A CONSUMING AMBITION:

What A "Fairer" Tax Code Might Look Like: A reelected Bush may rework the existing system -- or try for a consumption tax (Howard Gleckman and Mike McNamee. 9/20/04, Business Week)

How would a shift toward taxing consumption differ from what we have now?

The existing code is a complicated hybrid. We call it an income tax, but it doesn't actually tax all income: The value of fringe benefits, such as health insurance and parking, goes untaxed. And the treatment of investment income verges on haphazard. About half of all capital income goes to tax-exempt accounts such as 401(k)s or pension funds. And companies often shelter their earnings from corporate taxes.

On the other hand, many companies do pay tax on their profits, then investors pay tax again on dividends or capital gains. So returns on investment may be taxed twice, once, or not at all.

A consumption tax, by contrast, is simply a levy on spending. In other words, you would take all the money you earn, subtract what you save, and pay tax on the rest.

How would Washington collect such a tax?

It could add a sales tax to the final price of goods and services we buy at the retail level, just as most states do today. Or it could have businesses pay the tax at each stage of production and pass the cost on to consumers in the form of higher prices. This is the value-added tax, or VAT, that most European countries use. Finally, the feds could collect the money through a system of tax withholding and annual returns, much as they do today. That version is called a "consumed income tax."

How would a consumed income tax work?

Think of an unlimited individual retirement account. You would simply list your income -- including, possibly, all your fringe benefits and other goodies that are currently excluded -- then subtract everything you save and invest and calculate tax on what is left. Investment earnings would be taxed once they are cashed in and you have used them to buy something.

Isn't that like the retirement savings accounts Bush has already proposed?

Bush has proposed two new savings vehicles: retirement savings accounts (RSAS) and lifetime savings accounts (LSAS). Together they would let a couple sock $20,000 a year into savings and never pay tax on the earnings -- eliminating all taxes on capital for 95% of individual taxpayers, according to William G. Gale of the Urban-Brookings Tax Policy Center.

Are those a step to a consumed income tax?

Not at all. RSAs, LSAs, and cuts in capital gains and dividend taxes are not tax reform. They are merely cuts in taxes on investment. Under a true consumption levy, allowing investment income to go tax-free would have to be coupled with ending the tax deduction for interest paid by corporations and by homeowners on their mortgages -- a huge and far less popular change. [...]

Don't many experts argue that a consumption tax is the way to go?

Only if done right. That would require eliminating interest deductions and other tax breaks -- a tall order for politicians. But if Washington did adopt a well-designed consumption tax, would be simpler than the current code, it would eliminate the double taxation of capital income, and sharply reduce the use of shelters. And most economists believe it would boost growth at least by a few tenths of a percent each year. Economist Alan J. Auerbach of the University of California at Berkeley figures it would push up gross domestic product by 9% over several decades. But a consumption tax's biggest virtue, say supporters, is that it is fair. "You work and save. I work and don't. Why should you pay more tax than me over your lifetime?" asks Urban Institute senior fellow C. Eugene Steuerle, who helped draft the 1986 tax reform.

It'll be amusing to see how heavily the President stacks his proposed tax reform commission.

Posted by Orrin Judd at September 16, 2004 10:51 AM