A consumption tax is a wealth tax
By Scott Sumner
When I advocate a (progressive) consumption tax to replace our current income tax system, some commenters reply that wealth provides benefits beyond consumption, such as peace of mind and security. I think that’s true, but to me it seems to be an argument for making the consumption tax progressive, not switching to a tax on capital income or wealth.
It’s important to keep in mind that (correctly measured) wealth is the present value of all future consumption by you, your heirs, and anyone you donate money to. If you tax all consumption at a 50% rate, then you’ve essentially put a one time 50% tax on wealth. Actual real world proposals for wealth taxes have something else in mind, an annual levy that implicitly taxes people at a higher rate when they spend their wealth in the future, as compared to spending their wealth today.
Here’s another way of thinking about this point. Two people with identical wage income can allocate consumption over their lives in different ways (including deferring some consumption to their heirs.) When you decide to defer consumption to the future, there are both benefits and costs. The benefit is the option value of deferred consumption; it allows you to change your mind if an emergency comes up, requiring an unexpected change in plans. That’s an advantage. On the other hand most of us prefer a bird in the hand to two in the bush. We are impatient. That’s one reason why savers have traditionally been rewarded with interest; it’s a form of compensation for saving. All of those things get factored into the market interest rate, which reflects the relative price of current and future consumption.
Now assume a 50% consumption tax. Anytime you save $100, you don’t really have $100 available for emergencies, you have $50 available for after tax purchases. You are able to buy $50 worth of goods when you decide to spend the $100. That means the 50% consumption tax has cut your economic security in half, as compared to the no tax case. So it’s not really correct to say that consumption taxes don’t address the security and peace of mind conferred by great wealth.
On closer inspection, I find that almost all the arguments against consumption taxes are actually arguments in favor of progressive taxes. It is extremely hard for most people to think about taxes without getting drawn into the progressivity debate, even though there are many other issues such as efficiency and horizontal equity. (Horizontal equity means that two people with equal lifetime resources should pay an equal tax rate.)
For any income tax regime, there is a consumption tax regime of equal progressivity. Unfortunately that equally progressive regime will look much less progressive. This is one of the biggest barriers to tax reform. Democrats don’t want a reform that looks more regressive, and to make the system look as progressive as our current system the top rates on the consumption tax would have to be too high for the GOP to stomach. Hence we don’t do win-win tax reform, which would benefit both Democrats and Republicans, mostly because of cognitive illusions. Coincidently that’s why we don’t have sound monetary policy—cognitive illusions.
And let’s not even talk about trade.
PS. This post is a sort of reply to Frances Woolley.