The Consumption Tax: Macroeconomic Effects
and its Potential As a Tool for Discretionary Fiscal Policy
By Edward Cremata
Over the last thirty years the concept of taxing consumption in the United States, as opposed to
income or labor, has been posited by many, each time being dismissed as either
too complex, unnecessary, or critically unsupported by research. Much has
been written on the potential benefits and drawbacks of the implementation of
various proposals and their ability to affect savings, investment and the
equitable distribution of income, especially in the long run. While these
are certainly important issues and should continue to be researched,
particularly if such a proposal becomes a political reality, I believe
that an important potential benefit of a consumption-type tax is not being
considered. This paper proposes that in addition to the macroeconomic
effects of such a proposal, which will be discussed later in this paper,
policymakers should also consider the potential for a National Retail Sales Tax
to act as a tool for discretionary fiscal policy, complementing the actions of
the Federal Reserve in their attempts to promote economic growth and stabilize
the economy. But first, what is a consumption tax and how does it differ
from the current system of taxation in the United States?
As mentioned before, a consumption tax is a tax whose base is consumption rather
than income or labor, which have been the primary sources of federal revenue in
the U.S. for most of the last century. A consumption tax can take various
forms, such as a National Retail Sales Tax, a Value Added Tax or a Flat Tax.
A National Retail Sales Tax would take the form of a tax on every good purchased
in the U.S., from oranges to BMW's and everything in between. In a
practical sense, rather than expecting stores across America to change their
prices whenever the government dictates it, the tax would be imposed at the time
of sale, entered into the cash register before the opening of the store and
posted outside either on paper or in a digital format of some sort. A
Value Added Tax, much like those found in Europe, is also a method for taxing
consumption, albeit before the customer ever sees the final product. These
taxes provide many of the general benefits attributed to consumption-type taxes,
in addition to the theoretical arguments, such as those posed by John Laramer of
the Harvard Law Review. In essence, he believes that it is more
appropriate in a free society to tax what an individual takes out of the
communal pie rather than what they put in. If income is seen as
representative of the productive contributions one makes to society then an
income tax does in fact fine heaviest those individuals contributing the most
to our collective wealth. A consumption tax, in contrast, taxes only that
which an individual removes from society and is thus, from this perspective,
more fair. As interesting as this line of inquiry may be, these arguments
are theoretical in nature and are therefore rather unsuited to inform the
pragmatic decisions of policymakers. In this regard, a VAT is
significantly less well-suited to act as a fiscal policy tool and is not
considered in this paper. A Flat Tax has many fundamental problems in it
as well, primarily its inherent regressivity in a country more-or-less dedicated
to some form of progressive taxation. It is for these reasons that an
NRST, combined with a rebate system to insure that the poor pay very little to
no taxes and progressivity is maintained, will be the form of consumption tax
considered here. Now that the form of the tax has been decided, what are
some of the potential benefits and drawbacks of the implementation of a
consumption tax?
The primary microeconomic argument in support of a consumption tax is based on a
concept known as the power of deferral. For example, assume one dollar is
put aside for retirement at a 9% compound interest rate. In the absence of
taxes this will grow to eight dollars in 24 years. Now assume that the
same dollar is put aside for retirement at a tax rate of 33%, giving only .67
cents to invest. Since you can only collect at an effective rate of 6%,
the remainder of the yield going to taxes, after 24 years you will have only
$2.67 to spend in retirement. This situation is an example, albeit a
dramatized one, of the current system which employs both income and capital
gains taxes. Now assume that you are able defer taxation until retirement,
only being taxed once, at the same 33% rate, when the money is actually spent in
retirement. You will now have $5.33 to spend in retirement, twice as much
than with the other system of taxation although the tax rate is the same.
The drawback to this is that the government's revenue equation is exactly the
opposite as that of the individual investor and no matter what your opinion on
the appropriate level of government spending, the fact remains that the
government needs to collect revenue to function. This leads to the more
compelling macroeconomic justifications.
The most widely discussed potential macroeconomic benefit of a consumption tax
is that it would almost certainly raise the savings rate in the U.S. By
eliminating part of the return on investment an income tax penalizes savings.
Many economists believe that this tax wedge results in lower saving, less
investment, less innovation and capital formation and thus a lower standard of
living in the long run than if savings were not taxed. In essence, the
income tax creates a bias in favor of current consumption at the expense of
savings and future investment. Other potential benefits include a lower
real interest rate, as postulated by Alan Garner of the Federal Reserve Bank of
Kansas City. Bachman, Haughton and Tuerck of Suffolk University propose
that the absence of business taxes would help make American products more
competitive overseas. Arduin, Laffer and Moore of the ALM Econometrics
Group believe that it would also increase the tax base while making it much
harder to cheat given its simplicity. The IRS estimates that 40% of
Americans are out of compliance with the current tax code costing 372 billion
dollars in lost revenue. They also estimate that Americans spend six
billion hours and 265.1 billion dollars on tax filing, record keeping and tax
reduction advice. These costs of compliance would drop an estimated 90%
under a consumption tax, restoring billions to the economy. The
aforementioned literature also concludes that a consumption tax would lead to
higher output, more savings, higher take home pay for workers, faster employment
growth, more capital formation, lower mortgage rates, and a more efficient and
stable revenue system.
Both Hubbard in the American Economic Review and Cheng in the Journal of Finance
discuss some of the potential drawbacks, such as the inherent trade-off between
efficiency and fairness. They conclude that measures which would be most
effective at alleviating the regressivity of the system would also do the most
in terms of limiting the potential benefits of a consumption type tax. And
even if fairness is the primary motive, there is still a choice between the
mitigation of lifetime wealth disparities and the preservation of pretax
relative price of present and future consumption as equity goals. Hall and
Ritter both discuss the potential disruptions from the move to a consumption tax
including a potential rise in the after tax interest rate, a decline in the
value of existing capital goods, a decline in the value of housing and a sharp
rise, equal to the amount of the tax, in the price level. And Ballentine
proposes the potential for increased tax rates, because the tax base will no
longer include savings, making it less neutral between and work and leisure,
potentially lowering output as real taxation rises. Advocates claim that
any negative effect from this will more than be offset from increases in
investment and savings. In fact, most research does conclude that a
consumption tax would increase output per person if the reform eliminated tax
related distortions to work, save, and invest. Most research suggests that
switching to a consumption tax would increase GDP between 1% and 7.5% in the
long run. Whalley postulates that consumers will need to have a money illusion,
essentially making wages sticky in a downward direction, for changes in a
consumption tax to affect real consumption. He concludes that a dollar of
consumption taxes will reduce consumption by more than will a dollar of income
taxes. In fact, he concludes that a dollar of consumption taxes will
reduce income by the full dollar. This finding forms the basis for my
proposal with the consumption tax as a fiscal policy tool.
I propose that a Federal Tax Advisory Board should be modeled after the Federal
Reserve's Board of Governors. They would be appointed by the President and
approved by congress for terms long enough to make them apolitical. FTAB
would have the power to raise or lower the National Retail Sales Tax in response
to economic conditions with the intent of manipulating aggregate demand.
This would work much like traditional Keynesian fiscal stimulus, such as
changing government expenditures or the rate of taxation, but with significantly
diminished inside and outside lags. The group could use much of the same
data as the Fed, such as the beige and green book, as well as generating its own
policy options and forecasts (blue book). As an example of how they would
function, imagine a situation in which all of the tell-tale signs of a looming
recession are upon us and the federal funds rate is already on the way down but
not fast enough to prevent it. FTAB would have the power to almost
immediately increase individual expenditure by dropping the NRST by an
appropriate amount.
Some of the advantages to a system like this would be the near elimination of
inside lags after certain economic parameters have been reached, thereby
conferring congressional authorization to act. Outside lags would be
reduced to the amount of time its takes store register the price change and
customers to react. In essence, we could mimic the 2001 recession, the
shortest and shallowest since World War Two due primarily to well-timed tax
cuts, without the necessary foresight or luck. Much like a semi-automatic
stabilizer congress would set a limit contingent on certain economic parameters
being reached. This would then give the board the ability to raise or
lower the NRST by up to five percent. The next step in this research would
be to run a series of regressions to determine the effect of a change in
consumption tax rates on aggregate demand and consumer spending and determine
the appropriate base level tax rate. The particular effects of a
consumption tax on output and expenditure should also be more closely
determined, particularly in the “medium-run,†a time frame long enough to allow
the effects to take place but not so long as to be worthless from a public
policy point of view. Much thought need also be given to the interactions
and potential disruptions of policy between the Fed's decisions and those of the
Tax advisory board. This is a potentially powerful and therefore
potentially very dangerous tool for discretionary fiscal policy.
In addition to all of the potential benefits mentioned above, it should also be
mentioned that this would give policymakers a way to regulate the economy as we
enter a liquidity trap. This is an interesting idea with a lot of
potential and given the current state of taxation and expenditure, it deserves
further research.
Works Cited
Arduin, Laffer and Moore. A Macroeconomic Analysis of the Fairtax
Proposal.
www.arduinlaffermoore.com (February 2006).
Bachman, Haughton, Kotlikoff, Sanchez-Penalver, Tuerck. Taxes Sales Under
the Fairtax; What Rate Works?
www.fairtax.org. (Sept. 1, 2006).
Balentine, Gregory. The General Nonneutrality of Income and Consumption
Taxes; Comment.
The American Review, Volume 71, no. 4. (Sept., 1981), pp.
770-772.
Brown, Cary. Analysis of Consumption Taxes in Terms of the Theory of
Income Determination.
The American Economic Review, Volume 40, no. 1.
(March, 1980), pp. 74-89.
Cheng, Pao. A
note on the Progressive Consumption Tax. The Journal of Finance, Volume 8,
no. 3. (Sept. 1953), pp. 333-342.
Engen and Gale. ConHubbard, Glen.
How Different Are Income and Consumption Taxes? The American Economic
Review, Volume 87, no. 2. (May 1997), pp. 138-142.
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