THE United States is a low-saving, slow-growing economy that would benefit from taxing consumption instead of income. That change would provide a powerful incentive to increase the nation's saving and investment and, hence, economic growth and living standards.
This would also be one of the few pain-free ways of reducing the federal budget deficit! A consumption-based tax structure that is initially revenue-neutral compared to the income tax system that it displaces would, in the long run, generate more revenue.
It is necessary to counter the key criticisms that have been leveled against a consumption tax.
Much of the impact would depend on how the tax was structured. The two major alternatives are:
* A tax on total purchases (top down).
* A tax on individual sales, such as a value-added tax (bottom up).
A "top-down" consumption tax would be collected much as the income tax is. The annual return would continue to be the heart of the collection system, containing exemptions and deductions, as at present. One major change would be instituted: The portion of income saved would be exempt from taxation.
The difficult bookkeeping requirement to tally all consumption outlays can be readily assessed by deducting saving from income. What is left is the amount of income currently consumed - or consumption.
Opponents of taxes based on consumption contend that they are regressive - poorer people pay a larger share of their income than richer taxpayers. They note that conventional sales taxes hit low-income people harder than high-income earners because the wealthier save more.
It is true that a "bottom-up" consumption tax such as a value-added tax is regressive. That effect can be reduced by exempting food and medicine or by making special refunds to low-income taxpayers. But such variations make the collection of the tax more complicated.
A top-down consumption tax need not be regressive, either. Like the income tax, the rate table each taxpayer faces can be made progressive.
Under a shift from today's income tax to a top-down consumption tax, the average taxpayer would experience no change in tax burden. Yet above-average savers would pay less and below-average savers would pay more.
A second argument against consumption taxes is that they are inflationary. Unlike income taxes, sales taxes show up in the prices of the products we buy. A top-down consumption tax, however, would not have such an inflationary impact because it is levied on taxpayers and not on goods and services.
The critics note that a value-added tax would require a new tax-collection system and new record-keeping by taxpayers. But, a top-down consumption tax would rely on the existing collection system. Existing restrictions would be lifted on Individual Retirement Accounts and specialized investments.
To a typical taxpayer, the change proposed here is essentially the equivalent of adopting a universal IRA, while amending the rate table.
Conservative critics worry that adding a new consumption tax to the existing revenue sources would enable the government to finance an even larger public sector. Moreover, it would be unfair to state and local governments that traditionally depend heavily on sales taxes.
Once again, these shortcomings do not apply to a top-down consumption tax. Converting the existing income tax does not generate additional revenue for the US Treasury. Similarly, states and localities would not encounter a new federal tax on the products and services they now tax.
Thus, a top-down consumption tax would achieve most of the benefits intended for a value-added tax with few of the shortcomings of that bottom-up type of revenue measure.