3-Mar-05 —

Ray Suarez: The president’s advisory panel on tax reform met for the second time today, this time seeking the input of Fed Chairman Alan Greenspan. Greenspan said the tax code needed to be simplified and suggested one idea worth considering was implementing some kind of consumption tax. It’s a broad idea that’s also gained favor among some policymakers in Washington.

For a closer look at consumption taxes, what they are and how they might work, I’m joined by two men who study these issues closely. William Gale is a senior fellow at the Brookings Institution. And Len Burman is a senior fellow at the Urban Institute. They’re the co-directors of the institutes’ Joint Tax Policy Center, which is non-partisan.

And William Gale, why don’t you get us started by just explaining what a consumption tax is, who pays it, what does it tax?

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William Gale: What does it tax? A consumption tax essentially taxes people when they spend money. And the income tax you’re fundamentally taxed when you earn money or when you get interest, dividends, capital gains, and so on. And a consumption tax that wouldn’t happen, you would be taxed essentially when you actually spent the money at the store.

Now one way to think about a consumption tax relative to the existing income tax is suppose we had our current system, but we made IRA contribution limits infinity, so you could put as much as us wanted into an IRA and you could take it out for any reason, all right. That to the first order of approximation would be a consumption tax.

Ray Suarez: Okay, Len Burman, first of all, do you buy that definition?

Len Burman: Well, yes, quite close. One thing that Bill left out was that under a consumption tax you’d actually pay tax on money you borrowed at the same time. So you wouldn’t be taxed on your interest, dividends and capital gains, but you wouldn’t be allowed a deduction for interest expense.

And that’s actually an important distinction. We’re actually sort of moving toward that system Bill is talking about, but without the limit on the interest deductions you could actually create a situation where it’s a recipe for unlimited tax shelters, which is not what I think any of the tax reform advocates would like.

Ray Suarez: And for people who are sitting with receipts on week nights and pieces of paper and an adding machine trying to figure out as April 15 looms, this would mean filing a tax return would become a very different business from what it is today.

Len Burman: Yeah, it depends on how you implemented the consumption tax. If you started with our income tax and then said look you’re going to have a deduction for all of your interest dividends, capital gains and you have to include in the tax base the interest expense, it actually could make it more complicated.

Some other variants are you could have a consumption tax where you just pay tax on your spending, a value added tax which they use in Europe and Japan; it’s a variant of a sales tax and it’s actually transparent to individuals, you don’t have to, individuals don have to file tax returns to pay that tax.

But an important distinction is that in Europe, the value added tax is a supplement to the income tax; it’s not a replacement, so people still have to file income tax returns every year.

Ray Suarez: So William Gale, anybody who’s paying sales tax in the 40 states that have it are already pretty familiar with the concept? Is it as simple as just a new sales tax?

William Gale: Not really. The sales taxes that exist in the states may serve the purposes of the states quite well, but they are very poor models for a federal consumption tax. The state sales taxes omit all sorts of spending, typically health, food is often omitted, a variety of other things, housing. Health, food and housing is half of all consumption.

So, if we want to have a consumption tax at the federal level we need to tax a very broad base of consumption, almost all consumption. So, if anything, the state, the experience that the states have with the sales tax tell us that it’s very hard to actually implement a clean simple broad based consumption tax.

Ray Suarez: Well, let’s talk a little about implementation, Len Burman. Alan Greenspan said today getting from the current tax system to a consumption tax raises a challenging set of transition issues. Like what?

Len Burman: Well, if you just say scrap the income tax and replace it with a sales tax or a value added tax, then it would be a huge tax increase on old people, old people who are paying tax on their income as they’re earning it, thinking that when they got to retirement they could spend money and they’d be paying a dollar for everything they bought.

If you replace, Bill actually did some estimates that if you replaced all of our taxes with the sales tax, the sales tax rate would be something like 60 percent, so you could just imagine getting into retirement and finding out the price of all the goods you’re buying is now 60 percent higher than it was the day before. That would be like a 60 percent tax on all of the money that you had saved up over the course of your life. And there are other transition issues too, like the way it affects businesses.

There are variants on the consumption tax, but basically nobody has figured out how to deal with the transition issues without tremendous cost to the Treasury. You can basically say you could have transition rules that would try to protect old people, that would try to protect businesses that have made investments under the old rules that could be harmed under the new system, it would be tremendously expensive.

And in fact, when economists look at the transition from an income tax to consumption tax, most of the gain to productivity comes from this tax on old savings, this tax on old capital, and the reason that Congress got excited about this, because it’s a tax that can’t be avoided, it doesn’t alter people’s behavior. But that’s also the same reason why people think it’s so unfair, you can’t get out of it, and it’s basically changing the rules after you’ve been making decisions over a whole life.

Ray Suarez: Well, the president asked his new tax commission to create a revenue neutral model for changing the tax code, meaning that he didn’t want the federal government to collect more taxes, about the same.

But underneath that umbrella, would people be paying roughly the same amount of tax if we move to a consumption tax? Or are we assuming that different people would pay more or less than they used to pay?

William Gale: In theory you can set up a consumption tax to have any group of households pay it. In the real world, every consumption tax out there is going to hit low and middle income households to a greater extent than the income tax does.

Ray Suarez: Why?

William Gale: For two reasons: One is that, well, the main reason is that low and middle income households consume more of their income than high income households do. Another way of saying that is high income households save more of their income than low income households do.

So if you move the tax from income to consumption, you’re raising the relative burden on low savers, which are low and moderate income households, so almost any revenue neutral shift from the income tax to a consumption tax will be regressive in that manner. There are ways, there are conceptual ways to do it that doesn’t add burdens to low and middle income households, but I don’t think that they would actually happen.

Ray Suarez: Well, right now a lot of low income people pay no federal income tax, but they do buy things. Does that mean that they’re almost inevitably going to pay a consumption tax?

William Gale: That’s a very good example. A family of four doesn’t pay any federal income tax until their income is in the 20s or 30s, something like that. If you go to a national sales tax or value added tax, they’d be paying that tax on the very first dollar that they buy.

Now, again, there’s a way to insulate them from that by giving each household cash payments, but no country in the world actually does that. So in the real world, consumption taxes end up being more regressive than income taxes, although Len and I or anyone else could design a consumption tax on paper that wasn’t like that.

Ray Suarez: Len Burman, the Fed chairman said today that one effect of changing the tax code in this way, moving away from income tax to consumption tax, would be to change people’s economic behavior by making it make more sense to save and less sense to spend.

Do we know that that’s really what would happen, and how would it change what makes sense to do in the economy when you have this different kind of tax?

Len Burman: Well, a lot of economists favor a consumption tax because they think it would reduce the penalty on savings. It’s basically savings wouldn’t be taxed, so you have an incentive to do more of it. How much more is, it’s not actually clear; there’s a lot of empirical evidence, research evidence, to suggest that there wouldn’t be a huge increase in savings.

There’s also when you get outside of the economist models, there’s a concern that if we switch, the current system we have now encourages a lot kinds of savings, you get a special break if you put money into a 401-K or your employer puts money in a pension or an IRA.

Under a consumption tax system all savings would be tax-free, it would all be taxed like a 401-K, but the question is if people don’t get the special tax break will they still be putting money into retirement savings and if they don’t, if they just put it in their regular bank account, are they as likely to keep it until retirement, and a lot of people are concerned that in fact without the special tax breaks you could actually end up with less retirement savings and possibly even less savings overall.

The other thing that’s important to note, and the chairman said that there are two things that we needed to do, one is to get people to save more; the other is to get people to work more so as the baby boomers get older they don’t drop out of the labor force. Well, if you’re not taxing savings, inevitably the tax burden has to increase on labor. There’s labor and capital. If capital is exempt, the tax on earnings has to go up. And that means that switching to a consumption tax would penalize working.

So the question is on balance, is the extra incentive to save enough to offset the extra disincentive, the penalty on working? And it’s not clear. In any event it’s not likely to be a very large effect, it’s not going to turbo charge the economy.

Ray Suarez: Well today also the Fed chairman said, William Gale, that there’s likely to be a lot of opposition to this. Who would be, you know, as the two sides line up to do battle, who would be the kind of forces people, institutions who would be against it?

William Gale: Well, it depends on the exact form of the consumption tax. Certainly low and middle income group would be very concerned that their tax burden would go up.

The other groups that would be concerned is anyone who gets a tax break under the current system. Most of these consumption taxes, like a retail sales tax or value added tax or the flat tax, or whatever, talk about cleaning out the tax system, all the special exemptions and deductions and credits and stuff like that. So the charitable sector doesn’t like these things because the charitable contribution disappears.

The entire health sector doesn’t like them because the deductions for health insurance disappear. Businesses, a lot of businesses don’t like tax reform because they lose deductions for payroll taxes and other things. So you have to gore someone’s ox in tax reform, and any time you do that they’re not going to like it.

Ray Suarez: William Gale, Len Burman, gentlemen, thank you both.

William Gale: Thank you.

Len Burman: Thank you.