Should the income tax be replaced with a progressive consumption tax?

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Conservatives love to complain about the income tax. They say that taxing income undermines incentives and suppresses innovation and economic growth. Why should you work hard if the government is just going to take away a substantial portion of your hard-earned income? 

Instead, some propose the so-called “Fair Tax” which replaces all personal federal taxes with a national sales tax. To raise comparable revenue such a tax would need to be about 30 percent of the pre-tax price. Such a tax would be very regressive. In other words, it would take a much higher percentage of income from low income people than from high income people. Such a tax would be certain to draw the ire of the working class and middle class and be a nonstarter politically. So forget about the “Fair Tax” which imposes tax on purchases directly.

But what about a progressive consumption tax?  This tax would allow all earned income to be nontaxable as long as it went directly into savings and stayed in savings. It would be essentially an unlimited traditional individual retirement account (IRA). In other words, you could put your earned income directly into a savings account, buy certificates of deposit or stocks and bonds without paying income tax.  However, any withdrawal of money from any of these forms of savings would be progressively taxed annually at rates higher than the current income tax rates. Basically, as under the current income tax, you could probably cover a modest monthly rent and essential food expenditures while paying little or no tax. However, a high flying life style of buying exclusive properties, frequently eating out at the most expensive restaurants, and traveling around the world on costly vacations would cost you an arm and a leg in tax payments, because it would require withdrawing a lot of money from your savings. 

In theory there could be some real advantages to a progressive consumption tax. First, it would not undermine work incentives as much as the income tax, at least not directly. It would encourage frugality. You could earn a lot of money and not pay a penny in tax as long as you saved most of it. Since wealthy people have more money than necessary to meet basic needs, they often purchase items that do not involve producing more goods, such as in buying exclusive real estate or rare artifacts such as famous paintings. Their motivation is more in displaying their relative wealth and in accumulating more wealth than other wealthy people. A consistently and evenly applied progressive consumption tax would reduce absolute wealth but not relative wealth so their incentives would not be undermined by a progressive consumption tax. A progressive consumption tax would not bump anyone from their position on the Forbes list of wealthiest people unless they consumed relatively more than their peers. 

Second, a progressive consumption tax would encourage savings. Certainly, getting people to save more would help reduce the severity of recessions. Instead of cutting back dramatically on expenditures with a reduction in overtime pay, a reduction in work hours generally, or a temporary layoff, people could draw on their savings to maintain their basic expenditures when the economy slowed.  Moreover, with more money saved, they would have a more secure retirement. Overall, this would certainly serve as an automatic stabilizer and keep the economy from experiencing deep recessions.  

All this sounds good. If a progressive consumption tax was applied in the decades after World War II when interest rates on savings were higher and consumer demand was very strong relative to aggregate supply, it might have worked, although higher estate and inheritance taxes might have had to be added to maintain adequate revenues.

But there are some serious difficulties with implementing a progressive consumption tax during the current period. In recent decades our money flow has become so distorted that huge amounts of money are being diverted to the financial markets as the wealthy get ever wealthier. In the face of weak consumer demand, most of this money is not going into real investments in our economy, but is instead used to increase dividends and stock buy-backs. So little money is being retained by consumers that they can no longer afford to buy back the value of the goods and services they are producing. The government has had to step in with deficit spending to make up the difference. Stock and bond prices have been driven up, while interest rates have fallen so low that it is hardly worth bothering with a savings account. Under current rates, even a modest level of inflation could significantly reduce the real value of your savings over time. 

What this all boils down to is that to create and maintain a healthy economy, we need to eliminate the tax loopholes and distortions that enable wealthy individuals and corporations from shifting the burden of taxation onto the middle class and pouring huge amounts of money into the financial markets. Instead we need to direct money to working class and middle class people who will actually spend that money on the goods and services they are producing. Higher tax revenues from either a progressive income or consumption tax would enable us to cut back and ultimately eliminate the federal deficit spending. With less money in financial markets, interest rates would rise, which, along with a progressive consumption tax, would encourage people to save more money, which in turn would strengthen our automatic stabilizers in keeping our economy healthy.  

Please add your insights and comments on the potential advantages and disadvantages of the progressive consumption tax below in the comment box.

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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame
and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone. You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh  
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