Monthly Proposal, No.1: charge consumption instead of income

I’ve chosen to start with this topic, because even right after the election several parties still talk about the necessity of a tax reform in favour of the tax payer. Maybe they expect every tax payer to cheer up on that. But even if we ignore the so called debt crisis for a moment, a promise like this one still leaves crucial questions. What can be understood by a tax reform in favour of the tax payer? The easy and myopic answer could be: a tax reduction. But then we still need to know who this favoured tax payer is. And it is clearly not a homogenous everybody, because we individually pay different taxes in different heights. In this sense every serious politician would honestly tell us which voter is overreached and who is getting discriminated in comparison to the status quo. Such concrete information can of course not be found on posters during the election. And the announcement of a flat tax on income in favour of hard working people shows us that they either not know what the word “favour” means, or what a flat tax ceteris paribus would imply for the relative tax burden of “hard working” people. So I rather focus on declaring my own proposal:

I want affordability for the necessities for living at the expense of unnecessary comfort and wealth. That means I do not hesitate to admit that in return to the relief for poor and sparing households I have to tax wastefulness, abundance and excessive luxury. One way to do that is to charge individual consumption instead of income. And this is only one of the reasons why I want a big scale reform towards a direct progressive expenditure tax.

Another reason is that by charging just the purchase of consumables we would expect savings to rise. If these savings are used for investments this should imply economic growth. Of course such investments have to be correspondingly triggered but the first impression leads to the thought that the individual decision process is nudged in a sustainable direction.

In this sense also other forward-looking expenditure for like family, health or education should get even more attractive because they would reduce and avoid taxes. Thereby people could still decide day by day which lifestyle is worth the corresponding burden and are not principally charged for being productive or having a well-paid job.

This raises the topic of another advantage which would be the non-existing discrimination of production factors. It would be irrelevant whether the income is earned out of labour or capital. Once more: Instead of charging the source we would focus on the use. And latter seems to be a pretty good base to estimate what a person is able to give as well as obviously taking from society. So tax it!

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18 thoughts on “Monthly Proposal, No.1: charge consumption instead of income

  1. I totally agree. Would you favor a flat consumption tax or a progressive one? I am actually not sure whether redistribution should be part of the primary functions of a tax system (which can be much more efficiently handled on the spending/transfers side), but a flat consumption tax would unavoidably be regressive, maybe even too much so.

    • As I wrote I would favor a “reform towards a direct progressive expenditure tax”. So far I expected the tax system to already consider resdistribution, because can redistribute only what I’ve taken before – e.g. by taxes.

  2. Thanks Timon! This post is awesome. It’s great, because I disagree with it on so many levels.

    One question that came immediately to my mind was: would a consumption tax be regressive? And the answer is, of course: not if the consumption tax is sufficiently progressive. In order to get a progressive consumption tax (Average Tax Rate rising with income) you need Marginal Tax Rate x Marginal Propensity to Consume > Average Tax Rate. So if you keep the current Average Tax Rate at 40% of income and assume a Marginal Consumption Propensity of 2/3, the Marginal Consumption Tax Rate should be at least 60%. (I don’t have a question here, it’s just more like a note to myself)

    But I have a question on why you think your proposal would be “in favor of the taxpayer”? And what does that mean anyway?

    Also, from what you write, I get the impression that you regard every expenditure above a certain level to be wasteful and excessively luxurious. Does that mean you want a 100% marginal tax rate above a certain level of consumption?

    • As I wrote I would expect a “reform towards a direct progressive expenditure tax”. So first, yes, I would expect it sufficiently progressive by design. But second, no, in this sense I can not claim, that my proposal would be in favor of every tax payer. And I wasn’t – I rather mentioned the “relief for poor and sparing households” on the “expense of unnecessary comfort” and “excessive luxury”. So after all, yes, I know that there has to be some normative decision about the height of marginal tax rates. And I have to confess, that I can not rule out even 100% above a certain level of consumption. But thereby I have to emphasize that there of course has to be a reasonable definition of “consumption”.

  3. When talking about doing a tax reform “in favor of the tax payer” I think it is useful to keep in mind that many European economies find themselves constrained by the Zero Lower Bound (ZLB) on nominal interest rates momentarily. (I’m doing some research in this direction now, that’s why I depart a little bit from the original topic)

    After all I’ve read I don’t think that a simple tax reduction in labor taxes would favor anybody at the ZLB. The reason for that being that, at the ZLB, the economy suffers due to a lack of aggregate demand. So what a reduction in labor taxes would do is to decrease the cost structure of firms thereby shifting aggregate supply (AS) to the right and lowering prices. As the central bank cannot accomodate the fiscal policy change by decreasing short-term nominal interest rates, the situation will not get better for some people, but worse for everybody.

    A recent paper by Correia et al. (http://cep.lse.ac.uk/seminarpapers/22-11-11-PT.pdf) addresses this problem and proposes, just like you, a shift from labor taxes to consumption taxes (They also opt for a temporary investment tax credit). However, these policy changes are not supposed to take place instantaneously, but gradually over time, thereby making use of expectations. I’m inclined to think that such a policy mix might work quite well to increase aggregate demand and thus output in a difficult situation like the one we find ourselves right now. This is related closely to the announcement of Shinzō Abe early in October 2013 to raise consumption taxes in 2014 – economic actors have an incentive to shift their consumption into the present, as consumer prices (at least to some extent) are increasing in the future.

    However, I didn’t consider any equality aspects in this argument – I like your idea concering a direct progressive expenditure tax though. But how would you manage that? Definitely must be something very different to our European system of value added taxation… And am I right that your conception of a consumption tax is nearly diametrically opposed to the “normal” understanding of a consumption tax as a value added tax?

    • Gerald, I think what you mean is a revenue-neutral reduction in labor taxes, right? If you just reduce labor taxes ( with no offsetting expenditure reductions or other tax increases) that should increase AD as well as AS. And then the effect at the ZLB is not so clear.

      • Max, I was actually not thinking about a budget-neutral reduction in labor taxes. It is sufficient to assume that there are liquidity-constrained agents in an economy. If that is true, then the AD curve will rather shift to the left, and no to the right.
        Reason: Increasing AS lowers price level and thus consumption of constrained actors (via Debt-deflation-mechanism). The lower labor tax rate, however, will increase the actors willingness to work – which in a ZLB economy will lead to a fall in real wages, thus further aggravating the situation. This is because, as I mentioned before, AD is the limiting factor, and not AS.

        This is basically just the story Krugman and Eggertsson (2012) tell us… But I myself am having some doubts about that also. Particularly, what troubles me is that the whole story relies on Fisherian type debt-deflation – that’s what makes the AD curve backward bending – however, I didn’t hear so much about deflation since the beginning of the crisis. Is it enough to have deflation in the housing market alone for this effect to work?? I would be grateful for thoughts on that one…

      • OK, this leads us far away from the original point of Timon’s post. But nevertheless: If you just cut labor taxes, this is expansionary fiscal policy. So that, seen in isolation, should shift AD to the right. It also shifts the AS to the right, which is a bad thing at the ZLB, as you rightly point out, because the AD curve is backward bending/upward sloping. The question then becomes which curve shifts more.

    • I’m talking about capitation, a direct tax in opposite to an indirect value added tax. I have to, because I’m asking for a progressive design. Anyway there is literature about the management of a tax like that – Kaldor, Fischer, etc.
      Concerning the economic effects and the dependency on demand I just want to add the importance of tax incidence. Because a reform in favour of poorer households would of course have effects on demand too.

      • Sorry about missing the “progressive” part there, Timon.

        As you point out, implementation might at best pose some technical difficulties which should be fairly easily resolved from a theoretical perspective. The politics are something else, of course. The whole idea also atleast goes back to Milton Friedman. Just google “Milton Friedman progressive consumption tax” for the basics.

        This is, however, clearly different from what the IV proposes.

        Ps: nvm Friedman, kaldor’s article preceeds it by 20 years it would seem.

  4. Couldn’t have said it better than Max: “Thanks Timon! This post is awesome. It’s great, because I disagree with it on so many levels.”

    The first things that jumped to my mind were a couple that were raised above regarding the issues if the tax will be regressive (after all poor people spend a higher percentage of their income on consumption) and how you would implement it (VAT?). I like Florian’s point about transfers.

    Two more quick thoughts:
    1. I’m currently living in Sweden where alcohol is heavily taxed. So what do people do? – They hire a care and drive to Germany (or Tallin, depending on the side of Sweden). What I’m trying to say is that it is probably easier to find loopholes around consumption taxes and that it is probably even easier to find and exploit these loopholes if you’re filthy rich.

    2. Secondly, while it annoys me as well that some people spend money on completely useless stuff, I’m more worried about the money they are NOT spending, but pushing into offshore accounts, trust funds or dubious investments and the money they in turn make out of such endeavours and that never finds any productive use in the economy. I read an article a while ago that put it very well: if somebody wants to by a yacht, at least that creates a LOT of economic activity and employment 😛

    In any case, it’s an interesting idea, but your proposal would have to be a bit more specific to seriously debate it.

    • Just realized that I didn’t finish the thought about Sweden: they hire a car, fill it with alcohol and drive back to Sweden.

    • Katharina and Gerald, I broadly share your concerns. But I think it’s not right to focus only on the short-run effect on output and employment. Because Timon is clearly talking about a permanent change in the tax system. And in the long run, we hopefully aren’t at the ZLB and monetary policy could and probably would offset any contractionary effect of a consumption tax. So yes, introducing a consumption tax might reduce the demand for yachts but that has no effect on the overall level of output and employment in the long run.

    • ad 1: I’m not talking about an value added tax. It is more like an income tax but corrected for the use of it (especially savings and investments). Of course nevertheless loopholes have to be considered, but in a different way.
      ad 2: Of course not all alternative uses are better uses by definition. As I wrote even “investments have to be correspondingly triggered” and people maybe nudged. Nevertheless I want to add: Even if economic activity, employment and labour income are correlating, they have to be differentiated. But anyway I’m not intending an unreserved rise in economic activity and employment. When I ask for consumption tax I also have in mind sustainability.

  5. Timon seems to have read the Industriellenvereinigung’s position paper on taxes quite well ; ) Basically they suggest a budget neutral reform lowering taxes and other costs on labor and raising the VAT to 22% instead. In my humble opinion this approach makes a lot of sense since decreasing labor costs has positive effects on unemployment, growth and international competitiveness. However, one should keep in mind that a shift from income to consumption taxes is typically not in favor of the poor. Income taxes are progressive and consumption taxes have regressive impacts. I can hardly imagine a consumption tax could be designed to be progressive. So the big question is, whether the efficiency gain (employment, growth, competitiveness) of such a reform outweighs the probably negative effects on equality. As discussed in the previous post on development economics and the following comments, this is a highly normative question because the exact consequences of a reform like this can only be approximated.
    Nevertheless, there are some quick wins with respect to the VAT that has grown historically and is full of strange exceptions and privileges. For instance, why do 4 and 5 star hotels only charge the reduced tax of 10%? Why swimming pools, cable tv broadcasting companies? Cleaning up this stuff will at least give some scope for tackling the problem of cold progression (that we might discuss another time).

    • As far as I’ve read Timon’s post, he talks explicitly about introducing progressive consumption taxes (specifically expenditure taxes), which basically would have little to nothing in common with a simple change to value added taxes. Am I wrong? I find the idea by Timon quite interesting and tempting!
      But yeah Wolfgang, I agree with you, I also can’t really imagine how progressive consumption taxes could be introduced. Timon, do you have any ideas about design and implementation?

      • Yes, Gerald, I’m talking about an direct “progressive consumption tax”. A a value added tax would rather be regressive.
        There are ideas about the design and the implementation. Old ones you can find in writings of Kaldor and Fisher, more actual ones in the Mirrlees Review. I do not fully agree with those papers, but I think any such references is more helpful than a spontanous description of my own ideas up to now.

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