Who’s the fairest (and most efficient) of them all, income or consumption taxes?
Peter Davidson
Social policy and tax blogger at http//:pagdavidson.wordpress.com,
Senior Advisor Australian Council of Social Service
(views expressed are my own)
One of the long standing debates in tax policy is that between advocates of income and consumption taxes. As the Government prepares for its Tax White Paper, we're about to go once more round the mulberry bush! The argument has already been made byformer Treasury SecretaryMartin Parkinsonthat if we increased the GST and cut income tax, Australia's economic growth prospects would improve. This article summarises the issues and looks at the research evidence in favour of each of these tax bases.
Income and consumption taxes: what's the difference?
Before we begin, it's worth spending some time to clarify the difference between income and consumption taxes. We're all familiar with the personal income tax on wages, but income taxes also apply to investment income (capital gains, interest and dividends) and to companies and other entities as well as individuals.
On the consumption tax side, we're all familiar with sales taxes such as the GST. Yet there is another kind of consumption tax, one which is levied directly on taxpayers rather than indirectly (the GST, which taxes retailers in order to tax consumers, is an indirect tax). Direct expenditure taxes are relatively unknown in Australia because they have not been used here (or pretty much anywhere). Yet they have long been advocated as a substitute for income taxes. The basic idea is to exempt income from savings (investment returns) from the personal income tax, since the difference between income and saving is consumption. Advocates of expenditure taxes such asMeadeargued that a direct expenditure tax could in this way be levied at progressive tax rates (at higher rates for those who consume more), and that if accompanied by a tax on inherited wealth they were as equitable (or more so) than personal income taxes.
So the key difference between an income and a consumption (or expenditure) tax is not whether they are levied directly on taxpayers or indirectly through retailers, nor is it whether they are levied at a flat rate or progressive rates. It is whether that part of income we save is taxed each year. An income tax does so, a consumption tax does not.
While people are accumulating wealth, a consumption or expenditure tax has the same effect as a tax on wages since it falls on labour income but not investment income. So to raise the same revenue without taxing investment income, it must be imposed at higher rates, and these would fall on wages. On the other hand, once people began drawing down their wealth to spend it (mainly after retirement) they would be taxed on the draw-down of their capital, much as superannuation benefits were taxed up until 2007. So increases in wealth would still be taxed, only later than underan income tax.Anincome tax taxes annual investment returns from wealth whereas a consumption tax 'waits' until wealth is spent.
More detailed analysis of the impacts of income and consumption taxes on equity and economic growth is offered byBrooks,Auerbach, andHenry. Those wanting to keep up with current Australian tax debates can visit theTax Watchsite, theACOSSsite or my blog site at
Who's the fairest?
Whether a tax is equitable depends how we measure 'ability to pay'. Theequity case for income taxes rests on two pillars. First, that income or 'spending power' isabetter measure of 'ability to pay' than expenditure because the ability to save and invest part of ourincome enlarges life choices (for example, to improve ourhousing security by buying a home). Second, that the ability to save is skewed in favour of the well-off and the tax-transfer should redistribute spending power to those with the least. The 'ability to pay' casecould be described as the 'soft argument' for income taxes whereas the re-distributional case can be described as the 'hard argument'.
Expenditure tax advocates put acontrary view: that spending is a better measure of well being and that by taxing the returns from saving, an income tax imposes a bias in favour of current spending and against future spending.
When we compare theimpact of consumption taxes on householdsat different income levels, we find they are generally regressive (imposing higher tax rates on those with less income then those with more) when measured in proportion to household incomes, but close to proportional (a flat or uniform tax) when measured in proportion to spending.
The deferral of tax on savings under an expenditure tax benefits people who save the greatest part of their incomes. So whether an income or consumption tax is more equitable depends to a large extent on household saving patterns.
Inany given year, high income earners in Australia save a great deal more than low income households. If we compare saving rates (saving as a proportion of household disposable income) among each 20% of Australian households ranked by income in 2010, we find that the top 20% saves on average about one third of its income but the bottom 20% spends more than its income (by drawing down savings or borrowing). This means that in a given year, one third of the income of the top 20% would be exempted from a tax on consumption, while low income earners would be taxed (at the rate of the consumption tax) on more than 100% of their income.
Due to these household saving patterns and the progressive tax rates that apply to personal income (including a high tax free threshold), a recentACOSS analysisusing ABS data found that in 2010 Australian income taxes (blue bars) were progressive while consumption taxes (red and green bars) were regressive (i.e. tax rates fall with income). The bottom 20% of households paid 3% of their income in income taxes and 21% in consumption taxes, while for the top 20% the order is reversed (20% in income taxes and 8% in consumption taxes).Joe Hockeyplease note, these are average (overall) tax rates, not marginal tax rates.
OECD analysis has found that consumption taxes aregenerally regressive,iftheir impact is measured in the conventional way - as a proportion of income in a single year. A direct expenditure tax at progressive tax rates (as distinct from a sales tax) might be progressive, but less so than an income tax with identical tax rates. Again, this is due to the household saving patterns described above.
From the standpoint of 'ability to pay' in a given year, anincome tax takes better account of differences in spending power by taxing those with more capacity to save at higher rates than those who spend all (or more) of their income due to financial constraints (for example unemployment or marital separation). A key exception is householdswithsubstantial wealth which they are drawing down mainly for consumption rather than investment, but those circumstances would be unusual today.
Advocates of expenditure taxation argue that the equity of taxes should be measured over a life-time, not a single year. If we accepted this argument, there are two key tests we can use to establish whether income or consumption taxes are fairer.
Thefirst testis whether the annual saving pattern in the earlier graph is repeatedacross working life. If not, then taxing consumption instead of income would shift the incidence of tax across the life course (from youth to old age) but it would not necessarily advantagepeople who are better off throughout life.
If on the other hand, the ability to save is unevenly distributed among different groups in the community across life, replacing the income tax with a consumption tax would increase inequality of lifetime spending power. There are many possible reasons for this: inherited wealth, innate ability, and the other advantages that accrue to people who make the 'right' choice of parent including parental investment in education and being raised in a good suburb. If this is so, then exempting investment income from tax is likely to enlarge the life choices of those who are already ahead of the game.
We can shed light on this issueby establishing whether people with higher incomesacross working lifesave a greater share of their income. Dynan and colleagues researched this question inthe US and their answer to the questionDo the rich save more?throughout working life was 'yes'. They found that themedian saving rate among people in the lowest 20% ofoverallworking-ageincomes was less than 1% compared with11% for the top 20%.
What does this mean for tax policy? If people with higher incomes across their working lives save more, then the income tax is likely to be progressive across working life as well as in a single year.There's evidence tosupport this view from the UK.
Brewer posed the question:How does the tax system redistribute income?Hefound that the UK income tax was almost as progressive when women's incomes were measured across working life as it was on an annual basis. The exception was amuch larger 'negative' annual income tax rate for the bottom 20% (the blue bar on the left of the graph). This was due to the the system of tax credits for low paid workers which partly replaced family allowances in the UK at that time.
Asecond testof the equity of a tax across the life cycle is whether it imposes higher tax rates on people at those stages of life when people can best afford to pay (for example just before they have children and just after they leave home) and lower tax rates at stages when their finances are tight (for example when raising children and after retirement).
This is what the income tax system (together with social security and family payments) does. Theyplay an insurance role - shifting resources from timeswhen people's ability to save is strongest to times when they are more likely to struggle financially.
Income taxes are lowest when people are young or old, highest in between, and slightly lower in the early child raising years. Consumption taxes are less sensitive to changes in the 'ability to pay' across the life cycle - though this is really another way of saying that they are more likely to be regressive in a given year (as discussed previously).
This discussion suggeststwo conclusions. First, that deciding whether taxes are equitable involves much more than a simple comparison of tax rates. Second, that despite the complexity of these issues the common sense view that income taxes are more progressive than consumption taxes is probably right.
There is another equity argument raised in favour of consumption taxes: that they are harderfor high income-earners to avoid. Few tax experts support this view. AsWarrenandAuerbachpoint out, if economic activity is 'off the radar' of the income tax, it's probably off the radar of consumption taxes also. Greece relies more on consumption taxes than most OECD countries, but from all accounts the Government there still has a big problem with tax avoidance. The argument that well-off people can take advantage of income tax shelters is an argument for closing tax shelters.
Which is more efficient?
Since the 1980s, when Governments struggled with low levels of economic growth, high inflation and high unemployment, the debate over the ideal mix of tax between income and consumption has shifted from equity concerns to the impact of tax on the efficiency of the economy. Taxes almost invariably have an economic cost, though of course this shouldbe weighed up against the economic and social benefits the programs they finance.
The economic costs of taxation can be reducedby taxing investment incomes consistently (and not so much that mobile capital decides to invest elsewhere), and avoiding high tax rates on those whose workforce participation decisions are strongly affected by tax (it turns out this is mainlymothers on low incomes).
As the'Henry Report'found, most studies of the economic costs of different taxes conclude that taxes on land, resources such as minerals, and inheritances have the least adverse effects on the economy, that consumption taxes are less economically 'efficient' than these taxes but more so than income taxes, and that taxes on business inputs and transactions such as Stamp Duties are the least efficient. They generally also conclude that taxes which are broadly based (raised in a consistent way on different items or economic activities) are more efficient than narrowly based taxes (State Payroll Taxes, which exempt the majority of businesses, are an example of a narrowly based tax).
But be wary of simple'league tables' of the efficiency of taxes. The impact of a tax on the economy depends on many factors including how broadly based it is, how high are the tax rates, a country's economic structure, levels of inflation and interest rates, and whether the tax clearly falls into one of the above idealised categories. For example, the treatment of investment income under the Australian personal income tax is actually a hybrid of income and consumption tax treatment. I'll return to these issues in Part 3 of 'A brief history of tax'.
In theory, moving from taxing income to consumption should encourage saving and investment but discourage workforce participation. The logic here is that the cost of an income tax is shared between wage earners and investors whereas a consumption tax that raises the same revenue would fall more heavily on wage earners. The claim that shifting from income taxes to consumption taxes would improve paid work incentives doesn't withstand close scrutiny.A reduction in income tax rates would, all things being equal, boostworkforce participation. But if this is paid for by higher taxes on spending, consumer prices would rise and the spending power of wages would either remain the same or fall.
WhenRandolph and Rogersevaluated the economic effects of proposals to replace the US federal income tax with an expenditure tax in 1995, they concluded that the proposed reforms would probably boost long-run economic growth but there was a great deal of uncertainty about the extent of any improvement, and a significant chance that they would reduce growth. A key reason for this ambiguity was the offsetting impacts of higher saving and investment and lower workforce participation.
In theory, a switch from taxing income towards taxing consumption should boost household saving because the portion of income that is saved would be exempted from tax. Academic studies over the past two decades have examined whether expenditure tax treatment of saving (either by allowing deductions for contributions to savings accounts or exempting investment income from tax) increases household saving.Engen, Gale and Scholzfound that tax breaks for saving influenced the choice of savings vehicle (e.g. towards superannuation and away from interest bearing deposits) but were unlikely to strengthen household saving overall. TheOECDfound that tax breaks for saving by high income earners were generally ineffective because they were likely to save anyway in the absence of incentives.
Unlike most research on the economic impact of taxes, the work ofApps and Reestook account of the unpaid labour of women, including its significance as an alternative to paid work. One implication is that women, especially mothers whose potential wages are modest, are relatively sensitive to the impact of taxes on the spending power of their wages. They found that a shift from taxing income to consumption was likely to reduce their workforce participation, and that this would reduce household saving since single-income families were lesslikely to save than two-income families.
The strongest potential economic efficiency gains from taxing consumption rather than income come from two sources. The first is the impact of the removal of income taxes on levels of investment, especially across international borders. Investment is more 'mobile' than labour. For example, people can more readily move their savings out of Australia than pull up stumps and work overseas. This implies that taxes on investment income should ideally be lower that taxes on wages since investment is more responsive to tax levels. The risks to public revenue and economic growth from increasing mobility of capital (due to internationalisation and new technology) were emphasised by theHenry Report.Recently,Operation Wickenbyhasshone a spotlight on the use of tax havens by high income earners to shelter personal investment income and assets.
The second potential efficiency improvement from taxing consumption rather than income comes from an unexpected source: an increase in the taxation of the wealth of retireesas it is drawn down and spent. An income tax does not tax savings unless they are invested and yield income. A consumption tax taxes the draw-down of savings, which mostly happens after retirement. For example, a sales tax reduces the spending power of retirement savings. A shift from taxing income to consumption thus leads to a one-off devaluation of retirement savings. This is unlikely to affect saving decisions and future economic growth because it is largely unanticipated and retirement savings are the product of decisions made throughout working life. To the extent that this windfall public revenue gain is used to reduce other taxes that distort economic decisions, it is likely to improve economic efficiency.