Should Income be Taxed or Consumption?

When taxes induce people to change their behavior — such as inducing Jane to buy less pizza – the taxes cause deadweight losses and make the allocation of resources less efficient. As we have already seen much government revenue comes from the individual income tax. In a case study we discussed how this tax discourages people from working as hard as they otherwise might. Another inefficiency caused by this tax is that it discourages people from savings.

Consider a person 25 years old who is considering saving $ 100. If he puts this money in a savings account that earns 8 per cent and leaves it three, he would have $ 2,172 when he retires at the age of 65. Yet if the government taxes one fourth of his interest rate it is only 6 per cent. After 40 years of earning 6 per cent the $100 grows to only $1,029 less than half of what it would have been without taxation. Thus, because interest income is taxed saving is much less attractive.

Some economists advocate eliminating the current tax system’s disincentive toward saving by changing the basis of taxation. Rather than taxing the amount of income that people earn, the government could tax the amount that people spend. Under this proposal all income that is saved would not be taxed until the saving is later spent. This alternative system is called consumption tax which would not distort people’s savings decisions.

Various provisions of the current tax code already make the tax system a bit like a consumption tax. Taxpayers can put a limited amount of their saving into special accounts – such as Individual Retirement Accounts and 401(k) plans – that escape taxation until it is withdrawn at retirement. For people who do most of their savings through these retirement accounts their tax bill is, in effect based on their consumption rather than their income.

European countries tend to rely more on consumption taxes than does the United States. Most of them raise a significant amount of government revenue through a value added tax, or a VAT. A VAT is like the retail sale tax that many US states use, but rather than collecting all of the tax at the retail level when the consumer buys the final goods, the government collects the tax in stages as the good is being produced (that is, as value is added by firms in the chain of production).

Various US policymakers have proposed that the tax code move further in the direction of taxing consumption rather than income. In 2005, economists Alan Greenspan offered this advice to a presidential commission on tax reform. As you know many economists believe that a consumptions tax would be best from the perspective of promoting economic growth — particularly if one were designing a tax system from scratch – because a consumption tax is likely to encourage savings and capital formation. However getting from the current tax system to a consumption tax raises a challenging set of transition issues.

Administrative Burden:

If you ask the typical person on April 15 for an opinion about the tax system you might hear about the headache of filling out tax forms. The administrative burden of any tax system is part of the inefficiency it creates. This burden includes not only the time spent in early April filling out forms but also the time spent throughout the year keeping records for tax purposes and the resources the government has to use to enforce the tax laws.

Many taxpayers especially those in higher tax brackets hire tax lawyers and accountants to help them with their taxes. These experts in the complex tax laws fill out the tax forms for their clients and help clients arrange their affairs in a way that reduces the amount of taxes owed. This behavior is legal tax avoidance which is different from illegal tax evasion.
Source: Principles of Economics