Consumption Tax - Economic Impact

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 (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.