By Matthew Nolan*
As a note, so far in this series on tax the following issues have been touched on: Why do we tax? What are the distortions of tax? What are poll taxes, and how does fairness matter? What are factor/income taxes?
In the first article in this series it was stated that tax and spending was how government redistributed goods and services within the economy.
Last time involved going through the tax part of this process by looking at taxes on labour, capital, and land and how they change the incentives for labour, capital, and land owners regarding what to produce.
But this all seems a bit indirect when, in essence, our interest is in terms of the underlying goods and services that are produced with these factors of production – not the factors of production themselves.
As a result, why not just tax the goods and services (consumption) directly?
This makes thinking in terms of consumption taxes logical.
Consumption is the “final purchase of goods and services” at which point we either eat them up then, or eat them gradually over time without resale.
It is the consumption that we value as individuals, we earn income by producing goods and services specifically because we want to consume.
And so it is the ultimate “ability to consume” that we are really taxing, and more broadly it is consumption we are considering redistributing in the name of fairness.
As a starting point, let us treat consumption as one gigantic block that everyone is involved in producing and consuming, although consumption and production by individuals occur at different points in time.
When it comes to taxation we reach another potential view of fairness: we would like to avoid taxing consumption at different points in time differently. This is really just an example of horizontal equity which we mentioned here.
Although we can talk about this in terms of fairness, this principle is largely talked about with regards to efficiency – by treating consumption over time the same way, we are not distorting the incentives about when to consume. We will get into this more below, but first let’s expand the amount of commodities we could tax.
Frank Ramsey worked out that if, instead of taxing all commodities in the same way, we had relatively higher taxes for goods whose quantity supplied and demanded are relatively less responsive to tax, we can lower the deadweight loss/inefficiency from taxation.
However, there are two issues with this. Firstly, the information required and the compliance costs involved are likely to be prohibitive (for example, here is recent work solely on income elasticities in New Zealand).
Secondly, by viewing things solely in terms of efficiency we have again strayed down the same path as a poll tax or a land tax – we need to think about how this fits into our earlier principals of vertical and horizontal equity based on ability.
To help us start to think about these issues, it is useful to compare income taxes and consumption taxes.
Consuming, saving, and capital markets
When we look at our taxing the inputs to producing things we want to consume, we are in a sense taxing consumption – just in an indirect manner. As a result, we can use these thoughts on consumption taxes to understand a bit more about income taxes.
To do this lets use the idea that consumption at a point in time is equal to income minus additional saving.
Capital income is the return on capital investment, and the value of the stock of capital someone has will bear a relationship with the stream of expected returns from that capital through time.
These “returns” have value because we can consume with them, and as a result the value of the stock of capital can be thought of as a stock of savings for future consumption. This also implies that investment is really a flow of savings – an addition to the stock of capital/savings.
The return on capital, capital income, is then the return on savings – it is a form of interest rate. In fact, the return that you get from savings with a bank can be thought of in exactly this sort of way.
Interest rates, or the expected rate of return on capital, are a price in capital markets – which in turn sets the quantity of capital supplied and demanded equal to each other. This price represents a variety of things, including people’s inherent willingness and ability to “shift their consumption through time” (eg borrowing when their income is low relative to future income, and saving when their income is high).
Taxing capital income creates a wedge between the cost to the borrower and the return to the saver.
However if we think in terms of consumption we can say the following. By taxing capital income, we place the burden of taxation on future consumption as the tax can be “avoided” by consuming income now instead of investing it.
Essentially, capital income taxes involve taxing people more when they want to spend current income in the future than if they use that income now. As a result, we are also violating the idea of “treating consumption at different points in time the same way”.
Of course, our distinction between capital and labour is a little bit loose – after all we are not born with a clump of skills and knowledge, we have to accumulate them.
In this way, a tax on labour income also reduces the incentive to invest in human capital! [Note: This “wedge” is unlikely to be as large as for capital income, given that the upfront cost of human capital accumulation is lower, and the opportunity cost (sacrificed labour income) is also taxed at the income tax rate!]
The key difference
Here we’ve noted that the key difference between “output taxes” and “factor taxes” is that output taxes treat consumption through time equally (outside of credit constraints) while taxes on the labour and capital income tax future consumption of income more – and thereby reduce the incentive to accumulate capital in its broadest sense.
Now this is not to say that the level of the consumption tax doesn’t reduce the incentive to accumulate capital – it does due to the fact that it reduces the “goods and services” you can buy from the additional income you earn from any investment you make. But as we are inherently taxing current consumption at the same rate as future consumption we are not “biasing against investment” in the same way income taxes do!
This is not a slam dunk for replacing income taxes with GST, but it is one of the driving ideas behind why there should be a shift from income tax to GST.
For perspective, one of the costs associated with a consumption tax are that they tend to hurt those with more “volatile” income more (eg students), due to the fact that credit markets are not perfect and future income is genuinely uncertain. Furthermore, if different countries have different rates of consumption-income taxes, the decisions around where to work, buy consumer goods, and where to retire will be distorted (Note recent online discussions on this and solutions here, here, here).
Here we have run through the idea of consumption taxes, and inadvertently come up with the main reason why economists tend to state, that in terms of efficiency, we should have lower capital taxes relative to income/consumption taxes.
Having now run through the basics of income and consumption taxes, and shown the similarities between them, we are now prepared to start discussing the structure of these taxes.
Next time we will discuss what “regressive”, “flat”, and “progressive” tax systems are – and the efficiency and fairness challenges that are associated with them.