TCS Daily

Consumption Junction, What's Your Function?

By Tim Worstall - August 3, 2004 12:00 AM

We all know we shouldn't believe everything we read at The Drudge Report so the news that Republicans plan to abolish the IRS and the income tax should be taken with a pinch, perhaps a shovel-load, of salt.

As a vote winner the idea has its attractions, for who would not feel a visceral surge of joy at the realization that those who have been, for the past century, garnisheeing every paycheck in America will now be in need of that hand-up not a hand-out that the welfare system has now become? Yet within that very thought there is contained the problem. Government will still exist (no, that's not the problem) and will still have to raise money to function. The problem will be with what is the income tax replaced?

Dennis Hastert is quoted as being all over the place, that the replacement could be a sales tax, a value added tax (VAT), a consumption tax, well, something. It might be a good idea to actually work out how the Feds are going to get the money they need (if only for National Defense for the more libertarian amongst us) so that, when called upon to explain the idea, we can actually have an answer.

Sales taxes and VATs suffer from one huge problem in that they are regressive, and as such weigh more heavily upon the poorer sections of society. Even though I have a certain sympathy with the view that the poor are as protected by the military as the rich I don't think that this particular idea will fly.

And when countries have differential rates of such taxes then problems seem to multiply further. It took some years of campaigning for women's sanitary products to be moved from the fully taxed to zero rated categories in the UK recently, just as a trivial example. That this might be a more productive use of their time for the National Organization of Women than what they do now is just me being bitchy, or as I prefer to regard it, fully in touch with my feminine side. There was also one case that took a decade to sort out, whether something called a Jaffa Cake (one of those ineffable contributions of the English to world cuisine) was in fact a half chocolate covered biscuit (and thus a luxury food taxed at 17.5%) or a half chocolate covered cake (taxed at zero%) with the final decision (apologies, after the first five years I stopped following the case so I cannot remember the verdict) coming from the Court of Appeal, one step below the UK version of the Supreme Court. Again, this might give lawyers something more useful to do than the damage they are currently inflicting with the tort law but it still is not an attractive basis for a taxation system.

The one alternative that has some legs is the consumption tax. This would be collected in much the same way as the current income tax, with payroll deductions, annual filings and all the rest. So, unfortunately, not the death of the IRS. The major difference is that a consumption tax falls on what you spend, not upon what you earn. All savings and all gains on savings which themselves remain as savings are exempt from taxation. So a consumption tax does away with capital gains tax, dividend taxation, estate confiscations...well, you get the picture, the rational economist's wet dream of a system and getting close to Steve Forbes' postcard sized tax return.

Very simply, at the end of the year you have to report three numbers. Your savings at the beginning of the year, your income during it and your savings at the end of it. That portion of your income which you have saved is deducted and the net figure is what you pay the consumption tax on. Similarly, any reduction in your savings (not from market movements, only what you have cashed in and spent) is added to your income and that is the adjusted figure upon which you pay the consumption tax.

This may all seem very like simply making all savings tax sheltered and there are indeed similarities. Yet the huge benefit of the consumption tax is that the very rich will end up paying a great deal more tax than they do now. The people this form of taxation hits the worst are those with the odd few hundred million tucked away in family trusts, family charities, foundations and the like. Presently the money grows tax free, is used to buy houses and boats and such tax free, only that miniscule portion that is actually paid over to the beneficiaries as actual cash gets taxed. Under a consumption tax all of those other benefits get counted as spending from savings and so get taxed at the same rate as income. Another way to put the same point is that we all get the same protection for our savings as the trustafarians and they have to pay tax on their spending just like the rest of us.

So the people who would do worst under this system of taxation, a consumption tax, would be Mrs. Kerry (I) and (II), Senator Ted Kennedy (just how much of old Joe's money did the Feds get in the end?), a Sulzberger or two, the Ford family, the younger Hewletts and Packards, um, sorry, which political party was it that you said these people supported?

OK, OK, it was just Matt Drudge making a mountain out of a molehill of a throw-away line from an upcoming book by Dennis Hastert. I agree, it's not going to happen.

Yet there has to be something valid about a taxation concept that would make the entire Kennedy clan cry.


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