Business, Domestic — December 1, 2004 at 10:41 am

Can America Stomach the Consumption Tax?

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Illustration by Clara Bryant

The idea of ownership has had particular appeal for Americans ever since Thomas Jefferson envisioned a country full of independent yeoman farmers. It was therefore unsurprising that President Bush made an “ownership society” the domestic centerpiece of his reelection campaign. In his convention speech, he said that such a society would inspire “greater opportunity, more freedom, and more control over your own life.”

No one would argue with those goals, but many commentators have pointed out that when Bush says “control,” he actually means a radical redistribution of risk onto lower-income Americans. A central and widely discussed part of Bush’s plan is to privatize Social Security by allowing citizens to invest in the stock market, rather than have their contribution paid immediately to the beneficiaries. As many critics have noted, not only is the Administration’s math fuzzy to the tune of trillions of dollars, but a crash in the stock market, particularly if it coincides with retirement or a medical crisis, could create enormous misery. Without the guarantees that stable government programs offer, some people will almost certainly be worse off under a privatized system, and chances are they will be the poorest Americans.

Tax code reform was much less prominent than Social Security privatization during the campaign. But two days after securing reelection, the President acknowledged what many had suspected for months: that one of his second- term priorities would be a sweeping tax overhaul. “We must reform our complicated and outdated tax code,” he told reporters. “We need to get rid of the needless paperwork that is a drag on our economy, to make sure our economy is the most competitive in the world.”

President Bush is leading a major tax code overhaul. For more than two decades, a growing number of free-market economists and conservative politicians have been planning to overthrow the entire federal taxation system. If successful, these radical reformers would effectively shift the burden of taxation from wealth onto wages and therefore onto lower income Americans. This idea is known as the consumption tax.

A Flawed System

Advocates of the consumption tax have tried to claim the mantle of reformers challenging a broken and unfair system. They’ve been helped by the fact that our current method of taxation has a lot of problems.

The Sixteenth Amendment to the Constitution was passed in 1913, and ever since then Congress has had the power to tax income. From the beginning, its guiding principle of has been progressive taxation—people should pay taxes according to their ability. Richer Americans’ income, therefore, is taxed at a higher percentage than poorer Americans’. Even conservatives agree with this philosophy; the President’s own Council of Economic Advisers (CEA) wrote in 2003 that “the income tax system should relate a taxpayer’s tax liability to his or her ability to pay and to his or her economic well-being.”

So far so good. But “income,” according to Princeton tax economist David Bradford, has two parts: “what [an individual] consumes during the year and what he adds to his wealth.”. Unfortunately, it turns out to be devilishly d i ff ic ult to measure additions to wealth, especially from assets like stocks. In order to accurately measure income, Congress has had to pass innumerable amendments to the tax code. “If you’re observing individuals,” Bradford said, “a lot of the wealth changes that accrue to them will go unnoticed.” Since much of this income is “invisible” at the individual level, the government taxes corporations instead, which is almost as difficult. “It’s a mess,” Bradford said, “it’s a huge mess.” The enormous complexity of the corporate income tax is a big reason that the tax code today is 6000 pages long and contains 9,277 sections.

A second reason for the complexity is that our government has traditionally chosen to make policy by using the tax code as an incentive system. For example, to encourage home ownership, the government makes interest on a home mortgage tax-deductible. There’s also the important exemption for donations to nonprofit or charitable groups.

The third and final reason for the tax code’s complexity is that it is full of exemptions for politically powerful groups. Take Section 34(a)(1), which allows for a deduction from the income tax for “gasoline used during the taxable year on a farm for farming purposes.” Or 5811(a), which places a $200 tax on the transfer of a firearm—unless, of course, it is a manually re-loadable rifle-shotgun combination that is between 12 and 18 inches in length, in which case the tax is $5.

All of this complexity comes at a high cost. According to the CEA, Americans spend three billion hours each year filing taxes. And The Economist reports that the country pays $100 billion in “compliance costs.” This is pure waste, since it’s money that should be spent improving the general welfare by the government or individuals. But notwithstanding the (decreasingly) progressive nature of the income tax, the code already works against lower-income people. For one thing, all of those deductions apply only if a taxpayer “itemizes” each expense, and fewer lower-income taxpayers do so than those with higher incomes. Chris Edwards, the head of tax policy for the libertarian Cato Institute, points out that many low-income people donate to religious organizations but do not benefit from the deduction. Lower-income people are also more likely to rent their home, he says, and so they cannot make deductions for home ownership or mortgage payments.

Another Option

Clearly, there’s a lot of potential political gain in attacking such a chaotic and dysfunctional system, but the tax code has defeated previous attacks on its complexity. The biggest was Ronald Reagan’s massive reform of 1986, which succeeded for a while in stripping many exemptions and complications. Soon, though, members of Congress started inserting their favorite provisions again, and the simplification proved unsustainable. As Bob McIntyre of Citizens for Tax Justice notes, “You can make the system perfect, but people start scribbling in the margins.”

In the 1980s, some economists proposed replacing the income tax entirely. By simple arithmetic, an equivalent way of expressing income is expenditures plus savings. Changes in expenditures, or consumption, are a lot easier to track than changes in savings, so if consumption alone were taken as the tax base, much of the tax code could be vastly simplified. Any money that was deposited into savings accounts wouldn’t be taxed when it was earned but would be taxed when it was taken out and spent. Someone might be able to avoid paying taxes on their savings immediately, but there would be no escape in the long run.

How the government might levy such a tax is a serious question, and one that is tied to the biggest concern about a possible consumption tax: its potential for regressivity. The fact that poor people spend a greater proportion of their income than rich people suggests that they would be unfairly taxed. This is especially true of a national sales tax, which Bush has called “an interesting idea that we ought to explore seriously.” The problem with a sales tax is that on products that everybody needs––like food–– taxing rich and poor the same dollar figure would be highly unfair.

But, said economist Bill Gentry of Williams College, while “it’s harder to get progressivity in the consumption tax, it’s not impossible. Once you have individuals in the tax system filling out forms, you can make judgments based on their ability to pay.” A tax could also easily include major deductions that explicitly help poorer people. And given the relative simplicity of a consumption tax, it might even be easier and fairer than the income tax. If President Bush were considering a real consumption-tax reform, as aides have said he might be, the country might have reason to cheer.

The Kicker

Even though there is no White House tax proposal yet, it has become clear that what Bush actually wants is a “wage tax”: a tax on the income earned by working people. Of course, it isn’t politically viable for him to ask for such a tax, but he can reduce taxes on businesses and investment so much that a wage tax will effectively be all that remains.

Even The Weekly Standard agrees. “Because ‘consumption’-tax advocates inconsistently define investment to mean investment in property but not in people, taxing ‘consumpt ion’ essentially means taxing labor compensation.” In other words, Bush wants to make income that goes towards financing corporations and industries tax-exempt, but not the part of income that is invested in “human capital”— people—through food, education, and housing. Everybody makes those kinds of investments, and since human capital is the country’s most valuable resource, those expenses should be tax-exempt, too. But during its first term, the Administration cut taxes in dividends and capital gains, which are both earnings from corporate stock, and did little to help the plight of workers who don’t invest much on Wall Street.

This is why Bush has been so infuriatingly vague on his plans for tax reform. Jon Chait of The New Republic said, “What they’re going to end up doing is call what they’re doing tax reform, but it’ll just be more tax cuts.” There has been only vague talk of a consumption tax, but The Washington Post recently reported that Bush’s specific ideas do include abolishing all taxes on capital gains and dividends, and passing even more tax breaks for businesses.

The huge and growing budget deficit, however, looms over the tax debate, and even though Chait says he does not think the red ink affects this Administration’s desire to slash taxes, it still has to make a show of paying for its cuts. It has become clear that the plan is to eliminate two huge and essential deductions. The first is the employer’s deduction for providing health care to employees, which is how most people get their health insurance in this country; the consequences of such elimination would be catastrophic. The second cut is so cruel that it’s almost funny. Bush wants to eliminate the Federal deduction for state and local tax payments, which would disproportionately affect Americans in high-tax states and cities. Most of those people just happen to be in taxfriendly blue states. Thus, to pay for his cuts to the very wealthy, President Bush plans to bill not only the poor and the middle class but also those who voted against him in November. Shifting the burden of taxation from wealth to wages is already a violation of America’s compact with its government. Using the tax code for political retribution by taxing your opponents to pay off your supporters is something this country hasn’t seen for two centuries.

Hold on to your wallets.

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