A better way to tax - consumed income tax

Public Interest, Wntr, 1994 by Laurence S. Seidman

IN THE SUMMER OF 1992, Senators Pete Domenici (R-NM) and Sam Nunn (D-GA) decided to move beyond the short-term tinkering that usually dominates congressional debate over taxation. The senators reached onto the academic shelf and pulled down an idea that many economic thinkers have advocated: replacement of the personal income tax with a consumed income tax (CIT).(*)

The consumed income tax is not a new proposal. The distinguished economists Irving Fisher and Nicholas Kaldor, writing from different philosophical perspectives, each wrote treatises advocating a CIT, and many economists have long found the proposal attractive in theory. Prior to the 1970s, however, it was widely assumed that a CIT would be hard to implement. In the last two decades, however, tax experts have reexamined the consumed income tax and concluded that it might be easier to operate than the current income tax. Two major studies undertaken by tax specialists--the U.S. Treasury's Blueprints for Basic Tax Reform (1977) and the U.K. Institute for Fiscal Studies' The Structure and Reform of Direct Taxation (1978)--have concluded that converting the income tax to a CIT is both feasible and desirable.

Support for a CIT is in fact quite broad and ideologically diverse. Consider this list of prominent economists and other experts who have endorsed the idea in one form or another: David Bradford (Princeton), Martin Feldstein (Harvard), Lawrence Summers (Harvard), Lester Thurow (MIT), Michael Boskin (Stanford), John Shoven (Stanford), Henry Aaron (Brookings), Harvey Galper (Peat Marwick), and William Andrews (Harvard).

How would a consumed income tax work? Under a CIT, all household savings would be tax deductible. Meanwhile, all consumption would be taxed. Every April 15th, each household would determine its taxable consumed income by adding up its total cash inflow and subtracting savings and previous tax payments.

Why do it?

It is an inescapable fact that investment--in plant, equipment, and technology--must be financed by domestic saving or borrowing from abroad. When domestic saving falls, so does investment. Take a look at what happened in the 1980s: Between 1980 and 1990, the United States' gross national saving rate declined from 17 percent to 13 percent of gross domestic product (GDP). Of this 4 point drop, 3 points were due to a fall in private saving (the other 1 point was due to a rise in government dissaving). Not surprisingly, gross private investment fell nearly 3 points, from 17 percent to nearly 14 percent of GDP; only a 1 point increase in borrowing from abroad prevented the fall in investment from fully matching the 4 point drop in saving.

If the U.S. had begun the 1980s as a high saving nation, one bad decade might be shrugged off. But the pattern is long term. From 1960 to 1984, the U.S. gross saving rate averaged 19 percent. By contrast, in France it averaged 24 percent; West Germany, 25 percent; and Japan, 34 percent. It is no surprise that these high saving nations gained economic ground on the United States. In 1950, France's output per person was only 47 percent of ours; by 1980, it had risen to 84 percent. Over the same three decades, West Germany's output per person rose from 40 percent to 86 percent of ours, while Japan's rose from 17 percent to 72 percent.

Conversion to a CIT would raise national saving in three distinct ways. First, consider the incentive effect. Unlike the income tax, the CIT would let a household reduce its taxes by saving, thereby giving it a financial incentive to save. True, tax would be owed if the saving was eventually spent. But in the meantime, the household could earn interest. And if the saving was left as a gift or bequest, then it would escape tax until the recipient spent it.

Second, consider the horizontal redistribution effect ("horizontal" because the redistribution is between persons in the same income class). Under a CIT, above-average savers would pay less, and below-average savers would pay more; the result would be more saving, overall, from each income class. To see this most easily, suppose the $100,000 income class has only two people: S and C. They are each extremists. Person S saves everything and person C consumes everything. Under a 20 percent income tax, S and C each pay $20,000 in tax. Thus, total tax revenue is $40,000. S saves $80,000 and C, nothing, so total saving is $80,000. Under a CIT that raises the same $40,000 of tax revenue, C will pay $40,000 in tax and S, nothing; so S will save $100,000 and total saving will rise to $100,000. Conversion has caused a horizontal redistribution effect: $20,000 has been redistributed from C to S, and the result is an increase in total saving. Of course, if C surprises everyone by actually saving to take advantage of the new saving deduction, then total saving would rise by more than $20,000.

Third, consider the postponement effect. Conversion shifts some of the tax burden from the work stage of life (when money is saved) to the retirement stage (when money is spent). That enables workers to save more. In an economy with growing real wages and labor force, the higher saving of workers outweighs the higher dissaving of retirees, resulting in an increase in aggregate net saving. Thus, conversion would give workers a greater ability to save (by postponing some tax to retirement age) as well as a greater incentive to save. Is it fair?