# Presentation: 132549

## THE PRESIDENT’S ADVISORY PANEL ONFEDERAL TAX REFORMINCOME AND CONSUMPTION TAXATION:CENTRAL CONCEPTSLouis KaplowFebruary 16, 2005

## BASIC STORY

- In the First Period - Our Taxpayer Works . . .
- ◦		Earns labor income
- 	  	      consumes a portion, and
- 	  	      saves the rest
- In the Second Period - Our Taxpayer Retires . . .
- ◦	Receives return (e.g., interest) on savings
- ◦	Consumes what was saved, along with the return (e.g., interest) on the savings

## WHAT IS AN “INCOME TAX”?

- •	Tax Base Is All Income:  What is Income?
- ◦	Income = Consumption + Change in Wealth
- 	 	     so-called “Haig-Simons” definition of income
- What is Taxed?
- ◦	First period’s tax base: labor income
- ◦	Second period’s tax base: return on savings (interest)
- Pure Implementation of Income Tax: Income is Taxed as It Accrues
- ◦	Gains and losses taxed as they occur
- ◦	No realization event required

## WHAT IS A “CONSUMPTION TAX”?

- Tax Base is All Consumption
- 	  ◦     so-called personal, “cash flow” consumption tax
- What is Taxed?
- ◦	First period’s tax base: consumption in first period
- ◦	Second period’s tax base: consumption in second period
- Pure implementation of Consumption Tax
- ◦	Consumption Tax Base = Income Tax Base - Change in Wealth
- 	  	    Recall:  Income = Consumption + Change in Wealth, which implies that
- 	  	 	 Consumption = Income - Change in Wealth
- Possible Real World Version:
- 	  ◦ 	Income tax with all savings in 401k / IRA-type vehicles: savings untaxed when  	earned and as interest accrues; taxed on withdrawal

## EQUIVALENCE  IINCOME TAX PERSPECTIVE ON CONSUMPTION TAX

- A Consumption Tax is Equivalent to a Labor Income Tax
- ◦	In other words, a Consumption Tax is equivalent to an Income Tax that exempts capital income (return to savings)
- Intuition: Consider a 25% tax . . .
- ◦	25% Consumption Tax → individuals can consume 75% as much, each period, as they could with no tax
- ◦	25% Labor Income Tax → leaves individuals with 75% of their earnings, allowing them to consume 75% as much, each period, as they could with no tax

## EQUIVALENCE  IICONSUMPTION TAX PERSPECTIVE ON INCOME TAX

- An Income Tax is equivalent to a Consumption Tax that applies a higher rate to later consumption
- ◦	This is because an Income Tax taxes savings on earnings already subject to tax
- Intuition:
- ◦	Period 1 apples and period 1 oranges are taxed at same rate by an income tax (and by a consumption tax)
- ◦	But a taxpayer who buys period 2 oranges instead of period 1 oranges pays an additional tax, on the return to savings, under an income tax, which makes period 2 oranges *relatively* more expensive than period 1 oranges, compared to a no-tax world

## WHAT IS THE DIFFERENCE IN DISTRIBUTION?

- Apparent Contrast:
- ◦	High-income taxpayers tend to save greater fraction of income, so seem to fare worse under an income tax
- Do the Two Tax Bases Inherently Have Different Distributional Consequences?  *No*
- ◦	Generally feasible to design a consumption with same distributive incidence as a given income tax
- 	  	 ▪ and vice versa
- 	  	 ▪ recall 1986 Act: idea of reforms holding distribution constant
- ◦	This suggests that *intrinsic* differences are matters of efficiency and administration

## TYPES OF CONSUMPTION TAX SYSTEMS

- Personal, Cash-Flow Consumption Tax: As Described Above
- A VAT and a National Sales Tax Are also Types of Consumption Taxes
- ◦	They tend to use a single rate – i.e., they are “flat” (proportional)
- ◦	Could be supplemented with either a personal, cash-flow consumption tax or an income tax, with any desired rate structure
- ◦	VAT supplemented by an income tax is most typical in developed economies outside the U.S.

## WHAT (REALLY) IS OUR EXISTING INCOME TAX?

- Ostensibly, a Tax on Income
- In Fact, Substantial Departures Make It a *Hybrid* Between a Pure (Accrual) Income Tax and a Consumption Tax

## DEPARTURES FROM PURE INCOME TAXATIONIN DIRECTION OF CONSUMPTION TAX

- Consumer durables (notably housing): return to capital implicitly exempt
- Retirement savings (in many forms): consumption tax treatment
- Preferential treatment of much other investment income:
- 	 ◦	realization requirement (deferral reduces effective tax rate)
- 	 ◦ 	step-up basis at death
- 	 ◦ 	preferential rates for capital gains, and dividends (for now)
- 	 ◦ 	accelerated depreciation, various expensing provisions
- “Human capital”: taxed upon realization

## DEPARTURES FROM PURE INCOME TAXATIONIN THE OPPOSITE DIRECTION

- Inflationary gains
- 	 ◦ 	interest not indexed
- 	 ◦ 	basis not indexed
- Corporate income tax
- 	 ◦ 	to the extent corporate tax system is not “integrated”

## PRACTICAL EFFECTS OF HYBRID SYSTEM

- Implementing Pure Income *or* Consumption Tax Involves Substantial Reform
- Costs of Hybrid System:
- ◦	Economic distortion: due to wide variations in how different sorts of capital are taxed
- ◦	Administrative, compliance, and avoidance costs: induced by boundary policing and attempts to game the system