How To Design A Consumption Tax That Isn’t Stupid

~by Ryan B

Every presidential campaign, there is inevitably a candidate or two (usually Republicans, although maybe Mike Gravel too) who advocate the Fair Tax. They would replace the income tax with a national retail sales tax of 30 percent. They call it 23 percent, but that relies on doing math in a way no one actually does math. Either way, the whole idea is basically silly.

First, retail sales taxes are a mess because compliance is really hard to enforce. At a level like 30 percent, there is a lot of incentive to dodge the tax. Under the table deals are relatively common. Europe and a lot of other places use a value-added tax (VAT) precisely because it’s a cumulative sales tax that can be enforced several times over the lifecycle of a product. The government may not get 30 percent of the cost of the coffee table or whatever, but they can fairly easily require the manufacturer of the coffee table to pay 30 percent of the cost of the lumber. Generally speaking, taxing businesses is easier than taxing individuals from a compliance standpoint.

Second, and related, lots of consumption doesn’t really involve buying a thing. People pay for rent or a doctor’s visit or a fortune teller. How do you collect sales tax on something like that? If I were renting out my house to a tenant, you can bet I would be working hard not to have to figure out the tax paperwork involved with the Fair Tax.

Third, the Fair Tax is hugely regressive (the lower the income, the more you spend on stuff, generally speaking). Fourth, 30 percent is probably not enough money to cover all the taxes it is intended to replace. And so on.

Now, the cynic in me realizes that a lot of this is kind of the point. Fair Tax advocates are usually pretty conservative. They are exactly the kind of people who look at this list of problems and think, “Won’t raise enough money? Easy to dodge? Regressive? Check, check, and check.” But that doesn’t mean that the whole thing is a bad idea. Taxing consumption instead of income is probably the right way to go. What we want to do, from a long-term perspective, is encourage both work and investment. To the extent that an income tax – or a general labor tax, like FICA – discourages work, it discourages economic growth. Even if you think that effect is small, it’s probably not zero.

The key to saving this whole thing is realizing that you can basically just turn the income tax into a consumption tax. Add an unlimited deduction for savings and voila. The trick, of course, is that income = consumption + savings. A little algebra, and that becomes consumption = income – savings. You can make one minor change, turn the current system into a consumption tax, and pretty much call it a day. No one has to know what you spend your money on (rent or pizza or hookers, it’s all up to you!), just that, because you didn’t save it you must have spent it.

You can use this trick to preserve anything you like about the current tax system, like its progressivity. A consumption tax doesn’t have to be regressive if you levy it right (i.e., not as a retail sales tax). Just keep the tax brackets as they currently exist, although you might have to raise the rates to keep revenue constant. You can keep any deductions you want, although you probably shouldn’t keep very many anyway. You can even institute Milton Friedman’s negative income tax if you want. My personal favorite small-bore change is a continuous tax bracket (or continuous infinite tax brackets – not sure what the lingo is); we have computers do our taxes anyway, so there’s no reason they can’t do a little calculus and help rid us of the weird incentive effects we get from our current system of discrete tax brackets.

Anyway, that’s my attempt to save the Fair Tax from its own advocates. Thoughts?