The superiority of an ideal consumption tax over an ideal income tax.

AuthorBankman, Joseph

INTRODUCTION I. THE CORE ARGUMENT A. Basic Definitions and Relationships Between the Bases B. Arguments for an Income Tax C. The AS 1976 Argument--Efficiency D. The AS 1976 Argument--Redistribution II. RISK AND PROFITS III. WEALTH WITHOUT LABOR INCOME IV. SAVINGS HETEROGENEITY A. Rational Savings Decisions B. Savings Myopia and Similar Problems V. DOES SAVINGS BRING VALUE BEYOND FUTURE CONSUMPTION? VI. QUALIFICATIONS CONCLUSION INTRODUCTION

Perhaps the single most important tax policy decision is the choice between an income tax and a consumption tax. The topic has been discussed and argued over since at least the time of Hobbes and Mill, without apparent resolution. (1) Consumption and income taxes both represent substantial sources of revenue in all modern economies.

This Article considers the choice between an income tax and a consumption tax, focusing on an argument first made by Anthony Atkinson and Joseph Stiglitz in 1976 ("AS 1976"). AS 1976 shows (under the assumptions of the model) that taxes should be imposed on all commodities at the same rate-that is, taxes should be neutral. For reasons illustrated below, this conclusion implies that a consumption tax is superior to an income tax. AS 1976 has recently attracted substantial attention in the economics literature but, perhaps because the arguments are technical, has yet to receive any attention in the legal literature. (2) Our primary task here is to explain the intuition behind AS 1976 and explore its implications for the income tax versus consumption tax debate. In addition, we examine what happens when some of the strict assumptions of AS 1976 are relaxed and, in doing so, revisit a number of arguments that have been made in favor of income taxes. We conclude that, based on current understanding, ideal consumption taxes are superior to ideal income taxes.

We will generally compare only the ideal forms of income and consumption taxation. The actual choice of a tax system has to be based on how the system would be implemented, focusing on administrative and compliance costs. Neither an income tax nor a consumption tax would likely be implemented in its pure form, and differences in administrative and compliance costs might be dispositive in the choice between the two. Nevertheless, it is worth examining the ideal forms for two reasons. First, determining which ideal form is most desirable helps us design actual systems and helps us understand the flaws of actual systems--ideals matter in tax reform.

Second, the case for the income tax is likely to be strongest if the comparison is made between ideal forms. This is true because the income taxes we have had for almost a century are much worse than the ideal income tax, and they contain structural features that make reform difficult. For example, an ideal income tax would tax the change in the value of investments each year. Under existing law, the change in investment value is taxed only if it is "realized" in the form of a sale or exchange. The so-called realization requirement is responsible for much of the current complexity and distortion. Elimination of that requirement, however, raises difficult liquidity and valuation issues and, in part for those reasons, has never been seriously considered. An ideal income tax would also measure gain and loss on an inflation-adjusted basis. Inflation adjustments, while possible, would be difficult and also have never been seriously considered. A consumption tax raises neither of these difficulties, and most scholars believe that a consumption tax is easier to administer, and can be administered in purer form, than an income tax. By comparing ideal systems and ignoring administration costs, we are deliberately making the best possible case for the income tax. If a consumption tax is superior to an income tax even ignoring the major implementation problems of an income tax, it follows that a consumption tax will be even more desirable once those problems are taken into account.

Part I of this Article presents the core argument, focusing on the simplest case, in which investments produce only risk-free, time-value returns, and individuals vary by their ability. Income taxes tax the risk-free return while consumption taxes do not. In this simple world, the AS 1976 arguments show that a consumption tax can be structured to be a Pareto improvement over an income tax. Importantly, this argument addresses both efficiency and redistributive concerns. Everyone is equally well off or better off under a properly designed consumption tax. It is either more efficient, more redistributive, or both.

The AS 1976 model, like all models, contains assumptions and simplifications. To understand the practical impact of the AS 1976 arguments, we need to understand the realism of the assumptions and the effect of relaxing them. The remaining Parts of the Article consider these issues. We consider the four most prominent issues and show that the conclusions from the simplified world of only risk-flee investments carry through, almost in their entirety, to more realistic cases.

Part II considers the taxation of risky returns and economic profits. Extension of the basic case to risky returns and profits is straightforward. There is a long line of literature showing that ideal, flat-rate income and consumption taxes treat risky returns and economic profits the same way, leaving the riskfree rate of return as the only difference, as discussed in Part I. Part II very briefly explains this literature and then discusses whether imposing graduated rates on capital income changes the conclusions.

Part III considers how labor income and wealth are related and the extent to which the possibility of wealth without labor income affects the arguments. One might think, for example, that because they tax capital income, income taxes are better at capturing the benefits of inheritances. Part III shows that if correctly implemented, a consumption tax can tax such wealth; therefore, such wealth should not affect the choice between the two tax bases.

Part IV considers the difference between spenders and savers and whether savers are better off in a manner that would support an income tax. The basic argument given in Part I assumes that within an earnings or ability class, individuals make similar savings decisions. In the real world, there may be significant heterogeneity in savings, and this heterogeneity has been thought by some to support an income tax. Part IV argues that it does not.

Part V examines the argument that savings brings prestige, power, and security and that the benefit of savings is more than future consumption. This extra benefit of savings is thought by some to support an income tax. Part V shows that this is not the case. Consumption taxes properly tax the benefits from savings.

The AS 1976 model, like all models, is subject to a number of qualifications and extensions. The economics literature examining and extending AS 1976 is large and complex. Our goal here is to explore the core arguments that arise from the literature and their practical implications. Newer models show that a complete, optimal tax analysis could produce exotic taxes that look like neither a pure consumption tax nor a pure income tax. These models may also help explain deviations from pure income and consumption taxes (such as deductions granted to particular types of individuals or activities) that might otherwise seem troubling. In Part VI, we will briefly discuss the possibility that newer models might show that a tax on savings is desirable.

Before we begin the analysis, we should clarify our terminology and the origins of the ideas explored here. Throughout the Article, we will refer to the argument as originating with AS 1976 because that paper was the first in a line of papers on the topic. AS 1976 and many later papers in the economics literature analyzed the problem of taxation by assuming that there was a perfectly designed and implemented labor income or consumption tax in place and asked whether any small perturbations from such a tax were desirable. (3) An alternative method of analyzing the problem was first developed by Hylland and Zeckhauser and substantially strengthened and extended by Kaplow. (4) This method uses a "replicating tax" argument. It starts with a nonneutral commodity tax and shows how to construct a Pareto superior neutral tax. This latter method of analyzing the problem has two key strengths. First, it extends the result to cases in which a labor income or commodity tax is not optimal, which is extremely important for applying the argument to the real world. Second, the analysis is more direct and intuitive. We follow the Hylland/Zeckhauser and Kaplow method of analysis here; to avoid constant parsing of which paper in the economics literature developed which idea, however, we simply refer to the entire literature as AS 1976.

  1. THE CORE ARGUMENT

    1. Basic Definitions and Relationships Between the Bases

      We begin with the simplest case. We assume in this Part that investments produce only the risk-free, time-value return and that individuals vary by their ability to earn. All of the AS 1976 intuitions can be illustrated in this simple case. We relax these strict assumptions in later Parts.

      As is well known, the difference between an income tax and a consumption tax is the taxation of the return to savings or capital income. In a consumption tax, the risk-free return to investing is exempt, while in an income tax, the return is taxed.

      A consumption tax, as a matter of legal implementation, is imposed on consumption and not on labor, but it is economically equivalent to a tax on labor earnings. The reason is that on a going-forward basis, there are two sources of consumption: earnings from labor (wages) and earnings from capital. If, under a consumption tax, capital income is not taxed, all that is left to tax is wages. (5)

      Another way to see that a consumption tax is...

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