Beyond the Pro-Consumption Tax Consensus

Abstract

In the last two decades, the dominant norm in fundamental tax reform has shifted from income taxation to consumption taxation, among academics no less than policymakers. Few have recognized, however, that the case for a consumption tax overlaps substantially with that for lifetime income averaging, an idea that has drawn considerably less support. Likewise, few have recognized that the grounds for unease about the case for income averaging (as an ideal system, leaving aside administrative concerns) apply equally to the case for consumption taxation. Within a welfare economics framework, the case for both norms is close to irrefutable if one makes three key assumptions: that markets are complete, that individuals engage in consistent rational choice given their preferences, and that the only relevant information about taxpayer "ability" is that provided by an undifferentiated measure of lifetime earnings. Where these assumptions fail to hold, (1) allowing income averaging between periods may be undesirable, (2) the case for a consumption tax becomes less clearcut, and (3) as revealed by the "new dynamic public finance" literature in economics, there may actually be a strong rationale for taxing saving.

Keywords: income averaging, tax reform, optimal income taxation, consumption taxation, permanent income hypothesis

JEL Classification: H20, H21, H24, H31