leave the money untouched until they retire?

Con: Could be Considered Regressive

There’s been a lot of debate going on regarding the word “fair.” It would seem that a consumption tax would create a level playing field. Everyone gets to take advantage of government support and services that ensure a certain standard of living, and everyone pays their proportionate share.

However, some argue that a consumption tax would place a bigger burden on poorer Americans. That’s because people with lower incomes typically spend a larger percentage of that income than wealthier Americans. It’s also true that higher-income earners are able to save and invest more of their money.

However, Porter refers to statements made by Lawrence Summers in 1988 that once again make a consumption tax seem quite “fair.”  Summers said that while the poor may pay a higher share of consumption tax, they also are more likely to take advantage of government assistance and social programs.

Summers, an economist and former U.S. Treasury Secretary suggests that liberals and conservatives are looking at consumption tax from the wrong perspective. Most liberals say it would be oppressive on the poor when they could focus on the amount of money that could be raised. Most conservatives only see a new tax and bigger government when they could see it as a way for the poor and middle class to subsidize the government assistance they receive.

Pro: Could Reduce the Budget Deficit and National Debt

It’s no secret that the United States is spending way more money than it’s bringing in. That problem grew even worse during the Great Recession.

One of the biggest criticisms of the Buffet Rule is that it would do very little to reduce the deficit.

A 2011 report by the Congressional Research Service (PDF) found that a value-added tax could be a much more efficient way to generate revenue. The author states that “a broad-based VAT in the United States would raise revenue of approximately $45 billion to $55 billion for each 1% levied.”

Under the proposed Buffet Rule, raising taxes on the rich would only bring in an estimated $4.7 billion per year. That’s compared to a 2011 budget deficit of more than $1.5 trillion. The Buffet Rule would only reduce the deficit by around 0.3%.

Con: Would Create a Tough Transition

Change can be good – but change can also be difficult.

If the U.S. were to switch to some sort of consumption tax system, it would mean the price of all goods and services would take a jump. One concern is how much that could slow down consumer spending, which drives the economy. However, if Americans weren’t paying income tax (or at least less income tax) they’d have more money to spend (or save).

A broad-based consumption tax or value-added tax would be levied on virtually all goods and services. So economists say it should have a minimal effect on consumer spending behavior. For example – if you raise taxes on apples but not oranges people would likely buy less apples and more oranges. But if you raise taxes on all fruit, the playing field stays neutral.

The only aspect of consumer behavior that a consumption tax would theoretically affect is savings.

The people who this might actually hurt is older Americans living off their retirement savings, which have already been taxed under the current system. These people weren’t planning on the cost of living taking a big jump. So a broad-based consumption tax would be a huge tax increase for retired and nearly-retired Americans.

Figuring out how to deal with a transition appears to be the hardest and costliest part about implementing a consumption tax in the U.S. As Burman explains…

“There are variants on the consumption tax, but basically nobody has figured out how to deal with the transition issues without tremendous cost to the Treasury. You can basically say you could have transition rules that would try to protect old people, that would try to protect businesses that have made investments under the old rules that could be harmed under the new system, it would be tremendously expensive.”

Your Turn

What do you think about the concept of a consumption tax? Would you support it? Leave a comment below and start a conversation!

Note: The quotations and opinions from economists William Gale and Len Burman were taken from a 2005 interview on the PBS Newshour with Jim Lehrer. Read the full transcript

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Image Courtesy: Dana Fred Ryman

+Kasey Steinbrinck writes regularly on personal finances and the U.S. economy for Check Advantage. Visit them today and view their offerings including Basic Checks as well as a collection of cool personal checks.

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