1. Copyright © 2002 by Thomson Learning, Inc. Chapter 16 Taxes on Consumption and Sales Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X

2. Copyright © 2002 by Thomson Learning, Inc. 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.

3. Copyright © 2002 by Thomson Learning, Inc. 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.

4. Copyright © 2002 by Thomson Learning, Inc. 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.

5. Copyright © 2002 by Thomson Learning, Inc. 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

6. Copyright © 2002 by Thomson Learning, Inc. 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

7. Copyright © 2002 by Thomson Learning, Inc. 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 = $20,583.33  T A = $4,166.66  S A = $5,000 Second Year I B + Proceeds from Saving +S B = 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

8. Copyright © 2002 by Thomson Learning, Inc. 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.

9. Copyright © 2002 by Thomson Learning, Inc. 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.

10. Copyright © 2002 by Thomson Learning, Inc. 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.

11. Copyright © 2002 by Thomson Learning, Inc. 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 If people save 20% of income then t i I = t c (.8)I which means that 1.25t i = t c. 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.

12. Copyright © 2002 by Thomson Learning, Inc. Figure 16.1 Substituting a Comprehensive Consumption Tax for a Comprehensive Income Tax: Investment Market Effects Yield (Percent) Investment per Year 0 r* rNrN Net Return under the Income Tax S G E F Gain in Efficiency Q1Q1 D r* G

13. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. Figure 16.2 Substituting an Equal Yield Comprehensive Consumption Tax an Income Tax: Labor Market Effects Wages Labor Hours per Year 0 WG2WG2 WG1WG1 L1L1 L2L2 SLSL L3L3 WN2WN2 WN1WN1 WOWO D = W G W G (1– t 1 ) W G (1– t C ) A' A B C C'

15. Copyright © 2002 by Thomson Learning, Inc. 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.

16. Copyright © 2002 by Thomson Learning, Inc. 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.

17. Copyright © 2002 by Thomson Learning, Inc. 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 that says that a consumption tax should be imposed on the consumer.  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.

18. Copyright © 2002 by Thomson Learning, Inc. 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.

19. Copyright © 2002 by Thomson Learning, Inc. Turnover Taxes  Turnover taxes are multistage taxes that are 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).

20. Copyright © 2002 by Thomson Learning, Inc. 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)

21. Copyright © 2002 by Thomson Learning, Inc. 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

22. Copyright © 2002 by Thomson Learning, Inc. 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.