Consumption Taxes by lmJTcd8


									Consumption Taxes
Consumption as a Tax Base
• Renewed interest by economist in the
  consumption base reflects the belief that
  consumption is in fact a good index of the
  ability to pay taxes.
• Concern is also increasing about the relatively
  high efficiency losses associated with taxation
  of income from savings and investment.
• Consumption taxes are more favorable to
  savings and investment incentives than
  income taxes.
• A general tax on consumption is equivalent to
  an income tax that allows savings to be
  excluded from the tax base.
• Annual comprehensive consumption is annual
  comprehensive income minus annual savings.
• The dominant form of taxation of consumption
  in the United States is the retail sales tax used
  by state and local governments.
• The federal government taxes consumption
  mainly through the use of the excise taxes
  which is a selective tax on particular items.
• Excise taxes include those levied on cigarettes,
  gasoline, telephone services, and alcoholic
• The federal government also uses customs duties
  as a means of taxing consumption of imported
Direct Taxation of Consumption:
      the Expenditure Tax
• Under an expenditure tax, annual declarations
  of consumption expenditures, similar to annual
  declarations of income would be accomplished
  by filing annual returns on which taxable
  consumption would be calculated and taxed
  according to an appropriate rate structure.
• Such a system would allow progressive taxation
  of consumption in a fashion similar to the way
  progressive rates are applied to taxable income.
• Taxable consumption would be calculated
  directly from data on income simply by
  excluding that portion of income that is saved
  rather than spent.
Consumption,Saving, and
  Economic Capacity
• Nicholas Kaldor argues that consumption is a
  better index of the ability to pay any income.
• Kaldor’s contention is based on the notion
  that personal satisfaction is obtained when
  goods and services are consumed.
• Consumption of goods and services uses up
  resources and prevents them from being used
  by others.
• On the other hand savings entails sacrifice
  and results in no increase in well-being
  during the current tax period.
• The act of saving adds to a nation’s capital
  stock and benefits all insofar as it allows
  increased future consumption.
• The social benefit of saving,Kaldor argues,
  exceeds the private benefit of consumption
  insofar as it adds to the nation’s capital stock
  and improves productivity of resources.
• Some aspects of an expenditure tax are included
  in the current income tax system.
• For example, taxpayers have been allowed to
  exclude a limited amount of savings deposited in
  qualified retirement accounts from their adjusted
  gross income.
• These savings, and interest and other earnings
  accumulate on the account, are not taxable into
  until they are withdrawn ( that is, consumed).
• Under an expenditure tax, all savings, without
  limit, no matter for what purpose would be
  excluded from income.
• To see the advantages of this tax consider the
  following example.
• Two persons who began life with the same
  endowment of physical and human capital, and
  therefore the same economic capacity pay taxes
  would be taxed differently according to the way in
  which they differ in their tendency to defer
  consumption under an income tax.
• The individual who preferred to save nothing would
  be taxed entirely on the basis of his labor income
  where as the individual who preferred to save would
  pay taxes both on labor earnings and income from
  accumulated capital.
• When economic capacity is defined in terms
  of basic endowments of skills and physical
  capital, an income tax taxes savers relatively
  more than those who immediately consume
  everything that they earn.
• A tax on consumption avoids discrimination
  again savers by a exempting their savings and
  interest income from taxation until they are
Kaldor’s Original Version of the
       Expenditure Tax
• Bank balances and cash at the beginning of the year
• Plus
• Receipts such as wages and salaries, interest and
  dividends, and all other kinds of income to which the
  present income tax applies including gift, bequest,and
• Plus
• Money borrowed or money received in repayment of
• Plus
• Proceeds of sales of investments including houses
• Equal
• Total receipts
• Less: (subtracted from total receipts)
• Money lent or money paid in repayment of
  previous borrowing
• Purchases of investments including houses
• Bank balances and cash at the end of the year
• Equal
• Gross expenditures
• Less: (subtracted from Gross Expenditures)
• Exempted expenditures
• Allowance for spreading of expenditure on
  durable goods
• Plus
• Proportion of expenditure on durable goods
  incurred in previous years and chargeable in
  the current year
• Equal
• Taxable expenditure for current year
An Illustration: Income Tax
versus a Consumption Tax
• Assume that two individuals are economically
  the same in all respects. Both individuals are
  viewed as having the same ability to pay taxes;
  thus the principle of horizontal equity suggest
  that they would pay equal taxes over their
• Assume that they both face the same wage
  rates and interest rates over their lifetime.
• Furthermore, assume that the only way they
  can obtain capital income is to defer present
• If one worker is unwilling to do this, he will
  never save and never received interest income or
  a return on investment.
• If the other worker has a high rate of saving in
  her early years but then draws from the
  accumulated capital and interest as she ages, she
  will earn interest income over her lifetime in
  addition to her wage income.
• Under the income tax she is taxable on all of her
• The present value of taxes paid by the saver
  would exceed that paid by the nonsaver over the
  life cycle.
Income Tax
                    Individual     Individual  Diff
                        A              B
                 Period Period 2 Period Period
                   1                1      2
Income            30000     30000 30000 30500

Flat Tax @ .20    6000       6000    6000    6100
Consumption      24000     24000    19000   24400
Saving             0         0      5000      0
Present Value    6000      6000/    6000   6100/
of Tax                     (1.10)          (1.10)
                          = 5455          = 5545
Total PV               11455           11545        90
• On the other hand, if the tax base were
  consumption, the present value of taxes paid by
  the two workers over their lifetime would be
  equal and independent of the pattern of
  consumption and savings.
• Thus, the consumption tax treats these two
  workers equally according to the equality of
  their economic capacity.
• That is, it complies with the principle of
  horizontal equity.
Consumption Tax
                   Individual     Individual Diff
                       A              B
                Period Period Period Period
                  1         2     1       2
Income           30000     30000 30000 30000

Consumption     30000      30000   25000   35500
Saving            0         0      5000     0
Tax @ .20       6000      6000     5000    7100
Present Value   6000      6000/    5000   7100/
of Tax                    (1.10)          (1.10)
                         = 5455          = 6455
Total PV              11455           11455        0
• For the saver, the amount of taxes she would
  have paid had she not saved can be thought of as
  a loan from the government.
• For example, under the consumption tax, the
  saver in the last table would have saved $1,000
  in income taxes by deferring $5,000 of first
  period consumption to the second period.
• When the savings were spent in the second
  period, the taxpayer repaid the government
  $1,000 in deferred taxes plus 10% interest on
  the deferred $1,000 tax.
• The total tax liability in second period was thus
A Comprehensive Consumption
         Tax Base
• Comprehensive income is defined as the sum
  of the annual consumption and increases in
  net worth.
• The comprehensive consumption tax base
  excludes any increases in net worth from the
  tax base.
• With a consumption tax it is not necessary to
  measure either realized or unrealized capital
• Capital gains are taxed when they are spent.
• Inflation is no problem under the consumption
  tax because only current expenditures are
• A capital gains on asset held for many years
  includes the effect of inflation.
• However, when the gain is liquidated at any
  point in time, the cash obtained is also used to
  buying goods at the current inflated values (real
• Therefore, adjusting the purchasing power of
  the gain under a consumption tax is no longer
  necessary; it is done automatically by current
Implementation of an
  Expenditure Tax
• Consumer durable present a problem in
  implementing an expenditure tax.
• For example, the consumption of housing
  services flowing to occupants of owner
  occupied dwellings would have to be included
  in the tax base if it were to be truly
• Similarly, all consumer durable goods would
  have to have consumption flows imputed in to
  their use.
• However, similar problems arise with an income
  tax for income in-kind.
• Consumer durable could be taxed at purchase by
  applying the appropriate tax rate to their
  purchase price.
• In effect this would levy a tax on the present
  value of the service stream from the durable
• Nevertheless, for higher priced assets, for
  example homes, this creates a liquidity problem
  for buyers.
• This problem could be solved by allowing
  payment of taxes on such items over a period of
• Transfers would be included in the tax base to
  the extent to which they were consumed.
• Contributions to retirement funds, including
  Social Security taxes, would be treated as
  savings and therefore excluded from taxation.
• Bequests at death would have to be treated as a
  form of final consumption and taxed accordingly.
• Expenditure taxes would include the proceeds of
  loans in the tax base as they are spent and would
  allow the interest to be deducted from
  consumption as the loan is paid off.
The Cash Flow Tax
• A cash flow tax is a modified form of the
  general expenditure tax.
• Under this tax, savers would be permitted, in
  computing their tax liability each year, to
  deduct from their income those funds deposited
  in qualified accounts.
• The cash flow tax would extend the current
  treatment of IRAs to a broader array of
  qualified accounts and allow taxpayers to
  withdraw and spend funds from these accounts
  whenever they wished, at which time they
  would incur a tax liability, but not a penalty.
• Taxpayers could defer tax liability on
  withdrawals from existing accounts simply by
  redepositing the withdrawal into qualified
• Under the cash flow tax, loans would be added
  to adjusted gross income as the are received and
  would be deducted from income as the are
• Purchases of durable assets by consumers would
  not be considered a form savings, and such
  purchases would be subject to a tax.
    A General Tax on
Comprehensive Consumption
• Let’s compare a comprehensive expenditure tax
  with a comprehensive income tax.
• Assume that both taxes raise the same amount
  revenue and finance the same mix of
  government services.
• Assume as well that both taxes are levied at a
  proportional rate.
  Substituting a Proportional
Expenditure Tax for an Equal-
Yield Proportional Income Tax
• If both taxes are to raise the same amount of
  revenue, and if saving in a given year is positive
  , then the tax rate under the consumption tax
  would have to be higher than the tax rate under
  an equal yield income tax.
• For example, if savings is 20% of income after
  the consumption tax is introduced, and income
  does not increase in response to the substitution
  of the consumption tax for the income tax, then
  the consumption tax would have to be 25%
  higher than the income tax to raise the same
• This is because with a savings rate equal to
  20%, income is equal to 125% of consumption.
• The consumption tax taxes only 80% the the
  income base.
       Tax Revenue = tII  tCC  tC (.8) I
       tC  tI  1.25tI
Impact on Savings and Excess
 Burden Investment Markets
• The higher tax rate required under the
  consumption tax to raise the same revenue as
  the income tax is of no consequence for the
  impact of the tax on the capital market because
  interest income is not taxable under a
  consumption tax.
• If the expenditure tax replaces a pre-existing
  income tax, then any excess burden existing
  because of tax induced distortions in interest
  rates is eliminate.

   rN        F

                         Net Return Under
         DQI             the Income Tax

                     Gain in Efficiency
   rN        F

                         Net Return Under
         DQI             the Income Tax

• Under the income tax, the net return to
  savings fall short of the gross return.
• The substitution of the flat rate consumption
  tax for the income tax removes the wedge
  between the gross interest rate and the net
  interest rate.
• The gain in well- being is the area of the
  triangle FGE.
• Investment increases by DQ.
Impact on Efficiency in Labor
• The gains from achieving efficiency in the
  market for loanable funds must be balanced
  with the possibility of additional losses in the
  labor markets.
• This is because the higher tax rate required for
  the consumption tax further decreases the return
  to work effort and induces further efficiency
  losses in the labor market resulting from
  distortions in the work-leisure choice.
Wage                               SL

       WG2            A’

       WG1                 A

       W0                      B

       WN1                 C


                                                 D = WG


             0    L3 L2 L1
• In the figure, the efficient allocation of labor
  corresponds to point B.
• Under the income tax, the effective wage
  received by workers falls to WG(1-tI) at point C.
• The gross wage is WG1 and the net wage is WN1.
• The efficiency loss is represented by triangle
• Under an expenditure tax, wages would fall to
• This results in a further decline in net wages at
  the new equilibrium C’.
• The loss in efficiency now is measured by the
  excess burden A’BC’.
• The substitution of the consumption tax for
  the income tax increases the excess burden by
  the area A’ACC’.
• Remember that the excess burden increases
  with the square of tax rate.
• The increased excess burden is more than
  proportionate to the increase in the tax rate.
Incidence of an Expenditure Tax
• The major burden of a consumption tax is likely
  to fall on labor income.
• Insofar as the bulk of the tax is borne by labor
  income, and capital income escapes taxation, the
  consumption tax is likely to be more regressive
  the with respect to income than equal-yield
  income tax.
• However, if an expenditure was actually used,
  the rate structure of the tax could be modified to
  achieve a collectively chosen distribution of the
  tax burden.
Sales Taxes
• In practice, few sales taxes are implemented in such a
  way as to conform to a comprehensive consumption tax
• For example, many retail sales taxes are levied only on
  the consumption of tangible goods.
• The consumption of professional services and personal
  services are usually exempt from tax .
• The most conspicuous exemption is housing services.
• Many states exempt necessity goods.
• Many consumption taxes are levied on the purchase of
  capital goods which leads to tax pyramiding. Durable
  goods purchased by businesses lead to higher retail
Retail Sales Taxes
• A retail sales tax is usually an ad valorem levy
  of a fixed percentage on the dollar value of
  retail purchases made by consumers.
• A true retail sales tax is levied only on
  consumption at its final stage is collected from
  business establishments that make retail sales.
• The tax is usually added on to the retail price of
  goods and services.
• A possible effect of local sales taxation is a
  loss of retail trade to neighboring jurisdictions
  where the sales taxes either absent or applied at
  a lower rate.
• The migration of retail sales to another taxing
  jurisdiction can have the effect of reducing
  employment, business profits in the taxing
  jurisdiction, or both.
• This in turn could decrease the actual amount
  taxes collected.
• Only partial shifting to consumers of the retail
  sales tax would occur if the tax cause sales to
• This means that retail prices would not rise by
  the full amount of the tax.
• If the consumption tax base were elastic with
  respect to the rate of taxation, then increases in
  the rate of sales taxation would result in less not
  more revenue collected.
• In some cases, a local tax can be levied on items
  purchased in a neighboring jurisdiction but used
  in the taxing jurisdiction.
• This is accomplished through use taxes.
• However, use taxes are difficult to enforce for
  consumption goods that are not required to be
  registered with a government agency.
• One way of avoiding sales taxes is to
  purchase items in one state for delivery to a
  resident in another state.
• This can be accomplished either by visiting
  the state, by mail order,or by ordering over
  the Internet.
• Typically, the transaction is viewed as an out
  of state sale if the buyer has a resident in
  another state and if the seller does not operate
  in a state in which the buyer resigns.
Excise Taxes
• Excise taxes are selective taxes levied on certain
  types of consumption activity.
• They tend to distort choices among goods and
  services and result in efficiency losses to the
• Some excise taxes are designed to raise revenue,
  while others are intended to discourage
  particular consumption activities.
• Both federal and state governments tax liquor
  and cigarette consumption.
• Federal excise taxes are also led the on gasoline,
  telephone services, and tires.
Incidence of Sales and Excise
• Sales and excise taxes are usually considered
  to be regressive with respect to income.
• This is based on the notion that annual
  consumption expenditures, as a percentage of
  annual income, are higher for low-income
  taxpayers relative to high-income taxpayers,
  and that the tax is shifted forward so that it is
  borne according to purchases.
• Research by Pechman on the incidence of
  retail sales and excise taxes in the United
  States concluded that they were regressive
  the with respect to income.
• His research showed that the rates paid decline
  steadily from about 9% of income for the lowest
  income groups to a little more than 3% for the
  highest income groups.
• The national effects of sales taxes are likely to
  be similar to those of the national consumption
• The tax would be borne according to labor
Turnover Taxes
• Turnover taxes are multistage sales taxes that are
  levied at some fixed rate on transactions at all
  levels of production.
• The effective tax rate on various goods and
  services depends on the number of stages of
• The turnover tax provides an incentive to vertical
  integration among firms so as to reduce the
  number of production stages and interfirm
  transactions and consequently reduced the tax
• The tax is usually reflected in higher final
  consumption prices.
• Pyramiding occurs when companies applying
  percentage markups to purchase prices to
  include the turnover tax.
Value-Added Taxes
• The value added tax (VAT) is a general tax
  on consumption levy on the value added to
  intermediate product by businesses at each
  stage of production.
• While the value added tax is not used to any
  extent in United States, it has been seriously
  considered in the past.
• The tax has been considered both as a full or
  partial substitute for the existing corporate
  income tax and also as a new source of
The Meaning of Value Added
• Valued added is the difference between sales
  proceeds and purchases of intermediate goods
  and services over certain period time.
• Suppose that a grocery store total sales
  receipts of $150,000 for a given month.
• If it purchased $75,000 of groceries from its
  suppliers and $10,000 of goods and services
  from other firms, its value added would be
  $65,000 that month.
• Netting out the dollar value of intermediate
  transactions from all transaction leaves the
  dollar value of final sales.
• Final sales represent the dollar value of all
  domestic wages, interest, rent, depreciation, and
• Valued at by all business firms at each stage of
  production is another way of defining the GDP.
• A general tax on value add therefore is
  equivalent to a tax on national product.
• There different types of value added taxes
  classified according to how they handle a firm’s
  purchase of capital goods.
Types of Value Added Taxes
• The base for the consumption type tax is the
  same as that for a general tax on comprehensive
  consumption, while that for the income type tax
  is the same as for a proportional income tax.
• The consumption type tax used in most nations.
• Thus the tax base for the value-added tax is
  equivalent to that of any general consumption
Administration of a Value Added
• Administration of the value added tax does not
  require firms to calculate value added.
• Under the invoice method, all transactions are
  taxed at a fixed proportional rate regardless of
  whether they are final or intermediate
• Taxpayers are allowed to deduct the taxes paid
  on intermediate purchases from the taxes
  collected from their sales in determining their
  tax liability.
• Payment of the tax requires firms to maintain
  invoices on sales and purchases for a each the
  tax payment period.
• Tax liability is determined by applying the fixed
  rate of taxation to total sales invoices and then
  deducting the amount of tax paid previously on
  intermediate purchases as indicated on purchase
  invoices, where the taxes usually separately
• Tax liability = Tax Payable on Sales minus Tax
  Payable on Intermediate Purchases
•                = [(t)(Sales)] – [(t)(Purchases)]
     •          = (t)(Total Sales – Total Intermediate Purchases)
     •          = (t)(Value Added)
• At the final stage of production, consumers
  purchase goods with the value added tax
  included in the price; and because consumers
  have no intermediate transactions to offset the
  tax liability, the end up paying the entire
  amount of the tax with no tax offset.
• Firms that make capital purchases are allowed
  an additional tax credit for taxes paid on
  capital goods.
• Tax Liability = [(t)(Total Sales – Total
  Intermediate Purchases] – [(t)(Capital Purchases)]
  • = (t)(Total Sales – Total Purchases – Capital Purchases)
  • = (t)(Value added – Investment)

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