Tuesday, April 26, 2005


A law review article:
A New Understanding of Tax

University of Southern California - Law School; California Institute of Technology

Michigan Law Review, 2005

The traditional understanding of broad-based tax systems contrasts an income tax with all forms of a consumption tax. The income tax, alone, includes the yield to capital in its base; consumption taxes do not. Simple financial analysis demonstrates the equivalence of the two most common classes of consumption taxation - prepaid, or wage-based, and postpaid, or sales taxes - under certain assumptions, most importantly including constant tax and interest rates between the periods in the model. Advocates of redistributive taxes insist on both progressive rates and an income base, in large part to tax the yield to capital; opponents clamor for flat-rate consumption taxes, often invoking Mill's celebrated argument against the income tax's "double taxation" of savings to support their case.

Once progressivity is presumed, however - as its enduring popular appeal suggests it ought be - the traditional understanding is flawed. Asking a different timing question, "when, in a taxpayer's flow of funds, ought progressive taxes be imposed?," casts tax systems in a new light. The present tax system emerges as an onerous wage-based one. A progressive cash-flow consumption tax, in contrast, emerges as the best - most consistent and principled - tax on the yield to capital, under just the conditions in which it is fair and appropriate to tax such yield. This gives a further reason to support a progressive cash-flow consumption tax, sounding in reasons familiar to income tax supporters. A consistent, progressive cash-flow consumption tax will lower the burden of taxation when capital transactions (borrowing, saving, and investing) are used to smooth labor earnings within or between lifetimes (or taxpayers), and will increase the burden of taxation when capital transactions are used to enhance labor earnings within or between lifetimes (or taxpayers). Critical reflection based on a near century of experience reveals such a tax to give form to attractive normative ideals.

The new understanding helps to show that the traditional and most common arguments for consumption taxation are not compelling. The best, most appealing case for a consumption tax does not rest on "horizontal equity" models, nor on claims about the economic, consequentialist importance of savings on an individual or an aggregate social level. Rather it is claims of fairness, in a social contractarian sense in the manner of John Rawls and other liberal theorists, that argue for a properly designed consumption tax - in part precisely because of the way such a tax sometimes but not always burdens capital and its yield, and in greater part because such a tax points the way towards greater, more meaningful progressivity in tax.

The new understanding of tax yields important insights into pressingly practical matters of tax policy and design, and opens up an important window to critique contemporary trends in tax reform. The battle in tax policy should not be over income versus consumption taxation - as it has been for centuries - but rather over what kind of consumption tax to choose. Failure to address this question head-on has led tax policy to move, seemingly inexorably, towards the wrong choice, with the fate of progressive, redistributive taxation hanging in the balance.
McCaffery always has interesting things to say. I've posted about his articles before, here and here.


Blogger P. G. said...

Que? Progressive consumption tax? How does one construct a progressive consumption tax? That's very difficult for two reasons that I should think would be obvious:

1. The poor spend a higher percentage of their income on consumption than the rich. Those things that are necessary for subsistence, as well as basic luxuries like cars, are ordinarily classified as "consumption." The rich have the luxury to save and invest. Hence a consumption tax will affect a higher percentage of the income of a poor person than a rich person.

2. The very definition of progressive taxation is one that imposes a higher burden on those who earn more. How can this be enhanced by disconnecting taxation from income? What an topsy-turvy idea! That's like creating a cabinet-level Department of Eliminating Unnecessary Bureaucracy.

So while I'm not ruling the possiblity out, pending a chance to read the article, I think the idea of a progressive consumption tax has an uphill battle.

I suppose a system could be constructed so that point-of-sale taxes would be imposed at varying rates depending on the income of the purchaser, but can you imagine the administrative costs of such a complex system?

9:29 PM  
Blogger P. G. said...

This comment has been removed by a blog administrator.

10:13 PM  
Blogger P. G. said...

ps. I suppose you could structure a tax such that it was imposed only on "luxuries," and at higher rates, but not on stuff like food, sorta like the VAT, but I have my suspicions about the vaunted progessivity of VAT, especially as compared to income tax.

10:14 PM  
Blogger Stuart Buck said...

I think a consumption tax could effectively be implemented by taxing income from all sources (as we sort of do now), but by exempting any money that is invested or saved. Income minus savings = consumption. This might be useful in that any income from those savings/investments is not taxed under a separate system (let alone exempted by any step-up in basis at death). Instead, whenever investment income, capital gains, inheritances, etc., are consumed, they are taxed.

11:47 PM  
Blogger Paul said...

That would be more regressive than the current system, I would think, because it would allow investment to occur with pre-tax dollars rather than post-tax dollars, and thus provide a net benefit to the wealthier classes that are able to invest.

Plus it would allow the rich to engage in long-term tax deferral by putting all their income in investments except for the bare minimum necessary for their chosen level of consumption. That too is regressive, since all or almost all of the income of the poor would get taxed close to the time of gain.

8:24 AM  

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