Should we tax consumption?

PUBLIC INTEREST in changing the tax system is growing much faster than understanding of the competing proposals. Democrats and Republicans, liberals and conservatives, all have come up with their favorite nominees for tax cuts--the poor, middle class, manufacturers, savers, investors, producers of luxury goods, etc.

It seems desirable, under these circumstances, to broaden the public debate to go beyond the present inconsistent array of specific proposals to modify slightly the income tax, which is the heart of the existing Federal revenue system. It is time to consider the most basic change in the government's income structure--abandoning the entire idea of taxing income and shifting to a consumption tax as the primary Federal revenue source.

Taxing consumption instead of income generates many consequences, most of them desirable. A constant theme among reformers is the need for increased incentive for saving, capital formation, and economic growth. This requires examining the pros and cons of consumptive taxation and analyzing the major alternative approaches to structuring a new tax of that type.

The governments of most industrialized nations, especially in the European Community, use consumption taxes far more than the U.S. does. While 18% of government revenue comes from taxes on consumption in the U.S., the comparable figures are 26% for Germany, 29% for France, and 31% for the United Kingdom.

The increasingly international nature of business competition requires updating the American tax system to global realities. There are several basic arguments economists have offered over the years for shifting the primary base of taxation from income to consumption. Primarily, it puts the fiscal burden on what people take from society--the goods and services they consume--rather than on what they contribute by working and saving. Thus, saving is encouraged at the expense of consumption. Unlike current consumption, saving makes possible investment in future economic growth. Nevertheless, problems will arise in setting up a new tax, just as difficulties are encountered with the more limited changes that Congress has been enacting yearly.

There are two major types of consumption taxes. One is a value-added tax (VAT), such as is customary in Western Europe. The second approach is to change the current income tax to an expenditure one by exempting savings. Unlike selective excise taxes (such as those levied on cigarettes and alcohol), a value-added tax is comprehensive. It is paid by each enterprise in the entire chain of production-manufacturer, wholesaler. and retailer. Duplication is avoided by taxing only the added value the firm contributes to the goods or services it produces. Essentially, value added is the difference between a business' sales and its purchases from other companies.

It is instructive to examine the basic argument for encouraging capital formation by means of tax reform. To many citizens, any discussion of capital formation immediately brings to mind visions of greedy bankers, wealthy coupon clippers, and--to use what is to many a pejorative word--capitalists. Nevertheless, capital plays a pivotal role in providing, the basis for the future standard of living of any society. It is essential for increasing productivity. and thus providing the basis for rising real incomes.

Educators at times find it amusing when some of their students discover communist-oriented economists writing about the necessity to hold down consumption in the Chinese economy in order to free up the capital resources needed to invest in the future growth of that economy. "Why, they are not even a capitalist society," these students will note in wonderment.

Then the thought will sink in that a rising stock of capital is necessary for any growing society--capitalist (that is, private-enterprise or market-oriented) or other (socialist, communist, etc.). It really is a basic matter of how much people want to eat, drink, and be merry today, and how much they want to set aside for tomorrow.

Boiled down to its fundamentals, assuring an adequate flow of saving and investment is little more than demonstrating a proper concern for the future. A slow pace of capital formation in the U.S. is especially troublesome at a time of heightened global competition, when modern, state-of-the-art machinery and equipment are necessary to match those foreign firms that benefit from low-wage structures.

Any doubt about the tendency of the American tax system to be biased in favor of consumption and against saving can be resolved quickly with a very simple example. Consider three factory workers, A, B, and C, each of the same age, with the same work experience and size of family, and with the same compensation. Mr. A regularly spends what he earns, no more and no less. Mrs. B deposits a portion of her paycheck into a savings account each week. Mr. C not only spends everything he earns, but also borrows to the hilt, having bought as expensive a house as he possibly could obtain financing for.