Progressive Consumption Taxation Alan D. Viard, January 18,

Gains from consumption taxation Removes income tax’s saving disincentive, though not its work disincentive Ensures neutral treatment of different types of capital income, which is difficult to achieve under income tax Simpler than income tax, because changes in wealth need not be measured 2

Consumption tax options Completely replacing income tax with sales tax/VAT is undesirable – deeply regressive, monetary policy dilemma (large price rise or large nominal wage cuts) Two other options are more promising – partially replace income tax with VAT, completely replace income tax with progressive consumption tax 3

Partial VAT replacement Smaller efficiency and growth gains than full replacement, slight simplicity gains Monetary policy dilemma, though less severe than with full sales tax/VAT replacement Possible spur to government spending Imperfect solution, but may well be adopted in long run 4

Progressive consumption tax Full simplicity and efficiency gains No regressivity problem No monetary policy dilemma, because wages taxed at household rather than firm level Requires unfamiliar tax (Bradford X tax or personal expenditure tax) – faces political obstacles 5

Bradford X tax Splits consumption into two components, wages and business cash flow Households taxed on wages, above exemption, at graduated rates – refundable tax credits Businesses taxed on cash flow at flat rate equal to rate on highest-paid workers – investment expensed, interest payments and other financial flows ignored 6

Personal expenditure tax Households file returns on which they compute consumer spending as income minus net saving Taxed on consumer spending, above exemption, at graduated rates – refundable tax credits More refined approach to progressivity than X tax – requires more household information 7

Challenges confronting X tax Optical problems – Buffett/Romney problem, doesn’t look like consumption tax Distinguishing wages from cash flow at closely held firms, treatment of firms with negative cash flows Financial intermediation, international trade Transition 8

Challenges confronting PET Optical problems – tax on borrowing, lack of business tax Taxation of homes and consumer durables Transition Hybrid option of PET and business cash flow tax should be considered 9