Although voters like public services, they detest paying taxes. To cover the resulting budget deficits, we borrow hundreds of billions of dollars each year from other countries, loans that must be repaid in full with interest. Deficits also erode savings, choking off investment that drives economic growth. Except for the end of the Clinton years, this has been the dynamic of our economy for the past four decades.
Things are poised to get worse. Rising Social Security and Medicare costs, overdue infrastructure maintenance, and some form of universal health insurance will all require substantial federal revenue. Even if the next president and Congress are more successful at cutting wasteful spending than any modern democratic government has ever been, they will still need major sources of new revenue to put our fiscal house in order.
Replacing the current income tax with a progressive consumption tax is the only way to cover our current revenue shortfall without demanding painful sacrifices from voters. Such a tax, which has been proposed both by conservative economists like Milton Friedman and liberal economists like Edward Gramlich, would be simple to implement. Families would report their incomes and their annual savings to the IRS, just as many now do with 401(k) and other similar retirement savings accounts. Their taxable consumption would then be calculated as income minus savings minus a large standard deduction–say, $30,000 for a family of four. For example, a family that earned $50,000 and saved $5,000 during a given tax year would have taxable consumption of $50,000–$5,000–$30,000, or $15,000 total. Tax rates on taxable consumption would start off low–say, 10 percent for the first $30,000 of taxable consumption. Under the consumption tax, this family would owe $1,500, about half of what it would pay under the current income tax.
Because the progressive consumption tax exempts savings from tax, it cannot generate even the same revenue as the current income tax unless marginal rates on the highest consumption levels are significantly higher than the highest current rates on income. But higher marginal rates would be problematic under the current income tax, because they would undermine people’s incentives to save and invest. In contrast, higher marginal rates on consumption, as opposed to income, would actually encourage savings and investment.
Moreover, a steeply progressive consumption tax would raise additional revenue without causing significant reductions in consumer welfare. For families that already consume at a high absolute level, evidence suggests that psychological well-being depends much more on relative consumption than on absolute consumption. By encouraging an across-the-board reduction in high-end consumption, a progressive consumption tax would thus have little effect on the relative consumption levels that shape well-being.
Consider a wealthy man who wants to host a “special” coming-of-age party for his daughter: Because the incomes of top earners have been soaring in recent years, the required expenditure levels have increased in tandem. To celebrate his daughter’s birthday in 2005, David H. Brooks, the chief executive of a company that supplies body armor to the American military in Iraq, invited 150 of her friends to the Rainbow Room atop Rockefeller Center in Manhattan, where they were serenaded by 50 Cent, Don Henley, Stevie Nicks, and other luminaries in
a celebration reported to have cost $10 million. If all wealthy families spent a little less on such parties, as high marginal consumption tax rates would encourage them to do, everyone’s daughter would feel just as special as before.
Although some people worry that tax incentives for reduced consumption might throw the economy into recession, it is total spending, not just consumption, that governs output and employment. Phased in gradually, a progressive consumption tax would slowly shift spending from consumption to investment, causing productivity and incomes to rise faster. In addition, during recessions, a temporary cut in consumption taxes would provide a much more powerful stimulus than the traditional temporary cut in income taxes, because a temporary consumption tax cut would be advantageous only if people spent more right away (in contrast, consumers who fear losing their jobs in a recession are often reluctant to spend temporary income tax refunds).
The Bush tax cuts for the nation’s wealthiest families threaten American economic prosperity, yet they have done little for their ostensible beneficiaries. Higher spending on larger mansions serves only to raise the bar that defines adequate housing for economic elites. Even in terms of naked self-interest, everyone would have fared much better if the same money had been spent to repair aging bridges and inspect the cargo containers that enter the nation’s ports. Realistically, the progressive consumption tax is the only policy that can make this happen.