Chocolate and Gold Coins

Friday, March 25, 2005

Consumption Tax

It’s tax time and time to revisit an old idea: the consumption tax. A lot of economists have advocated a shift from an income tax to a consumption tax. Here is Arnold Kling’s essay on this subject. Taxing investment income lowers the amount of investment and lowers the growth rate of the economy. However, a sales tax, which is a consumption tax, is essentially a flat tax and most people would be unfair to poor. Is it possible to create a progressive consumption tax? Yes it is, and it would not be hard to do at all. But first, let’s look at the problem caused by the current ad hoc ways Congress has created to encourage investment.

Currently, there are several mechanisms in place for people to invest and not pay taxes on the interest on those investments. For example, there are IRAs and 401k plans for retirement, college savings accounts for a child’s college plan, and flexible spending accounts for medical expenditures. However, the big problem with these kinds of accounts is that they prohibit an efficient flow of money from one form of investment to another. The flexible spending account is the worst of these: if you don’t use the money in a calendar year, you lose it. My proposal is to treat all flows of money into investment as equal and non-taxable until these investments are cashed in. Flows of money between investments would not be prevented or discouraged in any way.

The simplest way of explaining this idea is to assume that most people have a checking account and a money market account. Any flows of money into the checking account would be considered consumption (in the near term) and would be taxable even if they came from investments. Any flows from the checking account into the money market account would be fully deductible. Any expenditure from the money market account on investments would not be counted since this would be an exchange from one form of investment to another. Using your money market account to pay your credit card bill though would mean you would have to pay tax on that transaction, so you would probably first transfer money to your checking account and then write a check for the credit card bill, but you wouldn't have to.

There two big issues that I can anticipate with this new type of tax. First issue is how to treat the taxation of investments made prior to the enactment of the consumption tax. The second issue is how to treat home mortgage interest deduction.

Since investments were made out of after-tax income up until the passage of the new consumption tax, then it would be unfair to tax investment again once the investor decides to cash in on that investment. One simple way of transitioning to the tax is to do an accounting of each person’s net worth exclusive of special tax-free funds. This money would be divided by 10 and be deducted from consumption for 10 years, (10 years is arbitrary but you don’t want to have negative consumption in any year and you don’t want the transition to stretch out forever). So if your net worth is $100,000, then you get to subtract $10,000 from your consumption income for the next 10 years, even if you don’t cash in any of your investments in that period. Of course, you will have to pay tax on all of your investments as consumption when you cash them in some day.

Home mortgage interest deduction would not make any economic sense in this framework, but interest deduction would be very hard to repeal. The logic of interest deductibility probably started with the observation that if you borrow money to make investments and then pay tax on the interest on those investments, then logically you should be able to deduce the interest you paid on the original loan. However, if we are not taxing interest income, we won’t allow interest deductibility either.

If we think of a home purchase as an investment, then both the interest and the principal associated with a home purchase would be fully deductible if they are paid out of checking. However, if you are going to be living in your own home, which presumably you will be, you will have to include an imputed rental value of that home as part of your consumption. This calculation would not be too complicated ― your county could probably estimate it fairly well ― but it would almost completely wipe out the home mortgage interest deduction. In fact, people that own their own home free and clear would have to pay an additional imputed rental value tax that they currently do not pay. I suspect that this might be a sticky issue.


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