1. Chapter 9: Consumption Taxes 9 - 1 Chapter 9 Consumption Taxes Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Chapter 9: Consumption Taxes 9 - 2 A household consumption tax The flat tax and the X-tax A retail sales tax compared to a value-added tax Replacing the income tax with a consumption tax A consumption tax vs. a labor income tax Which tax is fairest? Pollution, transportation, and health taxes Introduction

3. Chapter 9: Consumption Taxes 9 - 3 A consumption tax is a percentage tax that imposes a burden on a household according to their consumption. A percentage tax on the sale of consumer goods Tends to be regressive with respect to income Consumption Taxes A retail sales tax (RST) IncomeConsumption TaxSavingTax/Income $20,000$16,000$4,000$020% $100,000$60,000$15,000$25,00015% Table 9.1: Burdens from a 25% Retail Sales Tax

4. Chapter 9: Consumption Taxes 9 - 4 A value-added tax is a percentage tax on the value that is added at each stage of production. A Value-Added Tax (VAT) A Consumption Good (Bread) PurchasesSalesValue-addedVAT Farmer$0$30 $3 Miller$30$70$40$4 Baker$70$100$30$3 TOTAL$100$200$100$10 Table 9.2: A 10% VAT

5. Chapter 9: Consumption Taxes 9 - 5 Subtraction method A Value-Added Tax (VAT) Credit-invoice method T = t(S – P) Miller $4 = 0.1($70 – $30) T = tS – tP Miller $4 = 0.1($70) – 0.1($30) A VAT is equivalent to a RST RST is a consumption tax VAT is a consumption tax A consumer bears a burden from either according to her consumption spending Comparing a VAT to a RST

6. Chapter 9: Consumption Taxes 9 - 6 Exemptions under a RST or a VAT Fairness and the fact that consumption taxes are regressive are arguments for exemptions Efficiency, administrative costs, and appropriate targeting of the exemptions are arguments against exemptions To reduce regressivity, a rebate could be issued A Household Rebate with a RST or a VAT

7. Chapter 9: Consumption Taxes 9 - 7 The Flat Tax and the X-Tax To reduce the regressivity of the VAT is to modify it to become a flat tax or the X-tax. A portion of wage income is not taxed (exemption) Same as flat tax except… Flat Tax X–Tax The graduated rates are progressive with respect to labor (not capital) income Wages above the exemption are taxed at a single rate

8. Chapter 9: Consumption Taxes 9 - 8 A Household Consumption Tax All savings would be tax deductible in the year it occurs Revenue neutral History of a household consumption tax Computing household consumption A progressive consumption tax on very high consumption Could be progressive Practical problems Do not replace the income tax, add a progressive consumption tax on very high consumption as a supplement

9. Chapter 9: Consumption Taxes 9 - 9 Replacing the Income Tax with a Consumption Tax Table 9.3: The Impact on Saving 10% Income TaxIncomeTaxConsumptionSaving Person C$100,000$10,000$90,000$0 Person S$100,000$10,000$0$90,000 TOTAL$200,000$20,000$90,000 25% Consumption TaxIncomeTaxConsumptionSaving Person C$100,000$20,000$80,000$0 Person S$100,000$0 $100,000 TOTAL$200,000$20,000$80,000$100,000 33% Consumption TaxIncomeTaxConsumptionSaving Person C$100,000$20,000$60,000$20,000 Person S$100,000$0 $100,000 TOTAL$200,000$20,000$60,000$120,000

10. Chapter 9: Consumption Taxes 9 - 10 The horizontal redistribution effect The postponement effect VAT and RST are regressive Impact on saving Replacing the Income Tax with a Consumption Tax Impact on the distribution of the tax burden The incentive effect

11. Chapter 9: Consumption Taxes 9 - 11 Replacing the Income Tax with a Consumption Tax Impact on efficiency loss Reduces efficiency loss in the choice between saving and consuming May increase the efficiency loss in the choice between work and leisure D $20 $16 20,000 P S L (Annual Hours) Figure 7.9 (MRPL) 22,000 A B D

12. Chapter 9: Consumption Taxes 9 - 12 Impact on the Distribution of the Tax Burden Table 9.4 and Table 9.5 Average IncomeShare of Income Income CategoryPre-taxAfter TaxPre-taxAfter Tax Lowest Quintile$15,900$15,3004.0%4.8% Second Quintile$37,400$33,7008.5%9.6% Middle Quintile$58,500$50,20013.3%14.4% Fourth Quintile$85,200$70,30019.8%20.6% Highest Quintile$231,300$172,20055.1%51.6% All Quintiles$84,800$67,400100% Top 10%$339,100$246,30040.9%37.4% Top 5%$520,200$369,80031.1%27.8% Top 1%$1,558,500$1,071,50018.1%15.6%

13. Chapter 9: Consumption Taxes 9 - 13 Neither reduce the reward for saving A Consumption Tax vs. a Labor Income Tax Initial Deposit Interest Earned Taxes Paid on Withdrawal Retirement Consumption Y Tax (Saving)$850$34$5.10$878.90 C Tax (Regular IRA)$1000$40$156.00$884.00 W Tax (Roth IRA)$850$34$0.00$884.00 Table 9.6 Similarities Differences Fairness Capital accumulation

14. Chapter 9: Consumption Taxes 9 - 14 Regressivity Which Tax is Fairest? Tax what you take vs. tax what you make The ant and the grasshopper How should “ability-to-pay” be measured? Is this fair? Wage Summer Consump. TaxSavingInterest Winter Consump. Tax PV of Taxes Grasshopper$1000$800$200$0 $200 Ant$1000$400$100$500$250$600$150$200 Table 9.7

15. Chapter 9: Consumption Taxes 9 - 15 Pollution Taxes Polluters will find it profitable to reduce pollution if: TAX < CBO estimates a tax of $100 per ton of carbon would reduce carbon by about 15% A carbon tax would also increase federal tax revenue MARGINAL ABATEMENT COST

16. Chapter 9: Consumption Taxes 9 - 16 Transportation Taxes User fees (tolls) should be used to finance roads Tolls are sometimes unfeasible or costly Instead of a toll, a gasoline tax is used A gasoline tax is inferior to a toll The toll should be equal to the wear and tear and congestion each vehicle causes

17. Chapter 9: Consumption Taxes 9 - 17 Externality argument Careful quantitative analysis is required to measure net costs to others Estimating the optimal taxation Health Taxes Internality argument The excessive use of an unhealthful product may impose costs on himself that he underestimates The excessive use of an unhealthful product may impose a cost on others

18. Chapter 9: Consumption Taxes 9 - 18 Summary A household consumption tax The flat tax and the X-tax A retail sales tax compared to a value-added tax Replacing the income tax with a consumption tax A consumption tax vs. a labor income tax Which tax is fairest? Pollution, transportation, and health taxes

19. Chapter 9: Consumption Taxes 9 - 19 Preview of Chapter 10: Optimal Federalism when household incomes are similar Optimal Federalism when household incomes differ The property tax Grants from a higher government to lower governments State and Local Public Finance