Beyond the Pro-Consumption Tax Consensus

Daniel Shaviro - New York University School of Law

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For many decades in United States tax policy debate, fundamental tax reform was identified primarily with adopting a comprehensive income tax base.  In the last ten or so years, it has increasingly come to denote instead replacing the income tax with a consumption tax.  This shift has been as unmistakable in the academic literature as in public political debate.  Its occurrence is important, even though in my view the prospects for fundamental reform are decidedly dim, because ideas and ideals matter.

In academic circles, the shift reflects an emerging new consensus (widespread if not universal) that an ideal consumption tax is unambiguously superior to an ideal income tax, taking into account concerns of both efficiency and distribution.  This view rejects any tradeoff between the two types of ideal tax bases, such as between greater progressivity and greater efficiency, or by a choice between different kinds of efficiency.  Rather, the ideal consumption tax is viewed as capable of being equally progressive but more efficient, or equally efficient but more progressive, causing it to dominate the ideal income tax in any comparison.

There is something mystifying about this shift in ideals, no matter how intellectually persuasive one finds it.  Consider a second possible shift in normative framework, from favoring an annual income or consumption tax to favoring one that is lifetime-based.  Under a lifetime-based system, even if tax payments are remitted annually, lifetime rather than merely annual economic results determine how much one must pay.  Thus, people with fluctuating incomes do not end up paying more tax than those with stable incomes, as happens under an annual system with graduated marginal rates.  A lifetime-based system that still employs annual tax returns can be implemented through income averaging, a system that the economist William Vickrey proposed nearly seventy years ago, and that the U.S. federal income tax featured in a much more limited fashion from 1964 through 1986.  Income averaging has received extensive, but on the whole surprisingly unfavorable, attention in the tax policy literature, even though the intellectual case for it substantially overlaps with that underlying the new pro-consumption tax consensus.  At the level of ideals, leaving aside differences in administrative feasibility, it makes little sense for the one idea to be accepted while the other is rejected.

The reason for the overlap is that the case for a consumption tax, no less than that for income averaging, relies on taking a lifetime, rather than a current-year or snapshot, perspective in evaluating individuals’ welfare and in predicting their behavior.  A simple example can help to demonstrate this intuitively.  Suppose that, in a given year, Xavier and Yolanda each spend their entire $100,000 salaries on consumption, and thus are treated the same by a consumption tax even though Xavier has a million dollars in the bank while Yolanda has no savings.  How can this be justified, when Xavier is obviously so much better off?  The answer, from a consumption tax standpoint, is that Xavier does indeed bear a much higher tax burden, because in the long run he will be taxed just as heavily as if he had spent the million dollars, on top of the $100,000, this year.  This argument, however, requires taking a lifetime rather than a merely annual perspective—and indeed, perhaps, a longer than single-life perspective if Xavier leaves money to his heirs—raising, as we will see, the very same issues as the case for income averaging.

The persistence of the peculiar disjuncture between the income tax versus consumption tax debate and the income averaging debate reflects under-appreciation both of the affirmative case for income averaging and of its relationship to the case for a consumption tax.  In addition, while consumption taxation certainly does not lack critics, its reliance on the same long-term perspective as income averaging remains under-appreciated.  However, this reliance on a long-term perspective makes the cases both for income averaging and for consumption taxation subject to the assumptions needed to support the use of such a perspective.  In particular, such reliance rests on three critical assumptions, each of which is subject to challenge.

1)  Complete markets—Markets are complete when they cover every possible commodity and combination thereof.  In illustration, with complete labor markets one can work at one’s wage rate for any number of hours between zero and full-time.  With complete capital markets, one can hold financial positions that would pay off in every possible state of the world, thus providing effective insurance against any possible contingency.  Complete markets are necessary to the full achievement of allocative efficiency in the economy.  In the income averaging and income versus consumption tax debates, their absence would mean that people with the same lifetime resources might actually face very different circumstances in each period, suggesting that they should not necessarily pay the same lifetime taxes.

2) Consistent rational choice—Under conventional economic assumptions, people have stable preferences that determine the utility they will experience in alternative states of the world, and which they consult to make decisions aimed at maximizing expected utility.  People therefore are assumed to engage in consistent rational choice, suggesting that they will make the same choice from within a given opportunity set no matter how the choices are presented or framed.  Weakening this assumption, such as by positing that people are myopic, can undermine the cases for income averaging and consumption taxation by suggesting that behavior and wellbeing may significantly depend on current period resources, rather than simply on the lifetime total.

3) Within-period information—A final assumption underlying use of the long-term perspective to support income averaging and consumption taxation relates to achieving the tax system’s distributional objectives, rather than to the choice of analytic timeframe as such.  Specifically, this assumption holds that, once one has picked the relevant period for evaluating how well-off people are (such as by measuring their income or consumption for the period), information about when within the period the taxpayer acted or benefited does not provide further useful guidance for distribution policy.  Thus, in an annual system, people who earn or spend a lot in January typically are treated the same as those who ended the year in the same overall position but followed a different sequence (such as earning or spending more evenly across time, or with back-loading instead of front-loading).  With a lifetime perspective, this assumption becomes more controversial. The gap between, say, the ages of 21 and 75 is a lot bigger than that between January and December of a single year.  An individual may change a lot more during such an extended period, and the tax system may have a lot more to gain informationally from looking within the period, rather than just at total results for the period as a whole.  This undermines the case for income averaging and consumption taxation by suggesting that the particular sequence of the taxpayer’s earnings and/or consumption, not just the taxpayer’s lifetime income, should affect how she is treated both overall and at different times within her lifespan.

None of the three assumptions fully holds.  Contrary to the complete markets assumption, people often cannot borrow against their future expected earnings, and one cannot change past consumption decisions by reason of new information about available lifetime resources.  Contrary to the consistent rational choice assumption, people may be myopic or prone to hyperbolic discounting, and the use of mental accounts may lead them to violate the principle that a dollar is a dollar is a dollar.  Finally, as the new dynamic public finance (NDPF) literature in public economics particularly emphasizes, within-period information, such as about the relationship between when one earns and when one consumes, can have important normative policy implications.

Incomplete markets and departures from consistent rational choice can make current-period information about an individual’s circumstances more relatively important than consumption taxation and income averaging effectively recognize.  The effect, however, is more to muddy the analysis than affirmatively to support income taxation or a predominantly annual system.  Problems with the third assumption, pertaining to within-period information, potentially have stronger implications.  In principle, the within-period components of lifetime information could affirmatively support taxing saving, in keeping with an income tax but not a consumption tax, although likely using a very different methodology.  In addition, in some circumstances there may be grounds for imposing higher taxes on people with declining earnings than on those with level earnings, in keeping with an annual but not a lifetime-based system if both have graduated marginal rates.

While the importance of these departures from the new conventional wisdom remains unclear, collectively they cast doubt on the core conclusion of a recent leading article that “based on current understanding, ideal consumption taxes are superior to ideal income taxes.”1 Reality is simply too messy for overly definite statements about ideal systems to be completely persuasive.  Nonetheless, the case for consumption-based tax reform remains powerful, in large part because it has huge administrative advantages over an income tax by reason of not needing to address issues of realization.  Moreover, there ought to be further exploration of how a limited income averaging system might work.dingbat

 

Acknowledgments:

Copyright © 2009 Stanford Law Review.

Daniel Shaviro is Wayne Perry Professor of Taxation at New York University School of Law.

This Legal Workshop Editorial is based on the following full-length Article: Daniel Shaviro, Beyond the Pro-Consumption Tax Consensus, 60 STAN. L. REV. 745 (2007).

  1. Joseph Bankman & David A. Weisbach, The Superiority of an Ideal Consumption Tax Over an Ideal Income Tax, 58 STAN. L. REV. 1413, 1414 (2006).

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