Consumption Tax
March 14, 2009
A Consumption Tax is levied on the amount spent on services and goods. It is based on consumption. It is normally an indirect tax like value added tax or sales tax. Although it can be levied as a type of personal direct taxation such as an income tax that does not include savings or investments. It is also known as a cash flow tax, a consumed income tax or expenditure tax, among others. Taxes such as these were introduced very briefly in Sri Lanka and India previously.
Proposals have been made to adjust the consumption tax to reduce its effects since it has been considered to have a regressive effect on people’s income. A consumption tax can be made progressive by using graduated rates, rebates, deductions or exemptions, and permit tax free savings to accumulate.
A number of consumption taxes that have been proposed have similar features with some of the income tax systems that are prevalent today. These proposals allow tax payers to get certain exemptions and standard deductions to ensure non-payment of taxes by the poor. A consumption tax that is inflexible would not permit any deductions because all savings would then be deductible.
Also, in order to calculate the tax liability, a withholding system could also be introduced. Not having to pay tax all year and then pay it all together at the end would create difficulties for many taxpayers.
The basis on which the value of investments is calculated could also be eliminated by consumption tax. Normally, income which is invested in savings accounts, stocks and property is considered tax free. The asset is not taxed even when it appreciates in value. Tax is levied only when the income from the asset is spent. This is unlike the existing system whereby land bought for $15,000 and resold for $20,000 results in a profit of $5,000. Since a consumption tax is levied only on consumption, if one investment is sold to purchase another, tax is not levied.
It has been noted that when renters take a property on rent, they are consuming housing and hence will be taxed on the expenditure or consumption. On the other hand, homeowners who also consume housing but pay for a mortgage, do not have to pay for consumption since the mortgage payments are considered savings and not consumption, based on the premise that equity is built on an asset.
The imputed rental value of a property explains the difference between savings and consumption. If a homeowner opts to stay in the home instead of renting it out for money, the homeowner is consuming housing. The imputed rental value of the property is the amount that the homeowner could have received as rent. The imputed rental value of the property would be taxed by a proper consumption tax instead of the increase in the value of the property being taxed.
The federal government permits a deduction on mortgage interest expenses in order to subsidize home ownership, and exempts a considerable increase from capital gains tax on the value, in the US. Hence, it may not be feasible to treat homeowners and renters at par in the US.
Finally, fairness can be maintained with the utilization of progressive rates by the consumption tax. The higher the amounts spent on consumption by a person, the higher the amount of tax to be paid by them. The rate structure could be similar to the current bracket system, or a new one can be introduced.
Consumption taxes are favored over income taxes for the growth of the economy by tax experts and economists. Unlike income taxes, consumption taxes are neutral when it comes to investments. It is considered an advantage for consumption tax to increase productivity and capital stock, by not disfavoring investment and thereby increasing economic growth.
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