26 Oct 2011

Yet More Clarity (Confusion?) on Mainstream Tax Analysis

Economics 5 Comments

OK this is almost out of my system, but people keep asking good questions in the comments. “May I have another, sir?”

Chris asked:


Doesn’t a consumption tax also hit you when you earn interest, dividends, and capital gains? After all one doesn’t earn interest to roll it over for perpetuity — it’s eventually cashed out for consumption. Does this not lower the return in a similar way as the income tax?

If I invest $1,000 and grow it (income tax-free) to $2,500, but have to pay a %20 consumption tax, this necessarily reduces my return to $2,000. Is this any different than if I had been paying an income tax on my dividends each year? Under a revenue-neutral income tax, wouldn’t I still have roughly $2,000 to consume at the end of the period? I’m not sure I see how a consumption tax is a benefit over an income tax.

I gave a somewhat technical reply, and then I realized what I think is tripping a lot of you up. (Note, I’m not saying, “You are wrong and the mainstream guys are right,” rather I am saying that you are missing what their argument is.) So I followed-up by writing:

This might help: Don’t think of it as a 20% consumption tax versus a 20% income tax, because they wouldn’t raise the same revenue. Even if the worker works the same # of hours, he ends up saving less under the income tax, so his lifetime income is lower. Hence, a 20% income tax wouldn’t raise the same revenue from him, as the 20% consumption tax. {EDIT: Assume he doesn’t pass any wealth to his heirs. He consumes everything on his deathbed. So lifetime consumption = lifetime income in present value terms, income and consumption don’t need to be equal in any particular time period. If you think through this contrived example, the point might jump out.] Since the guy is going to save less (and thus earn less interest income), maybe the government has to impose a 23% income tax to raise the same lifetime revenue from his, as it would get from a 20% consumption tax.

And then to take the principle further, suppose that either the 20% consumption tax or the 23% income tax would let the government extract $10,000 per year from this guy. If instead it imposed a $10,000 head tax, then the guy’s consumption would probably end up higher than under the consumption tax regime. This is because the marginal incentive to work for money (instead of using those hours as leisure) would go up, since consumption isn’t being taxed on the margin anymore. (After you pay the flat $10,000, you’re free.)

So when mainstream economists say that a head tax is better than a consumption tax is better than an income tax, they mean “if you allow the government to fiddle with the parameters under each regime, so that even after individuals adapt to the new regime, the government is taking the same amount of total tax revenue.”

Rothbard and others have raised some good objections to this approach; he’s got an essay today at LRC. I’m just trying to be clear on what the standard mainstream analysis is.

5 Responses to “Yet More Clarity (Confusion?) on Mainstream Tax Analysis”

  1. Brent says:

    What I never understood about the mainstream analysis was the effect on the supply and demand for investment projects. As you’ve alluded to, ultimately the final products from any production process are going to get hit with a tax, reducing the incentive to produce as much, implying that the demand for factor inputs will go down. In essence, the marginal productivity of the factors of production will generally be reduced. So the question remains, how exactly does that spur savings and investment? It would seem that any tax, while distorting the structure of production in different ways, would always result in lower real incomes.

    In other words, it is easy to see the claim that people would work longer / save and invest more without getting taxed (at progressively higher rates in the current scheme) on their marginal income. But the way I see it, the consumption tax reduces the value of the work you do, effectively making work / investment no more attractive than before.

    • Bob Murphy says:

      Brent, I thought for sure if I said, “Would you rather pay a 20% consumption tax or a 23% income tax,” you guys would see it. 🙂

      Nobody is saying that if you start from scratch, then impose a consumption tax, that this will spur work and saving. (Or at least, nobody should be saying that.) The claim is that if you take away an income tax and replace it with a consumption tax that will yield the same revenue (over an x-year window perhaps), then people on the margin will have more of an incentive to save. (I’m not sure if they’d have an incentive to work more. But they’d definitely save more.)

      And that’s actually not the end of the argument. Who cares if people save more? The end of the argument is, “And they achieve a lifetime consumption flow that they prefer to the one they’d choose under the income tax regime.”

  2. Brent says:

    I think some people are saying that a consumption tax spurs work and savings. People WILL say things like “a consumption tax is better because it doesn’t penalize work / production”. But it seems obvious that it does.

    And it also seems to me that you are assuming what you set out to prove. Of course I would prefer a 20% consumption tax to a 23% income tax, but that seems to presuppose that the income tax rate would need to be higher in order to be revenue neutral. This would only be true if you had already proved that the consumption tax led to a more productive economy. Yet, isn’t that the question?

    • Bob Murphy says:

      Brent: That’s why I said first consider a person who, over his lifetime, consumes all his income. It’s not that he blows it all on his deathbed, it’s that he (say) saves 20% of his income from age 20-65, then he consumes more than his income from age 65-100. At the moment of death, he just consumes the last bit of his savings so his total lifetime income = total lifetime consumption, in present value terms.

      OK now in one scenario, gov’t levies a 20% consumption tax. In the other scenario, gov’t levies a 20% (sic) income tax. Which one raises more revenue for the government?

      In either case, the guy ends up consuming all of his income. So the question boils down to, in which scenario will the guy have a higher lifetime income?

      One possible difference is that the guy chooses to work more hours in one scenario versus another. At first glance, you’d think a 20% income tax would penalize work effort more than a 20% consumption tax. And actually it would, if the guy bequeathed any wealth to his heirs (or to charities). But if we assume that the guy consumes all of his income over his life, then the two are equal in this respect, since any income he earns will at some point be consumed. So thus far, I’ve shown that if the guy consumes 100% of his income, then we’d expect him to work as many hours under either scenario. Thus, his labor income is the same under either scenario. (Again, I’m stacking the deck in your favor. If in reality he donated any of the $$, then he’d end up working more hours under consumption tax than income tax.)

      But now we look at what he does with his saving rate, from ages 20-65 when he is building up assets that he plans on drawing down in retirement. And here the equivalence breaks down. It’s no longer true to say that “It’s all the same, he gets hit with 20% whether he consumes it now or consumes it later.” Once he earns his labor paycheck for a given period, under an income tax he already has 20% taken out. Now he can spend it on immediate consumption tax-free, OR he can save it to spend on future consumption, but it will then get dinged 20% again (not the principal but the interest). So on the margin, present consumption is relatively more attractive than it is if there is a consumption tax.

      Because of this, even if the guy chooses to consume 100% of his income over his lifetime, and thus works the same total # of hours, he still ends up saving a lower fraction of his income during the working years when there is an income tax. Thus, his lifetime interest income is lower in that scenario, meaning his total lifetime income is lower.

      So, if we know by construction for this guy that lifetime consumption = lifetime income, and we know that lifetime income is lower under an income tax than a consumption tax, then it must be that a 20% income tax brings the government less total revenue than a 20% consumption tax would. So, if the government is going to raise the same lifetime revenue from this guy, it will have to impose a (20+x)% income tax.

      (Note that the lower “lifetime income” and lower “lifetime consumption” under the income tax regime aren’t by themselves sufficient to show the guy is worse off, because you could have different flows of consumption over time that give more or less utility, even though they are valued the same in present value terms. E.g. someone with the same paycheck history could either consume $50,000 per year for life, OR he could consume $1 per year until age 100, at which points he consumes say $15 million. Both might be equally affordable, but most people would opt for the former.)

    • Bob Murphy says:

      Brent wrote: “People WILL say things like “a consumption tax is better because it doesn’t penalize work / production”. But it seems obvious that it does.”

      Brent you’re right, people do talk like that and it’s sloppy. It’s why I originally thought they were totally wrong. But what I’ve been trying to get across for this past week is that there really is a sense in which the consumption tax doesn’t distort the consumption/saving decision, except for the general reduction in standard of living from any tax.