Consumption tax
A consumption tax is a tax levied on consumption spending on goods and services. The tax base of such a tax is the money spent on consumption. Consumption taxes are usually indirect, such as a sales tax or a value-added tax. However, a consumption tax can also be structured as a form of direct, personal taxation, such as the Hall–Rabushka flat tax.
Types
Value-added tax
A value-added tax applies to the market value added to a product or material at each stage of its manufacture or distribution. For example, if a retailer buys a shirt for twenty dollars and sells it for thirty dollars, this tax would apply to the ten dollar difference between the two amounts. A simple value-added tax would be proportional to consumption but would also tend to be regressive on income at higher income levels, as consumption tends to fall as a percentage of income as income rises. Savings and investment are tax-deferred until they become consumption. A value-added tax may exclude certain goods to make it less regressive against income. It is imposed in European Union countries.Value added tax is a consumption based tax and is levied each and every time the value of a good gets increased in the process of manufacturing to the point of sale.
In Australia, Canada, New Zealand and Singapore, it is instead called a "Goods and Services Tax." In Canada it is also called Harmonized Sales Tax when it is combined with a provincial sales tax.
Sales tax
Sales tax is a part of government revenue and is normally a consumption tax applicable to sales of goods & services. It is accepted by the government to collect the sales tax by the retailer and further deposit it to the government. A sales tax typically applies to the sale of goods, and sometimes also to the sales of services. The tax is applied at the point of sale. Laws may allow sellers to itemize the tax separately from the price of the goods or services, or they may require it to be included in the price. The tax amount is usually ad valorem, that is, it is calculated by applying a percentage rate to the taxable price of a sale. When a tax on goods or services is paid to a governing body directly by a consumer, it is usually called a use tax. Often laws provide for the exemption of certain goods or services from sales and use taxes.Excise tax
An excise tax is a sales tax that applies to a specific class of goods, typically alcohol, tobacco, gasoline, or tourism. The tax rate varies according to the type of good and quantity purchased and is typically unaffected by the person who purchases it.Sin taxes, are a type of excise tax imposed on items which are considered harmful to society, in an effort to decrease their consumption by increasing their prices.
Expenditure tax
A direct, personal consumption tax may take the form of an expenditure tax, that is, an income tax that deducts savings and investments, such as the Hall–Rabushka flat tax. A direct consumption tax may be called an expenditure tax, a cash-flow tax, or a consumed-income tax and can be flat or progressive. Expenditure taxes have been briefly implemented in the past in India and Sri Lanka.This form of tax applies to the difference between the income of an individual and the increase/decrease in his savings. Like the other consumption taxes, simple personal consumption taxes tend to be regressive with respect to income. However, because this tax applies on an individual basis, it can be made as progressive as a progressive personal income tax. Just as income tax rates increase with personal income, consumption tax rates increase with personal consumption. Economists from Milton Friedman to Edward Gramlich and Robert H. Frank have supported a progressive consumption tax.
History
Consumption taxes, specifically excise taxes, have featured in several notable historic events. In the United States, the stamp tax, the tax on tea, and whiskey taxes produced revolts, the first two against the British government and the latter against the new federal government. In India, an excise tax on salt led to Mohandas Gandhi's famous Salt March, a major event in the Indian Independence Movement.United States
In the early United States, taxes were levied principally on consumption. Alexander Hamilton, one of the two chief authors of the anonymous The Federalist Papers, favored consumption taxes in part because they are harder to raise to confiscatory levels than income taxes. In The Federalist Papers, Hamilton wrote:Although personal and corporate income taxes provide the bulk of revenue to the federal government, consumption taxes continue to be a primary source of income for state and local governments. One of the first detailed proposals of a personal consumption tax was developed in 1974 by William Andrews.
Japan
The Liberal Democratic Party government of Masayoshi Ōhira had attempted to introduce a consumption tax in 1979. Ohira met a lot of opposition within his own party and gave up on his attempt after his party suffered badly in the 1979 election. Ten years later Noboru Takeshita successfully negotiated with politicians, bureaucrats, business and labor unions to introduce a consumption tax, which was introduced at a rate of 3% consumption tax in 1989.In April 1997 under the government of Ryutaro Hashimoto it was increased to 5%. The 5% is made up of a 4% national consumption tax and a 1% local consumption tax. Shortly after the tax was introduced Japan fell into recession, which was blamed by some on the consumption tax increase, and by others on the 1997 Asian financial crisis.
Prime Minister Junichiro Koizumi said he had no intention of raising the tax during his government, but after his massive victory in the 2005 election he lifted a ban on discussing it. Over the following years a number of LDP politicians discussed raising it further, including prime ministers Shinzō Abe, Yasuo Fukuda, and Tarō Asō.
The Democratic Party came to power in the August 2009 elections with a promise not to raise the consumption tax for four years. The first DPJ prime minister, Yukio Hatoyama was opposed, but Naoto Kan replaced him and called for the consumption tax to be raised. The following prime minister, Yoshihiko Noda "staked his political life" on raising the tax. Despite an internal battle that saw former DPJ leader and co-founder Ichirō Ozawa and many other DPJ diet members vote against the bill and then leave the party; on June 26, 2012, the lower house of the Japanese diet passed a bill to double the tax to 10%.
Despite considerable opposition and an attempted no-confidence motion from minor opposition parties the bill was successfully passed through the upper house on August 10, 2012, with the result that the tax was increased to 8% in April 2014 and to 10% in October 2019.
Savings effect
Consumption taxes do not tax savings, which allows invested assets to grow more quickly. If, in the absence of taxes, one dollar of savings is put aside for retirement at nine percent compound interest, savings will grow to $7.91 after twenty-four years. Alternatively, by assuming a thirty-three percent tax rate, the same dollar is reduced to about sixty-seven cents after taxes when earned. The effective interest rate, thereafter, is reduced to six percent, since the rest of the yield is paid in taxes.After twenty-four years, the balance increases only to $2.73. The cumulative taxes in the latter case are $1.02. The other $4.16 is not lost by the economy in any sense, as the $4.16 is what the government would make in interest, if it had invested its tax revenue in the same investment. If the initial invested amount is not taxed when earned, but the earnings are taxed thereafter, the cumulative taxes paid are the same, but are spread more evenly across the period. These results are primarily sensitive to the rate of return; for example, with a three percent return most of the tax receipts come from the tax on the initial dollar.
To the extent that taxing something results in less of it, taxing consumption instead of income should encourage both work and capital formation, which will increase economic growth, while discouraging consumption. Secondly, the tax base will be larger because all consumption will be taxed.
Some critics argue that consumption taxes can shift the tax burden to the less well-off. The ratio of tax obligation to income tends to shrink as income increases because high-earners tend to consume proportionally less of their income. An individual unable to save will pay taxes on all his income, but an individual who saves or invests a portion of his income will be taxed only on the remaining income.
Practical considerations
Many proposed consumption taxes share some features with income tax systems. Under these proposals, taxpayers would be given exemptions and/or a standard deduction in order to ensure that the poor do not pay any tax. In a pure consumption tax, these other deductions would not be permitted.A withholding system may also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.
A consumption tax could also eliminate the concept of basis when computing the value of investments. All income that is put in investments would be tax-free. As the asset grows in value, it would not be taxed. Only when the proceeds from the investment are spent is any tax imposed. This is in contrast with an income tax system where if land is bought and sold it with a profit, the gain is taxable. A consumption tax taxes only consumption, so if an investment is sold to buy another investment, no tax is imposed.
Andrews notes the inherent problem with housing. Renters necessarily "consume" housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption.
The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent the home to others in exchange for money but instead chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home.
A true consumption tax would tax the imputed rental value of the home and would not tax the increase in the value of the asset. Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States, home ownership is subsidized by the federal government by permitting limited deductions for mortgage interest expense and capital gains. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible there.
This issue would not arise under an expenditure tax, since all withdrawals of funds from a pre-tax investment account are treated as taxable consumption, whether these funds are used to pay rent, buy a house, or pay down mortgage principal. A person may buy a house within a pre-tax account, but would not be allowed to live there.
Also, a consumption tax could utilize progressive rates in order to maintain "fairness". More consumption means more tax liability.
Economic impact
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.Many economists and tax experts favor consumption taxes over income taxes for economic growth.
Depending on implementation and circumstances, income taxes either favor or disfavor investment. By not disfavoring investment, a consumption tax would increase the capital stock, productivity, and therefore increase the size of the economy. Consumption also more closely tracks long-run average income. The income of an individual or family can often vary 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 lower or middle income person into a higher tax bracket. On the other hand, a wealthier individual may be temporarily unemployed and earn no income.