Consumption–based taxes solve better – greater efficiency and administration

When a family saves for future generations, it provides resources to finance capital investments, like the start‐​up of new businesses and the expansion of old ones. Greater capital, in turn, affects the earnings of both existing capital and workers.

Because capital is subject to diminishing returns, an increase in its supply causes each unit of capital to earn less. And because increased capital raises labor productivity, workers enjoy higher wages. In other words, by saving rather than spending, those who leave an estate to their heirs induce an unintended redistribution of income from other owners of capital toward workers.

The bottom line is that inherited wealth is not an economic threat. Those who have earned extraordinary incomes naturally want to share their good fortune with their descendants. Those of us not lucky enough to be born into one of these families benefit as well, as their accumulation of capital raises our productivity, wages and living standards.

All of this raises what appears to be a policy dilemma. How can we have a tax system that does not penalize beneficial wealth accumulation but also distributes the tax burden equitably? How do we ensure that the rich pay a fair share of taxes while not discouraging saving?

The answer is consumption‐​based taxation. Consumption‐​based taxes can be taxes on transactions, such as retail sales taxes and value‐​added taxes. Or they can be taxes assessed on individuals and businesses, such as the “flat tax” designed by economists Robert Hall and Alvin Rabushka and the “X-Tax” designed by economist David Bradford.

Both income and consumption‐​based taxes tax income from labor and capital. But unlike income taxes, consumption‐​based taxes exempt the “normal” return to capital, which removes the bias against saving and investment. The normal return is usually thought of as the yield on a riskless investment, which represents the time value of money.

Both income and consumption‐​based taxes tax the “above‐​normal” returns to capital. Those include the returns, or profits, attributable to market power, innovations, windfalls, and various rents available to certain businesses and investors. Economist Glenn Hubbard notes that wealthier households receive a larger portion of their capital income from these items, so consumption‐​based systems can be quite progressive.

Bradford agrees that “sources of great wealth,” such as monopolies and highly profitable technology firms, are taxed under both income and consumption‐​based systems. However, by exempting the normal returns, the latter system is more conducive to growth. Bradford also long argued that consumption‐​based tax systems allow for much simpler administration and compliance.93

Consumption‐​based systems are also better at equalizing taxes on capital across activities and industries, and they capture some activities that escape taxation under the income tax. As one example, the “buy‐​borrow‐​die” strategy in real estate investment can allow individuals to go years without paying income tax if they borrow against appreciating properties to fund their consumption. That is the sort of loophole that angers the public about wealthy people, and it would be closed under a consumption‐​based system.

Theoretical models suggest that consumption‐​based taxes are superior to income taxes on both efficiency and distributional grounds. The key is that income taxes distort both work effort and savings, but consumption‐​based taxes just distort work effort. Consumption‐​based taxes are superior on efficiency because you can raise a given amount of revenue with fewer distortions than under income taxation. Regarding distribution, you can design a consumption‐​based tax to match the progressivity of an income tax, but which collects revenue with fewer distortions.

Tax law professors Joseph Bankman and David Weisbach conclude that “everyone is equally well off or better off under a properly designed consumption tax,” as compared to an income tax.96 They note that consumption‐​based taxes would tax the “idle rich,” which is often the motivation for taxes on the wealthy.97

Economists Kevin Hassett and Alan Auerbach agree that consumption taxes would target wealth, noting that “consumption taxes reduce the value of wealth, just as wealth taxes do” and “if the disproportionate political power of the wealthy is the concern, a consumption tax is potentially a more powerful tool.”98

Wealth taxes are an inefficient method for taxing the rich because they treat profits in the opposite way as consumption‐​based taxes. Wealth taxes exempt some above‐​normal returns to savings and tax the normal returns, which would distort savings and investment.99 In its report on wealth taxes, the OECD pointed to this problem: “The taxation of normal returns is likely to distort the timing of consumption and ultimately the decision to save, as the normal return is what compensates for delays in consumption.”100