20 Oct 2011

Quick Note on Consumption vs. Income Tax

Economics 17 Comments

[UPDATE: This whole “disagreement” with Rothbard may have been a figment of my bad memory; see this post.]

Some people are asking me about Robert Wenzel’s take on Peter Schiff/Herman Cain on tax theory. I would have to sit and think through Rothbard’s argument about a consumption tax getting shifted back onto the incomes of land, labor, and capital (goods).

In the meantime, though, let me say that there really is a legitimate sense in which taxing income is more distortionary than taxing consumption. The reason I stress this is that I used to think this was a neoclassical myth. But I realized I was wrong when I was working on a tax reform paper for PRI. None of this is an endorsement of Cain’s 9-9-9 plan, of course, but anyway this is what I can quickly add to the discussion for what it’s worth. From a post a while ago:

When it comes to people arguing for a consumption tax instead of an income tax, a typical argument is, “The income tax discourages savings.”

Now for a long time, I agreed with Murray Rothbard’s take on this. I thought it was a dumb argument, because there’s nothing magical about saving more; it would clearly be terrible if the government said, “Save 99% of your income or else you get executed.” And the whole point of saving is to consume in the future, so why wouldn’t a consumption tax discourage saving just as much?

Well, when working on my PRI Flat Tax pamphlet [.pdf], I realized Rothbard and I were wrong. An income tax really does distort the consumption/saving decision, moving it away from the margin that the consumer would have chosen in the absence of taxes. In other words, the consumption tax makes the consumer poorer, to be sure, but at least the consumer gets to decide in which time period to distribute the blow. But an income tax is a double whammy–it takes away from your overall budget, but then puts on extra penalty on your decision to carry income forward. (This is because interest income or dividends is hit afresh with the income tax in the next period.)

To repeat, I am not here saying that Wenzel is wrong and Schiff/Cain are right. I’m just firing off a quick point that might move the ball forward for some of you.

17 Responses to “Quick Note on Consumption vs. Income Tax”

  1. Silas Barta says:

    For my part, I’m worried about the implementation issues. Say you try to only tax consumption, and not income or investment. Now everyone has a gigantic incentive to reclassify purchases. Good luck distinguishing what is “really” consumption from what is “really” investment.

  2. Anonymous says:

    I agree. consumption tax, makes everyone poorer, but does not shift the proportion of savings to consumption. However with an income tax, marginal savings are valued less due to an income tax lowering the rate of return for investments and a reduced income results in an increase in time preference and therefore an increased rate of consumption.

    My only problem with Rothbard is that he states transfer payments/redistribution result in malinvesment. Theoretically if $1 of real savings were taken from a tax payer and given to a tax consumer, why would this result in malinvestment? The tax consumer still wants to maximize his return and therefore has the same incentives as the tax payer. They also both have the same opportunity cost of capital. I don’t see how if both the tax payer and tax consumer have the exact same incentives, why malinvestment must result. I would love to be wrong on this though.

    • RS says:


      It’s a ma-investment because the tax payer, in order to have the dollar before it was taxed, had to have produced it by taking some action that was worth $1 to somebody. In other words, he increased economic output by $1, if that dollar is taxed away and given to someone who is not productive then that $1 is lost.

      Moreover, even if the tax consumer will invest it in a productive activity it still represents a loss of production because the tax payer will cease his productive activity since his actions do not result in improving his own condition.

      • Anonymous says:

        I agree with those arguments, but those basically relate to the decreasing marginal utility of work and increased marginal utility of leisure. Rothbard makes and argument, leaving all else constant, that $1 taken from the savings of a tax payer and put into the savings of a tax consumer, will result in malinvestment. I don’t understand this, since both individuals will invest at the risk adjusted market rate.

        • RS says:

          Perhaps I am missing some nuance to the marginal issue but to me the malinvestment comes from the fact that the force used to grant one person command over an extra dollar’s worth of goods at the direct expense of another means that what would have been demanded by the former is now demanded by the latter and hence the outcome would be different absent the use of forceful taxation, thus a malinvestment.

  3. Scott says:

    Can anyone tell me something wrong with this math:


    It appears to show that consumption taxes lead to more after tax dollars and higher tax revenues, but I’m probably missing several important things here beyond tax incidence.

    • jjoxman says:


      What exactly are you trying to show there? It’s hard to interpret from the available information.

  4. Tel says:

    Yes, it would be equivalent if they didn’t tax interest on your savings at marginal income tax rates (high in Australia, over 30% for most people) and/or if there was no inflation.

    The way it stands now, you get perhaps 5.5% interest on a cash savings in Australia, and typical tax on that is say 30%, but inflation is probably between 3% and 4% or there about. In effect you are going nowhere, but after bank fees you are going backwards, so as a consequence no one holds cash for long periods of time.

    The end-effect is that the only cash savings in the system are self-funded retirees (who pay significantly less marginal income tax) and short-term saving for mortgage deposits. So the backing behind the banks is not cash savings, but mortgages instead (i.e. a claim on land). Because big government and big banking are in cahoots, the government does it’s level best to keep property prices high by throttling supply wherever possible (they panic whenever prices fall because it risks undermining bank stability and government have gone guarantor on the banks). This in turn makes any industry that requires land very expensive (e.g. our retail prices are higher than equivalent overseas prices because when you buy from a retail store you are mostly paying rent on the store, rather than paying for the goods).

    Stupid… probably, but then again, Australia is primarily floating on resources, farming and tourism, then we have a complex system to squabble over who gets the spoils. People have got used to the deal, and it’s all pretty stable so why bother rocking the boat? I guess that semi-socialism is our way of avoiding the “resource curse” and as Thatcher said:

    Socialist governments traditionally do make a financial mess. They always run out of other people’s money. It’s quite a characteristic of them.

    But with a resource rich economy, you don’t run out of other people’s money, you just sell them more iron and coal. I mean eventually the iron will run out, but I’ve been to Iron Knob, which is a mountain made of iron and a pit dug out of the top, and it’s a really big pile of iron — but that mine got closed because others were even bigger and better. We are seriously not going to run out of iron for a very long time.

    Anyhow, Australians only tolerate so much socialism and no more, the voters seem to have a good balance on such things. The current government pisses me off but I know they will be gone in a few years (mind you, the previous government pissed me off too, and probably the next one will have it’s share of problems).

  5. Mak C says:

    All taxes have a negative impact on an economy. The question is how we fund basic Government services. I like the idea of a sales tax versus an income tax for a few reasons. Sales tax captures dollars from all people including tourists, immigrants etc. so it is broader based. Sales tax also captures tax revenue from the 50% or so that pay no federal income tax. People and Politicians will still try to manipulate the sales tax code for their own gain but if State sales tax is any indication it is harder to do.

    The real problem with Herman Cains plan is that it introduces another tax and we should firmly oppose that. 9 9 9 will turn into 7 15 20 at some point when some politician wants to blame evil rich people and corporations for all the problems created by Government. Then the income part will turn back into a progressive bracketing scheme. I can see all the politicians lining up to support this because it is another revenue stream for Big Government. If a national sales tax is the answer the income tax must be abolished 100% on all income.

    • Tel says:

      Yeah, I agree. Sales tax is more difficult to avoid.

      The real problem with Herman Cains plan is that it introduces another tax and we should firmly oppose that. 9 9 9 will turn into 7 15 20 at some point when some politician wants to blame evil rich people and corporations for all the problems created by Government.

      Herman answered that one, and pointed out that if you judge every policy on whether it might become a bad policy at some future time then it’s an argument no one can win. In general I’d say that any highly visible tax is going to be difficult to increase, while invisible tax is easier to increase. For example, in Australia (where we have GST which is a consumption tax) you must by law show the tax amount on every docket.

  6. david stinson says:

    I thought the typical argument against the incentive effects of income tax was that it discouraged production, not that it discouraged savings per se.

    • Daniel says:

      It does both. It discourages production since it lowers income from production. This makes leisure, which is an alternative to production, look relatively more attractive..

      An income tax also increases the proportion of consumption vs. income. If an individual will save if he is paid 10% in the future, and a 20% income tax is levied, his return is decreased to 8%. At this reduced rate, consumption begins to look relatively more attractive than investment. Additionally, as income is reduced people generally save less and consume more. This is because the lower an individual’s monetary assets the higher their time preference.

  7. Major_Freedom says:

    But an income tax is a double whammy–it takes away from your overall budget, but then puts on extra penalty on your decision to carry income forward. (This is because interest income or dividends is hit afresh with the income tax in the next period.)

    We all have Keynesians to thank for this. They advised the government to put a tax on savings, based on the flawed belief that the additional employment and production will otherwise lead to a “savings leakage.”

    The working class riled up by Marxism was OK with it, because it appeared to only be against the interests of “the rich.”

    Taxing savings is the most counter-productive (literally!) policy ever to have come out of the economics profession.

  8. Joseph Fetz says:

    I don’t think that there is any question that any tax will create distortions and that different taxes will distort in different ways. I may be wrong in this, but I always thought that the Rothbard position was that just focusing on the distortions of each tax (i.e. this one is less/more intrusive than that one) misses the entire point- that taxation is a burden on production. That no matter how a particular tax distorts certain areas of the economy, all taxes ultimately fall on the original factors, thus making us all poorer. Basically, that it is the level of taxation that is most important.

    You can move the deckchairs all you want, and sure some people will get screwed more than others initially, but ultimately we all get screwed in the long run.

  9. Adrian Gabriel says:

    All taxes are bad, none are good. Rothbard was right, and Schiff is letting the politician in him take over. Schiff fails here, even though he is right on many other points. To assume things can only be changed through government, and to compromise on giving them their lifeblood (taxes), is a slap in the face of the revolutionaries that seceded from the British Government. We all know the founding fathers #@$*-ed it all up.

  10. Charlie says:

    Another way consumption and income taxes are different is the transition from one to the other. The effect of moving from an income to a consumption tax would be a one time tax increase on the current old generation. Since the older generation had their incomes taxed and saved to consume in retirement, they will now be taxed again.

  11. bruce says:

    No one’s mentioned that a head tax at least in basic public finance courses is ideal. There’s be no way to avoid it, baring autoabortions.

    Taxes are universally dissed here, but they just exist because not all goods can be privately consumed (paid for and consumed by individuals who decide how much and what private goods to consume). We can’t individual decided what wars to fight, how much defense is enough, or how much privation and relief of it we want to see on the street. We collectively make these choices and nobody is happy with them. We all pay for that shared consumption through taxes. In the end it seems likely we wouldn’t like a no national defense or collective consumption world better, or at least the cost of privatizing everthing would be more than the benefits of doing so. Frank Knight said (roughly): What’s necessary is ideal.

    So, taxes are a necessary part of our reality until we can make all goods privately consumable. They’re like – weather that makes us purchase heating and cooling; drugs we buy because our bodies are frail and impermanent; and scarcity itself that makes us, not Gods who decide what we want without constraints, but frail temporary being that make the best (optimal) choices within limits, including taxing ourselves.

    Death and taxes are just part of the reality of our existence. It makes no sense to call them bad, or good. they just are…reality. Even if it may serve our ideolgy to feel otherwise.