Issue #8, Spring 2008

Progressive Consumption Tax

To read the other essays in the “What's Next? The New Progressive Agenda” symposium, click here.

Although voters like public services, they detest paying taxes. To cover the resulting budget deficits, we borrow hundreds of billions of dollars each year from other countries, loans that must be repaid in full with interest. Deficits also erode savings, choking off investment that drives economic growth. Except for the end of the Clinton years, this has been the dynamic of our economy for the past four decades.

Things are poised to get worse. Rising Social Security and Medicare costs, overdue infrastructure maintenance, and some form of universal health insurance will all require substantial federal revenue. Even if the next president and Congress are more successful at cutting wasteful spending than any modern democratic government has ever been, they will still need major sources of new revenue to put our fiscal house in order.

Replacing the current income tax with a progressive consumption tax is the only way to cover our current revenue shortfall without demanding painful sacrifices from voters. Such a tax, which has been proposed both by conservative economists like Milton Friedman and liberal economists like Edward Gramlich, would be simple to implement. Families would report their incomes and their annual savings to the IRS, just as many now do with 401(k) and other similar retirement savings accounts. Their taxable consumption would then be calculated as income minus savings minus a large standard deduction–say, $30,000 for a family of four. For example, a family that earned $50,000 and saved $5,000 during a given tax year would have taxable consumption of $50,000–$5,000–$30,000, or $15,000 total. Tax rates on taxable consumption would start off low–say, 10 percent for the first $30,000 of taxable consumption. Under the consumption tax, this family would owe $1,500, about half of what it would pay under the current income tax.

Because the progressive consumption tax exempts savings from tax, it cannot generate even the same revenue as the current income tax unless marginal rates on the highest consumption levels are significantly higher than the highest current rates on income. But higher marginal rates would be problematic under the current income tax, because they would undermine people’s incentives to save and invest. In contrast, higher marginal rates on consumption, as opposed to income, would actually encourage savings and investment.

Moreover, a steeply progressive consumption tax would raise additional revenue without causing significant reductions in consumer welfare. For families that already consume at a high absolute level, evidence suggests that psychological well-being depends much more on relative consumption than on absolute consumption. By encouraging an across-the-board reduction in high-end consumption, a progressive consumption tax would thus have little effect on the relative consumption levels that shape well-being.

Consider a wealthy man who wants to host a “special” coming-of-age party for his daughter: Because the incomes of top earners have been soaring in recent years, the required expenditure levels have increased in tandem. To celebrate his daughter’s birthday in 2005, David H. Brooks, the chief executive of a company that supplies body armor to the American military in Iraq, invited 150 of her friends to the Rainbow Room atop Rockefeller Center in Manhattan, where they were serenaded by 50 Cent, Don Henley, Stevie Nicks, and other luminaries in a celebration reported to have cost $10 million. If all wealthy families spent a little less on such parties, as high marginal consumption tax rates would encourage them to do, everyone’s daughter would feel just as special as before.

Although some people worry that tax incentives for reduced consumption might throw the economy into recession, it is total spending, not just consumption, that governs output and employment. Phased in gradually, a progressive consumption tax would slowly shift spending from consumption to investment, causing productivity and incomes to rise faster. In addition, during recessions, a temporary cut in consumption taxes would provide a much more powerful stimulus than the traditional temporary cut in income taxes, because a temporary consumption tax cut would be advantageous only if people spent more right away (in contrast, consumers who fear losing their jobs in a recession are often reluctant to spend temporary income tax refunds).

The Bush tax cuts for the nation’s wealthiest families threaten American economic prosperity, yet they have done little for their ostensible beneficiaries. Higher spending on larger mansions serves only to raise the bar that defines adequate housing for economic elites. Even in terms of naked self-interest, everyone would have fared much better if the same money had been spent to repair aging bridges and inspect the cargo containers that enter the nation’s ports. Realistically, the progressive consumption tax is the only policy that can make this happen.

 

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Issue #8, Spring 2008
 
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FT:

An interesting suggestion, but one that would further complicate an already byzantine tax code. It appears to arise from the same political calculation that landed us in the morass we are already in.



What would be wrong with "demanding painful sacrifices from voters"? Admittedly, openness about taxes does not generally lead to election. But it is this fear of honesty and simplicity (and their admitted consequences) that led to such a twisted tax code to begin with.



Far better would be a dramatic cut in subsidies, cessation of pandering to the middle class, and targeted consumption taxes (e.g., a gas tax). Even better - a serious attempt to design a flat tax.

Apr 1, 2008, 6:16 PM
Renee:

Sounds interesting, however, in our current financial

environment I don't think it would work as smoothly

as it sounds. How about cutting some corporate

welfare aka subsidies? How about those at the higher

end of the economic scale actually pay a fairer share?

How about not subsidizing agri-business, and

gentleman farmers and paying farmers not to farm

the land? How about that military industrial complex?

Cutting out a fair share of these programs as they

are currently written and distributed would allow us to

allocate that money to:universal healthcare, investing

in research for alternative energy (other than

ethanol), investment in our infra-structure,

investment in our education system, etc. There are

just so many areas where needed resources are

currently being siphoned off in the name of "the free

market", and that good old "trickle down" economic

theory. Both of which have contributed to the greatest

economic disparity since the Gilded Age.





Apr 25, 2008, 12:43 PM
Vivek Mohta:

I'd like to offer a couple of thoughts, on an additional benefit of the progressive consumption tax and on a complementary tax reform:



- In the modern economy, households have greater income volatility than in the past. Income volatility might arise from changing employment, retraining, caring for a young child, etc. A progressive consumption tax allows households to save income tax-free for subsequent years, and not just for retirement, thus allowing households to stabilize their annual consumption. While not all households would think to do this naturally, the "choice architecture" for the savings plans could make it a default option--similar to proposals for default 401k contributions.



- A complementary reform that is now getting more attention is "ecological tax reform" or "green tax shifting." The basic idea is to tax natural resource consumption and pollution rather than labor and investment--that is, to tax waste not work. Good examples are a carbon tax that displaces payroll taxes and a land tax that displaces a property tax. Current proposals could displace a significant fraction, but not all, of Federal tax revenue. A good overview is at: http://www.tompaine.com/articles/tax_waste_not_work.php?dateid=20050421.



While a progressive consumption tax narrows shifts the tax base from income to consumption, ecological tax reform shifts it further to natural resource consumption and pollution. This reflects the principle that consumption ought to be taxed to the extent that it diminishes the commons.

May 12, 2008, 8:43 AM
Jadiker:

The problem with this article, to me, is that it makes a key number of assumptions that I'm just not on board with.



"Rising Social Security and Medicare costs, overdue infrastructure maintenance, and some form of universal health insurance will all require substantial federal revenue."



Well, the simpler - and, as someone else has said, less "byzantine" - solutions would be the at least partial privatization of Social Security as well as avoiding universal health insurance.



This article also sorely understates the measures of curent "wasteful spending". We're not just talking about standard political pork, we are talking about being engaged in military conflicts that are costing this country $12 billion a month. From a purely fiscal perspective, if you're looking for a place to start saving - this is it.



The point about overdue infrastructure maintenance is well-taken, though. The most hardcore of libertarians might suggest the privatization of that, as well, but I'm not ready to go down that (poorly maintained?) road just yet.

May 30, 2008, 10:58 AM

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