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Chapter 16

Taxes on Consumption and Sales

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Consumption as a Tax Base

Consumption can be an alternative to income as a measure of ability to pay.

Comprehensive consumption: Income-Savings

Note that capital gains would not be taxed if it were not spent.

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An Expenditure Tax

An expenditure tax would have the same practical impact as an income tax.

Taxpayers would add all sources of income and deduct additions to savings accounts.

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Comparing a Tax on Income to a Tax on

Consumption Assumptions: Two equally situated 18 year olds with no physical capital Wages = $30,000 per year Interest rates = 10% Flat rate tax for either consumption or income of 20%. Two earning periods.

They have equal ability to pay taxes over their lifetime so they should pay equal taxes over their lifetime.

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Comparing a Tax on Income to a Tax on Consumption

Step 1 An Income Tax IA = IB = $30,000

SA = 0

SB = $5,000

  TA = $6,000 + $6,000/(1+.1)

= $6,000 + $5,455 = $11,455 TB = $6,000 + $6,100/(1+.1)/(1+.1)

= $6,000 + $5,545 = $11,545

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Comparing a Tax on Income to a Tax on Consumption

Step 2 A Consumption Tax for the Non-SaverIncome = Consumption + Consumption Tax +Savings First and Second Year IA = CA + TA + SA

$30,000 = CA + .2CA + 0 CA = $25,000 TA = $5,000 SA = 0

Present Value of All Taxes TA = $5,000 + $5,000/(1+.1)

= $5,000 + $4,545.45 = $9,545.45 

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Comparing a Tax on Income to a Tax on Consumption

Step 2 A Consumption Tax for the Saver First Year

IB = CB + TB + SB

$30,000 = CB +.2CB + $5,000

CA = $20,583.33

TA = $4,166.66

SA = $5,000

Second Year

IB + Proceeds from Saving

= CB + TB

$35,500 = CB + .2CB

CA = $29,583.33

TA = $5,916.67Present Value of All TaxesTB = $4,166.66 + $5,916.67/(1+.1)

= $4,166.66 + $5,378.79 = $9,545.45

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Comparing a Tax on Income to a Tax on Consumption

Under an Income tax, savers pay more in tax than non-savers.

Under a consumption tax, they pay the same present value of taxes.

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A Comprehensive Consumption Tax Base

Inflation is no longer a concern with capital gains.

Taxing Durables becomes a problem as this would add substantially to the price of a car or home.

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A Cash-Flow Tax

A Cash-Flow Tax would operate like the current income tax, except that the amount placed in qualified accounts would be deductible. Assets that increased in value would not be taxed unless cash was removed from the accounts.

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Substituting a Consumption Tax for an

Income Tax To be revenue neutral Tax Revenue = tiI = tcC

Where ti = income tax rate

tc =consumption tax rate

I = income C =consumption

If people save 20% of income then tiI = tc(.8)I which means that 1.25ti = tc. That is, when people are saving, in order to be revenue neutral, the tax rate on consumption must be higher than the tax rate on income.

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Figure 16.1 Substituting a Comprehensive Consumption Tax for a Comprehensive Income Tax: Investment Market Effects

Gain in Efficiency

Yie

ld (

Per

cen

t)

Investment per Year 0

F rN

Net Return under the Income Tax

S

E

Q1

r*

G

D

rG*

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Impact of a Sales Tax on the Efficiency in Labor Markets

A substitution of a consumption tax for an income tax (with equal yields) would require a higher tax rate because of savings.

The net efficiency change depends on whether the gain in the investment market is greater than the loss in the labor market.

Estimates suggest such a change would have a positive impact on GDP.

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Figure 16.2 Substituting an Equal Yield Comprehensive Consumption Tax an Income Tax: Labor Market Effects

Wa

ge

s

Labor Hours per Year 0 L1

SL

WO

D = WG

B WG1

L2

WN1

WG(1– t1)

A

C

WG2

L3

WN2

WG(1– tC)

A'

C'

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A Sales Tax

A retail sales tax is typically a fixed percentage on the dollar value of retail purchases.

Sales taxes are a major source of tax revenue for state and local governments. Some state rates are as high as 7% with local governments adding an additional 3% on top of that.

Often food and medicine are exempt.

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An Excise Tax

An excise tax is a selective tax on particular goods.

In the United States excise taxes exist on car tires, long-distance telephone service, airline tickets, gasoline, and many other goods.

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The Incidence of Sales and Excise Taxes

Generally, sales taxes are regressive when food and medicine are not exempt.

A national sales tax would be borne by labor income and would lack the progressive rate structure of the personal income tax.

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Turnover Taxes Turnover taxes are multistage taxes levied at

some fixed rate on transactions at all levels of production.

The effective rate of tax depends on the number of times the good is sold during the production process.

This creates a significant bias toward vertical integration (where all production stays within the same firm).

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A Value-Added Tax

A value-added tax (VAT) is a consumption-based tax levied at each stage of production.

 Value Added = Total Transactions – Intermediate Transactions

= Final Sales= GDP= Wages + Interest + profits + Rents + Depreciation

 Tax Liability = Tax on Payable Sales – Tax Paid on Intermediate

Purchases= t(sales) – t(purchases)= t(sales – purchases)= t(value added)

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Implications of a VAT

keep compliance costs high, encourage saving, and encourage barter and other

evasion/avoidance.

A complete substitution of all income and payroll taxes for a VAT would

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The VAT in Europe The VAT accounts for about 20% of EU member nation revenue.

The average rates within the EU are between 15 and 20%.

Different rates apply to different types of goods, with luxury items facing the highest rate and necessities facing the lowest.

The tax applies to services as well as goods (unlike most sales taxes in the U.S.).

Economists find the VAT a good alternative to an income tax

because it does less to discourage savings and investment.

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Sales Taxes with Mail Order and the Internet A 1967 Supreme Court case declared it unconstitutional for a state to

insist on sales tax collections for sales to residents of other states (when there is no outlet for the good in the customer’s state).

This is because of the destination principle, which states that a consumption tax should be imposed on the consumer wherever consumption takes place; the state in which the purchase occurred would have no way to determine where consumption takes place.

Some states have imposed use taxes (at the same rate as their own sales taxes) on the customer because local retailers claim they are at a disadvantage relative to mail order.

There has been a general moratorium on new taxes for sales over the internet. This does not apply to businesses that have local counterparts (like Dell and Gateway) but to internet only retailers.

The moratorium is less important than it might seem, because a large volume of internet sales are business to business, which is not taxed anyway.