Consumption taxation is still superior to income taxation.

• Author: Bankman, Joseph
• Position: Response to article by Daniel Shaviro in this issue, p. 745

INTRODUCTION I. OUR ANALYSIS IN THE SUPERIORITY OF AN IDEAL CONSUMPTION TAX A. Basic Argument B. Qualifications II. SHAVIRO'S ARGUMENT III. DISCUSSION A. Imperfections in the Credit Market B. Inadequate Insurance Markets C. Myopic Savings Behavior D. Savings as Signal of Ability CONCLUSION INTRODUCTION

We appreciate the opportunity to comment on Dan Shaviro's important piece on how the permanent income hypothesis relates to tax policy. (1) In this piece, Shaviro points out that the arguments in favor of a consumption tax on the one hand, and income averaging on the other, raise significantly related issues. As far as we know, Shaviro is the first person writing in the legal literature to make this connection, and his insightful work is sure to inspire further explorations of the issue. (2)

Shaviro's basic claim is that the permanent income hypothesis is a central underpinning of both the arguments for income averaging and consumption taxation. Market or rationality imperfections that limit the permanent income hypothesis similarly weaken the case for income averaging and consumption taxation. In particular, Shaviro raises a number of important complexities regarding the choice between an income tax and a consumption tax that are related to how capital markets work and how individuals choose their consumption patterns. He claims that these complexities make the efficiency and distributional case for a consumption tax sufficiently nuanced and dependent on empirical assumptions that the choice of tax base is better made on administrative grounds. On administrative grounds, however, Shaviro strongly prefers a consumption tax, notwithstanding the title of his article.

We agree with three of the central points of Shaviro's argument: that more complex models of behavior are likely to weaken the strong conclusions one gets from simple models; that administrative concerns may well be dominant; and that a consumption tax remains the preferred tax base. Like Professor Shaviro, we think that additional research into administering consumption taxes should be given a high priority.

The fact that we are in broad agreement on these issues may surprise readers of his article. Shaviro writes that his analysis "refute[s] the conclusion of a recent leading article," and it is our article he cites. (3) The structure of his article is to cite our article for its presentation of the core argument in favor of a consumption tax, and then to critically discuss the assumptions on which that argument relies. The implication is that our article ignores these assumptions. In fact, the bulk of our article is devoted not to presenting the core argument in favor of a consumption tax, but to critically discussing the assumptions on which it relies. We discussed in detail no less than ten such assumptions and we concluded that "a complete, optimal tax analysis could produce exotic taxes that look like neither a pure consumption tax nor a pure income tax." (4) This conclusion is similar to the conclusion reached by Professor Shaviro.

In other respects, however, our papers and analyses differ. Shaviro's primary goal is to show the connections between the permanent income hypothesis, income averaging, and the consumption tax debate. A secondary goal is to show the divergence between an ideal welfarist tax and a consumption (or income) tax. Flaws in the consumption (or income) tax matter to him even if they don't clearly alter the relative merits of the consumption tax over the income tax.

Our paper focuses on the choice between an income tax and a consumption tax. We focus on this choice, rather than the possibility of exotic taxes suggested by some of the optimal tax literature, for two reasons. First, these are the two leading tax bases, and real world reforms will be aimed at moving the tax system toward one of those two bases. Second, relatively simple and transparent taxes reduce political economy problems, such as rent seeking, that more complex taxes create.

While we agree with Shaviro that the study of administrative and compliance costs is vital, we believe that analysis of the efficiency and distributional effects of the two ideal systems remains relevant. The reason for this is that we cannot measure the benefits of administrative and compliance cost savings without a reference point. For example, if a consumption tax is easier to implement, we need to know if an income tax is otherwise desirable to be able to determine whether the administrative savings are worth the costs in using the less preferred base.

Our two papers also differ in their evaluation of the simplifying assumptions made in the base case for a consumption tax. We conclude that, even once one examines these assumptions, including the assumptions that Shaviro finds most questionable, a consumption tax is superior to an income tax. Shaviro does not take a position on that issue.

1. OUR ANALYSIS IN THE SUPERIORITY OF AN IDEAL CONSUMPTION TAX

   1. Basic Argument

      Whether the tax system ought to be built around an income or a consumption tax has been a primary--some would say the primary--issue in tax policy for many years. Both tax bases have some attractive features. However, most scholars (including Professor Shaviro) believe that a consumption tax would be easier to implement and superior in that respect. Support for an income tax, therefore, is generally based on the belief that an income tax is fairer or (less frequently argued) more efficient than a consumption tax. Our article focuses on (and rejects) the fairness and efficiency arguments made in support of an income tax.

      We begin by assuming that individuals in society vary along one or more dimensions, and in particular, in their ability to earn. The government wants to redistribute toward those with low ability to earn for some reason, whether it is declining marginal utility of income or an aversion to inequality. Unfortunately, it cannot directly observe ability, so it must rely on signals such as income or consumption. If it taxes high incomes at too high a rate, individuals will choose to work less, thereby reducing the government's ability to redistribute. The complicated balancing between redistribution and working less was analyzed in detail in James Mirrlees's work on optimal taxation. (5)

      Mirrlees imagined that individuals varied by their ability to earn--effectively their wage rate--and that the government imposed a tax only on labor income. Would a tax on savings help in such a system? The answer--given by Atkinson and Stiglitz in 1976 and further developed by Louis Kaplow in recent years--is no. (6) The reason is that anything we can achieve with a tax on savings can be achieved better by an adjustment to the rate schedule to the tax on labor income.

      Consider the following illustration, previously set forth by one of the authors:

      [S]uppose that there is a 20 percent income tax. Suppose also that an individual earns $250 before taxes, pays a $50 tax on his labor income, and is left with $200 to spend. Finally, suppose that the individual spends $100 today and saves $100 for his retirement in 25 years. The annual interest rate on savings is 5 percent. Under the income tax, as normally conceived, the tax on capital income reduces the return on the savings by the tax rate, here from 5 percent to 4 percent. Thus, with no taxes on savings, the individual in retirement would have the future value of $100 at 5 percent, or roughly $340 to spend. With taxes, the individual earns only 4 percent and his future consumption is reduced to about $270. The reduction in future consumption from $340 to $270 is like a 20 percent excise tax on that future consumption. Suppose that instead of the conventional income tax, we impose a tax on labor income at 29 percent, a subsidy of 12 percent for current consumption, and a 12 percent tax on future consumption. Under this tax, the individual has after-tax wages of approximately $180. If he spends half this amount, $90, and receives the 12 percent subsidy, he can spend $100 today as before. He saves the other half of his after-wage-tax earnings and must pay the additional 12 percent tax on savings. This leaves him with about $80, which grows at the pretax interest rate to the same $270.... If the individual would choose this pattern under the usual income tax, he could also choose this pattern under the [restated] tax. (7) The wage or labor...