Time neutral consumption taxes
The field of economics is regressing. We are forgetting what we knew about monetary policy back in 2007, and we are also forgetting what we knew about public finance back in 2007. This is incredibly discouraging.
For non-economists, I’ll start with a simple thought experiment to explain the basic principles of public finance.
Imagine a country where everyone earns exactly the same wage income, $80,000/year from age 25 to 65. No one inherits any money.
The only investment is a safe asset that earns a 5% rate of return. Assume no inflation.
Some people like to save a lot for future consumption, while others spend their money today and save very little.
What do we know about this world?
1. There is substantial income inequality.
2. There is lots of inequality in measured wealth.
3. Actual wealth is identical, in the sense that every single person has identical lifetime consumption in present value terms.
(Wealth, properly measured, is supposed to represent the present value of future expected consumption, for you and those to whom you give money.)
The society that I described does not have any economic inequality, in any meaningful sense. Everyone has exactly the same amount of resources to work with over their lives; they simply choose to spend their money at different points in time.
[I’ve seen people argue that a lack of patience is a disability, like being born without a right arm. I view preference for current goods over future goods as being no different from preference for strawberries over blueberries. Maybe that’s because I made the mistake of consuming too little when I was young. I don’t view myself as being better off than those who enjoyed life while young.]
ALL TAXES ARE CONSUMPTION TAXES!
All taxes are 100% consumption taxes. That’s public finance 101. The burden of a tax is its impact on consumption. Saving and investment are simply a way of generating future consumption, for you or the person you give the money to.
When economists like me use the term “consumption tax” we are referring to taxes that tax current and future consumption at the same rate. We actually mean, “time neutral consumption taxes”. Examples include VATs, payroll taxes, and income tax systems with unlimited 401k privileges. (I.e., no limit on contributions and no mandatory withdrawal date.)
An ordinary income tax system does tax capital income, as do corporate income taxes, capital gains taxes, etc. These are also consumption taxes in a sense, but they are not called consumption taxes because they tax future consumption at a higher rate than current consumption.
In my imaginary example above, an income tax would tax those who preferred future consumption at a higher rate than those who prefer current consumption. At first pass, that looks distortionary.
Now it’s perfectly OK to say that the simple public finance theories do not work in the real world. Some “capital income” is disguised labor income. Maybe for that reason we should tax capital income. I’ve argued that when in doubt, capital income should be treated as labor income. But you’d have to be completely insane to believe that all capital income is disguised labor income.
Unfortunately, the profession seems to be completely insane, as I see more and more economists making nonsensical comments such as claiming that the super rich pay a lower rate of tax than the middle class. In making that claim, they are treating “income” as the correct base to use when evaluating tax incidence, not consumption. That’s a freshman level error, completely unacceptable. If you see an economist doing that, just stop reading. Nothing they have to say will have any value. In fact, income is a meaningless concept. The tax rates faced by billionaires are meaningless numbers.
Progressives should be advocating a progressive consumption tax. This tax system would tax current and future consumption at the same rate, but would tax high levels of consumption at much higher rates than low levels of consumption.
There are many ways to get there, and undoubtedly many compromises that must be made. Perhaps “second best” options need to be considered. But if you don’t even understand the proper destination, what chance is there of developing a sound strategy?
PS. Tim Peach recently pointed out to me that Estonia is the country whose tax system is closest to being time neutral.
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17. October 2019 at 12:20
In your world, does “consumption” include real estate, art, collectible cars, etc?
17. October 2019 at 12:32
Good post. Can you recommend any public finance texts? I’ve been reading some reviews of Saez and Zucman and my eyes just glaze over.
17. October 2019 at 12:40
“Freshman level error”
I 100% agree with you that all taxes are consumption taxes. But I don’t remember this being in any micro or macro college courses and definitely not the intro courses. I picked it up at some point off the internet. So I don’t believe its quite clear its a freshman level mistake. And the concept of all taxes being consumption taxes gets tough to visualize.
I’ve realized for a long time that you can’t tax Warren Buffett. He doesn’t consume much. If you tax his wealth he’s forced to sell some stock and it traces its way thru capital markets to the point where it lifts someone mortgage rate a tenth of a basis point.
17. October 2019 at 13:52
I’d love to understand, but it’s hard to understand why a 50% wealth tax on Warren Buffett doesn’t steal 50% of his wealth, but *in reality* taxes someone else completely. If this is not explicitly in your text, you seem to imply it, or at least sean does.
There is also the question of why your analysis can only be read here and close to nowhere else, at least not from economists like Krugman. Actually, I’ve never heard of it before, well I may be an ignorant idiot, but sean etc. haven’t heard of it either, at least not in the usual courses. How do we reconcile this weird situation? What don’t other economists see? And what don’t you see? Why did they change their opinions compared to 2007?
Thirdly, there’s the follow-up question of why economists are once again so far apart on a question that one should assume to be an absolute basic question.
17. October 2019 at 13:59
This was an economics post I could actually understand. Thanks.
So an example of a progressive consumption tax would be a properly scaled VAT?
17. October 2019 at 14:12
Nice post.
Some of the history of Estonia’s tax system is set out here
https://repository.upenn.edu/cgi/viewcontent.cgi?article=1158&context=curej
17. October 2019 at 14:43
Effem, Yes, either the purchase itself, or (in the case of real estate) the flow of services should be taxed.
17. October 2019 at 16:00
Property taxes seem like the way to go.
I am not sure what it means to tax the services of real estate. I guess Scott Sumner means the rental value.
Import tariffs have a lot of advantages also.
Of course, fuel taxes make sense if we are worried about pollution.
I think property taxes must be assessed on property value, in the most simple form possible. The big advantage to property taxes is that it would eliminate the domestic and international shell game Gong Show. Income taxes have become less and less collectible.
17. October 2019 at 17:53
Scott, didn’t you just give an argument against progressive consumption taxes?
The most you can support here is to make consumption taxes progressive over the whole life. Otherwise you tax someone who saves a lot in the first year, and then consumes a lot in the second year, more than someone who spreads out consumption equally over both years.
I find your arguments interesting. But I also have a soft spot for the ‘radical markets’ idea of having a self-assessed wealth tax on everything. (Though I wonder why they suggest 7% p.a., surely something like 1% or 2% should work in a low real interest rate environment.) A soft spot, because some ways of consumption can be very hard for the tax man to see: imagine a zillionaire who can normally get 2% on his investments gives a no interest loan of one billion USD to MoMA, and in return the Museum of Modern Art names a wing after him. Our zillionaire is essentially spending 2% of 1 billion every year to buy status. But it’s hard to design a consumption tax to catch that consumption.
You can imagine similar scenarios of throwing your weight around, for eg political influence as well.
A somewhat funny way to plug the whole would be to charge owners of wealth for consumption of an assumed risk free market return, unless they can point to the money they actually made. In that case, we only tax them when they spend it. (Funny, because it would be absolutely politically unworkable.)
Benjamin, import tariffs have lots of supply side disadvantages. Basically, they weaken one of the best levers we have for increasing domestic productivity: international competition. In the long run, productivity is all that matters.
About property taxes: they are already essentially a tax on the rental value. Exactly how much a given property tax rate extracts of the rental value depends on prevailing interest rates.
17. October 2019 at 19:14
Scott,
I totally agree with your policy prescriptions, but I have two major quibbles with the post.
1. The assumption (implied) that wage equality is a precondition for economic equality is muddled thinking and a cop-out concession to errant socialist thought. Lots of people work harder and longer hours to generate to generate more income. Lots of people invest huge numbers of hours to develop the skills needed to generate higher income.
2. The assumption that people do not immediately consume all of their current income (production) simply in order to enjoy future consumption is horribly wrong. Many people view it as ethical and moral imperative to create and preserve wealth (capital) that will benefit society and their fellow men (women) on an ongoing basis with no expectation of future benefit (or consumption) for themselves. This kind of erroneous sloppy thinking kind of irks me.
17. October 2019 at 21:51
An example of “time neutrality” that comes to mind is the real estate partnerships before the 1986 tax reform. Doctors, lawyers and other high income professionals would invest as LPs in real estate partnerships and the non-cash depreciation would pass through to the LP’s personal income.
In a pure logical view, the pass-through depreciation was perfectly fine. If the depreciation actually approximated the reduction in value of the property, the LP took real losses. If the tax code overestimated depreciation, then the LP will eventually pay taxes on the difference.
The political reality is deferring taxes for decades was very unpopular. To not increase the deficit, Congress had to pay for lower overall tax rates in the 1986 bill immediately, not decades from then.
Indeed, a pure consumption tax could take multiple decades or even generations to finally pay the consumption tax. Someone who inherits $1 billion needs a mere 1% return to have $10 million before-tax for spending. If their effective tax rate is 40%, then they can live a very luxurious lifestyle of $6 million annual spending indefinitely. The political reality is that inheritors spending money will be far more unpopular than the original earner’s spending.
Plus there are practical issues with consumption taxes. Actual VATs have large sectors of the economy which are not taxed. The UK VAT does not tax residential housing or any health or education services. If a big portion of value added is in the last step, then it’s easier to evade.
A pure labor tax will move up the taxation in a “time neutral” way, but pure labor taxation leads to extremely bizarre outcomes. Buffett has not had substantial labor income since he closed his partnership in 1969. Berkshire’s stock has return 12,000x since then and none of it would be taxed. Even if you do tax that capital income as labor income, since Buffett worked to increase Berkshire’s value, the passive owners earning 12,000x returns would pay no tax. Hell, would lottery winners pay a tax in a pure labor tax system, since the lottery ticket was expenditure of previously taxed income?
So if, politically, the US doesn’t want decades-long tax deferral and doesn’t want tax-free capital income, then we have to have a system of double or triple taxation. Corporate tax/GDP was 4% in the 50s and 60s, versus less than 2% since 80s. Total tax revenue/GDP has been around 20% since World War II, but has shifted remarkably from corporate and higher bracket income taxes to payroll taxes. This shift will probably not survive politically and a VAT in practice would increase regressivity.
18. October 2019 at 01:13
Andrew Yang, the democratic presidential candidate, is running on a (very) progressive consumption tax, a 10% VAT with $12000 rebate which might result in about only the top ~5% of consumers actually ending up effectively paying more in the VAT than they get back in the rebate in a given year (obviously not revenue neutral on its own, he’s also suggesting a pigovian carbon tax among others).
It seems though that consumption taxes have a hard time shaking their “regressive” reputation in many progressive circles somehow no matter how obviously progressive you might try to design it. Progressives instead seem to be flocking to wealth taxes at the moment, if Sanders and Warren are any indication.
I’m reminded of the unpopularity of the FairTax, another flat consumption tax + rebate suggestion. It seems that time-neutral, progressive consumption taxes are politically quite difficult to get off of the ground in the US.
What are some good “second best” ideas that might be more politically feasible?
18. October 2019 at 01:53
Scott, in your ideal system, you are proposing some kind of lifetime tracker on how much one has consumed? as you go into different bands you pay higher consumption tax?
Certain things would be deemed taxable consumption, vs certain things would be untaxed i presume to avoid things everyone would find quite unpalatable? i cant imagine for example we would deem someone who has consumed millions of dollars of medical services for childhood cancer treatment in the same was as someone who buys nice cars and holidays.
Or does the progressiveness of this system come from the fact that out of the tax various things are made free at the point of use for all, and as such those that consume less inherently have proportionally less consumption in the taxable bracket? (obviously much easier to administer)
Unfortunately it seems tax policy is about making things as obscure as possible to hide how much tax is really paid and fairness seems a secondary consideration. in the UK for example we have numerous taxes on employment income that all do functionally the same thing, most people end up just quoting the largest single one “income tax”.
18. October 2019 at 03:51
Matthias, Yes, a progressive consumption tax also has distortions, such as discouraging work effort. But it has benefits as well. Taxation of capital income produces distortions with no gains.
dtoh, Innocent on both counts. My example assumed equal wage incomes. I did not deny that those with higher wage incomes may work longer hours, and that impacts the amount of redistribution that you want to do. So I basically agree with you.
On the second point, when you talk about producing benefits for future generations, that is what I meant by “giving it away”. If a miser doesn’t consume much and saves a lot he is adding to capital formation, which benefits the consumption of future generations. Thus misers are actually very generous people, as Steve Landsburg has pointed out (check out his essay.) So I agree on both points.
Matthew, Investments should be expensed all at once, not depreciated over time. Again, “income” is a meaningless concept.
There are many types of consumption taxes, and the problem you refer to only applies to some of them (such as VAT.) If you switch to that type system then you can do a once and for all tax on existing wealth, to be paid gradually over time.
And what makes you think corporate taxes are “progressive”?
We already have a property tax; we should tax health care, and we should tax the consumption portion of education (dorms, food, etc.)
Georg, I agree with your comments. The most feasible approach is to expand the 401k program. It looks like Congress is about to raise the age for mandatory disbursements from 70 1/2 to 72, evidence that it is feasible. It should be entirely removed. People should also be allowed to contribute more each year into their 401k.
You still have all the complexity of income taxes, but at least the 401k reduces the time bias.
Nick, Tracking lifetime income would be ideal, but I’d probably compromise with a tax on either wage income or annual consumption.
18. October 2019 at 05:02
Scott, thank you for this post. Nothing in it is new (although it is correct), it is just Grumpy Scott Sumner, but Grumpy Scott Sumner is one of my very favorite characters especially when he’s right!
18. October 2019 at 05:24
I like the idea of a consumption tax I just don’t think it’s workable in practice. This distinction between consumption vs investment vs “streams of services” is nearly impossible to get right and would be heavily gamed by those with the means to do so.
If someone buys a $50m house what do they use to estimate the “stream of services?” The rent on a comparable sized house in the same zip code? My guess is something like that would underestimate the true consumption enormously.
What if you buy a second house and use it a few times per year and rent it out the rest. Are you only consuming a few weekends? Would the same apply to a private jet that you only use once per month? Or a piece of art that sits in the house you only use a few times per year?
What if instead of buying a house, i build one? Do building materials suddenly become investment instead of consumption?
What if i buy a yacht and it’s primary purpose is to entertain clients? Etc etc.
Obviously our current system is gamed by the wealthy…but a consumption tax may be even worse given how much of their “consumption” is in things which are quasi-assets.
18. October 2019 at 06:18
I think loss of privacy is a cost too. Complying with an income tax, for example, requires divulging more information about yourself than does complying with a property tax.
18. October 2019 at 08:14
Having no depreciation would have substantial NOL carryforward for most enterprises. A $10 million building may not pay taxes until year 5 or 10. Taxes could be much higher later. But for better or worse, politics has a very high discount factor.
Corporate tax incidence depends on a lot of factors. I would argue that the corporate tax, as it existed in 50s and 60s, probably was very progressive. The US was more of a closed economy and many companies had franchises (IP, brands, etc.) where location of labor or capital factors was insignificant. That assumes it was infeasible for, say, Coca-Cola to do a tax inversion or doing abusive transfer pricing.
Since US is smaller part of world economy, the worldwide corporate tax system wouldn’t have same effect today. It’s still highly progressive where companies have strong, pre-existing franchises and there is effective enforcement against inversions or transfer pricing. Even a 50% incidence on capital is progressive as capital owners skew so much higher in income and wealth.
Anyway, a pure consumption tax system just doesn’t seem feasible based on no country having a current approximation. If a real-world system does have multiple levels, then basic things can make taxes more progressive. For example, carried interest and capital gains basis step up should both be eliminated. Capital gains rates could go back up to early-90s levels (23% top rate to 30%).
18. October 2019 at 09:10
A zillionaire can only consume so much. People won’t tolerate that you don’t tax all the rest of his wealth and income. No wonder the other economists don’t agree with you.
18. October 2019 at 09:28
Another argument in favor of the poor, maligned multi-millionaires. I suppose it’s worth pointing out for the ten-millionth time that capital gains taxes are only taxing the GAINS. I.e. the capital gains tax is not on the millionaires’ labor income, it is on the additional profit they’re making off of their unspent income.
Btw, households with over $10 million in net worth (the top 1%) hold 50% of all equities. So excuse my lack of tears for their hardship.
https://finance.yahoo.com/news/the-richest-1-own-50-of-stocks-held-by-american-households-150758595.html
18. October 2019 at 13:45
Effem, You said:
“If someone buys a $50m house what do they use to estimate the “stream of services?” The rent on a comparable sized house in the same zip code? My guess is something like that would underestimate the true consumption enormously.”
We already have a consumption tax on property, it’s a percentage of the value.
You said:
“What if I buy a yacht and it’s primary purpose is to entertain clients? Etc etc.”
Entertainment is consumption, regardless of whether it’s done for a business reason or some other reason. Ditto for “business” lunches
Carl, I agree.
Matthew, Estonia comes pretty close to a pure consumption tax. Some European countries have no capital gains taxes.
Christian, Read the post again, I think you missed the entire point. Again, all taxes are consumption taxes.
Bob, Wouldn’t your time be better spent trying to understand the post, rather that responding to a post that you clearly did not understand?
I’m perfectly happy taxing the super rich at higher rates than they pay now.
18. October 2019 at 16:17
Okay, thank you Scott. This clears things up.
You want time neutral consumption taxes in order to “encourage” investment (ceteris paribus), right?
Let us extend this idea to other fields that may be even similar to taxes: what about money? Why no time neutral money then? We create money (target: 2% inflation) so that people experience the hot potato effect so that they spent money faster than they otherwise would, no? Doesn’t this lead to less saving and thereby to less investment as well?
18. October 2019 at 16:24
Implicitly you assumed that, in your model world, everybody lives at least to age 65. Even so, there will still be inequality in lifetime consumption if some give assets to others. And you cannot allow anyone to die unexpectedly, with unused wealth; else he would fall short in lifetime consumption.
18. October 2019 at 17:49
Thanks Scott! I think the best proposal in the US was the USA (Unlimited Savings Account) tax bill.
Pretty much it was unlimited 401k plus a VAT. No company tax either!
And the best overall tax review would be the IFS Mirrlees Review, IMO.
18. October 2019 at 20:13
It bothers me a great deal to see comments about applying higher wealth and consumption taxes. Look, I understand that people are jealous. I get it. You look at Trump, buffet, gates and their billions, and you say gosh that’s not fair. Actually, it is fair! There is no more equitable system than capitalism. They produced something, you didn’t. If you want to get rich, I will tell you precisely how to do it. Go build a machine using python, go, java, any programming language, along with any supplies – I will even buy the material for you – and build a machine with a neural network that has the capacity to learn. If you do that, you too will become a billionaire. Too hard? Yeah, it is. And I’m sorry that you don’t have the ability. Neither do I. But the next time you think it is unfair, you might want remember the work, the intelligence, and the sacrifice that went into building a product or service that brings forth billions in revenue. In other words, the only fair tax system, is a flat tax. Period.
19. October 2019 at 13:06
It seems to me the most important issue is how much the government spends. Our government is already spending so much that it appears to me that taxes will have to go up a lot in the future.
I have heard many conservative TV and newspaper editorials claim that increasing taxes on the rich cannot come close to being enough to pay for all this future government spending. Scott, I would be interested to know if you agree with these conservative editorialists.
19. October 2019 at 14:34
Christian, I don’t want to encourage investment, I want to stop discouraging investment.
Philo, I agree but that wasn’t my point. My point was that even if lifetime consumption were identical, the society would look very “unequal” to progressives.
Thanks Tim.
Bob, Yes, I think the middle class will also have to pay more, because of the reckless policies that we have in place today.
20. October 2019 at 00:14
Hi Scott, it’s my understanding that a 401k requires you to be 59 before you can touch that money without significant penalty. Isn’t this requirement actually kind of a big deal in terms of how distortionary it is in addition to all of the usual distortions of income taxes? It seems to me that if the point is to have time-neutrality in your consumption taxes then having different tax rates depending on whether you’ve hit an arbitrary age goes a long way in ruining that, even moreso than the mandatory disbursements that you mentioned.
Incidentally, do you have any interesting opinions on the superannuation system in Australia? My understanding is that it is somewhat similar to a 401k but all employers are required to pay ~10% of their employees’ pay into one. The result is that Australians seem to hold a disproportionately large amount of savings, both in general (2nd highest median wealth) and in systems of its kind ($2.7 trillion). Is it a good idea for governments to “force” people to save in 401k style systems like this?
20. October 2019 at 08:43
Georg, For me, the biggest problem is that we are forced to withdraw money at age 70 1/2. At that point, you are forced to pay tax even if you don’t plan to use the funds for consumption.
The Australia system sounds similar. Chile and Singapore also have that sort of system. I like forced saving as a “second best” regime. It may not be optimal, but it’s better than the other government systems that it can replace.
21. October 2019 at 08:10
Taxes are a big indicator of happiness. Also how taxes are spent. Look at Sweden. High taxes, low inequality, they spend money on keeping the population healthy and productive. We spend a lot on war and bailing out farmers or others after trump starts a fire diplomatically.
The focus should be on what we spend tax money on not what we tax. High taxes are fine and yes the rich pay most taxes because our system is progressive. The economists and you are dodging the real problem. How we spend. Let’s spend on making people better. It’s not a surprise that the USA is in real psychological turmoil that manifests itself as movements against billionaires and pharma. It’s a symptom of a social problem caused by the predation of the system.
21. October 2019 at 23:15
“Tim Peach recently pointed out to me that Estonia is the country whose tax system is closest to being time neutral.”
I think that link exaggerates at least a bit. Especially this part:
“Estonia allows for full expensing of capital investment.”
But that’s not the way it works to my knowledge. If I’m not mistaken, companies in Estonia pay a corporate income tax on the profits distributed to shareholders as dividends. This means that profits retained in the company are not subject to the kind of double taxation that taxing capital income entails. However, this is far from neutral, because it incentivizes keeping one’s assets stuck in that one company. There is no deduction for new capital in the form of corporate equity from the shareholders.
22. October 2019 at 11:09
QW, Yes, it’s not a pure consumption tax, but closer than other countries.