The Consumption Tax, Part II

One year ago today, I wrote about the virtues of a consumption tax. It is a decent essay and worth reading. I thought I would add to those thoughts but first let me introduce the idea

The idea is that instead of taxing income, which has the problem of discouraging investment since it is taxed as soon as an investment is liquidated even it an investor intends to reinvest these earnings, the government would tax your consumption. The idea is not to tax the goose that lays golden eggs but just the gold eggs.

Here is an excerpt:

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.

Read the whole post here.

The idea of a progressive consumption tax (i.e. one that taxes low consumption at a lower rate) has been around for many years but has always been considered impractical. I do not believe it to be impractical at all.

The issues of the progressive consumption tax are many: first there is the issue of transitioning to it, second is the issue of how complex would it be to compute, third there is the issue of tax incidence and who wins and who loses under the new regime, and fourth there is the issue of getting the required information to tax all consumption.

I addressed the first two issues in the essay above. I will just say that transitioning could be gradual and phased in over a decade. Computing consumption is easy if you keep your accounts well. Any money flowing into your checking account is likely to fund consumption. You might write a check to buy an investment – and this would be fully deductible – but it would be easier just to fund investments out of an interest earning money market account.

The third issue – the issue of who pays that taxes and tax fairness – is the real reason I wanted to readdress this issue. There is a big issue here. Republicans are using the issue of tax efficiency to argue for an almost complete repeal of capital gains taxation. Obviously this helps the wealthy. In fact, a wealthy person living solely off of investments might pay less tax as a fraction of his or her consumption than a common laborer – a regressive tax system.

The only fig leaf of respectability for this swindle is that taxing investment income would discourage investment. Basically, you are grinding down investment over time because each transaction requires a check to the government. The government should simply wait until you are finished investing.

But under the current scheme, investors don’t pay much tax on either the goose or the gold eggs. Even if all consumption is liquidated and spent, the investor pays merely 15 percent – a really small tax on a fortune.

The fourth issue is how to compute all consumption. One form of consumption that really should be tax is the imputed rental value of owner occupied housing. Basically, if you were to rent your home out, you could be making a good income. But you are living in it. So you pay yourself the rent. This should be taxable consumption. But how much is this?

The issue of fairly estimating the value of property that never comes up for sale in the market is always a contentious issue. I think the county assessors do a reasonable job – I say this with the knowledge that they have over-assessed my home by 20 percent. Is there a better way?

I thought about a scheme in which owners would simply self-assess their property with a huge penalty if they self-assessed too low. When you sell your home and if you self-assessed for less than the sale price, you pay a penalty based on the difference to compensate for the lost real estate tax. If the penalty is sufficiently high – maybe 30 percent of the difference – then you would want to be honest and reveal the true value of your home. The issue with this, of course, is that everyone will self-assess too low in a rapidly rising real estate market.