Taxing the Creative Spirit

"Necessity is the plea for every infringement of human freedom. It is the argument of tyrants; it is the creed of slaves." So wonderfully does William Pitt speak in the House of Commons in November 1783, one would count him as a friend of liberty. Yet twenty-five years later, in response to the necessities which governments ever find, Pitt introduced the world's first income tax. Liberty and human freedom have not been the same since.

The income tax wormed its way into this country by way of the 16th amendment to the Constitution, ratified in 1913. Until then, most taxes collected on the federal level were import tariffs or excise taxes. Since then, it has become one of the most dreaded and detested taxes with a seemingly unlimited reach into the pockets and the privacies of individual Americans; in terms of unfairness, people consider it second only to the estate tax.

Why don't we abolish the income tax and replace it with a consumption tax?

How would a consumption tax work? There are two types of candidates: a national sales tax; and a value-added tax (VAT). A national sales tax, similar to state sales tax regimes, charges businesses a percentage of the final sale price of retail goods and services. A value-added tax, which is used extensively by other industrialized countries, charges businesses only the difference between the sales price it charges on goods and services (to consumers or other businesses) in wholesale or retail trade and the cost it paid to other businesses; they pay a tax on the value they add.

How much would a consumption tax need to be if it was to replace income taxes? When the idea of tax reform was actively debated in Congress in 1997, there were many proposals put forward. In order to eliminate the individual and corporate income tax and still obtain the same revenue, the Congressional Budget Office estimated that the consumption tax would need to be about 17%. In order to also eliminate payroll taxes, estate taxes, and excise taxes, it would need to be about 23%. Opponents of the consumption tax sometimes float estimates of "30%" or "60%" tax rates, but these are the rates that would be needed if large groups of constituents were rebated the tax and if large sectors of the economy were exempt from the tax, e.g., food, medical care, education, services, etc. In some of these studies, it seems that only your car and the kitchen sink would be taxed.

To illustrate the favorability of a consumption tax compared to an income tax, consider two men. Joe Producer starts his working life with no money, earns $1 million over his lifetime, lives a spartan existence consuming none of his earnings, and leaves the million dollars to his children. Todd Consumer starts his working life with $1 million, earns nothing, consumes the million, and dies with a zero balance in the bank. Income taxes take money from Joe (whether he consumes his earnings or not) but take nothing from Todd. Consumption taxes take money from Todd but nothing from Joe. Which is more fair?

The general idea is not to punish work, which is a creative force for good in the world, but instead punish consumption, which is necessary but nevertheless destructive.

While opponents of a straightforward consumption tax claim that it is regressive, this argument uses an erroneous definition of tax progressivity and regressivity. The notion of regressivity used is that lower-income individuals are taxed more per dollar of income. But this notion is only useful if we accept the idea that income is a reasonable proxy for well-being. The insight of the consumption tax is that income only translates into well-being if it is consumed—Joe Producer gets nothing directly from income and lives a life of poverty if he doesn't actually spend it. Consumption is a better proxy for well-being: the more one consumes, the better off one lives. If we reframe regressivity to more correctly mean that some individuals are taxed more per dollar of consumption, we find that a consumption tax is completely fair—neither progressive nor regressive. We also find that income taxes are too progressive in some instances we find unfair (Joe Producer) and too regressive in some instances we find unfair (Todd Consumer).

It is also important to point out that Americans see fairness as everyone paying a share commensurate with their well-being. A March 8-13 poll by the Tax Foundation found that 53% favor a system of either a "flat-rate income tax with no deductions" or a "national sales tax" while only 21% believe that the "current graduated income tax with no deductions" is preferable. Also, the survey indicated that by 63%-21%, Americans believe that everyone should pay some amount of tax. Clearly, most people see tax fairness as an effort to stop tax dodgers and have people of all economic levels contribute in proportion to their means.

In effect, all savings would be treated like retirement savings are today—taxes are deferred until the money is actually spent; every bank account becomes an IRA. With the U.S. economy experiencing its lowest savings rates in years (we actually had a negative household savings rate in 2005, the first time ever), replacing the income tax with a consumption tax would remove the impediment to natural incentives to save.

One of the most important benefits of a consumption tax is the enormous difference in compliance burdens. The income tax requires 6 billion hours of work a year and is estimated to cost a total of $265 billion in either direct compliance (tax professionals) or the opportunity costs of individuals and businesses who do their own taxes. With an annual take of $1205 billion dollars a year, this represents a 22% compliance cost. In contrast, state sales taxes and foreign VAT taxes have compliance costs in the 2-5% range. This excess compliance costs is a deadweight loss: they are resources society flushes down the toilet.

Of course, transition to a consumption tax would be no easy matter. One important hitch is that current savings (though not tax-deferred savings) have already been taxed as income and would thus be taxed again if used for consumption after the transition occurs; people who have high current savings levels would be unfairly penalized.

Another issue is political considerations. If the new tax system is not to affect revenues, some will be better off while others will be worse off. While it is reasonable to assume that eliminating the excess deadweight loss of income tax compliance would make all of us better off, there would likely be some for whom the present income tax system even with the compliance effort is better than a consumption tax. Many of these will be those who use the loopholes and deductions in the tax code to their benefit. Why should we pity them? They have used an unfair system to their benefit and deprived the rest of us of their fair contribution to society. Those who would squeal the loudest are those who have chiseled the most. Let them expose themselves.

Workers of the world unite! Stop the government from taxing your laboring, creative spirit. Have them tax those who would consume what you have produced, who live a life of leisure while you toil. The virtue of work need not pay tribute to the vice of consumption.