C h a p t e r 16 TAXES ON CONSUMPTION AND SALES COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Consumption as a Tax Base General tax on consumption equivalent to an income tax that allows savings to be excluded from the tax bases Annual comprehensive consumption is annual comprehensive income minus annual savings Comprehensive consumption tax, sometimes called an expenditure tax, would work like an income tax that allows exclusion of retirement savings from the tax base All savings, without limit, no matter for what purpose, would be excluded from income No tax penalty for withdrawing funds from savings Tax paid only when funds are converted to cash and spent

Consumption Versus Saving Can be argued that ability to pay more appropriately measured by a person’s basic capacity to earn income On basis of horizontal equity, two people with equal potential to earn should pay same amount of taxes over their lifetimes Would be taxed differently according to the way they differ in tendencies to defer consumption One who saves nothing is taxed entirely on basis of labor income; one who prefers to save pays taxes both on labor earnings and income from accumulated capital

Comprehensive Consumption Tax Base Comprehensive consumption tax base excludes any change in net worth from the tax base Under consumption tax, measuring realized or unrealized capital gains is unnecessary; would not be taxed until converted to cash and spent Under consumption tax, inflation not a problem as only current expenditures are taxed Anything that increases net worth of taxpayer would be excluded from tax base Savings accounts at financial institutions, business inventories, stocks and bonds

Incidence of Consumption Tax Because capital income excluded from taxation under consumption tax, tax would be borne according to labor earnings Portion borne by labor income could be shifted to consumers if workers adjusted work hours in response to tax Consumption tax likely to be more regressive with respect to income than income tax Though tax rate structure could be modified to achieve collectively chosen distribution of burden

Sales Taxes Few sales taxes implemented to conform to comprehensive consumption tax base Levied mostly on tangible goods, excluding things like professional services, haircuts, transportation, etc. Many states exempt certain basic goods regarded as necessities Food, grocery items, prescription drugs Many consumption taxes levied on purchase of capital goods Automobiles, consumer durables

Retail Sales Tax Ad valorem levy of fixed percentage on dollar value of retail purchases made by consumers Levied on consumption at its final stage, collected from businesses that make retail sales Usually added to retail price of goods and services Broadening sales tax base can increase revenue

Issues in Sales Taxation Services initially exempt from taxation for administrative reasons As services command more and more of consumption, states in financial crisis forced to consider taxing services Aging population can adversely affect states’ sales tax revenue while services exempt As percentage of population over 65 increases, consumption more weighted to services, pharmaceuticals, etc., now exempt Most states do not tax purchases by government agencies and nonprofits E-commerce presents challenges in state sales taxation

Excise Taxes Selective taxes levied on certain types of consumption activities Distort choices among goods and services, result in efficiency losses to economy Some designed to raise revenue, others intended to discourage particular consumption activities Excise taxes on tires are to raise revenue; excise taxes on liquor largely to discourage consumption Many consumption activities taxed are alleged to generate negative externalities or are considered luxury goods and services

Incidence of Sales, Excise Taxes Argued that they are regressive with respect to income Annual consumption expenditures, as percentage of annual income, higher for low-income taxpayers than high-income taxpayers This has led many states to exempt certain items, such as food Distribution of tax burden between buyers and sellers varies from state to state, ranges from 28% to 89% of burden borne by buyers

Turnover Taxes Multistage sales taxes levied at some fixed rate on transactions at all levels of production Effective tax rate conditioned by number of stages of production Extremely productive levy, producing high, stable yields at low rates Low rate believed to discourage tax evasion Studies have shown it to be somewhat progressive Effective rates on many food items lower than those on clothing and other manufactured goods

Value-Added Tax (VAT) General tax on consumption levied on the value added to intermediate products by businesses at each stage of production Value added is difference between sales proceeds and purchases of intermediate goods and services over a certain period Value Added = Total Transactions – Intermediate Transactions = Final Sales = GDP = Wages + Interest + Profiles + Rents + Depreciation Very popular in Europe Not currently used by U.S. federal government General tax on value added equivalent to tax on national product

Administration of VAT VAT typically rebated on export sales Goods of nations that use the tax more competitive in international markets when they are exported to nations where there is no national sales tax Imported products subject to VAT, increasing prices to domestic consumers A criticism of VAT is that costs of administration and compliance high compared to other taxes Estimated that administrative and compliance costs for new VAT in U.S. could be $8 billion per year