Chapter 16

Taxes on Consumption and Sales

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 Consumption as a Tax Base
 Consumption can be an alternative to income as
a measure of ability to pay.

 Comprehensive consumption:
Income-Savings

 Note that capital gains would not be taxed if it

were not spent.

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 An Expenditure Tax

 An expenditure tax would have the same

practical impact as an income tax.

 Taxpayers would add all sources of income

and deduct additions to savings accounts.

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 Comparing a Tax on Income to a Tax on
Consumption
Assumptions:
 Two equally situated 18 year olds with no physical capital
 Wages = $30,000 per year
 Interest rates = 10%
 Flat rate tax for either consumption or income of 20%.
 Two earning periods.

They have equal ability to pay taxes over their lifetime so they
should pay equal taxes over their lifetime.

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 Comparing a Tax on Income to a Tax on
Consumption
Step 1 An Income Tax
 IA = IB = $30,000
 SA = 0
 SB = $5,000

 TA = $6,000 + $6,000/(1+.1)
= $6,000 + $5,455 = $11,455
 TB = $6,000 + $6,100/(1+.1)/(1+.1)
= $6,000 + $5,545 = $11,545
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 Comparing a Tax on Income to a Tax on
Consumption
Step 2 A Consumption Tax for the Non-Saver
Income = Consumption + Consumption Tax +Savings

First and Second Year

 IA = CA + TA + SA
 $30,000 = CA + .2CA + 0
 CA = $25,000
 TA = $5,000
 SA = 0

Present Value of All Taxes

 TA = $5,000 + $5,000/(1+.1)
= $5,000 + $4,545.45 = $9,545.45

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Comparing a Tax on Income to a Tax on
Consumption
Step 2 A Consumption Tax for the Saver
First Year Second Year
IB = CB + TB + SB IB + Proceeds from Saving

$30,000 = CB +.2CB + $5,000 = CB + TB

CA = $20,583.33 $35,500 = CB + .2CB

TA = $4,166.66 CA = $29,583.33

SA = $5,000 TA = $5,916.67

Present Value of All Taxes
TB = $4,166.66 + $5,916.67/(1+.1)
= $4,166.66 + $5,378.79 = $9,545.45 7
Comparing a Tax on Income to a Tax on
Consumption

 Under an Income tax, savers pay more in

tax than non-savers.

 Under a consumption tax, they pay the

same present value of taxes.

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A Comprehensive Consumption Tax Base

 Inflation is no longer a concern with capital

gains.

 Taxing Durables becomes a problem as

this would add substantially to the price of
a car or home.

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 A Cash-Flow Tax

 A Cash-Flow Tax would operate like the

current income tax, except that the amount
placed in qualified accounts would be
deductible. Assets that increased in value
would not be taxed unless cash was
removed from the accounts.

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 Substituting a Consumption Tax for an
Income Tax
To be revenue neutral Tax Revenue = tiI = tcC
Where
 ti = income tax rate

 tc =consumption tax rate

 I = income
 C =consumption
If people save 20% of income then tiI = tc(.8)I which means that
1.25ti = tc. That is, when people are saving, in order to be revenue
neutral, the tax rate on consumption must be higher than the tax
rate on income.
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Figure 16.1 Substituting a Comprehensive Consumption
Tax for a Comprehensive Income Tax: Investment Market
Effects
S

G Gain in Efficiency
rG*
r* E
Yield (Percent)

rN F

D
Net Return under
∆ Q1 the Income Tax

0 Investment per Year 12

Impact of a Sales Tax on the Efficiency
in Labor Markets
 A substitution of a consumption tax for an
income tax (with equal yields) would require a
higher tax rate because of savings.

 The net efficiency change depends on whether the

gain in the investment market is greater than the
loss in the labor market.

 Estimates suggest such a change would have a

positive impact on GDP.
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Figure 16.2 Substituting an Equal Yield Comprehensive
Consumption Tax an Income Tax: Labor Market Effects

SL
WG2 A'
WG1 A
WO B
Wages

WN1 C
WN2
C'

D = WG
WG(1– t1)
WG(1– tC)
0 L3 L2 L1 Labor Hours per Year
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 A Sales Tax

 A retail sales tax is typically a fixed percentage

on the dollar value of retail purchases.

 Sales taxes are a major source of tax revenue for

state and local governments. Some state rates are
as high as 7% with local governments adding an
additional 3% on top of that.

 Often food and medicine are exempt.

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 An Excise Tax

 An excise tax is a selective tax on

particular goods.

 In the United States excise taxes exist on

car tires, long-distance telephone service,
airline tickets, gasoline, and many other
goods.

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The Incidence of Sales and Excise Taxes
 Generally, sales taxes are regressive when
food and medicine are not
exempt.

 A national sales tax would be borne by labor

income and would lack the progressive rate
structure of the personal income tax.

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 Turnover Taxes
 Turnover taxes are multistage taxes levied at
some fixed rate on transactions at all levels of
production.

 The effective rate of tax depends on the number

of times the good is sold during the production
process.

 This creates a significant bias toward vertical

integration (where all production stays within the
same firm).
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 A Value-Added Tax
A value-added tax (VAT) is a consumption-based tax levied at each stage of
production.

Value Added = Total Transactions – Intermediate

Transactions
= Final Sales
= GDP
= Wages + Interest + profits + Rents + Depreciation

Tax Liability = Tax on Payable Sales – Tax Paid on

Intermediate Purchases
= t(sales) – t(purchases)
= t(sales – purchases)
= t(value added)

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 Implications of a VAT
A complete substitution of all income and
payroll taxes for a VAT would

 keep compliance costs high,

 encourage saving, and
 encourage barter and other
evasion/avoidance.

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 The VAT in Europe
 The VAT accounts for about 20% of EU member nation revenue.

 The average rates within the EU are between 15 and 20%.

 Different rates apply to different types of goods, with luxury items

facing the highest rate and necessities facing the lowest.

 The tax applies to services as well as goods (unlike most sales taxes in
the U.S.).

 Economists find the VAT a good alternative to an income tax because

it does less to discourage savings and investment.

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Sales Taxes with Mail Order and the Internet
 A 1967 Supreme Court case declared it unconstitutional for a state to
insist on sales tax collections for sales to residents of other states (when
there is no outlet for the good in the customer’s state).
 This is because of the destination principle, which states that a
consumption tax should be imposed on the consumer wherever
consumption takes place; the state in which the purchase occurred would
have no way to determine where consumption takes place.
 Some states have imposed use taxes (at the same rate as their own sales
taxes) on the customer because local retailers claim they are at a
disadvantage relative to mail order.
 There has been a general moratorium on new taxes for sales over the
internet. This does not apply to businesses that have local counterparts
(like Dell and Gateway) but to internet only retailers.
 The moratorium is less important than it might seem, because a large
volume of internet sales are business to business, which is not taxed
anyway.

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