Consumption taxes and liberals

The Bush administration supports a fundamental tax reform that would move the federal tax system away from taxing income toward taxing consumption. This is a highly desirable goal, because it will raise growth and living standards for most Americans. Nevertheless, liberals are opposing it because it would benefit the rich too much. Traditionally, consumption taxation has meant taxing goods directly, with services generally exempted. Such taxes are common at the state and local level, where we are accustomed to paying as much as 10 percent at the checkout. According to the Federation of Tax Administrators, 45 states currently have general sales taxes, varying between 2.9 percent in Colorado and 7 percent in Mississippi and Rhode Island. Local sales taxes can raise the total tax as high as 9.75 percent (in Oklahoma), with excise taxes on some specific goods on top. The Federal Government also has many excise taxes as well, especially on gasoline, alcohol and tobacco. Consumption taxes are less burdensome than income taxes because of the way they treat saving. Under an income tax, all returns to saving and investment -- interest, dividends, rent and capital gains -- are fully taxed. Under a consumption tax, they would be exempt. Consequently, saving and investment are much higher with a consumption tax than an income tax. That is why European countries, which all have tax burdens much higher than ours but also raise more of their revenue by taxing consumption, are still able to grow. If it were just a matter of economics, there would be no contest between taxing income or consumption. Unfortunately, ideology and politics have prevented reductions in taxes on saving and investment that would move the United States toward a consumption-based tax system. Keep in mind that it is not necessary to tax consumption directly, through sales or excise taxes, to have a consumption tax system. Since there are only two things that can be done with income -- either save it or spend it -- eliminating taxes on saving necessarily shifts the tax burden onto consumption. If there were no taxes at all on saving, we would per se have a consumption tax system, even if there were no direct taxes on sales. Unfortunately, it is the case that most saving and investment are done by the wealthy. How could it be otherwise? Therefore, reducing taxes on saving necessarily involves a reduction in taxes on the well to do. Consequently, liberals strenuously fight efforts to lower taxes on saving even though the ultimate beneficiaries would be the working class. Higher saving and capital formation will lead to more investment, which will raise productivity and, ultimately, wages and living standards. Liberals also make the mistake of assuming that a consumption-based tax system is regressive -- taking more out of the pockets of the poor than the rich. In fact, over one's lifetime, consumption is roughly proportional to income, because over a lifetime we eventually consume all our income. Thus, a tax on consumption will also be roughly proportional -- taking the same percentage from all taxpayers. Furthermore, liberals make the mistake of assuming that those who are poor today will always be poor and those who are rich will always be rich. This is really their principal justification for income and wealth redistribution policies. However, new data reported in the latest Economic Report of the President show that there is substantial mobility up and down the income ladder. The Council of Economic Advisers looked at what rate taxpayers faced in 1987 and again in 1996. Two-thirds of those in the lowest tax bracket the first year were in a higher bracket 10 years later, and more than half of those in the top tax bracket were in a lower bracket. In other words, the bulk of those who would be considered poor in the first instance were much better off a decade later -- a few even became rich, going all the way from the bottom tax bracket to the top bracket. Simultaneously, most of those who would be considered rich weren't after a few years -- 5 percent fell all the way from the top tax bracket to the bottom bracket. The high degree of income mobility in American society is a key reason why many of the poor and middle class oppose high taxes on the rich -- 70 percent of Americans favor abolishing the estate tax, for example, even though it affects just 2 percent of the population. Implicitly, they know that they or their children might one day be rich and have to pay this tax. They also know that poor people don't create jobs; rich people do. Adopting a consumption-based tax system will help more Americans become rich. That is another reason why liberals oppose it.