1. 1 Chapter 16 Taxes on Consumption and Sales

2. 2 Consumption as a Tax Base Consumption can be an alternative to income as a measure of ability to pay. Comprehensive consumption: Income-Savings

3. 3 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.

4. 4 Comparing a Tax on Income to a Tax on Consumption Step 1 An Income Tax I A = I B = $30,000 S A = 0 S B = $5,000 T A = $6,000 + $6,000/(1+.1) = $6,000 + $5,455 = $11,455 T B = $6,000 + $6,100/(1+.1) = $6,000 + $5,545 = $11,545

5. 5 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 I A = C A + T A + S A $30,000 = C A +.2C A + 0 C A = $25,000 T A = $5,000 S A = 0 Present Value of All Taxes T A = $5,000 + $5,000/(1+.1) = $5,000 + $4,545.45 = $9,545.45

6. 6 Comparing a Tax on Income to a Tax on Consumption Step 2 A Consumption Tax for the Saver First Year  I B = C B + T B + S B  $30,000 = C B +.2C B + $5,000  C A = $20,833.33  T A = $4,166.66  S A = $5,000 Second Year  I B + Proceeds from Saving = C B + T B  $35,500 = C B +.2C B  C A = $29,583.33  T A = $5,916.67 Present Value of All Taxes T B = $4,166.66 + $5,916.67/(1+.1) = $4,166.66 + $5,378.79 = $9,545.45

7. 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.

8. 8 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.

9. 9 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.

10. 10 Substituting a Consumption Tax for an Income Tax To be revenue neutral Tax Revenue = t i I = t c C Where t i =income tax rate t c =consumption tax rate I =income C =consumption

11. 11 Figure 16.1 Substituting a Comprehensive Consumption Tax for a Comprehensive Income Tax: Investment Market Effects Gain in Efficiency Yield (Percent) Investment per Year 0 F rNrN Net Return under the Income Tax S E Q1Q1 r* G D rG*rG*

12. 12 Figure 16.2 Substituting an Equal Yield Comprehensive Consumption Tax an Income Tax: Labor Market Effects Wages Labor Hours per Year 0 L1L1 SLSL WOWO D = W G B WG1WG1 L2L2 WN1WN1 W G (1– t 1 ) A C WG2WG2 L3L3 WN2WN2 W G (1– t C ) A' C'

13. 13 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.

14. 14 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.

15. 15 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.

16. 16 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.

17. 17 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.

18. 18 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)

19. 19 Implications of a VAT keep compliance costs high, encourage saving, and encourage barter and other evasion/avoidance. A complete substitution of all income and payroll taxes for a VAT would

20. 20 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.