Why economists are in favour of a consumption-based tax system

Is it time for the United States to consider switching from income tax to a progressive consumption tax as a way of addressing growing wealth inequality? Many economists have long favored a consumption-based tax system for raising revenue on the grounds of efficiency and simplicity. However, despite occasional vocal adherents, it has never gained political traction. Is it time to think again?

One of the main objections is that switching systems would require a potentially complex transition to avoid penalizing existing wealth holders, who would be taxed when they try to spend accumulated savings on which they had already paid income taxes. Yet, in an environment where wealth inequality is rising inexorably, that drawback may be a virtue. Moreover, a great strength of a consumption tax system is that it does not tax saving, and also gives firms more incentive to invest.

Certainly, there are other, more straightforward ideas for tackling wealth inequality. US Senator Elizabeth Warren has proposed an ultra-millionaire tax on the 75,000 wealthiest American households, which would amount to a 2% annual wealth tax for those with more than $50 million, rising to 3% for billionaires. Warren’s bold proposal has set off an intense debate among economists on just how much revenue it would bring in. Emmanuel Saez and Gabriel Zucman of the University of California, Berkeley – heavy hitters in the inequality literature – have endorsed Warren’s plan, estimating that it would raise nearly $3 trillion over ten years. A number of prominent ultra-rich are also on board.

But Harvard’s Lawrence Summers – a former US Treasury Secretary and a towering figure in public finance – has argued that such estimates are wildly optimistic. Summers and his co-author, University of Pennsylvania law professor Natasha Sarin, have suggested that a better path to the same end would be to implement a broad range of more conventional fixes, including an increase in the corporate-tax rate and eliminating ultra-wealthy families’ ability to avoid capital-gains taxes through bequests.

The debate is ongoing. However compelling the moral case for a wealth tax may be, it has historically proven difficult to garner large revenues from it. But Saez and Zucman have held their ground, arguing that much depends on the resources the US Internal Revenue Service is given to implement the tax. Regardless, both sides agree on the objective, and the general direction of the debate foreshadows what to expect if a progressive like Warren wins the US presidency.

I am not unsympathetic to Warren’s plan, nor to the Summers-Sarin approach, but both are complex to implement. Why not target the same aims with a better system that enjoys broader support and will therefore prove more enduring?

Back in the mid-1980s, Stanford University’s Robert Hall and Alvin Rabushka advocated what was essentially a twist on a value-added tax (VAT) that segregated wage income and allowed for greater progressivity (even more so in a refinement proposed by Princeton University’s David Bradford in his “X-tax”). A consumption tax (which is not a sales tax, but rather uses similar information to that required by the existing tax system) is simple and elegant, and could save a couple hundred billion dollars a year in deadweight accounting costs. Importantly, these plans contain a large exclusion so that lower-income families pay no tax at all.

But instead of using an exclusion for low-income households, the system can achieve progressivity by providing a large lump-sum transfer (as in a universal basic income), as suggested by leading Portuguese macroeconomist Isabel Correia, who estimates that her plan would result in both higher growth and greater income equality than under the current tax system. Correia’s analysis focuses on the long run, but with a transition suitably designed to protect small family businesses, it should be possible to ensure short-run gains as well.

Of course, in terms of fairness, much depends on how large the transfers and exemptions are, and how low the tax rate is set. Until now, it has mostly been a smattering of Republicans who have favored switching to progressive consumption taxes (though a variant was championed by the liberal icon Bill Bradley, a former US senator from New Jersey). Ironically, one reason the idea has not received broader Republican support is conservatives’ recognition that a consumption tax would be so efficient that the government could too easily raise funds to expand social programs.

Many on the left, meanwhile, respond to the idea in knee-jerk fashion, believing that a consumption tax must somehow be regressive because sales taxes are regressive. They fail to understand that a progressive sales tax can be implemented entirely differently.

Of course, any large change in federal taxation has complex effects, including from its interaction with state and local tax systems. And the US Congress probably has an innate bias in favor of a complex tax system with lots of loopholes and exemptions, giving members leverage over potential donors. But that is all the more reason to jump at the opportunity to clean up the system and help mitigate wealth inequality at the same time.