Winner and losers in the shift to a consumption tax

Georgetown Law Journal, Jan 1998 by Bankman, Joseph, Fried, Barbara H

JOSEPH BANKMAN* AND BARBARA H. FRIED**

INTRODUCTION

The surprising popularity of various flat tax proposals now pending in Congress has refocused attention on the longstanding debate between an income and a consumption tax. The terms of debate over the flat tax are familiar ones. Commentators generally believe a switch to a consumption (or cash-flow) tax produces efficiency gains, although they hotly debate the amount of those gains. Despite potential efficiency gains, many find the distributional effects of a switch undesirable, or at least troublesome. The reason for the distributionrelated qualms is straightforward. Under conventional assumptions, a consumption tax reduces the tax on newly invested (new) capital to zero.1 It is generally assumed that a tax on capital is borne primarily by capital. In this country, the wealthy hold a disproportionately high percentage of capital,2 and hence earn a disproportionately greater share of income from capital. Thus, repealing the tax on (new) capital will disproportionately benefit the wealthy. In legal and political circles, at least, the debate over the flat tax thus shapes up as the age-old debate about the optimal tradeoff between equity and efficiency.

Several qualifications limit the validity of the foregoing (standard) account of the distributional impact of shifting to a consumption tax. This article lays out these qualifications and examines their empirical validity and normative implications. Part I dissects an investment return into various components and examines whether an income and a consumption tax treat these components differently, as well as any distributional effects of such differences.

Part II examines the two hypotheses that have given impetus to analyzing tax changes on a lifetime rather than an annual basis-income mobility, and the lifecycle hypothesis of savings behavior. The Part then summarizes empirical estimates of tax liability on a lifetime basis, which suggest that the shift to a consumption tax will be less regressive when judged from a lifetime perspective rather than an annual perspective. Part II concludes by discussing some of the arguments for and against a lifetime perspective.

Part III examines the implications of a switch to a consumption tax for old capital-resources already invested at the time of the tax change. Imposition of a consumption tax without any exemption for old capital would effectively impose a one-time tax on previously invested capital, with distributional effects that potentially swamp in magnitude the steady-state distributional effects of a consumption tax that preoccupy most analysts.

Before proceeding, we wish to clarify the scope of our analysis. The recent so-called "flat tax" proposals floated in Congress would change the existing income tax system in three ways. First, the proposals shift the tax base from income to consumption. Second, they change the definition of taxable consumption, in most cases broadening it by eliminating deductions for such things as childcare and charitable contributions. Finally, the proposals make the tax rate structure considerably less progressive.3 These changes are analytically, administratively, and politically separable. Legislators could adopt a consumption tax base without changing the rate structure or definition of consumption; alternatively they could retain our existing income tax base but broaden it and/or flatten the rate structure. The failure to separate these three changes has needlessly confused analysis of and political debate over the proposals.4 Here, we focus our efforts on the first change-the shift from an income to a consumption tax base. In Part I, we deal with that change only. However, some of the data presented in Parts II and III on the likely distributive effects of shifting to a consumption tax are based on models of a cash-flow tax that incorporate all three changes-shifting to a consumption tax base, changing the definition of that base, and changing the rate structure. In such cases, we could not always isolate the effects of the first change alone.

I. SIMILAR TREATMENT OF MOST COMPONENTS OF INVESTMENT RETURN UNDER AN INCOME AND CONSUMPTION TAX

As stated above, it is generally assumed that a cash-flow consumption tax, however administered, is equivalent to a wage tax with a zero rate of tax on (new) capital (the latter sometimes referred to as a "yield-exempt tax"). The conventional explanation for this equivalence is a taxpayer's ability, under the cash-flow tax, to use the tax savings from writing off her initial investments in year one to increase the level of her initial investment. This grossed-up investment generates a return that is greater than in the no-tax world by the amount of tax eventually owed on the aggregate return when dissaved.

The following example illustrates the point. Assume a taxpayer, who is subject to 50% marginal tax rate, has $50 to invest for one year in an opportunity with an expected pre-tax annual return of 10% (equal to the discount rate). In a no-tax world, the initial investment of $50 would have yielded $55 at the end of year one. Under an income tax, at the end of year one, the taxpayer would have $52.50 ($55 minus 50% of the $5 in income).5 Under a cash-flow tax, the taxpayer may deduct immediately the initial investment, whatever its amount. Assuming the taxpayer can use the deduction fully against current income, she can costlessly gross up her initial investment to $100: the $100 deduction at a 50% tax rate yields a tax savings of $50, for an after-tax cost to the taxpayer of only $50. (More formally, in moving from the no-tax to cash-flow tax world, the taxpayer can costlessly gross up her investment by l/1-t, where t = tax rate.) The grossed-up $100 investment yields a pre-tax return of $110. Under a cash-flow tax, if the taxpayer withdraws the proceeds for personal consumption at the end of the year, she will be taxed on the full $110. At a 50% tax rate, that will leave her with $55, precisely her position in a no-tax world.6