Our tax system relies primarily on the imposition of income taxes imposed upon persons and entities to fund governmental operations. Estate and gift taxes play a minor role in revenue collected by the Treasury. For  some time, consumption taxes have been discussed as a method of simplifying the tax system, while at the same time improving the equity of that system.

Consumption taxes are not new; nor are they popular. Gasoline, liquor, tobacco and sales taxes are but a few of the consumption taxes which are presently imposed by the federal and state governments.  Consumption taxes are also regressive, in that they disproportionately impact low income individuals. This is so because low income taxpayers spend a higher portion of their disposable income on items which are subject to consumption taxes.

In light of the regressivity of consumption taxes, it is somewhat surprising that some tax economists posit that a broad-based consumption tax, imposed in lieu of an income tax, would promote greater “equity” within the tax system. This argument is based principally on the notion that the present income tax regime penalizes those who save, rather than those who consume.

As an example, consider two individuals, each of whom has $10,000. The first individual spends the money on a cruise around the world, while the second invests the money in a bond paying 10 percent interest. Those who support a consumption tax would argue that the person who invests the money is treated inequitably vis à vis the person who takes the trip, since investor must  report interest income while the traveller enjoys his cruise without the imposition of any tax on the “benefit” conferred by the voyage.

The consumption tax advocates also argue that a tax system based primarily on income taxes encourages consumption, and discourages investment. In support of this assertion, they point out that if in the preceding example, a ten percent tax were imposed on the cruise, but no tax on the investment income, then more people would save rather than spend. However, while it may not seem inherently offensive to tax the consumer rather than the investor — in fact, much could probably be said for encouraging savings — this still does not justify the imposition of additional consumption taxes, for the following crucial reasons:

First, consumption taxes, even if they would accomplish the goal of increasing savings and reducing consumption, would also impose a significant hardship on those persons who are least affluent. Conversely, those with wealth and high incomes would benefit almost exclusively from a consumption tax. No longer would those persons be taxed on their salary income or on the income earned from investments. Although they would pay more in consumption taxes, the windfall they would reap, by reason of there being no tax imposed on their income, would more than offset the new consumption taxes.

Second, with no tax imposed on income, the disparity between wealthy and  nonwealthy persons would continue to grow. Thus, wealthy individuals would be able to engage in endless realization transactions without the gains ever being subject to a taxable event. High income individuals would be able to invest savings tax-free forever. With the immense tax savings realized by reason of the absence of an income tax, wealthy individuals could continue to consume and still fare better in a consumption tax regime.

To illustrate the inequity of imposing broad-based consumption tax in place of the presently existing progressive income tax, consider the case of  two individuals. The first individual, A, has $10,000, and the second, B, has recently inherited $1,000,000. A invests $5,000 in stock paying a dividend of 5 percent, and with the other $5,000 he purchases a sailboat. B invests $900,000 in secure Treasury Bonds yielding 5 percent. With the other $100,000, B buys a Porche.

Consider first the tax treatment under the present income tax system:

A reports dividend income of $250 at the end of year one. His purchase of the sailboat has no tax consequences. His total tax liability, since he is in the 31 percent income tax bracket, is $78.

B reports interest income of $45,000 on the Treasury bonds, and, being in the 40 percent income tax bracket, pays an income tax of $18,000. With respect to the purchase of the Porche, B pays a luxury tax of 10 percent on that portion of the purchase price which exceeds $32,000, or $3,200.  B’s total tax liability is $21,200.

Now assume that broad-based consumption tax of ten percent is imposed in place of an income tax:

A pays no tax on his stock dividend income, but pays a consumption tax of $500 on his sailboat purchase.

B pays no tax on his $45,000 of interest income, but pays a tax of $10,000 on his automobile purchase. In slightly more than two years, B will recoup his entire $1,000,000, even after purchasing the Porche and paying consumption taxes thereon. B clearly benefits by reason of a change to a consumption tax.

A, on the other hand, fares poorly under the consumption tax. Under the present income tax, A pays a $250 tax on dividend income. With the imposition of a consumption tax, it is true A pays no tax on his dividend income; however, he pays substantial consumption tax on the purchase of the sailboat.

Since B has a larger initial cash reserve, he can spend much more on consumables while still retaining, and even augmenting his wealth and future income. A, poorer to begin with, must spend a larger percentage of his available wealth on a consumable item. This leaves A with less money to invest in tax-favored ways. A derives little, if any real benefit from the absence of an income tax. B, on the other hand, clearly benefits from the change to a broad-based consumption tax.

Consumption taxes are regressive, inequitable, and tend to increase the disparity between wealthy and nonwealthy persons. The present income tax regime, though far from perfect, prevents exaggerated accumulations of wealth by reason of the mandated tax holiday on all business and investment income, which the consumption tax celebrates. Placing a disproportionate tax burden, as the consumption tax would, on those persons who are least able to pay, is both unfair and imprudent.