copyright © 2002 by thomson learning, inc. chapter 16 taxes on consumption and sales copyright ©...

Copyright © 2002 by Thomson Learning, Inc.

Chapter 16

Taxes on Consumption and Sales

Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license.

ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom

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ISBN 0-03-033652-X


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.


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.


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.


Comparing a Tax on Income to a Tax on ConsumptionStep 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)

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



Step 2 A Consumption Tax for the Non-Saver

Income = 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



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

+SB

= 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



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

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


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.


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.


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.


Figure 16.1 Substituting a Comprehensive Consumption Tax for a Comprehensive Income Tax:

Investment Market EffectsY

ield

(P

erce

nt)

Investment per Year 0

r*

rN

Net Return under the Income Tax

S

G E

F

Gain in Efficiency

Q1

D

r*G


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.


Figure 16.2 Substituting an Equal Yield Comprehensive Consumption Tax an Income Tax:

Labor Market EffectsW

ag

es

Labor Hours per Year 0

WG2 WG1

L1 L2

SL

L3

WN2 WN1

WO

D = WG WG(1– t1)

WG(1– tC)

A' A

B

C

C'


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.


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.


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 that says that a consumption tax should be imposed on the consumer.

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.


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.


Turnover Taxes

Turnover taxes are multistage taxes that are 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).


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)


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


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.

copyright © 2002 by thomson learning, inc. chapter 16 taxes on consumption and sales copyright ©...

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