73 Pages Posted: 23 Sep 2003
Date Written: September 2003
Shifting from an income tax to a consumption tax would offer major simplification advantages. Even if Congress created as many preferences and other special rules to what it has under the existing income tax, the massive set of complications that relate to realization and to the taxation of financial transactions would largely be eliminated. The main (though not the only possible) reason for opposing such a shift is the concern that it would require reducing progressivity. However, the capacity of a consumption tax to achieve progressivity comparable to that of an income tax is widely misunderstood, for two main reasons.
First, a consumption tax purportedly exempts "capital income," seemingly raising the specter of its exempting the likes of Bill Gates and Warrant Buffett. As recent tax policy literature has shown, however, the only difference in theory between an income tax and a consumption tax pertains to the risk-free return to waiting, which historically has averaged less than one percent per year. The point made by this literature is by now familiar and well-accepted in some circles, but in others it remains unfamiliar or has been unduly dismissed. This article aims to win it wider acceptance.
Second, many believe that wealthy people escape the burden of a consumption tax by deferring their consumption, and that advocates of such a tax ignore the effects of unconsumed wealth on one's security, political power, and social standing. The argument overlooks the fact that what makes wealth valuable is the real purchasing power that it commands. Otherwise, real money would be no different than Monopoly money. A consumption tax affects the purchasing power even of unspent wealth, and the burden it imposes generally is not reduced by deferring one's consumption.
The article also discusses the choice between use of the origin basis and the destination basis in taxing cross-border transactions. A consumption tax can use either method, but an income tax is practically compelled to use the origin basis. Use of the destination basis would eliminate transfer pricing issues, although in their place it would create various problems that an origin basis tax avoids, such as the need for border adjustments (e.g., tax rebates for exports).
Thoughtful consideration of the choice between the origin and destination basis upon shifting to a consumption tax requires dismissing a popular canard, which is that the destination basis, because it exempts exports, offers an "export subsidy" that would favor countries using it in international trade competition. Economists universally agree that well-functioning origin and destination basis systems have equivalent incentive effects on international trade once in place. This suggests that a destination basis consumption tax should neither be favored politically as a tool of trade war, nor subject to successful legal challenge under the GATT.
Keywords: tax reform, income taxation, consumption taxation
JEL Classification: H24, H25
Suggested Citation: Suggested Citation
Shaviro, Daniel, Replacing the Income Tax With a Progressive Consumption Tax (September 2003). NYU Law School, Public Law Research Paper No. 70; and NYU, Ctr for Law and Business Research Paper No. 03-18. Available at SSRN: https://ssrn.com/abstract=444221 or http://dx.doi.org/10.2139/ssrn.444221