Consumption Taxation and Our Hybrid Income/Consumption Tax

• Author: Deborah A. Geier
• Pages: 44-60

Chapter 2: Consumption Taxation

and Our Hybrid Income/Consumption Tax

In Chapter 1, you explored the core concepts informing the SHS concept of income, under

which an individual’s annual income generally equals her wealth increases less her wealth

decreases but only if the wealth decreases do not represent personal consumption. Stated another

way, an income tax base reaches both personal consumption spending and amounts added to

savings (capital expenditures) by preventing both from being deducted—though you also learned

that Congress frees subsistence consumption from taxation through various mechanisms (the

Personal and Dependent Exemption Deduction, the Standard Deduction, the Child Tax Credit, and

the Earned Income Tax Credit, to name a few). What if Congress decided to tax only the first part

of the SHS equation, i.e., only personal consumption spending (in excess of subsistence

consumption), protecting additions to savings from taxation? This chapter describes several

methods that would accomplish that goal.

We shall investigate consumption taxes for three reasons.

First, as you will read in more detail in the next chapter, the Federal government collected most

of its revenue in the form of consumption taxes for more than 100 years before the 16th amendment

was ratified and the modern income tax was enacted in 1913. Recent years have seen calls by some

to return to our roots by repealing the income tax (and sometimes the payroll and other taxes, as

well, which you will also read about in the next chapter) and replacing it with some form of pure

consumption tax or adding a Federal consumption tax.1 Thus, one goal of this chapter is to equip

you with a basic understanding of how consumption taxes differ from income taxes and how the

various forms of consumption taxation differ among themselves so that you can better digest these

modern-day debates.

A second—and far more important—reason to study the various forms of consumption taxation,

however, is that the current Internal Revenue Code is actually best understood as a hybrid

income/consumption tax. Some provisions in the Code that are inconsistent with an SHS income

tax are perfectly consistent with a consumption tax of one sort or another. A few of these provisions

will be introduced in this chapter, and we shall identify additional examples as we progress.

Finally, a third reason to study this material is so that you can begin to appreciate the serious

problem of tax arbitrage opportunities that arise when the income tax rules pertaining to

borrowed money (briefly described in this chapter and explored in more detail in Unit IV) are

applied to a debt-financed investment otherwise accorded more favorable consumption tax

treatment. If this attempt is successful, the investor can achieve a tax result that is better than

would occur under either a pure income or a pure consumption tax, which raises both fairness and

economic efficiency concerns (both of which are explored in the next chapter, as well.)

1 For example, several of the Republican candidates for President in 2016 advocated adopting a VAT and reducing

the tax collected under the income tax. See John Harwood, Momentum Builds to Tax Consumption More, Income

Less, at www.nytimes.com/2015/11/24/upshot/momentum-builds-to-tax-consumption-more-income-less.html?_r=0.

Chapter 2 Consumption Taxation Chapter 2

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A. Consumption taxation forms and comparison to income taxation

How could a tax be structured to reach only consumption spending and not additions to savings?

There are several approaches. At first, we shall ignore debt by assuming that the taxpayer uses no

borrowed money. Then we shall add the additional wrinkle of debt in Part C.

A retail sales tax

The easiest consumption tax to understand is a retail sales tax (RST), which is commonly

imposed by state and local governments. Under this method of taxation, amounts spent to purchase

consumption goods (and sometimes consumption services) are typically subject to a flat-rate tax

with no exemption amount on the first dollars spent. For example, suppose that Mary goes to

Specialty Toy Store and sees a child’s carved wooden toy on the shelf priced at $100. Mary takes

that toy to the store counter and purchases it to give to her child for his birthday. Suppose further

that the state in which Mary resides imposes a 5% RST on retail sales of consumption goods. When

Mary reaches the store counter, the clerk informs her that she must pay a total of $105, which she

pays. The receipt that she obtains shows that she paid $100 for the toy and $5 in tax. The store

transfers $5 of Mary’s total $105 payment to the state as RST.

A value added tax

A variation of an RST used by many other countries (in addition to their annual income taxes)

is a value added tax (VAT). You can think of it, essentially, as an RST collected on the “value

added” in each stage throughout the manufacturing and selling process, rather than all at once at

the point of the final retail sale to the customer. One of the weaknesses of an RST is that the tax is

collected only on the final retail sale to the consumer, so a seller must determine whether the buyer

is a consumer that is going to use the item for personal consumption (taxable) or another business

that is going to use it in the course of its own business (not taxable). Businesses can typically

obtain a tax-exemption certificate or number to present at a retail establishment to show to the

clerk to establish that a particular purchase is not to be taxed because it is not going to be used for

personal consumption but, rather, is going to be used in business. States with high RSTs often have

to deal with fraud in the form of phony tax-exemption certificates and numbers. A VAT avoids

the necessity of making this determination and thus tends to be less prone to fraud. Moreover, in

order for a business to get a benefit from any VAT paid by it to another, it must collect and remit

the VAT on its own sales. In this way, it tends to be self-reinforcing in a way that RSTs are not.

Because of enforcement difficulties with RSTs, public finance economists Joel Slemrod and Jon

Bakija noted in 2003 that “only six countries have operated retail sales taxes at rates over 10

percent. Four of them, Iceland, Norway, South Africa, and Sweden, have since switched to a VAT,

and a fifth, Slovenia, is about to.”2 The total collected in tax under a VAT should nevertheless be

the same as under an RST. Here is an example.

Example: Assume that the VAT rate is 5%. Toymaker purchases wood for $10

from Lumberman, who cut the wood from his own land. Lumberman must charge

a $.50 VAT ($10 x .05) on the sale of wood to Toymaker, collecting $10.50 and

remitting $.50 to the state. Toymaker carves a wooden toy from that wood, which

he sells to Specialty Toy Shop for $50. Toymaker must charge a $2.50 VAT ($50

2 JOEL SLEMROD & JON BAKIJA, TAXING OURSELVES: A CITIZEN’S GUIDE TO THE GREAT DEBATE OVER TAX

REFORM 214 (2nd ed. 2003).