Note. Income Tax, Consumption Tax, Flat Tax

• Pages: 505-510
• Author: Marvin A. Chirelstein,Lawrence Zelenak

505

Note

INCOME TAX, CONSUMPTION

TAX, FLAT TAX

“No income tax is really just, from which savi ngs are not

exempted,” wrote John Stuart Mill in Principles of Political Economy.

Often quoted and much debated, Mill’s notion, in simplest terms, was

that unless savings are exempted from tax, those who choose to save

their income are taxed twice, while those who choose to expend their

income on consumption are taxed only once. The point can easily be

explained by example. Assume we live in a tax-free world and that C

(for consumer) and S (for saver) both earn $1,000 in wages this year.

C chooses to consume the whole $1,000 currently; S chooses to save

the $1,000 and invest it in a 1-year 10% bond, because she prefers to

have $1,100 to consume next year. The arithmetical relationship

between C and S—between the decision to consume this year (C) and

the decision to consume next year (S)—is obviously 1 to 1.1. Now

suppose Congress enacts a 40% income tax so that C and S both have

to pay a tax of $40 0 on their current wag es, leaving each with $600.

Once again, while C chooses to consume her after-tax $600, S elects

to save by investing in a 1-year 10% bond, expecting to have $660 for

consumption in the year following. But will she? Plainly not if the

interest on her bond is taxable, as of course it would be under a

conventional income tax (and is under Code § 61). S will have to pay

a tax of $24 on the $60 of bond-interest and will have only $636 ($660

− $24) available for consumption in the second year. The 1:1.1

relationship tha t prevaile d in the tax-free world becomes 6:6.36 in

the post-tax world, i.e., 1: 1.06. At least arguably, S has been taxed

twice on the same bond investment. Much vexed, S may simply grind

her teeth and sulk, or she may decide to become a consumer like C

and give up being a saver. At all events, Mill condemns the outcome

as not “really just.” Others, to be sure, have disagreed.

Without worrying for the moment about the meaning of “justice”

in this context, it is useful to note that the extra tax on savers could

be eliminated, if we wished to eliminate it, in ei ther of two ways.

First, and most simply, we could amend the tax law to provide that

all inve stment income ( meaning interest, dividends, rents and

capital gains) should be exempt from income tax. Since “income” can

derive from only two sources, labor and investment,

1

the income tax

would then apply to personal service income alone. In other words,

1

Apart from the rare genuine windfall, which neither of the authors has ever

been fortunate enough to experience.