The University of Texas at Austin
  • Taxing Spending: The Case For a National Consumption Tax

    By Steve Brooks for Texas Enterprise, McCombs School of Business
    http://www.texasenterprise.utexas.edu
    Published: June 25, 2012

    If Rodney Dangerfield were a tax form, he’d be a 1040: As the federal income tax nears its 100th birthday, next year, it’s getting no respect. Presidential candidates have one-upped one another with plans to replace it — from Herman Cain’s 9-9-9 to Rick Perry’s file-on-a-postcard.

    consumption

    Although most of these tax plans have sunk as quickly as they’ve arisen, an income tax alone might not be the most effective way to finance the federal government, say several tax and finance experts at the University of Texas at Austin. None want to replace it entirely, but they suggest that the U.S. consider a parallel tax system: a national consumption tax.

    Penalizing Consumption Over Income

    Consumption taxes share one principle: Instead of taxing what Americans earn, tax what they spend. The most familiar variety is a sales tax, which sellers collect from consumers and pass on to government. But there are many variations, such as excise taxes, which single out specific goods like gasoline or cigarettes.

    Takeaways
    • Instead of taxing what Americans earn, consumption taxes are based on what they spend
    • The U.S. could adopt a federal consumption tax within the next 10 years
    • In a value-added tax system, each company pays tax on the difference between the materials it buys and the product it sells
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    Why levy a tax on spending? The underlying idea is that government should not penalize work more than other behaviors. “The theory is that if income tax rates are high enough, they discourage work and savings,” says Robert Peroni, professor at the School of Law. “A sales tax is discouraging consumption behavior, and better to discourage consumption than savings or work.”

    A more pressing and practical consideration is the national debt. It’s currently $15.7 trillion. Even with budget cuts approved last year by Congress, it will swell by another $3.5 trillion over 10 years, projects the Congressional Budget Office.

    “If you look ahead 10 years from now,” says Peroni. “We’ll probably have some mixture of income tax with some kind of federal consumption tax, to avoid becoming Greece.”

    He notes that the U.S. is one of the few industrialized nations that doesn’t already have a national consumption tax. Among the 27 countries in the European Union, 33 percent of revenue comes from consumption taxes, compared to 31 percent from income taxes. In the United Kingdom, a 20 percent consumption tax helps hold the income tax down to a top bracket of 50 percent.

    Understanding the VAT
    EU nations use a type of consumption tax called a value-added tax (VAT), and a few American public figures, like former House Speaker Nancy Pelosi and former Federal Reserve Chairman Paul Volcker, have suggested importing the model.

    A VAT works much like a sales tax. But instead of being collected once — when a consumer buys a finished product — it’s collected in bits and pieces at every step along the business supply chain. Essentially, each company pays tax on the difference between the materials it buys and the product it sells — the value it adds to the product.

    The virtue of a VAT, from a tax collector’s perspective, is that it’s harder to evade than an income tax or a traditional sales tax. That’s because businesses have a stake in keeping one another honest.

    Say a retail store buys a computer from a manufacturer for $600 and sells it for $1,000. If the VAT rate is 10 percent, the retailer owes the government $100 (10 percent of the sale price). But the retailer gets a credit invoice, documenting the $60 in tax the manufacturer has already paid. The retailer is only on the hook for $40.

    “It creates a self-enforcement mechanism,” says Lillian Mills, chair of the Department of Accounting at the McCombs School of Business. “If I’m a retailer, I want the credit from the supplier, so I buy from someone who’s remitting the tax.”

    For people other than tax collectors, a VAT might have some downsides, warns Peroni. For one thing, it would compete with existing sales taxes. “We have state sales taxes, which most foreign countries don’t,” he says. “State and local governments fear there would be pressure to lower or get rid of their sales taxes.”

    More obvious, he says, would be the shock to consumer prices. “People would see it right away. Suddenly everything in a restaurant would cost 10 percent more.”

    To fully replace the federal income tax, he adds, might require a VAT as high as 35 percent. A more palatable course might be to trade off a modest VAT for lower income tax rates and eliminate many high-dollar deductions.

    If you believe that taxes should be tilted toward those who can most afford to pay them, Peroni suggests using a VAT to replace Social Security and Medicare taxes. Such payroll taxes take their biggest bites out of low-income workers, who pay higher percentages of their incomes, whereas a VAT would spread the pain over all income levels.

    Creeping Up
    Not every finance expert is bullish on a national consumption tax. It might sound appealing to accept a small VAT in exchange for lower income tax rates, says Jim Nolen, a distinguished senior lecturer in finance who recently retired from McCombs. But small taxes tend not to stay small. “Once you give them the ability to tax something,” he says, “next year it goes up 1 percent, then the next year another.”

    That’s been the experience in Europe. Germany, which started with a VAT of 10 percent, now charges 19 percent. In the United Kingdom, it’s risen from 8 percent to 20 percent.

    The other danger, says Nolen, is that citizens pay less attention to taxes when they pay them a little bit at a time. “When it’s one tax, people complain a lot, but when you take it from multiple sources people don’t notice it as much. I’m afraid we’re going to leave the income tax in place and put a value-added tax on top of it.”

    Mills acknowledges the danger that a new tax could fuel higher government spending. “The political concern, if we create a value-added tax, is that it’s very difficult to maintain fiscal discipline when you have a new source of revenues.”

    Nonetheless, she says, Uncle Sam might have no better choice. “I look at Social Security and Medicare. Those two programs put a lot of pressure on our tax system. Without bigger increases in the retirement age, we will need new sources of tax revenue. It’s likely that at some point we will have a value-added tax or an excise tax.”

    Mentioned in this Article

    Jim Nolen
    Distinguished Senior Lecturer (retired), Department of Finance, McCombs School of Business, The University of Texas at Austin
    Lillian Mills
    Chair and Professor, Department of Accounting, McCombs School of Business, The University of Texas at Austin
    Robert J. Peroni
    The Fondren Foundation Centennial Chair for Faculty Excellence, School of Law, The University of Texas at Austin

    About the Author

    Steve Brooks
    In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award for best business story of the year. After working as a staff writer for The Times-Picayune, he moved to Austin in 1991, where he has freelanced for magazines like Fortune and BusinessWeek and newspapers like the Dallas Morning News and the Austin Business Journal.
    • Quote 2
      Jim Reese said on June 30, 2012 at 6:43 p.m.
      The value added tax (VAT) is just another hidden tax. In other words, it is hidden in the price of the item bought. The Fair Tax already has been introduced in the House (H.R.#25) and the Senate (S.#13). It has about 80 co-sponsors....and it eliminates the threat of having both the income tax and the sales tax. The legislation requires the repeal of the 16th amendment which authorizes the income tax. It is unfortunate that your article did not address the fair tax issue...fairly. Surely jobs could come flooding back into this country if we had no income tax...the recession would be a memory.
    • Quote 2
      Morris Woods said on June 28, 2012 at 11:50 a.m.
      I am rather disappointed that the cost of collection was not addressed. I too wish you would have discussed the fairtax. While implementation would be difficult and complex, the results would be superior judged by the cost of collection. The IRS which is neither efficient nor effective could be eliminated. The only advantage to the Vat tax is that by conforming to what our trading partners use could be easier to not be discriminated against, but having the largest consumer market in the world could be achieved by leadership.
    • Quote 2
      Tgriff said on June 28, 2012 at 11:12 a.m.
      Many are aware of the FairTax plan, but don't want to abide by it as it replaces Social Security and the current income tax. The unspoken objective is to add a consumption on top of the current setup. A truly fair consumption tax would be a great thing - and this is why they won't implement it: because it would remove the loopholes. Just think: A consumption tax that everybody would pay - even prostitutes, drug dealers and congressmen. A favorite critisizm is that it would tax the poor, too. My response is that there are many programs out there to subsidize (er: help) the poor already. Surely one of the existing handout systems could be used for this purpose. When considering any such system, one must insist that it do away with other taxes - including property taxes, which transforms ownership into long-term leasing.
    • Quote 2
      Kati Barry said on June 28, 2012 at 11:04 a.m.
      I am very disappointed that the article did not discuss the Fair Tax. Millions of dollars of research have been spent to determine what the fairest, revenue neutral tax system would look like if we could start from scratch. The Fair Tax answers a lot of the concerns raised by the authors and would make our government's collection of revenue much more transparent. On a side note - the Fair Tax was based - at least in part - off the Texas State revenue system.
    • Quote 2
      Jim said on June 28, 2012 at 12:56 a.m.
      I too am disappointed that your artical did not focus more on THE FAIR TAX. It is a concept that has had years of study, millon dollars of research, and is proven to work and would REPLACE the income tax, not add to it. The FAIR TAX also has a provision that will keep low income folks from paying any tax.
    • Quote 2
      Wayne said on June 26, 2012 at 6:09 p.m.
      Regardless of political leaning it is extremely easy to reason US Government spending is out of control. Rather than more taxes how about reigning in Washington and the unsustainable promises they make to constituents to be elected over and over? Of course that would require American voters to turn off the idiot box and tune in to who they are voting for (like that will happen). Without facts to back my view I anticipate most individuals (no matter their educational level) asked about simple government procedures and responsibilities would be clueless. Here’s a simple question; the Constitution provides for three branches of government each branch having no greater power than the other, name the three branches. But when ask about a Kardashian or Hilton who is famous for nothing they’ll know all. Now ponder that one for a while. Our Founding Fathers knew these things when they produced that brilliant document called the US Constitution. This great document does not begin “We the Government”, in grandeur big bold letters it shouts “We The People” and for good reason it was intended to limit government (try finding that these days). Coupled with the Declaration of Independence Americans had two amazing documents from which to govern. No the documents were not perfect but included a method to correct what the Founding Fathers could not perceive. However since most US educational institutes and particularly judicial academia no long teach the Constitution even under the pretense of constitutional law why would anyone expect anything different. Are the two greatest documents ever written in the history of mankind still relevant? No they might as well be stuffed in the kitchen catch-all drawer to be discarded at a later date. In my humble opinion “We The People” are the blame for where we sit not Washington. “We The People” allowed it happen because we want something for nothing. Here’s a question for the alert, a question I doubt most of Congress or even the POTUS would know; must the Speaker of the House be a member of the HOR or even congress in general?
    • Quote 2
      Chris Dolejs said on June 26, 2012 at 4:13 p.m.
      I am disappointed to see that nobody challenged the assumption that higher income taxes discourage or "penalize" work and savings--let alone the very notion that "higher income" is synonymous with "work and savings." Sales taxes are regressive taxes, and nickel-and-diming lower-income workers (a) penalizes poverty, (b) continues the trend of shifting the tax burden away from the very wealthy, and (c) discourages the very activity that makes an economy work (i.e., consumption). Corporate welfare, tax cuts for millionaires, and overkill defense spending also "put a lot of pressure on our tax system." Why are some people more inclined to "look at" Social Security and Medicare? In fact, why is this article even on the UT home page? I don't see any breakthrough findings or "What Starts Here Changes the World"-type information in this article at all. It's really more of a Wall Street Journal editorial than an announcement of an academic achievement.
    • Quote 2
      Mark Houtzager said on June 26, 2012 at 9:07 a.m.
      Nice article and summary of how VAT works, and the current thinking in the US. VAT is not just in Europe though - in fact, the US is the only major economy without a VAT (approx 135 countries have a VAT or something similar). I would expect that - like in some countries - a federal consumption tax would be pegged to specific federal expenditure, like medicare and social security. But is will only be acceptable if indeed the restaurant bill (or any bill) would not increase with the VAT rate, but that there are income tax incentives to cushion price increases. History and human nature dictate, however, that tax decreases are not always converted into lower consumer prices.
    • Quote 2
      Wayne Smith said on June 25, 2012 at 5:55 p.m.
      I am disappointed to see that the author completely ignores the well, documented plan called The Fair Tax. This is an inclusive retail sales tax, replacing all corporate and personal federal taxation. Http://www.fairtax.org
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