Switching to a Consumption-Based Tax from the Current Income Tax

Executive Summary

For the last five years, the U.S. economy has struggled with high unemployment and anemic growth. Despite recent improvements, the national unemployment rate remains at 7.6 percent (May 2013). According to the most recent estimates, non-residential private fixed investment is still below pre-recession levels. Given these facts and the persistent budget problems, rising demands of the aging baby boomers, and increased global competition, policymakers are increasing their efforts to overhaul the tax code. If successful, this will be the first major tax reform since 1986.

According to economic research over the past two decades, switching from our current income tax to a consumption-based tax system could achieve the goals of stronger investment and faster economic growth. A pure consumption tax is defined as a system that taxes individuals on the goods and services they purchase and exempts all saving from tax. Most economists believe that switching to a system where the tax base depends primarily on consumption rather than income could increase saving, investment, real output, and long run economic growth.

Over the past several years, members of Congress, commissions, and others have presented policy makers with a number of proposals to reform the Federal tax system. The majority of these proposals retain income from all sources as the primary tax base for the taxation of both individuals and businesses. However, the tax reform proposals being given the most consideration by policymakers today would not provide the type of saving and investment incentives that economic research shows would have the strongest impact on U.S. economic growth since they are not proposing a shift away from taxes on income toward a consumption tax base.

In this paper, we discuss three policy proposals put forth by 2005 the President’s Advisory Panel on Federal Tax Reform. The Panel looked at a progressive consumption tax (PCT) system that would completely eliminate the difference between the pre-tax and the after-tax return on investment. It also considered a more blended or hybrid tax structure that would move the current tax system towards a consumption tax, while preserving some features of income taxation. This blended option, called the Growth and Investment Tax Plan (GIT), would be more readily accepted by today’s policymakers and the public due to its simplicity, lower rates, and retention of some of today’s popular provisions such as the tax credit for mortgage interest. The panel also analyzed the Simplified Income Tax (SIT) plan which broadens the current income tax base.

Under GIT, households would file tax returns and pay tax on their wages and compensation based on three tax rates: 15, 25 and 30 percent. This system would include tax-exempt savings accounts that would shield many households from taxation on their savings. Businesses would pay a single tax rate of 30 percent on their cash flow. Cash flow is defined as total sales less purchases of goods and services from other businesses, less wages and other compensation paid to workers and could expense new investment. Non-financial businesses would not be taxed on income from financial transactions, such as dividends and interest payments, and would not receive deductions for interest paid or other financial flows.

Under PCT, the tax rates applicable to individuals and business cash flows would be slightly higher than GIT, 15, 25 and 35. There will be no taxation of capital income under the pure consumption tax system eliminating the need for special savings accounts. There would be lower deductions and exclusions for employee provided health insurance in order to maintain revenue neutrality.

The SIT provides four tax rate brackets for individuals: 15, 25, 30, and 33 percent. Other key features for individuals include replacing the mortgage interest deduction with a “home credit” equal to 15 percent of mortgage interest paid. Cost recovery allowances for business investment would be slowed.

Evaluation of these three plans by Office of Tax Analysis in U.S. Department of the Treasury concludes that both the GIT and the PCT would substantially increase the national capital stock and national income. In contrast, the SIT plan has very little impact on national income, the capital stock, net investment or consumption income.

As the United States faces the economic challenges of the twenty-first century, including funding the retirement of the “baby boom” generation as well as providing employment for workers of all ages, fundamental tax reform that moves the U.S. tax system toward greater reliance on consumption taxes can be an important policy lever for achieving stronger economic growth, funding important spending priorities and higher living standards.

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