Friday, April 6, 2012

How I Would Overhaul the U.S. Tax Code - Part III: The Progressive Consumption Tax

Continued from Part II.

The Mechanics of a Progressive Consumption Tax

Let’s look at how a progressive consumption tax would actually differ from the federal income tax by looking at the prospective tax bills of two fictional American families of very different means. The Smiths, a middle class family of four, earn $50,233 annually. That puts them very near the median income of the U.S. Under the status quo federal income tax, their first $16,700 of earnings is taxed at a 10 percent rate and the rest is taxed at a 15 percent rate. This adds up to a total liability of about $6,700. Without going into too much detail, we can assume that a family at this income level probably does not itemize deductions but is very likely to be eligible for benefits such as the child tax credit so their actual tax bill will be lower. Let’s assume a final liability of around $4,500.

Now, let’s recalculate the Smiths’ tax liability under the progressive consumption tax. The Smiths would report $50,233 in income. If they saved around the 2010 average of 6.4 percent, they would report $3,214 in savings. Then they would get a standard deduction for basic consumer necessities based on their family size. For a family a four, it would be $25,000. By subtracting their savings and their standard deduction from their total income, their taxable consumption is derived: $22,019. Using the same marginal rates as the federal income tax, the first $16,700 of taxable consumption would be taxed at 10 percent while the rest would be taxed at 15 percent. Therefore their tax bill would come out to be approximately $2,500. Even if we assumed that the Smiths were able to reduce their tax bill considerably more under the current income tax because of the various deductions and credits available, they probably could not get a better deal than under the progressive consumption tax.

But how would the federal government deal with the shortfall of revenue through lessened liabilities on middle class families like the Smiths? For the answer, we turn to the Joneses. The Joneses, a wealthy family of four, earn $20 million every year and that puts them firmly in the top one percent income bracket. They are movie stars or corporate executives but in any case they earn an obscene amount of money. Under the status quo federal income tax, they would owe about $100,895 on their first $372,951 of income and an additional $6,869,467 on the rest of their income. Leaving aside the innumerable deductions and credits they could use to lower their bill, they have a total liability of about $7,000,000.

To recalculate their liability under the progressive consumption tax, we would subtract the standard deduction ($25,000) and their savings ($6,600,000 or roughly a third of their income) from their total income to get their taxable consumption: $13,375,000. For ordinary people, it’s hard to imagine spending that much money in a single year but the rich are able to do it. They remodel their mansions, buy sports cars, collect highly valued art, fly all over the world, and stay in ridiculously expensive hotels for extended periods of time. For this reason, calculating their tax liability under the progressive consumption tax will be a bit more complicated than it was for the Smiths.

Under an income tax, governments must be careful to avoid raising effective rates too high for doing so would discourage work and earning more income. However, because discouraging excessive consumption is part of the point of the progressive consumption tax, it is actually quite desirable from an economists’ perspective to have steeply graduated rates. For the purposes of this proposal, I will keep the same rates as the income tax on their first $137,300 of taxable consumption for married joint filers with progressively higher rates for each dollar of further consumption.

According to this possible rate schedule for the progressive consumption tax, the Jones would owe approximately $11,593,819. Even assuming that there will be some further deductions available with a progressive consumption tax, this is dramatically higher liability than they would have under a federal income tax. And this would help make up for the lower tax liabilities of the middle class. Of course, the Joneses are unlikely to pay that total because they would probably scale back their consumption in order to pay less to the IRS at the end of the year. Thus they would save and invest more, which will be better for the economy.

A Progressive Consumption Tax Limits Excessive Consumption

The wealthy individuals who have made most of the significant income gains in recent decades have spent much of their new riches on positional goods. The value of positional goods hinges largely on how they compare with comparable goods bought by others in the same social strata. Many analysts have concluded this trend has occurred because individual consumer demands hugely depend on the surrounding social environment. Therefore, when one CEO buys a private jet, another CEO is likely to buy a bigger private jet. A third CEO might buy an even larger private jet, and the first CEO will finally respond by purchasing a grandiose yacht.

While this scenario may seem comical, it amply demonstrates the absurd wastefulness of much positional spending. It also begins to illustrate the cascading effect of such consumption. Greater spending by the rich also moves the goal posts that frame what the near rich consider necessary or desirable, which compels them to spend more. Of course, this moves the goal posts for those just below the near rich, and so on, all the way down the income ladder.

While this phenomenon of trickle-down consumption may seem ridiculous, it has very real and very detrimental effects on quality of life, not to mention the environmental costs of endless inefficient resource use. To give an example, the frame of reference for consumption determines acceptable housing for different income groups. Of course, a middle class family could choose to spend less on housing and take more vacation time or take on less debt. But without a positional focus on a maximal housing purchase, that family sacrifices its access to a good school district, which dooms the children to a lesser education and more narrow opportunities later in life. Indeed, the negative effects of the struggle for better positional goods have been linked to everything from the significant expansion of commuter hours to the drop in the number of vacation days both of which have occurred as inequality has risen.

Fortunately, a sufficiently progressive consumption tax could curb spending on positional goods significantly. With a top marginal rate of ninety or one hundred percent, the purchase of extremely expensive items such as a yacht or a private jet would become that much more expensive and the likeliest outcome will be that the richest families will respond by scaling back their positional spending. This will allow near rich families to scale back and so on. Of course, conspicuous consumption would continue but its greatest excesses will be limited and the country would actually benefit in a number of ways. Limiting endless positional consumption would undoubtedly help preserve our natural environment and lower individual debt burdens while redirecting resources towards savings and investment or increased leisure time. The former would strengthen our economy in a sustainable way while the latter would improve quality of life.

Progressive Consumption Tax Cuts Effective in Staving Off Recessions

During recent debates over how to best stimulate the economy in a recessionary environment, conservatives argued for more tax cuts while others contended that standard tax cuts would not have the intended effect because many Americans – understandably fearful about losing their jobs – would just save their tax cut or use it to pay off debts rather than spend it leaving aggregate demand unaffected. But if a progressive consumption tax cut were in place, a temporary rate cut for such a tax would be highly beneficial in a recessionary climate. This is because in order to take advantage of the cut, individuals would have to spend more right away. In effect, the federal government could stymie a recession by the public policy equivalent of declaring a sale on all goods and services in the country. Such a tax cut would likely have support across partisan lines and that would mean speedy enactment, which is crucial to alleviate the worst effects of a recession.

A Note on Deductions, Exemptions and Credits

One of the major reasons to overhaul the U.S. tax code is to clean up the myriad deductions, exemptions and credits that now riddle the system. With that in mind, many of the deductions available under the federal income tax should not be available under the progressive consumption tax, although useful ones could be included.

It would likely be necessary and helpful to exempt some but hopefully not all charitable donations from taxable consumption. Employer-provided health insurance is an issue that best remains part of broader debate about the U.S. health care system, so this overhaul would not touch the status quo tax policy on health insurance. The mortgage interest deduction is popular but has little basis in sound economics and should be eliminated.

The child tax credit would essentially be replaced by a standardized deduction that would increase with family size. However, the Earned Income Tax Credit presents another issue. My preference would be to convert the EITC into something like a living wage supplement. Workers with low wages would simply receive a wage supplement roughly equivalent to the EITC. This would have the added benefit of removing the complexity of the EITC application process. All working low-income tax filers would receive the living wage supplement.

Continued in Part IV.

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