1
Chapter 19 – Taxes on
Consumption and Wealth
Public Economics
2
Introduction
? There is substantial dissatisfaction with
the federal personal and corporate
income tax systems.
? One possibility is to adopt a consumption
tax whose base is actual consumption,
Another possibility is a tax on wealth,
whose base is accumulated saving.
3
Retail Sales Tax
? Several types on sales taxes levied on
wide variety of commodities:
– General sales tax impose the same tax rate
on the purchase of all commodities.
– Selective sales tax is levied at different rates
on the purchase of different commodities.
? Also known as excise tax or differential
commodity tax.
4
Retail Sales Tax
? Table 19.1 shows tax revenue collected
from various sales taxes.
? Federal government levies no general
sales tax,but does tax motor fuel,
alcoholic beverages,tobacco,and some
other commodities.
? Large majority of states have sales tax,
with rates between 2.9% and 7.25%.
Table 19.1
6
Retail Sales Tax
? Sales taxes generally take one of two
forms:
– A unit tax is a given amount for each unit
purchased (e.g.,motor fuel tax that is a
certain number of cents per gallon of
gasoline).
– An ad valorem tax is computed as a
percentage of the value of the purchase.
7
Retail Sales Tax
? Rationalizations for a sales tax
– Administrative Considerations
? Collected at retail level,have to monitor fewer units,
Nonetheless,still difficult,and defining the tax base
somewhat arbitrary.
? Underground markets / smuggling
– Optimal Tax Considerations
? It can be shown that the income tax is not optimal,
differential commodity taxes can improve welfare.
? Inverse elasticity rule could guide the rate setting
8
Retail Sales Tax
? Rationalizations for a sales tax
– Other considerations
? Sin taxes
? Merit goods
9
Retail Sales Tax
? Efficiency and Distributional Implications
– Would the pattern of sales tax rates minimize
excess burden?
– Overall excess burden depends on both the
elasticities of each good and the degree of
substitutability or complementarity with other
goods.
– Equal tax rates is almost certainly not
efficient.
10
Retail Sales Tax
? Efficiency and Distributional Implications
– When viewed in a lifetime perspective (rather
than an annual perspective),general sales
taxes are somewhat progressive.
– More generally,however,statutory incidence
of sales tax is not the same as the economic
incidence.
11
Retail Sales Tax
? Efficiency and Distributional Implications
– Exempting goods that are consumed
intensively by the poor (such as food) can
make the after-tax distribution more equal,
but achieving equality this way is difficult.
? Many upper-income families still benefit
? Administrative complexity
12
Retail Sales Tax
? Some proposals for replacing income tax
with a national retail sales tax.
? Advantages include simplicity and
compliance.
? Rates would have to increase from the
current 3-7% range to about 35%,
Benefits from cheating would increase
greatly.
13
Retail Sales Tax
? National sales tax creates transitional issues
– Those who had accumulated wealth under the
existing income tax structure would suffer,
Accumulated wealth was taxed through the personal
income tax.
– Saved for future consumption,which is now more
expensive.
? Viewed in this light,such a tax is essentially a
one-time tax on wealth.
14
Value Added Tax
? Goods are produces in several stages
before becoming final goods.
? The value added at each stage of
production is the difference between the
firm’s sales and the purchased material
inputs used in production.
? Table 19.2 gives an illustration.
Table 19.2
16
Value Added Tax
? A value-added tax (VAT) is a
percentage tax on value added applied at
each stage of production.
? VAT is just an alternative method for
collecting a retail sales tax.
17
Value Added Tax
? Implementation issues
– How are durable investment assets treated?
? In Europe,consumption-type VAT excludes the
investment from the tax base.
– Collection procedure
? In Europe,invoice method is used,Each firm is liable
for taxes on entire sale,but can claim a credit on
previous taxes paid by firms upstream with appropriate
invoices,Provides incentive for producers to self-police
against evasion.
18
Value Added Tax
? Implementation issues
– Rate structure
? In Europe,commodities are taxed
differentially (e.g.,food and health are taxed
at low rates).
? Nonuniform taxation increases administrative
complexity,especially when firms produce
multiple outputs that are taxed differently.
19
Value Added Tax
? A VAT for the U.S?
– Desirability of the VAT can be determined
only if we know what tax it would replace,
how the revenues would be spent,and so
forth.
– Possible that the VAT might be used to
sneak by an increase in the size of the
government sector.
20
Hall-Rabushka Flat Tax
? Legal incidence of a retail sales tax and
the VAT falls onto business,Consumers
make no explicit payments to government.
? Other proposals require personal
consumption taxes,and allow individuals
tax liabilities to depend on their personal
circumstances.
21
Hall-Rabushka Flat Tax
? Hall and Rabushka (H&R) plan a flat tax.
– Two tax collecting vehicles:
? A business tax
– Consumption-type VAT
– Firm also deducts payments to its workers
– Flat tax on the final amount
? Individual compensation tax
– Base is payments received for labor services
– No taxes on capital income
– Allow exemption,but no other deductions
22
Hall-Rabushka Flat Tax
? Why is this consumption tax?
– The business tax is essentially a VAT,which
is equivalent to a sales tax.
– The wage payments are taxed at the same
rate (19%) that is applied to businesses,
These were deducted on the business-side,
This simply changes the point of collection
for part of the tax.
23
Cash-Flow Tax
? Each household files a return reporting their
consumption expenditures during the year.
– Various exemptions and deductions can be taken.
– Tax bill from adjusted amount of consumption.
? How does one compute annual consumption?
– Cash-flow basis is difference between all cash
receipts and saving.
– Difficult recordkeeping
24
Efficiency and Fairness of
Personal Consumption Taxes
? Efficiency issues
– Using a life-cycle model,on the surface a
consumption tax does not create excess
burden as an income tax does.
? Income tax changes relative price of
consumption in the future versus today.
? This assumes labor supply is fixed,however,
A consumption tax does distort the rate at
which a person can trade off leisure versus
consumption.
25
Efficiency and Fairness of
Personal Consumption Taxes
? Equity Issues
– Progressiveness
? A personal consumption tax can be made as
progressive as desired with suitable
exemption levels
– Ability to pay
? Those who favor income tax argue that
potential (not actual) consumption is relevant.
26
Efficiency and Fairness of
Personal Consumption Taxes
? Equity Issues
– Annual versus lifetime equity
? Income taxation can lead to tax burdens that
differ substantially,even for those with the
same lifetime wealth.
? Savers are penalized because interest
earnings are taxed.
? Under consumption tax,lifetime tax burdens
are independent of saving.
27
Efficiency and Fairness of
Personal Consumption Taxes
? Equity Issues
– Annual versus lifetime equity
? Income tends to fluctuate more than
consumption during a year.
? Annual consumption is likely a better
reflection of lifetime circumstances.
28
Income versus Consumption
Taxation
Advantages of
Consumption Tax
Disadvantages of
Consumption Tax
No need to measure
capital gains &
depreciation
Administrative problems
Fewer problems with
inflation
Transitional problems
No need for separate
corporation tax
Gifts and Bequests
29
Wealth Taxes
? All the taxes discussed so far (such as
income taxes and consumption taxes) are
flow variables – and are associated with
a time dimension (such as one calendar
year).
? A stock variable has no time dimension,
Wealth is one such variable.
30
Wealth Taxes
? All the taxes discussed so far (such as income
taxes and consumption taxes) are flow
variables – and are associated with a time
dimension (such as one calendar year).
? A stock variable has no time dimension,
Wealth is one such variable.
? The property tax on housing is an example of a
wealth tax.
31
Wealth Taxes
? What are the justifications for a wealth tax?
– May correct problems that arise with the
administration of an income tax.
– The higher an individual’s wealth,the greater his
ability to pay,Ignores human capital,however.
– Reduces concentration of wealth,which may be
desirable socially and politically.
– Wealth taxes are payments for benefits that wealth
holders receive from government (e.g,defense).
32
Gift and Estate Taxes
? Federal government (and some state
governments) levy gift taxes and estate
taxes.
? Small source of federal tax revenue,In
principle,the,death tax” will be phased
out over the next six years.
33
Gift and Estate Taxes
? Rationales for estate taxes
– Payment for services
– Reversion of property to society
– Incentives
– Relation to the Personal Income Tax
– Income Distribution
34
Gift and Estate Taxes
? Provisions of the estate tax and gift tax
? Two taxes are linked; otherwise could
avoid tax by transferring resources inter
vivos,Officially referred to as the unified
transfer tax.
35
Gift and Estate Taxes
? Taxable base,The gross estate consists of all property
including real property,stocks,bonds,and insurance
policies,Also includes gifts made during the decedent’s
lifetime.
? The taxable estate has the following provisions:
– Gifts to charity are deductible without limit.
– Lifetime exemption of $1.5 million in 2004.
– Qualified transfers to spouse are deductible from the
taxable base.
– Annual gift exclusion of $11,000 per recipient,Married
couple with three kids could transfer $66,000 per year out
of their estate.
36
Gift and Estate Taxes
? Rate structure,maximal rate in 2004 is
48%,and is being phased down to 45%
in 2009,then to 0% in 2010.
? Legislation will revert back in 2011 to the
pre-2001 rules unless Congress makes
the repeal permanent.
37
Gift and Estate Taxes
? Problems with the estate tax
– Jointly held property
? Under current law,half of the value of jointly
held property is now included in the gross
estate of the first spouse to die.
– Closely held businesses
? Heirs may have to sell business to pay estate
tax,Law allows estate taxes to be paid off
over 14 years at favorable interest rates.
38
Gift and Estate Taxes
? Problems with the estate tax
– Avoidance strategies
? Trusts are arrangements whereby a person or
institution known as a trustee holds legal title to assets
with the obligation to use them for the benefit of
another party.
? Allows a household to get funds out of their estate.
? In general,many methods are available for making
intergenerational transfers of wealth without bearing
any taxes and without losing effective control of the
property during one’s life.
39
Recap of Taxes on Consumption
and Wealth
? Retail Sales Tax
? Value Added Tax
? Hall-Rabushka Flat Tax
? Cash Flow Tax
? Efficiency and Fairness of Personal Consumption Taxes
? Wealth Taxes
? Gift and Estate Taxes
Chapter 19 – Taxes on
Consumption and Wealth
Public Economics
2
Introduction
? There is substantial dissatisfaction with
the federal personal and corporate
income tax systems.
? One possibility is to adopt a consumption
tax whose base is actual consumption,
Another possibility is a tax on wealth,
whose base is accumulated saving.
3
Retail Sales Tax
? Several types on sales taxes levied on
wide variety of commodities:
– General sales tax impose the same tax rate
on the purchase of all commodities.
– Selective sales tax is levied at different rates
on the purchase of different commodities.
? Also known as excise tax or differential
commodity tax.
4
Retail Sales Tax
? Table 19.1 shows tax revenue collected
from various sales taxes.
? Federal government levies no general
sales tax,but does tax motor fuel,
alcoholic beverages,tobacco,and some
other commodities.
? Large majority of states have sales tax,
with rates between 2.9% and 7.25%.
Table 19.1
6
Retail Sales Tax
? Sales taxes generally take one of two
forms:
– A unit tax is a given amount for each unit
purchased (e.g.,motor fuel tax that is a
certain number of cents per gallon of
gasoline).
– An ad valorem tax is computed as a
percentage of the value of the purchase.
7
Retail Sales Tax
? Rationalizations for a sales tax
– Administrative Considerations
? Collected at retail level,have to monitor fewer units,
Nonetheless,still difficult,and defining the tax base
somewhat arbitrary.
? Underground markets / smuggling
– Optimal Tax Considerations
? It can be shown that the income tax is not optimal,
differential commodity taxes can improve welfare.
? Inverse elasticity rule could guide the rate setting
8
Retail Sales Tax
? Rationalizations for a sales tax
– Other considerations
? Sin taxes
? Merit goods
9
Retail Sales Tax
? Efficiency and Distributional Implications
– Would the pattern of sales tax rates minimize
excess burden?
– Overall excess burden depends on both the
elasticities of each good and the degree of
substitutability or complementarity with other
goods.
– Equal tax rates is almost certainly not
efficient.
10
Retail Sales Tax
? Efficiency and Distributional Implications
– When viewed in a lifetime perspective (rather
than an annual perspective),general sales
taxes are somewhat progressive.
– More generally,however,statutory incidence
of sales tax is not the same as the economic
incidence.
11
Retail Sales Tax
? Efficiency and Distributional Implications
– Exempting goods that are consumed
intensively by the poor (such as food) can
make the after-tax distribution more equal,
but achieving equality this way is difficult.
? Many upper-income families still benefit
? Administrative complexity
12
Retail Sales Tax
? Some proposals for replacing income tax
with a national retail sales tax.
? Advantages include simplicity and
compliance.
? Rates would have to increase from the
current 3-7% range to about 35%,
Benefits from cheating would increase
greatly.
13
Retail Sales Tax
? National sales tax creates transitional issues
– Those who had accumulated wealth under the
existing income tax structure would suffer,
Accumulated wealth was taxed through the personal
income tax.
– Saved for future consumption,which is now more
expensive.
? Viewed in this light,such a tax is essentially a
one-time tax on wealth.
14
Value Added Tax
? Goods are produces in several stages
before becoming final goods.
? The value added at each stage of
production is the difference between the
firm’s sales and the purchased material
inputs used in production.
? Table 19.2 gives an illustration.
Table 19.2
16
Value Added Tax
? A value-added tax (VAT) is a
percentage tax on value added applied at
each stage of production.
? VAT is just an alternative method for
collecting a retail sales tax.
17
Value Added Tax
? Implementation issues
– How are durable investment assets treated?
? In Europe,consumption-type VAT excludes the
investment from the tax base.
– Collection procedure
? In Europe,invoice method is used,Each firm is liable
for taxes on entire sale,but can claim a credit on
previous taxes paid by firms upstream with appropriate
invoices,Provides incentive for producers to self-police
against evasion.
18
Value Added Tax
? Implementation issues
– Rate structure
? In Europe,commodities are taxed
differentially (e.g.,food and health are taxed
at low rates).
? Nonuniform taxation increases administrative
complexity,especially when firms produce
multiple outputs that are taxed differently.
19
Value Added Tax
? A VAT for the U.S?
– Desirability of the VAT can be determined
only if we know what tax it would replace,
how the revenues would be spent,and so
forth.
– Possible that the VAT might be used to
sneak by an increase in the size of the
government sector.
20
Hall-Rabushka Flat Tax
? Legal incidence of a retail sales tax and
the VAT falls onto business,Consumers
make no explicit payments to government.
? Other proposals require personal
consumption taxes,and allow individuals
tax liabilities to depend on their personal
circumstances.
21
Hall-Rabushka Flat Tax
? Hall and Rabushka (H&R) plan a flat tax.
– Two tax collecting vehicles:
? A business tax
– Consumption-type VAT
– Firm also deducts payments to its workers
– Flat tax on the final amount
? Individual compensation tax
– Base is payments received for labor services
– No taxes on capital income
– Allow exemption,but no other deductions
22
Hall-Rabushka Flat Tax
? Why is this consumption tax?
– The business tax is essentially a VAT,which
is equivalent to a sales tax.
– The wage payments are taxed at the same
rate (19%) that is applied to businesses,
These were deducted on the business-side,
This simply changes the point of collection
for part of the tax.
23
Cash-Flow Tax
? Each household files a return reporting their
consumption expenditures during the year.
– Various exemptions and deductions can be taken.
– Tax bill from adjusted amount of consumption.
? How does one compute annual consumption?
– Cash-flow basis is difference between all cash
receipts and saving.
– Difficult recordkeeping
24
Efficiency and Fairness of
Personal Consumption Taxes
? Efficiency issues
– Using a life-cycle model,on the surface a
consumption tax does not create excess
burden as an income tax does.
? Income tax changes relative price of
consumption in the future versus today.
? This assumes labor supply is fixed,however,
A consumption tax does distort the rate at
which a person can trade off leisure versus
consumption.
25
Efficiency and Fairness of
Personal Consumption Taxes
? Equity Issues
– Progressiveness
? A personal consumption tax can be made as
progressive as desired with suitable
exemption levels
– Ability to pay
? Those who favor income tax argue that
potential (not actual) consumption is relevant.
26
Efficiency and Fairness of
Personal Consumption Taxes
? Equity Issues
– Annual versus lifetime equity
? Income taxation can lead to tax burdens that
differ substantially,even for those with the
same lifetime wealth.
? Savers are penalized because interest
earnings are taxed.
? Under consumption tax,lifetime tax burdens
are independent of saving.
27
Efficiency and Fairness of
Personal Consumption Taxes
? Equity Issues
– Annual versus lifetime equity
? Income tends to fluctuate more than
consumption during a year.
? Annual consumption is likely a better
reflection of lifetime circumstances.
28
Income versus Consumption
Taxation
Advantages of
Consumption Tax
Disadvantages of
Consumption Tax
No need to measure
capital gains &
depreciation
Administrative problems
Fewer problems with
inflation
Transitional problems
No need for separate
corporation tax
Gifts and Bequests
29
Wealth Taxes
? All the taxes discussed so far (such as
income taxes and consumption taxes) are
flow variables – and are associated with
a time dimension (such as one calendar
year).
? A stock variable has no time dimension,
Wealth is one such variable.
30
Wealth Taxes
? All the taxes discussed so far (such as income
taxes and consumption taxes) are flow
variables – and are associated with a time
dimension (such as one calendar year).
? A stock variable has no time dimension,
Wealth is one such variable.
? The property tax on housing is an example of a
wealth tax.
31
Wealth Taxes
? What are the justifications for a wealth tax?
– May correct problems that arise with the
administration of an income tax.
– The higher an individual’s wealth,the greater his
ability to pay,Ignores human capital,however.
– Reduces concentration of wealth,which may be
desirable socially and politically.
– Wealth taxes are payments for benefits that wealth
holders receive from government (e.g,defense).
32
Gift and Estate Taxes
? Federal government (and some state
governments) levy gift taxes and estate
taxes.
? Small source of federal tax revenue,In
principle,the,death tax” will be phased
out over the next six years.
33
Gift and Estate Taxes
? Rationales for estate taxes
– Payment for services
– Reversion of property to society
– Incentives
– Relation to the Personal Income Tax
– Income Distribution
34
Gift and Estate Taxes
? Provisions of the estate tax and gift tax
? Two taxes are linked; otherwise could
avoid tax by transferring resources inter
vivos,Officially referred to as the unified
transfer tax.
35
Gift and Estate Taxes
? Taxable base,The gross estate consists of all property
including real property,stocks,bonds,and insurance
policies,Also includes gifts made during the decedent’s
lifetime.
? The taxable estate has the following provisions:
– Gifts to charity are deductible without limit.
– Lifetime exemption of $1.5 million in 2004.
– Qualified transfers to spouse are deductible from the
taxable base.
– Annual gift exclusion of $11,000 per recipient,Married
couple with three kids could transfer $66,000 per year out
of their estate.
36
Gift and Estate Taxes
? Rate structure,maximal rate in 2004 is
48%,and is being phased down to 45%
in 2009,then to 0% in 2010.
? Legislation will revert back in 2011 to the
pre-2001 rules unless Congress makes
the repeal permanent.
37
Gift and Estate Taxes
? Problems with the estate tax
– Jointly held property
? Under current law,half of the value of jointly
held property is now included in the gross
estate of the first spouse to die.
– Closely held businesses
? Heirs may have to sell business to pay estate
tax,Law allows estate taxes to be paid off
over 14 years at favorable interest rates.
38
Gift and Estate Taxes
? Problems with the estate tax
– Avoidance strategies
? Trusts are arrangements whereby a person or
institution known as a trustee holds legal title to assets
with the obligation to use them for the benefit of
another party.
? Allows a household to get funds out of their estate.
? In general,many methods are available for making
intergenerational transfers of wealth without bearing
any taxes and without losing effective control of the
property during one’s life.
39
Recap of Taxes on Consumption
and Wealth
? Retail Sales Tax
? Value Added Tax
? Hall-Rabushka Flat Tax
? Cash Flow Tax
? Efficiency and Fairness of Personal Consumption Taxes
? Wealth Taxes
? Gift and Estate Taxes
