Chapter 9: Consumption Taxes

9 - 1

Chapter 9

Consumption Taxes

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 9: Consumption Taxes

9 - 2

A household consumption tax

The flat tax and the X-tax

A retail sales tax compared to a value-added tax

Replacing the income tax with a consumption tax

A consumption tax vs. a labor income tax

Which tax is fairest?

Pollution, transportation, and health taxes

Introduction

Chapter 9: Consumption Taxes

9 - 3

A consumption tax is a percentage tax that imposes a burden on a household according to their consumption.

• A percentage tax on the sale of consumer goods

• Tends to be regressive with respect to income

Consumption Taxes

A retail sales tax (RST)

Income Consumption Tax Saving Tax/Income

$20,000 $16,000 $4,000 $0 20%

$100,000 $60,000 $15,000 $25,000 15%

Table 9.1: Burdens from a 25% Retail Sales Tax

Chapter 9: Consumption Taxes

9 - 4

• A value-added tax is a percentage tax on the value that is added at each stage of production.

A Value-Added Tax (VAT)

A Consumption Good (Bread)

Purchases Sales Value-added VAT

Farmer $0 $30 $30 $3

Miller $30 $70 $40 $4

Baker $70 $100 $30 $3

TOTAL $100 $200 $100 $10

Table 9.2: A 10% VAT

Chapter 9: Consumption Taxes

9 - 5

Subtraction method

A Value-Added Tax (VAT)

Credit-invoice method

T = t(S – P)

Miller $4 = 0.1($70 – $30)

T = tS – tP

Miller $4 = 0.1($70) – 0.1($30)

• A VAT is equivalent to a RST

• RST is a consumption tax

• VAT is a consumption tax

• A consumer bears a burden from either according to her consumption spending

Comparing a VAT to a RST

Chapter 9: Consumption Taxes

9 - 6

Exemptions under a RST or a VAT

• Fairness and the fact that consumption taxes are regressive are arguments for exemptions

• Efficiency, administrative costs, and appropriate targeting of the exemptions are arguments against exemptions

• To reduce regressivity, a rebate could be issued

A Household Rebate with a RST or a VAT

Chapter 9: Consumption Taxes

9 - 7

The Flat Tax and the X-Tax

To reduce the regressivity of the VAT is to modify it to become a flat tax or the X-tax.

• A portion of wage income is not taxed (exemption)

• Same as flat tax except…

Flat Tax

X–Tax

• The graduated rates are progressive with respect to labor (not capital) income

• Wages above the exemption are taxed at a single rate

Chapter 9: Consumption Taxes

9 - 8

A Household Consumption Tax• All savings would be tax deductible in the year it occurs• Revenue neutral

History of a household consumption tax

Computing household consumption

A progressive consumption tax on very high consumption

• Could be progressive

• Practical problems

• Do not replace the income tax, add a progressive consumption tax on very high consumption as a supplement

Chapter 9: Consumption Taxes

9 - 9

Replacing the Income Tax with a Consumption TaxTable 9.3: The Impact on Saving

10% Income Tax Income Tax Consumption Saving

Person C $100,000 $10,000 $90,000 $0

Person S $100,000 $10,000 $0 $90,000

TOTAL $200,000 $20,000 $90,000 $90,000

25% Consumption Tax Income Tax Consumption Saving

Person C $100,000 $20,000 $80,000 $0

Person S $100,000 $0 $0 $100,000

TOTAL $200,000 $20,000 $80,000 $100,000

33% Consumption Tax Income Tax Consumption Saving

Person C $100,000 $20,000 $60,000 $20,000

Person S $100,000 $0 $0 $100,000

TOTAL $200,000 $20,000 $60,000 $120,000

Chapter 9: Consumption Taxes

9 - 10

• The horizontal redistribution effect

• The postponement effect

• VAT and RST are regressive

Impact on saving

Replacing the Income Tax with a Consumption Tax

Impact on the distribution of the tax burden

• The incentive effect

Chapter 9: Consumption Taxes

9 - 11

Replacing the Income Tax with a Consumption Tax

Impact on efficiency loss

• Reduces efficiency loss in the choice between saving and consuming

• May increase the efficiency loss in the choice between work and leisure

D

$20

$16

20,000

P

S

L (Annual Hours)

Figure 7.9

(MRPL)

22,000

A

B

D

Chapter 9: Consumption Taxes

9 - 12

Impact on the Distribution of the Tax Burden

Table 9.4 and Table 9.5

Average Income Share of Income

Income Category Pre-tax After Tax Pre-tax After Tax

Lowest Quintile $15,900 $15,300 4.0% 4.8%

Second Quintile $37,400 $33,700 8.5% 9.6%

Middle Quintile $58,500 $50,200 13.3% 14.4%

Fourth Quintile $85,200 $70,300 19.8% 20.6%

Highest Quintile $231,300 $172,200 55.1% 51.6%

All Quintiles $84,800 $67,400 100% 100%

Top 10% $339,100 $246,300 40.9% 37.4%

Top 5% $520,200 $369,800 31.1% 27.8%

Top 1% $1,558,500 $1,071,500 18.1% 15.6%

Chapter 9: Consumption Taxes

9 - 13

• Neither reduce the reward for saving

A Consumption Tax vs. a Labor Income Tax

Initial Deposit

Interest Earned

Taxes Paid on Withdrawal

Retirement Consumption

Y Tax (Saving) $850 $34 $5.10 $878.90

C Tax (Regular IRA) $1000 $40 $156.00 $884.00

W Tax (Roth IRA) $850 $34 $0.00 $884.00

Table 9.6

Similarities

Differences• Fairness• Capital accumulation

Chapter 9: Consumption Taxes

9 - 14

Regressivity

Which Tax is Fairest?

Tax what you take vs. tax what you make

The ant and the grasshopper

• How should “ability-to-pay” be measured?

• Is this fair?

WageSummer

Consump.Tax Saving Interest

Winter Consump.

TaxPV of Taxes

Grasshopper $1000 $800 $200 $0 $0 $0 $0 $200

Ant $1000 $400 $100 $500 $250 $600 $150 $200

Table 9.7

Chapter 9: Consumption Taxes

9 - 15

Pollution Taxes

• Polluters will find it profitable to reduce pollution if:

TAX<• CBO estimates a tax of $100 per ton of carbon would reduce carbon by about 15%

• A carbon tax would also increase federal tax revenue

MARGINAL ABATEMENT COST

Chapter 9: Consumption Taxes

9 - 16

Transportation Taxes

• User fees (tolls) should be used to finance roads

• Tolls are sometimes unfeasible or costly

• Instead of a toll, a gasoline tax is used

• A gasoline tax is inferior to a toll

• The toll should be equal to the wear and tear and congestion each vehicle causes

Chapter 9: Consumption Taxes

9 - 17

Externality argument

• Careful quantitative analysis is required to measure net costs to others

Estimating the optimal taxation

Health Taxes

Internality argument

• The excessive use of an unhealthful product may impose costs on himself that he underestimates

• The excessive use of an unhealthful product may impose a cost on others

Chapter 9: Consumption Taxes

9 - 18

Summary

A household consumption tax

The flat tax and the X-tax

A retail sales tax compared to a value-added tax

Replacing the income tax with a consumption tax

A consumption tax vs. a labor income tax

Which tax is fairest?

Pollution, transportation, and health taxes

Chapter 9: Consumption Taxes

9 - 19

Preview of Chapter 10:

Optimal Federalism when household incomes are similar

Optimal Federalism when household incomes differ

The property tax

Grants from a higher government to lower governments

State and Local Public Finance