A Consumption Tax or an Income Tax?

[I was asked by a journalist about the issue of alternative means of taxation: income tax or consumption tax. Here is my answer.]

The tax shift is one of the great games of government. In the game, the government uses the prospect of lowering one tax in order to buy support for raising another. The proposal to move from an income tax to a consumption tax is a good example of the game.

The essential key to understanding the trick is to realize that the government wants money and is going to get it one way or another. Zig zagging from one method to another does not change the reality. But it can fool the gullible. And it can raise a lot of money from affected groups during the transition period.

One helpful way to understand this is to think of a robber who promises to stop coming through your front door if you promise to leave the back door open. So it is with the state that promises to stop taxing your income if you let it tax your consumption. The issue is not the method; it is the amount.

The case for the consumption over the income tax rests on these essential claims:

1. The consumption tax is at least voluntary. Actually, it is just as coercive as any tax. Under the income tax, if I earn income and don’t pay the tax, I can be fined and jailed. Under the consumption tax, if I consume a taxed item and don’t pay the tax, I get fined and jailed.

It’s true that I can choose not to consume that item. Similarly under the income tax, I can choose not to earn income. Nothing is voluntary if I am not permitted to exempt myself. There is no such thing as a voluntary tax. If there were, it would be called something else.

2. The consumption tax doesn’t tax production. Yes it does. Businesses don’t set their own prices, which is why they cannot simply pass on the consumption tax to the consumer. If they could raise their prices without affecting their profits, they would have already done so. Imposing a new tax new on a business, all other things being equal, the business will have to absorb the cost of that consumer tax into its own operations. In this way, the consumption tax is a tax on production, wages, research, investment, and every other aspect of economic life.

3. The consumption tax is easier to collect. Assuming this to be true, why is this necessarily a good thing? A tax that is hard to collect suggests that it less tempting to raise. What’s more, a consumption tax might be easy to collect at 1%. But to replace the federal tax with a national consumption tax would require a tax approaching 20%. This would throw markets into chaos, create an overnight black market in everything, and give a great excuse for massive despotism and mandatory record keeping.

4. The consumption tax doesn’t tax savings. Generally this is true. But the government should not be in the business of prodding us into a particular pattern of saving and consumption. It should leave that up to us. Saving is great to the extent it reflects individual preferences. Consumption is great in the same way. But there is no way to know a priori what the right mix should be. And think of this: the degree to which the consumption tax discourages consumption is the same degree to which it does not raise revenue. How does the tax-hungry state deal with that paradox?

5. The consumption tax, whatever its problems, is at least not progressive. Far too much is made of the flat versus progressivity issue. Think of it this way. Would you rather pay a flat 40% tax, or finagle your way through a system with 20 different rates ranging from 1% to 39% (all else being equal)? If you knew that you would pay less under a progressive system, that is the one you would favor.

The champions of the consumption tax, particularly those who claim to support free markets, need to redirect their energies, away from the method of taxation to its level. They need to adopt the general principle that whatever the existing tax, it should be lower. Going back to the robber analogy, the ideal system would leave every door and window bolted down.

Let’s not reform taxes. Let’s eliminate them, starting with the income tax. That is not unrealistic. The income tax this year will yield $1 trillion for the federal government. Cutting that amount gives us a budget equal to the federal budget of 1987. Was the government intolerably small back then?

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