Have you met the perfect tax?
The duty that is both elegant, and fair. The regime that lets our economies grow, and have everyone partake in its fruits. The excise that reconciles efficiency with equity. The set of rules that raises the revenue for a potent polity, and, at the same time, curbs wasteful decadence, to form that more perfect union.
If you haven’t met the perfect tax, let me introduce you: the postpaid progressive consumption tax.
The secret of the perfect tax? It burdens that behavior which is truly wasteful and undesirable: excessive consumption. It leaves all other economic activities unaffected.
Together with a negative income-tax for poor income earners and, possibly, a wealth tax to avoid boundless capital accumulation, it can replace all other redistributive taxes, both on individuals and corporations. Read on for more.
Big Spenders, Beware: It’s Spend, then Tax
So, here it is, an innovative suggestion on how to reform and restore our public finances, in a fair and efficient way. It is also the topic of my MPP thesis here at Hertie.
A progressive consumption tax (PCT) acts, in effect, as if we were to finally slap those luxury taxes on those Burberry children coats (starting $340), Louis Vitton bags or Maybach cars. Except a PCT does it much more elegantly, and without undue market distortions.
So how does it work? You calculate the net worth of a person at the beginning of the year, add all incomes and subtract all losses (from investment, for example). That sum, minus the savings at the end of the year, is what that person consumed. That amount of consumption is then taxed progressively, and after the fact.
Let’s enlist Aesop‘s fabled Ant and Grasshopper to explain an example. (The analogy, which I take from McCaffery 2005, is somewhat amiss, for the original Grasshopper does not earn much, but sings.)
Grasshopper earns EUR 30,000 each year, of which he spends everything. He had no savings at the beginning of the year, and none at the end, when winter, or rather, the taxman comes. With no savings, all of his income is taxable at a progressive rate, of, say, 10%. Grasshopper owes EUR 3,000 to the state.
Thrifty Ant, who also earns EUR 30,000 per year, saves EUR 10,000. She also owns a house worth EUR 5,000. Her taxable consumption is EUR 20,000 at, for example, 5%, owing EUR 1,000 to the taxman. Ant will, of course at some point in the future consume what she has saved, but possibly spread more evenly (thereby avoiding sharply progressive rates) and while earning an interest on her savings (which is not income taxed).
Comparing the Ant to the Grasshopper, both of which earn equal incomes, is instructive, but captures only part of the genius that the PCT is: it encourages saving, and never punishes income from productive activities, be it in the form of hard work or risky investment. Contrast to this progressive income taxes, which tax labor once, and capital even twice (once it is initially earned, and again when it yields a return).
From Each According to Ability
But there is more. Let’s introduce a third beast, the Lion, who powerful as he is, earns a great income of EUR 600,000. He also consumes a lot (he is a predator, after all), say EUR 300,000. He has accumulated savings of EUR 900,000 to which this year, he adds EUR 300,000. Come winter, the (brave) taxman will collect a 33% due on consumption, that is, EUR 100,000. Note, that although Lion consumes relatively less (50%) than Grasshopper (100%), he has to pay relatively more taxes (33% as compared to 10%), because, in absolute terms, he is encouraged to spend less and save more, given his income-generating abilities.
It’s Not All Pleasure-Delaying
So far, the PCT appears to encourage thriftiness over all else. As Ant – and even the most die-hard supply-side economists – will attest, that alone would make for a fairly sad state of affairs, with all saving, and always delayed consumption. As Ant learns, the heart wants some music, too.
Correctly understood, the PCT is actually agnostic towards how much we, as a society, consume or save.
What’s missing in the description so far – as it is in much of the politics of tax – is what happens with the revenue. Taxation does not reduce resources, but merely redirects them. It is then up to the democratic state, or the individuals to which it redistributes, to decide how much should be saved or invested (and there are good reasons to do more of that) and how much should be devoted to consumption.
S-Classes to Schools
When implemented with an appropriate transition, the PCT does not lead to a drop in demand. It merely redirects some of those (otherwise conspicuous) consumption checks to other, more broadly beneficial, uses. The PCT does not change how much we consume, but what. It discourages excessive consumption for positional gain with individually concentrated benefits, and favors the provision of goods to a greater number of persons.
Does it really matter how extravagant your wedding gown (or SUV, for that matter) is in absolute terms, or how it compares relatively to the Joneses?
Incentives Remain
Some will fear that the PCT may reduce incentives to work hard, and invest wisely, because the ultimate reward of consumption is discouraged. Even accepting the (normatively troublesome, and empirically doubtful) premise of incentive-led, fully rational and egoistic human actors, it seems unlikely that the PCT would do anything to demotivate people to work hard. It does not abolish individual material rewards, the PCT just compresses the range of likely rewards.
Ever since Thorstein Veblen we have reason to believe that the main motivation of excessive consumption stems from the attaining or maintaining of social status. Appropriate rewards then need to be only relatively higher, but need not be infinitely excessive in absolute terms.
In other words, whether you compete for Volkswagens, or Porsches shouldn’t matter for how hard you work, as long as the Joneses won’t get that Porsche either.
A Lot of Pros, and No Cons
- No more need for corporate taxes (which were necessary to prevent progressive income tax evasion).
- Does not reduce incentives to work, or invest.
- Efficiently taxes, but does not authoritatively or arbitrarily forbid extravagant consumption.
- No harder to administer than progressive income tax.
- Curbs collectively wasteful activities.
- Does not distort prices, except in the way it wants to.
Ready. Willing? Able.
The progressive consumption tax will not resolve all public policy problems. But it appears to be a promising centerpiece for fiscal reform and rebuilding. It is a starting point for the long-overdue overhaul of redistribution, public revenue generation and social policy, with wide-reaching implications.
The progressive consumption tax is a disruptive innovation of “the analytic muddle” that tax is (McCaffery 2005: 921).
It begs many questions: How will it affect the wider economy and society? How can it be administered efficiently? How, and where, can the line between investment and pleasure, be drawn? How to treat inter-generational transfers? How to achieve the necessary international cooperation? How to transition to a PCT-regime?
Analytically, the progressive consumption tax serves as a normative counterfactual, asking why we are failing to achieve the equity and efficiency in our political economy it promises.
Politically, the progressive consumption tax is an unforgiving reminder, showing that, indeed, another world is possible. More specifically and more helpfully, it shows just how another brand of economic liberalization, with sustained progress for everyone, is doable.
References
McCaffery, E. J. (2005). A New Understanding of Tax. Michigan Law Review, 103(5), 807-938.
This is also posted at http://www.hertie-school.org/schlossplatz3/?p=92
Bevor ich das jetzt lese, will ich dir zunächst eine Mitgliedschaft in der Deutschen Debattiergesellschaft empfehlen (Mitgliedsbeitrag ist im Übrigen steuerlich ansetzbar ;P) – Thema des Masters’ Cup Finales vom Wochenende: “Dieses Haus glaubt, Steuerhinterziehung ist Notwehr.”
Hi Max,
I appreciate you innovative spirit.
I think your idea is great and it must
be if even Prof. M. above me here
couldn’t poke any holes in it. ;o)
In any case, how would you think
people ought to pay their tax?
Isn’t there a risk of freezing their
cash flow roughly around christ-
mas time and into the new year?
Best,
Steffen
Hey Henrik, thanks for your comment. Will give debating a chance, not sure I could take the cognitive dissonance to argue for tax evasion though …
.
Hey Steffen, thanks so much for your comment. I also thought about that; that could be a pretty ugly Christmas surprise, that postpaid progressive consumption tax … .
A solution may be to either, if sufficiently automated in its administration, to levy the tax monthly, or to actually use preliminary prepayments, based on historical data.
Glad to see you’ve joined the ranks of economists and other social scientists arguing for the consumption tax.
You get around the “Christmas problem” with a prepaid consumption tax: taxing income and giving full rebate for saving/investing. (You still need to define what exactly saving is. Are cars investment or consumption?)
How is this different from the current situation? “Income taxes” today really are “labor income taxes”. Warren Buffet is not paying any. The trick is not to differentially treat income based on where it comes from, as we generally do now, but where it goes, as we sometimes do now, but to a too small extent.
Hey Lucas, thanks for your comment! And yes, I am definitely bandwagoning the consumption tax side, gotta be progressive and postpaid, though.
How exactly the tax is to be implemented is a matter for tax administrators and practitioners – I know too little about administrative capability. But my guess would be that a rolling application, say, every month or so with some degree of historically determined prepayments might make sense. Just making the entire thing prepaid does, unfortunately, not change a a lot, because you still don’t know what you’re getting back around Christmas.
The car problem (more generally, the problem of durable consumer goods) is indeed significant. The solution lies in applying depreciation schedules, just as we do in corporate settings, too. Where exactly to draw the line between consumer goods and depreciated durables is not an easy call (household appliances?).
The progressive consumption tax is completely different from the current income taxation and (regressive!) VAT-style consumption tax. It reconciles the idea of taxing based on usage, not origin (that you mention) with a progressive schedule.
May be a great tax based on the seen but what about the unseen?
Frederic Bastiat would disagree with your excitement. Read:http://bastiat.org/en/twisatwins.html#frugality_luxury
Hey Scot, thanks for the comment. Your comment seems interesting, but opaque to me (pun intended.). Could you elaborate? What is seen and unseen?
interesting idea, but:
- how does it tax the wasteful if it’s non-discriminatory – if it taxes consumption no matter whether it has been cerosin for mallorca flights, cigarettes, alcohol and fatty food (ask the Danish) or charitable donations, bio food and Hertie school fees
- will it manage to replace all other taxes or be prohibitively high if it was to collect about 50% of GDP (again ask the Danish or Swedes)?
- does it not combine the negative side of an income tax (hard to collect and easy to evade, politically difficult) with the negative side of a consumption tax (being in its nature regressive and non-discriminatory) and then tries to get around that by being postpaid and progressive missing the strenghts of being easily collectable and attached to political values?
Meaning that we trumpet the “seen” or what we immediately claim as the good of the idea but dont (or cant) weigh the “unseen” or the negative of the idea.
I mainly direct the comment at the progressive nature of taxes and the reason to tax.
Bastiat Says: “The advantages which officials advocate are those which are seen. The benefit which accrues to the providers is still that which is seen. This blinds all eyes.
But the disadvantages which the tax-payers have to get rid of are those which are not seen. And the injury which results from it to the providers, is still that which is not seen, although this ought to be self-evident.
When an official spends for his own profit an extra hundred sous, it implies that a tax-payer spends for his profit a hundred sous less. But the expense of the official is seen, because the act is performed, while that of the tax-payer is not seen, because, alas! he is prevented from performing it. ”
Progressive taxes are hurtful to economies because of the unseen. Unseen is the money taken from top earners that would have been or could have been used to expand business, hire people, start new ventures, ect. All put the lower classes to work ot affect them in positive ways. instead govt takes that money and redistributes it and feeds a people for a day instead of giving them the ability to feed themselves for a life time. That is the unseen. The Unseen is the economic growth that never will be because that money was taken and used inefficiently by the govt for political gains.
For example: Pres. Carter proposed a winds fall tax on the oil companies in the US while president. The seen was that he could collect 500 bil dollars in tax revenues for the govt. This tax was implemented and the Unseen was soon realized. The companies started importing in foreign oil, stopped exploration and Us production. Foreign oil imports rose by 40+ percent. actual taxes collected was under 80 billion. this hurt the American economy and cost American jobs and money. Those are unseen, that should of been obvious. It was a very bad tax.
Read the whole essay to understand better what i mean, Bastiat says it much better: http://bastiat.org/en/twisatwins.html#frugality_luxury
Hey Christoph, thanks for your critical comment. Here’s my response:
- You’re right I should have been more specific. The PCT curbs wasteful consumption only with regard to consipuous consumption of what are likely positional good (think Ferrari). It does not tackle all sorts of wasteful consumption. I would argue, however, that the examples you mentioned (flights to Mallorca) should be captured by non-redistributive Pigouvian taxes or (emission) rights auctioning. These are classic common goods problems with externalities that are best solved through repricing – not the redistributive machine.
It’s great that you mention the costs of education – the great thing about the PCT is that these could, for example, be treated as investment in human capital and exempted from any taxation.
On to your second point: Yes, it should be able to raise all revenues through this one tax, except to the degree that an asset (wealth) tax is additionally required. And yes, it would be “prohibitively” at the very, very high end of the progressive schedule – but that’s precisely the idea, to have everyone who buys a yacht, pay a massive penalty to the state. Of course, a large share of the revenue generation would still have to be shouldered by the middle and upper-middle class. The precise design of the progressive schedule is of course up to debate.
To your last point: Yes it is no easier to administer than the income tax, but also no harder. My broader point is this: if you want taxation to be progressive, and I think we ought to want that (except for fees and pigouvian taxes), than they HAVE to be personal. Indirect or corporate taxes cannot do that, incidence and uniform progression (if any) make it impossible to really have every person contribute according to ability. So I don’t think there’s any way around the administrative burden of an individual tax. I just think the PCT is the best, simplest and most elegant way to do that.
I am not sure I understand your comment about political values. Is the progressive income tax (and its mess) or the VAT attached to a political value? If so, what values?
I would think that the PCT is in fact the tax that most perfectly institutes a set of values: everyone according to ability, and work/risk taking must be rewarded.
Hey Scot, again. I’m still not quite sure I understand the seen/unseen dichotomy, but I see your point. And I sure ought to read that Bastiat piece.
I think your assessment is wrong in a number of ways:
- First, the progressive CONSUMPTION tax does not create disincentives to invest in businesses or create new jobs. That’s the progressive INCOME tax you’re talking about.
- More generally, taxing the rich, particularly by means of a progressive consumption tax, DOES NOT DEPRESS INVESTMENT necessarily. It just puts these resources in different (public) hands, who then decide to which use to put them. Per se, taxation is actually a zero-sum game: the resources in the economy stay the same, at least from a static perspective.
- I am advocate of saving and investment, not tax-and-spend style publicly subsidized consumption. Still, the right balance between current consumption and future consumption isn’t easily found. It depends on the rate at which we discount the future, and the degree of responsibility we accept for future generations and years. I’d always be in favor of investing more, rather than consuming. What’s key is that this decision is completely independent of progressive taxation – states and individuals can then decide where to put their resources. If anything, the PCT reduces consumption in favor of investment.
I am not arguing against any particular tax but taxes in general. The point of the matter is the tax they take from the person so government can spend it. The quote says that when you do that the person has that amount less than he did to spend on good, service, savings, or whatever. Bastiat also talks about the inefficiencies of Government in the essay. Combine those things and you negatively effect the economy. Read the shop keeper example at the beginning to illustrate this point.
Taxes are never a zero sum game that is the whole point Bastiat is making about the unseen. You see the resources stay the same is the seen. What the tax payer could have done with that money is the unseen.
You are operating under the assumption that government can make better with that money then the tax payer.
Dont get me wrong Im not against taxes. Governments need to tax. But tax policies need to be created with extreme caution, IMO. They should be moral. Thomas Jefferson said this about taxes: “To compel a man to subsidize with his taxes the propagation of ideas which he disbelieves and abhors is sinful and tyrannical.” It was also believed by most the founders that Federal taxes should be for very limited enumerated things. Using taxes to compel any action is immoral and inefficient.
Changing gears: addressing the issue of consumption taxes, they are very good ideas as far as tax policies. I dont like your progressive spin on it but agree that consumption taxes would be better. The Fair Tax has been discussed for a few years now with some on the right advocating it. The positives are that it would reduce or eliminate a huge wasteful government entity in the IRS. saving billions a year. It would be fair and I guess progressive because it only taxes services and new goods. So used items and raw items like food( raw food) would be tax free. Therefore, the wealthy would pay the majority of the taxes. It is fair in that all could never pay taxes if they reduced consumption of new goods and services. You only pay taxes if you chose. If you want a new TV you pay taxes. No one is forcing you to get a new TV though.
Thanks for elaborating, Scot.
I think I respectfully disagree on a number of fundamental points with you:
- Yes, I do believe government can sometimes make better with decisions than the individual tax payer. I think of it as situations with cooperation problems, where hierarchy is necessary for social optima.
- Government need not, and should not only spend (as in consume) what it raises as tax revenue. It can, and should also invest (education, infrastructure). Taxation does not per se hurt the economy.
- I also think that a democratic government can and should put tax revenue to uses that are agreed upon by a majority, but not all of its citizens.
- To me, sharp progression and as little as possible otherwise market distortion are key to fair taxation. That leads me to the progressive consumption tax.
The Fair Tax that you mention is in fact harshly regressive, not progressive at all. Because it taxes consumption at a uniform rate, those who make a lot of income and spend relatively less, pay less relatively. People with capital can earn an interest which is entirely untaxed.
The refinements you suggest, between different kinds of goods is a pretty embryonic approach to progression, leads to all sorts of problems (what about canned food?) – and why tax only “new” goods?
I value your – and Bastiat’s (whom I still haven’t read) – cautionary call when it comes to government intervention and taxation. People like me, who like big government with big budgets always have to carefully justify each and every item in that budget.
Hi Maximilian,
cheers to the elaborate answer. It turned my critique into confusion on the first point though. You describe PCT as charging a tax rate according to how much you consume (in terms of the amount of money you spend each year), and then expect it to tax conspicious consumption (such as an expensive ferrari). From my initial understanding this would mean that the billionaire who buys tons of mosquito nets for the poor has to pay huge amounts of tax because he has huge amounts of expenditure, while the millionaire who buys just one ferrari is taxed at a much lower rate because his consumption was much lower in total. you got around my point by treating cheap flights with an extra tax and education as a special case but if you do that for every possible expenditure you get to the point where you introduce a conspicious consumption focused sales tax…I still don’t see any way in which PCT could overcome the issue unless you say that letting billionaires spend a lot of money on what ever is a positional good that you take away from them by high taxes and handing it to the state who can then do the same kind of consumption (buying mosquito nets) with the taxes collected.
Hey Christoph, you got me. You’re right, it’s difficult to draw the line between investment and consumption, it is the Achilles heel of what I’d say is still a perfect tax.
. For now, anyway. Conviced?
I think it WILL be possible to get around this problem, mostly by means of depreciating and thinking hard about what is investment.
I think education, for instance, is a pretty clear case of investment.
Some more complications apply. You bring up the question of donations, and I really haven’t thought or read about that. For the mosquito-net problem I can think of several solutions.
1) Taxing gifts on the receiver side. What’s happening here is not so much excessive consumption, but a substantial transfer of wealth, be it in the form of nets or money (a tax regime shouldn’t care). So from this perspective, it makes a lot of sense to make gifts and donations taxable at the receiving side. The people who get these nets, of course, would not have to pay much or any taxes (if they are governed by the tax regime at all).
2) Donations could be excluded from taxation on both spending and receiving side.
Saved it