The Founders and the consumption tax

Posted: Apr 05, 2002 12:00 AM
Throughout most of American history, taxes were levied principally on consumption, rather than income. Except during the Civil War, the federal government was financed almost entirely by import duties and excise taxes until 1913, when our current income tax was imposed. The Founding Fathers favored consumption taxes in part because they are harder to raise to confiscatory levels than incomes taxes. In the Federalist Papers, Alexander Hamilton had this to say: "It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess. ... If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens of this class, and is itself a natural limitation of the power of imposing them." Hamilton was thinking here about direct taxes on consumption, such as the sales taxes levied today by most state governments. He was right in thinking that there is a limit to such taxes. Experience shows that general sales tax rates much above 10 percent are very hard to collect. They encourage smuggling, black markets, evasion, production for personal use, substitution for untaxed commodities and other activities that erode the tax base. Thus, confining taxation to a form that is inherently hard to raise to excessive levels meant that the size of government would be severely limited. This view is consistent with the economic theories that earned James Buchanan the Nobel Prize in economics. In several academic papers, he argued that it is easier to hold down the size of government by limiting taxation than by trying to control spending directly. Another advantage of consumption taxation, long recognized by economists, is that it does not double tax saving, as income taxes do. To see why this is the case, think of what you could do with $1,000 saved from your after-tax earnings. If you buy a new television with it, the "income" you derive from this investment -- in the form of viewing pleasure -- is forever untaxed. But if you buy a stock or bond instead, the interest or dividends you receive are taxed again, even though the income you used to buy the assets were taxed when you earned it. World wars killed consumption taxation as the principal means of financing the federal government. The necessary rate would have been too high to be effective. Although the Treasury Department proposed a "spendings" tax to finance World War II, the idea was rejected by Congress in favor of higher and broader income taxes. Subsequently, the federal government essentially ceded the sales tax to the states, retaining only a few isolated excise taxes, such as those on tobacco and gasoline, for itself. In the 1960s, the Europeans developed a new method of taxing consumption that overcame many of the collection problems inherent in traditional sales taxes. Called the valued-added tax, it was collected from producers, rather than retailers, and was embodied in the prices of goods, rather than being collected separately at the checkout. For these reasons, the VAT could be levied at rates far higher than was possible with traditional sales taxes. Now, some European countries have VAT rates as high as 25 percent on top of their income taxes. The United States has always resisted the temptations of the VAT and is now the only major country on earth without one. It is not clear why this is the case. But every serious effort to establish a federal VAT has fallen flat in Congress. Still, the idea of taxing consumption, rather than income, is an attractive one. In a new book, "Fair Not Flat" (University of Chicago Press), University of Southern California law professor Edward McCaffery makes the case for it. However, he argues for what economists call a consumed income tax that looks like an income tax, but actually falls on consumption, rather than a VAT or sales tax. McCaffery makes the simple, yet profound, point that there are only two things one can do with income: either save (invest) it or consume it. If saving is entirely eliminated from the tax base, then the tax burden necessarily falls solely on consumption. McCaffery would remove taxation from saving by allowing people to have saving accounts like Individual Retirement Accounts, except with no restrictions. Contributions and withdrawals could be made at any time. At the end of the year, all net contributions would be fully deductible on one's tax return, and all withdrawals would be taxable. McCaffery argues that this would give the United States a de facto consumption tax without the problems inherent in taxing consumption directly. It is an idea whose time may have come.