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 by former Treasury Secretary Martin Parkinson that
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 as Meade argued 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 under an income tax. An income 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 by Brooks, Auerbach, and Henry. Those wanting to keep up with current Australian tax debates can
visit the Tax Watch site, the ACOSS site or my blog site at https://pagdavidson.wordpress.com.
Who's the fairest?
Whether a tax is equitable depends how we measure 'ability to pay'. The equity case for income taxes
rests on two pillars. First, that income or 'spending power' is a better measure of 'ability to pay' than
expenditure because the ability to save and invest part of our income enlarges life choices (for example,
to improve our housing 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' case could 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 a contrary 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 the impact of consumption taxes on households at 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.
In any 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 recent ACOSS analysis using 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 Hockey please note, these are average (overall) tax rates, not
marginal tax rates.
OECD analysis has found that consumption taxes are generally regressive, if their 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, an income 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 households with substantial 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.
The first test is whether the annual saving pattern in the earlier graph is repeated across 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 advantage people 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 issue by establishing whether people with higher incomes across working
life save a greater share of their income. Dynan and colleagues researched this question in the US and
their answer to the question Do the rich save more? throughout working life was 'yes'. They found that
the median saving rate among people in the lowest 20% of overall working-age incomes was less than 1%
compared with 11% 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 to support this view from the UK.
Brewer posed the question: How does the tax system
redistribute income? He found 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 a much 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.
A second test of 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. They play
an insurance role - shifting resources from times when 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 suggests two 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 harder for high
income-earners to avoid. Few tax experts support this view. As Warren and Auerbach point 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 should be weighed up against the economic and social benefits the
programs they finance.
The economic costs of taxation can be reduced by 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 mainly mothers 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, boost workforce 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.
When Randolph and Rogers evaluated 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 longrun 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 Scholz found 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. The OECD found 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 of Apps and Rees took 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 less likely 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 the Henry Report. Recently, Operation
Wickenby has shone 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 retirees as 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.
Yet a sudden loss of spending power is unlikely to be popular among retirees and Governments will
understandably face pressure to compensate them.
The impact of compensation for low income earners and retirees adds to the uncertainty surrounding the
impact of a shift towards taxing consumption on economic growth. Altig and colleagues found that
compensation, especially of retirees for the reduced value of the savings, substantially reduces any
improvement in long run economic growth from taxing consumption more and income less. More broadly,
the larger the 'compensation package' for higher consumption taxes, the weaker the long term
improvement in growth.
An OECD study undertaken in 2008 of the effects of different taxes on economic growth has been cited by
Australian advocates of taxing consumption more and income less. This study attempts to isolate the
impact of taxes on long run economic growth rates in OECD countries from other factors likely to have an
impact. It ranks different taxes according to their estimated long run effects on growth. The rankings are
the same as that used in the Henry Report (as listed above). It finds that, on average, consumption taxes
are more pro-growth than income taxes, and property taxes (such as Land Taxes), are more pro-growth
than either income or consumption taxes, but that the extent of the difference in their economic impacts is
difficult to quantify. It is worth quoting the conclusion in full:
'Estimates of the effect on GDP per capita of changing the tax mix while keeping the overall tax-to-GDP ratio
constant indicate that a shift of 1% of tax revenues from income taxes to consumption and property taxes would
increase GDP per capita by between a quarter of a percentage point and one percentage point in the long run
depending on the empirical specification.The magnitude of the estimated effect is larger than what would be
reasonably expected. Given that there is a wide dispersion of the point estimates across specifications it is clear that
the size of the effects cannot be measured precisely in a cross-country comparative setting. ...Thus, the magnitude of
the effects should be interpreted with caution.' (p43)
This underscores the difficulty in separating the 'pure' impact of a change in the tax mix from all of the
other factors that contribute to economic growth levels.
Conclusion
The research on the effects of replacing income taxes with taxes on consumption can be summarised as
follows:
The impact of a shift from taxing income to consumption on the distribution of income (at least in a single
year) can be measured reasonably accurately and is likely to be regressive. This is due to differences in
household saving patterns. The impact on economic growth in the long run is likely to be positive, but
hard to quantify. Any positive impacts on growth are mainly due to the effects of income taxes on
investment levels (especially foreign investment) together with a windfall public revenue gain from taxing
spending from the accumulated wealth of retired people.