74 Consumption taxation Consumption taxation interest, debt repayment). This approach is often characterized as the R (for real transactions) base Gilbert E. Metcalf approach, a terminology credited to Meade (Institute Tufts University for Fiscal Studies 1973). Alternatively, one can in- clude all financial transactions (R + F base). Thus, Taxation based on consumption, as opposed all cash proceeds are included as taxable income, to some other measure of ability to pay, and all cash outflows are deducted. So long as the most notably income. same tax rate applies to all transactions, these two approaches generate the same tax consequences to a Forms of consumption taxes firm. The present discounted value of taxes paid on proceeds from borrowing, for example, should just To understand the different ways in which con- equal the present discounted value of taxes saved by sumption taxes can be implemented, it is useful to deducting principal and interest on that debt. The begin with the Haig-Simons definition of income: R + F approach is better suited for use in taxing income (Y ) equals consumption (C ) plus changes in financial services where value added is difficult to wealth (W ) (Y = C + ∆W ) . First, note that the key disentangle from financial activities (borrowing and difference between income and consumption taxa- lending). tion is the inclusion or exclusion of ∆W in the tax As an accounting identity, value added is allo- base. Changes in wealth—or savings—are not taxed cated to workers (wages) and capital owners (divi- by consumption taxes but are taxed by income taxes. dends and retained earnings). However, as noted Second, note that this relationship suggests that con- above, investment expensing means that the taxes sumption can be taxed directly (e.g., via a sales or on value added allocated to capital owners are offset excise tax) or indirectly by imposing an income tax by the reduction in taxes due to expensing. In other with deductions for increases to savings (and inclu- words, the only capital owners who will incur the sion of withdrawals from savings in the tax base). A burden of a consumption tax are those who own national sales tax on all goods and services would be capital before a consumption tax is implemented one way to implement a consumption tax, while an (ignoring transitional rules). This gives rise to the income tax with IRA treatment of all savings would distinction between “old” and “new” capital and is be a way to implement the consumption tax indi- an important issue in tax reforms. rectly. The expenditure tax proposed by Kaldor It is often claimed that a consumption tax is a (1955) is an example of this indirect approach. Re- combination of a wage tax plus this lump sum tax cently, it has been revived as a component of the on old capital. There are (at least) two important ob- Nunn-Domenici USA Tax Plan. servations to make about this claim. First, if a future Value-added taxes (VATs) provide a third observer sees that individuals file tax returns paying method of implementing consumption taxes. Value taxes on their wage income only, that observer will added in production is the difference between the not be able to say if this is a “wage” or a “consump- sale price of produced goods and services and the tion” tax. To distinguish between the two forms of cost of goods and services used in production. A taxation, the observer would need to know what VAT can be viewed as a national sales tax where the happened to old capital at the time of the reform. If tax is collected in increments at each stage of pro- a wage tax has been enacted along with a levy on duction, from the producers rather than from the existing capital, then the observer would be looking retail seller. A key feature of a consumption-style at a consumption tax. In other words, the distinction VAT is that investments by the firm are deducted between a wage tax and a consumption tax based on (expensed) rather than depreciated. The effective tax treatment of old capital may mislead an observer. rate on investment equals zero if a firm can expense We would enact what looks like a consumption tax, its investment. While taxes are paid on the returns to but what really is a wage tax, by forgiving the tax on that investment (i.e., on the value of goods and old capital and vice versa. services generated by the investment), those taxes Second, the claim would suggest that in the ab- can be viewed as the government’s share of the re- sence of old capital, wage and consumption taxes turn to the investment because of its equity stake in are equivalent. But consider an entrepreneur who the investment following the tax deduction resulting thinks up a great idea after the new law has been en- from expensing. acted and sells it for $1 million. (Or perhaps he finds As described above, all financial transactions oil on a previously worthless piece of property and are ignored when calculating value added. All cash sells it for $1 million.) All consumption financed by proceeds into the firm (stock sales, proceeds from this $1 million would escape taxation under a wage borrowing) are ignored, as is all cash out (dividends, tax. A personal cash flow tax would tax all cash Consumption taxation 75 coming to an individual, with a deduction for any consumption tax should properly tax bequests. The savings (into qualified accounts); in this case, the Meade Commission’s approach to taxing bequests consumption financed by proceeds from the sale of was to propose a separate wealth tax to “encourage the idea would be taxed. In certain cases, the U.S. dispersion in the ownership of wealth” (Institute for Treasury staff’s blueprints (U.S. Treasury Depart- Fiscal Studies 1973: 518). ment 1977) allow for a tax prepayment option in which additions to savings are not deducted, nor are Historical antecedents the principal and return from that savings taxable The intellectual arguments for consumption taxation (when withdrawn for consumption). While tax pre- can be traced back to Thomas Hobbes. Writing payment is a useful—perhaps essential—option for some 350 years ago, he argued that “. the Equality certain assets (houses, jewelry, etc.), it could not be of Imposition consisteth rather in the Equality of used for taxing returns such as our entrepreneur re- that which is consumed, than of the riches of the ceives. In this context, the tax prepayment approach persons that consume the same” (Hobbes 1651: would be identical to a wage tax. 387). His argument was based on the logic that the Variations on these approaches to taxing con- state provides protection for the enjoyment of life sumption abound; generally, the focus on how one and that taxes are the price of that protection. Be- implements a consumption tax follows from admin- cause consumption is the material manifestation of istrative and distributional concerns arising from the enjoyment of life, so should consumption be the windfall gains and losses in the transition from some base of taxation. Or as Hobbes put it, “For what rea- existing tax system to the consumption tax system. son is there, that he which laboureth much, and One popular variant is the Hall-Rabushka Flat Tax, sparing the fruits of his labour, consumeth little, which is a two-part tax. The business tax is essen- should be more charged, than he that living idlely tially a VAT with a deduction allowed for compen- getteth little, and spendeth all he gets: seeing the one sation to workers. The second tax is a personal tax hath no more protection from the Commonwealth on compensation at the same tax rate. Described this than the other?” way, the shifting of the labor tax component from More recently, Kaldor (1955) argued for an ex- the business tax to a personal tax has no economic penditure tax as a surtax to coexist with the current effect. The motivation for shifting the labor tax income tax in the United Kingdom. More recently component is to allow a generous personal exemp- still, the Meade Commission (Institute for Fiscal tion to effect greater tax progressivity. A slight vari- Studies 1973) in the United Kingdom and the U.S. ant on the Hall-Rabushka Flat Tax is Bradford’s Treasury Department (1977) have made forceful (1987) X Tax. It differs in having a progressive rate cases for consumption taxation. Despite these pro- structure on the personal tax, the top rate of which posals, no country has shifted its tax system wholly equals the business tax rate. to a consumption base. However, there has been a An important unresolved question is whether shift in the mix from income toward consumption bequests and gifts should be included in the base of taxation in a number of ways in the last 20 years. a consumption tax when the tax is explicitly levied First, the European Community (EC) passed two di- on consumption. Clearly, the receipt of gifts should rectives in 1967, in which it mandated all EC mem- not trigger a consumption tax liability. One might bers to implement VATs. As a result, the mix of argue that the gift of a bequest (or other monetary consumption and income taxes has shifted to the gift) should be treated as consumption (and hence point where consumption taxes (VATs, excise taxes, taxed) because the bequest generates consumption etc.) constitute between 15 and 25 percent of tax benefits for the donor. An altruistic motive (e.g., revenues for the EC countries (see Metcalf 1995).