# Presentation: 707401

## A consumed income tax: a fair and simple plan for tax reform

- Ed McCaffery
- USC and Caltech
- President’s Advisory Panel on Federal Tax Reform
- May 11, 2005

## Last words (first)

- It is time to get the fair timing of tax down right
- We should tax people when they spend, not when they work, save, give, or die

## A consumed income tax

- From where we are:
- Place all savings accounts on traditional IRA, 401(k) models
- Remove *all* limits on contributions to and withdrawals from such accounts
- Include debt in tax base
- Repeal capital gains preferences
- Repeal gift and estate tax
- Repeal corporate income tax

## Three types of tax

- Income, prepaid consumption and postpaid consumption (a/k/a consumed income tax)
- Income = Consumption + Savings ( I = C + S) (Haig Simons)
- Two forms of consumption tax
- Prepaid = wage tax = Roth IRA
- pay tax now, not later
- Postpaid = spending tax = consumed income tax = traditional IRA
- pay tax later, not now
- C = I – S
- Equivalent under constant rates

## Key insight:
Equivalence of prepaid and postpaid consumption tax does NOT hold under progressive rates

Given progressive rates:
Income tax: double taxes ALL savings
Prepaid consumption tax: ignores ALL savings
Consumed income tax: splits the difference, by design

- Key insight:
- Equivalence of prepaid and postpaid consumption tax does NOT hold under progressive rates
- Given progressive rates:
- Income tax: double taxes ALL savings
- Prepaid consumption tax: ignores ALL savings
- Consumed income tax: splits the difference, by design

## Two types of savings 

- Two uses of capital
- Smoothing
- Translating uneven earnings into “smoothed” or even consumption – moving earnings to times of greater need
- Such as retirement, education, medical needs
- Shifting
- Using capital to raise or decrease standard of living
- Three taxes, again
- Income tax: double taxes both uses
- Prepaid consumption: ignores both uses
- Consumed income: favors smoothing, falls on shifting

## Slide 7

## A note on “hybrids”

- BAD hybrids:
- Cut and paste, mix and match income and consumption models
- Income plus prepaid consumption:
- Savers put “old” savings into Roth-style accounts
- No help for middle class living paycheck to paycheck
- Result is no new savings
- Income plus postpaid consumption
- Taxpayers put money into traditional IRAs and run up debt
- Result is tax deduction with (again) no new savings

## A note on “hybrids”

- GOOD hybrid:
- Tax some but not all savings
- “smoothing” or savings for ordinary uses – retirement, education, medical needs lowers taxes
- “shifting” or using the yield to capital as a source of enhanced consumption, raises taxes
- Progressive consumed income tax does this, by design, by taxing people when they spend
- Moving from high earnings periods to those of greater need lowers taxes
- Living “better” off the yield to capital raises taxes
- See graphics in appendix, McCaffery (2005)

## A consumed income tax

- A consistent consumed income tax:
- Encourages savings for ordinary purposes
- Taxes capital when its yield is used to elevate or enhance lifestyles, not otherwise
- Discourages consumptive debt
- Encourages real savings, across generations
- Mistake to think needs higher rates
- No capital gains preference
- Pick up debt-financed consumption

## Take home points

- Tax reform is needed
- We do not have, have never had, and will never have an income tax
- Not all consumption taxes are created equal
- Prepaid consumption taxes = wage taxes
- No burden on wealthy
- No marginal incentive to save
- Where we are headed
- Postpaid consumption taxes = consumed income tax = spending taxes
- Can be progressive
- Eliminate need for separate capital taxation
- Capital gains
- Gift and estate
- Corporate income
- Where we should be headed

## A consumed income tax: a fair and simple plan for tax reform

- Ed McCaffery
- USC and Caltech
- President’s Advisory Panel on Federal Tax Reform
- May 11, 2005

## Additional material

- See McCaffery, Fair not Flat: How to Make the Tax System Better and Simpler (U. Chicago Press 2002, _[www.fairnotflat.com](http://www.fairnotflat.com/)_)
- McCaffery, A New Understanding of Tax, Michigan Law Review 2005

## Two types of savings 

- Two norms of capital:
- Ordinary savings
- Don’t “double tax” people saving for ordinary needs, such as retirement, medical, and educational ones
- Yield to capital
- Do include the yield to capital in the tax base, tax people living off capital
- Two uses of capital
- Smoothing
- Translating uneven earnings into “smoothed” or even consumption – moving earnings to times of greater need
- Shifting
- Using capital to raise or decrease standard of living

## Further graphics

- Smoothing and shifting capital transactions, within and between generations, and with progressive tax rates
- Much more detail in McCaffery 2005

## Slide 16

## Slide 17

## Where we are heading

- “Income” tax:
- Basic tax planning obviates taxation of yield to capital
- Tax planning 101:
- Buy
- Borrow
- Die
- See McCaffery, Fair not Flat
- Low capital gains, dividend taxes
- Increasingly prepaid savings accounts
- Roth IRAS
- Medical and educational savings accounts

## Where we are heading

- Add on:
- Payroll tax
- Weak gift and estate and corporate income taxes
- You get:
- Relatively flat, highly burdensome wage taxes (prepaid consumption)

## Where we should be going 

- Towards a progressive *postpaid *consumption tax, a progressive consumed income tax
- Practical points
- C = I – S
- Could use VAT plus rebates at lower end, ala Graetz proposal
- Need to pick up debt in tax base
- Mistake to think needs higher rates
- No capital gains preference
- Pick up debt-financed consumption

## Implementation points

- 	Since a consumed income tax is analytically equivalent to a sales tax or VAT, we could use a VAT or a sales tax set at the lowest non-zero marginal tax rate plus a rebate ( = VAT/sales tax rate times “zero bracket” upper limit), then subtract the VAT/sales tax rate from the consumed income tax rate schedule, to get a two-tax system.  See next two slides.

## Consumed income tax, one-tax system (illustrative)

| Consumed Income | Marginal Tax Rate % |
| --- | --- |
| $ 0 – 20,000 | 0 |
| $20,000 – 80,000 | 10 |
| $80,000 – 160,000 | 20 |
| 160,000 – 320,000 | 30 |
| Over 320,000 | 40 |

## Consumed income tax, two-tax system, with 10% VAT and $2,000 rebate

| Consumed Income | Marginal Tax Rate % |
| --- | --- |
| $ 0 – 80,000 | 0 |
| $80,000 – 160,000 | 10 |
| 160,000 – 320,000 | 20 |
| Over 320,000 | 30 |

## Transition issues

- Main problem is “pre-enactment basis”
- But query how much basis there is, today
- Alternatives are to ignore (Kaplow 1995) or allow some form of credit/amortization
- Challenge is to tax debt
- Cash flow, financial reporting
- Simplification gains come from:
- Unified approach to savings
- No need for concept of “basis”
- No capital gains
- No gift and estate tax
- No corporate income tax

## Housing and charitable deductions

- Housing can be treated as savings, at least up to a certain principal value
- Hence not only mortgage interest but also principal payments deductible
- Charitable contributions deductible from consumed income

## A consumed income tax: a fair and simple plan for tax reform

- Ed McCaffery
- USC and Caltech
- President’s Advisory Panel on Federal Tax Reform
- May 11, 2005