Economic Food for Thought

I recently read an article proposing a “progressive consumption tax.” It made me look at economics and taxation from a totally different viewpoint. On the surface the ideas have merit, but I am a little concerned about the possible unforeseen consequences.

The author, Professor Frank, suggests that the Feds tax consumption rather than the income. You report your total income, the amount you saved, and the amount you spent. Both the amount saved and a pre-determined portion of the amount you spent are not taxed. The “excess” spending is taxed at a progressive rate. To me, it seems a lot more fair than the "fair tax."

The populist side of me has always sought a way to tax the super-wealthy. The article reminded me of Thorstein Veblen’s writings about “conspicuous consumption.” And it occurred to me that if we really want to “soak the rich,” we should find a way that does not penalize earning, but instead punishes wasteful consumption and enables and encourages spending of money on things for the common good. Theoretically, government revenue increases. With this approach, the economy is not driven by an "invisible hand," but by a very visible government.

The article does bother me a little because I believe that the purpose of taxation is to fund government operations, not to control human behavior.

I am including a link to the article. It is fun to see the (almost fanatic) comments it drew from the (somewhat conservative) Cornell alumni.

http://cornellalumnimagazine.com/index.php?option=com_content&task=view&id=483

If you are too dogmatic a conservative to read this with an open mind, please don't append knee-jerk tyrades in your comment. I am looking for calm analytic discussion of the merits and potential dangers of the concept.

The "Fair Tax" is NOT Fair

I will be the first to admit that I have not read a detailed proposal for the so-called "Fair Tax." I understand that the concept is to replace the Federal Income Tax with a Federal Consumption (or sales) Tax.

Its proponents may call it a Consumption Tax, if they wish, but I can think of two reasons that it should not be called a "Fair Tax."

• First, a personal one -- a significant portion of my income comprises my contributions to company pension, on which I have already paid Federal Income taxes. That income is reported, but not taxed a second time. If a consumption tax were implemented, I would be paying consumption tax on money that was already subjected to the income tax.
• Second, it appears to me that a consumption tax unfairly benefits high wage earners over lower wage earners.

To illustrate the second point look at two simple examples: one a laborer who earns $50,000 per year; the second an executive who earns $5,000,000 per year.

• The laborer now pays 15% of his earnings ($7,500) in income taxes. If he is frugal, he saves about 10% of the after tax money and spends the rest, $38,500 to live on. Under the so-called "Fair Tax," the laborer will still put $4,250 into savings. He will spend the remaining on goods taxed at a 23% rate ($37,195 in goods and services, $8,555 in federal tax). That means his tax bill has gone up from $7,500 to $8,555)
• The executive now pays about 24% of his earnings ($1,200,000) in Federal income tax, invests about $2,800,000 in savings, and spends the last 1,000,000 to live on. Under the so-called "Fair Tax," the executive will still live on 1,000,000 worth of goods and services, on which he will pay $230,000 in Federal Consumption tax, and he will invest the remaining $3,770,000 in savings, which will earn him even more money next year. His taxes decrease by $970,000. [Now, you rich guys can explain to me that you just can't get by on a measely $1,000,000 per year. But even if you significantly change the spending to investment ratio, the taxes still go down. Moreover, the laborer does not have the latitude to make that kind of adjustment.]

So the Consumption Tax is NOT a fair tax! It benefits the wealthy at the expense of the poor. Most tax laws are written this way because they are written by wealthy people. Then they present the tax in such a way that it appears to be "fair."

Most people will agree that any tax on a person who earns less than "the poverty level" is not really fair. Many will agree that at some point one's earnings are such that he can live comfortably, build his savings, and still have a LOT of money "left over." Just ask Bill Gates or Warren Buffet.

A flat tax on income, or a somewhat progressive variant thereof, is probably the only way to approach fairness in taxation. The variation I suggest is a tax on ALL personal income (regardless of source, no deductions, no adjustments, no credits) -- approximately the first $33,000 of income to be tax-free; from $33,001 to $200,000 of income to be taxed at 12%, and from $200,000 up be taxed at 25%. The break points should be adjusted annualy for inflation. The actual rates can be calculated to make sure that the structural change is "revenue neutral."

A few notes: (1) I said personal income. Taxes on corporations are never paid by the corporations; they are passed on to the consumers in the form of higher prices. (2) The highest rate of 25% may seem low to some ultra-liberals, but remember it applies to ALL income (i.e. no more 15% rate for capital gains). (3) ALL income may be hard to determine, because some people receive many types of income and do not report portions of it that are not salary, wages, or interest. (4) The consumption tax is even more cruel to the poorest of wage earners who now pay no income tax. Suddenly, they will see their buying power decrease by 23%.

I know this is all overly-simplified. The discussion is meant to be conceptual, as opposed to specific. But one of the keys to solving the tax problem is to simplify it. One important concept is that taxation should be used to fund the operations of government, not to control people's behavior. A typical governmental abuse of "consumption" taxes is to increase the consumption tax on "undesirable" products and services. A tax that is simply based on total personal income avoids that kind of abuse.