Fundamental Tax Reform: A Comparison of Three Options

Key Points

  • Consumption taxes have the potential to reduce taxes on saving, which may lead to economic growth.
  • A partial-replacement value added tax (VAT), a full-replacement X tax and a full-replacement personal expenditure tax (PET) all have different implications for how the tax is administered, transition costs, and international transactions. Policymakers will need to weigh the tradeoffs between a consumption tax and the current income tax system.
  • The economic impact of an X tax hinges on whether it is based on domestic consumption (includes a border-adjustment) or on domestic production.

Fundamental Tax Reform: A Comparison of Three Options

Editor’s Note: This article is part of a series of tax-related articles sponsored by the Penn Wharton Budget Model and the Robert D. Burch Center at Berkeley. All of the articles in this series are forthcoming in a book by Oxford University Press, co-edited by Alan Auerbach and Kent Smetters.

Fundamental Tax Reform: A Comparison of Three Options contrasts the economic consequences of three options to reform the current income tax to a consumption tax. Alan D. Viard (2016) finds that each has different implications for businesses, households and international transactions.

A Federal Consumption Tax

Policymakers are interested in consumption taxes because they want to encourage saving by reducing taxes on saving. In the United States household saving is lower than that of many other developed countries. More saving and investment can lead to economic growth. In turn, economic growth may increase tax revenues at a given rate. A well designed consumption tax stimulates new investment by lowering its tax rate.

A consumption tax may reduce or eliminate some distortions to economic activity present in an income tax system, such as different after-tax rates of return for different types of capital. However, a consumption tax may introduce other distortions, such as different returns to leisure and consumption.

Just like with the current income tax system, a consumption tax can include deductions and exclusions. Their inclusion can be used to maintain the progressivity of the tax system and encourage certain behaviors. However, including deductions and exclusions can introduce complexity and narrow the tax base, which could lead to higher tax rates.

Three Types of Consumption Tax

Viard compares three types of consumption tax reforms. The first is a partial-replacement value added tax (VAT). The second is a full-replacement X tax. The third is a full-replacement personal expenditure tax (PET).

Partial-Replacement Value Added Tax (VAT)

Under a VAT, firms are taxed at a flat rate on revenue less the cost of inputs. About 180 other countries have a VAT, including all other Organisation for Economic Co-operation and Development (OECD) countries. Some countries have a VAT in combination with an income tax. In the United States a VAT has been proposed by Graetz, in 2008, the Bipartisan Policy Center, in 2010 and Gale and Harris, in 2013.

Figure 1 shows that, under a VAT, households would not need to file a VAT tax return because wages are taxed at the firm level. However, because a VAT has one flat rate, it is not progressive. Some countries have introduced progressivity by excluding certain items, such as groceries, from tax while allowing firms to deduct the cost of inputs for those items. However, these different tax rates make a VAT system more complicated and can introduce distortions to economic decision making.

Figure 1: Characteristics by Type of Consumption Tax

Characteristic VAT X Tax PET Current Income
Tax Type Consumption Consumption Consumption Income
Who Files Firms Firms and Households Households Firms and Households
Distribution Flat Rate Progressive rates Progressive rates Progressive rates
Tax Base Firms: Revenue less purchases from other firms

Households: Wages are taxed at the firm level
Firms: Revenue less purchases from other firms less wages

Households: Earned income less exclusions and deductions
Firms: Income less saving plus drawing down savings and borrowing

Households: Income less saving plus drawing down savings and borrowing
Firms: Income less deductions and exclusions

Households: Earned and Unearned income less deductions and exclusions
Household Return Complexity NA Simple* Complex Complex
Possible Monetary Policy Response Inflation to reduce real wages None None NA
Tax incidence of gifts, donation and bequests NA Donor Recipient Recipient, Donors when above limits
Tax Social Security and public cash benefits Not Directly No* Yes* In some cases
Tax of housing and durable goods At construction At construction Purchaser When sales or rents produce income
Tax of employee benefits Tax on work related items Households and/or firms Households Households and/or firms
Nonprofit Organizations & Governments Firms: Only taxed on wages Firms: Exempt Households: Earned income less exclusions and deducations Households: wages included in calculation of taxable consumption Firms: not taxed Households: taxed on wages

*Characteristic could be changed, but is not present in pure form of the tax

Source: Viard 2016

The introduction of a firm level tax on wages could put downward pressure on paychecks because some of the VAT will be passed on to workers. If employers want to pay workers less, it could lead to unemployment if wages take time to adjust downward. Downward pressure on wages may induce the Federal Reserve to accommodate a VAT with inflation so that wages adjust faster.

Full-Replacement X Tax (X Tax)

An X tax is a modification of a VAT that can allow for wages to be taxed at progressive, graduated rates. As with a VAT, firms are taxed on revenue less the cost of inputs. However, with an X tax, firms also subtract wages from their tax base. Instead, wages are taxed at the household level. Progressivity is introduced because, as with the current income tax system, some wage income can be exempt, taxed at different rates and tax credits can be refundable. Currently, no country applies an X tax. An X tax has been proposed by Bradford, in 2004, the President’s Advisory Panel on Tax Reform, in 2005, Carroll and Viard, in 2012, Antos et. al., in 2015, and the House GOP, in 2016.

An X tax would reduce many distortions to economic decisions making. For example, the incentive to shift income between wages and capital are reduced because the top tax rate on wages could be the same as the tax rate firms pay. In addition, distortions to firm financing are reduced because debt and equity financing are both taxed at the same rate. Therefore, there is no incentive for firms to seek financing from banks rather than the stock market.

Figure 1 shows that under an X tax both firms and households file tax returns. Household tax returns may be simpler than under the current income tax system because households report only wage income and not capital income. One drawback with the X tax is that household consumption is not taxed directly as with a VAT or PET, rather it is approximated by taxing wages. In addition, owners of closely held firms may be able to shift income from the firm tax rate to a lower wage tax rate.

Full-Replacement Personal Expenditure Tax (PET)

Under a PET, households are taxed on their consumption. Households report income, less savings, plus spending out of saving. Saving includes deposits, asset purchases, loans to others and payments made on outstanding debt. Dissaving includes withdrawals, asset sales, new debt, and payments received on loans to others. A PET can be made progressive by taxing households at graduated rates with refundable tax credits. Under a PET, firms would not need to file a tax return. Only a few countries have ever implemented a PET. A PET has been proposed by the Alliance USA, in 1995, McCaffery and Hines, in 2010 and Heritage Foundation, in 2011.

Figure 1 shows that household tax returns are likely to be complex under a PET because of the need to track financial transactions. On the other hand, a PET taxes household consumption directly and allows for progressivity.

Moving to a Consumption Tax

The transition from an income tax to a consumption tax may benefit some taxpayers over others. In particular, the introduction of a consumption tax would lower the value of existing wealth because wealth would be taxed when it is spent. In addition, the treatment of non-business capital, cash-on-hand and retirement accounts need to be considered.

A VAT, X tax and PET can all be adjusted to include relief for wealth-holding taxpayers who are negatively affected by the introduction of a consumption tax. Under a VAT, the method of providing transition relief would hinge on if the Federal Reserve accommodates the introduction of a VAT by allowing inflation. If the Federal Reserve fights inflation then transition relief can be provided by allowing firms to deduct their existing capital stock. If the Federal Reserve allows inflation then it is less clear how to provide transition relief without changing the distribution of wealth. As with a VAT, under an X tax, firms could be allowed to deduct existing capital. Under a PET, households could deduct the income tax they would have paid on existing wealth.

A Consumption Tax and International Transactions

The impact of a consumption tax on international transactions and wealth depends on if the tax base is domestic consumption (destination) or domestic production (origin). A PET and VAT are likely to be based on domestic consumption while an X tax would be based on domestic production.

An X tax can be based on domestic consumption by taxing imports and not exports, so called “border adjustment.” On its face, a border adjustment tax would seem to increase tax revenue while promoting exports and discouraging imports. However, economic theory indicates that currency values would adjust and there would be no net effect on imports and exports. An additional consideration is that a border adjustment tax may not be compliant with the World Trade Organization (WTO) rules. An objection from the WTO could complicate the implementation of a destination-based X tax.

If an X tax is based on domestic production then the prices charged between a domestic firm and a foreign affiliate (transfer pricing) must be considered. Under an origin-based X tax, domestic firms could avoid taxes by shifting production to foreign affiliates and then pay a less than fair price for that production when it is sold back to the domestic firm. A destination-based tax would eliminate these transfer pricing problems.

Conclusion

Viard investigates the economic impact of three different types of consumption taxes. Policymakers must weigh difficult tradeoffs to reform the current income tax system to a consumption tax. Tax reform including consumption taxes can have an impact on international transactions. Further investigation into the impact of different reform options will help inform the debate.

A discussion of this paper is provided by James R. Hines Jr.