Taxing Spending: The Case For a National Consumption Tax

 

Takeaway

  • Instead of taxing what Americans earn, consumption taxes are based on what they spend
  • The U.S. could adopt a federal consumption tax within the next 10 years
  • In a value-added tax system, each company pays tax on the difference between the materials it buys and the product it sells

If Rodney Dangerfield were a tax form, he’d be a 1040: As the federal income tax nears its 100th birthday, next year, it’s getting no respect. Presidential candidates have one-upped one another with plans to replace it — from Herman Cain’s 9-9-9 to Rick Perry’s file-on-a-postcard.

Although most of these tax plans have sunk as quickly as they’ve arisen, an income tax alone might not be the most effective way to finance the federal government, say several tax and finance experts at the University of Texas at Austin. None want to replace it entirely, but they suggest that the U.S. consider a parallel tax system: a national consumption tax.

Penalizing Consumption Over Income

Consumption taxes share one principle: Instead of taxing what Americans earn, tax what they spend. The most familiar variety is a sales tax, which sellers collect from consumers and pass on to government. But there are many variations, such as excise taxes, which single out specific goods like gasoline or cigarettes.

Why levy a tax on spending? The underlying idea is that government should not penalize work more than other behaviors. “The theory is that if income tax rates are high enough, they discourage work and savings,” says Robert Peroni, professor at the School of Law. “A sales tax is discouraging consumption behavior, and better to discourage consumption than savings or work.”

A more pressing and practical consideration is the national debt. It’s currently $15.7 trillion. Even with budget cuts approved last year by Congress, it will swell by another $3.5 trillion over 10 years, projects the Congressional Budget Office.

“If you look ahead 10 years from now,” says Peroni. “We’ll probably have some mixture of income tax with some kind of federal consumption tax, to avoid becoming Greece.”

He notes that the U.S. is one of the few industrialized nations that doesn’t already have a national consumption tax. Among the 27 countries in the European Union, 33 percent of revenue comes from consumption taxes, compared to 31 percent from income taxes. In the United Kingdom, a 20 percent consumption tax helps hold the income tax down to a top bracket of 50 percent.

Understanding the VAT

EU nations use a type of consumption tax called a value-added tax (VAT), and a few American public figures, like former House Speaker Nancy Pelosi and former Federal Reserve Chairman Paul Volcker, have suggested importing the model.

A VAT works much like a sales tax. But instead of being collected once — when a consumer buys a finished product — it’s collected in bits and pieces at every step along the business supply chain. Essentially, each company pays tax on the difference between the materials it buys and the product it sells — the value it adds to the product.

The virtue of a VAT, from a tax collector’s perspective, is that it’s harder to evade than an income tax or a traditional sales tax. That’s because businesses have a stake in keeping one another honest.

Say a retail store buys a computer from a manufacturer for $600 and sells it for $1,000. If the VAT rate is 10 percent, the retailer owes the government $100 (10 percent of the sale price). But the retailer gets a credit invoice, documenting the $60 in tax the manufacturer has already paid. The retailer is only on the hook for $40.

“It creates a self-enforcement mechanism,” says Lillian Mills, chair of the Department of Accounting at the McCombs School of Business. “If I’m a retailer, I want the credit from the supplier, so I buy from someone who’s remitting the tax.”

For people other than tax collectors, a VAT might have some downsides, warns Peroni. For one thing, it would compete with existing sales taxes. “We have state sales taxes, which most foreign countries don’t,” he says. “State and local governments fear there would be pressure to lower or get rid of their sales taxes.”

More obvious, he says, would be the shock to consumer prices. “People would see it right away. Suddenly everything in a restaurant would cost 10 percent more.”

To fully replace the federal income tax, he adds, might require a VAT as high as 35 percent. A more palatable course might be to trade off a modest VAT for lower income tax rates and eliminate many high-dollar deductions.

If you believe that taxes should be tilted toward those who can most afford to pay them, Peroni suggests using a VAT to replace Social Security and Medicare taxes. Such payroll taxes take their biggest bites out of low-income workers, who pay higher percentages of their incomes, whereas a VAT would spread the pain over all income levels.

Creeping Up

Not every finance expert is bullish on a national consumption tax. It might sound appealing to accept a small VAT in exchange for lower income tax rates, says Jim Nolen, a distinguished senior lecturer in finance who recently retired from McCombs. But small taxes tend not to stay small. “Once you give them the ability to tax something,” he says, “next year it goes up 1 percent, then the next year another.”

That’s been the experience in Europe. Germany, which started with a VAT of 10 percent, now charges 19 percent. In the United Kingdom, it’s risen from 8 percent to 20 percent.

The other danger, says Nolen, is that citizens pay less attention to taxes when they pay them a little bit at a time. “When it’s one tax, people complain a lot, but when you take it from multiple sources people don’t notice it as much. I’m afraid we’re going to leave the income tax in place and put a value-added tax on top of it.”

Mills acknowledges the danger that a new tax could fuel higher government spending. “The political concern, if we create a value-added tax, is that it’s very difficult to maintain fiscal discipline when you have a new source of revenues.”

Nonetheless, she says, Uncle Sam might have no better choice. “I look at Social Security and Medicare. Those two programs put a lot of pressure on our tax system. Without bigger increases in the retirement age, we will need new sources of tax revenue. It’s likely that at some point we will have a value-added tax or an excise tax.”

 

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Faculty in this Article

Jim Nolen

Distinguished Senior Lecturer (retired), Department of Finance McCombs School of Business, The University of Texas at Austin

Jim Nolen received his BBA and MBA from The University of Texas at Austin. Until his retirement in May 2012, he taught both undergraduate and...

Jim Nolen teaches in the Texas Executive Education program, featuring open enrollment, custom and certificate classes for executives and organization teams.

Lillian Mills

Professor, Department of Accounting

Lillian Mills received her BA from the the University of Florida and her Ph.D. from the University of Michigan. Her research interests include...

Robert J. Peroni

The Fondren Foundation Centennial Chair for Faculty Excellence School of Law, The University of Texas at Austin

Professor Peroni joined the faculty in 2003, and his primary areas of teaching and scholarship are federal income taxation, international taxation...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

Comments

#1 Why create a new tax program

Why create a new tax program when all we need to do is fix the one we have. The one we have is not just about raising money for our needs. It's turned into a socialization system. Credits for this and heavy taxes for that. Steering our society. Having said that I am 100% for a system that taxes spending only. For the first time it gets government out of my personal business. The tax collector doesn't even need to know who I am. I am willing to pay more just for that. One note about illegal workers who don't pay taxes. That could be solved tomorrow if the IRS required all individuals and conpanies to withhold from 1099 workers a 20% tax and send it to the government. Then they either file a tax return or not, but so what we have their money now. The math is simple, 11 million illegals making $40,000 per year average with a 20% withholding equals $88 billion paid up front. Sure pays for a lot of social services currently falling on the legal American. Of course we all know spending is our real problem. We get our needs and wants confused.

#2 Taxing consumption instead of

Taxing consumption instead of labor would not only help avoid distorting labor markets and make the tax system less complex, but also change the debate about illegal immigrants. Why? Since everybody present in the US, legal or illegal, couldn't escape taxes on his/her consumption, any perceived issue of undocumented workers not paying their fair share of income taxes would go away.

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