With a lot of discussion in Congress regarding tax reform, there is also chatter about implementing a consumption tax rather than income tax. Very simply, a consumption tax is tax paid on the purchase of goods and services and occurs as sales or excise taxes or tariffs. The money paid on this type of tax is based on how much money you spend rather than how much money you earn, as is the case with income tax.

The idea of consumption tax is not at all a new one. In fact, prior to 1913 when Congress passed the 16th Amendment, the federal government primarily raised revenue by means of consumption tax rather than our current system of income taxation. Of course, income tax is levied on how much you earn, and that goes beyond your paycheck and includes interest, dividends, capital gains, etc.

There are pros and cons to each taxation system.

The Pros
At first glance, a consumption tax gives you the opportunity to control how much you pay in taxes. The less you spend – consume – the less of your money goes to the government. This tax becomes naturally limited since it will tend to automatically discourage spending activity when the tax becomes too high. Also, savings and investment accounts are unaffected and even encouraged by consumption tax since any gains they earn (e.g. interest, dividends, capital gains) are not taxed until that money is actually spent. This ultimately leaves more money in the hands of the taxpayer.

Those in favor of consumption tax argue that it comes as close to achieving taxation neutrality as possible – in essence, a flat tax in which every taxpayer pays the same percentage. This neutrality can also lessen, or perhaps eliminate, the paperwork involved with filing tax returns and reporting, which in turn, saves the government billions on compliance. Think: reduce or eliminate the IRS. April 15th will no longer be a day that most taxpayers dread.

The income tax model, on the other hand, makes it easier for the government to estimate revenues and is far less regressive than a consumption tax. While it’s nice to think we can pay less tax simply by spending less, there will also be consumption tax paid for certain necessities. With everyone paying the same tax percentage on the necessities, those with lower incomes end up spending a larger portion of their overall income and are hit harder by consumption tax than by a progressive income tax in which the tax percentage increases as income levels increase. Many argue that for this reason, the income tax model is fairer, with higher-income taxpayers contributing a larger percentage to the government’s revenues.

The Cons
The flip side of paying less tax by spending less in the consumption model is that it could discourage consumer spending, which would then create a domino effect of negatively impacting the economy, business revenues, and potentially jobs. However, there are many states that have eliminated income tax in favor of other forms of taxation, including Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. (Residents in New Hampshire and Tennessee only pay tax on interest and dividends, not on earned income.) Another argument against consumption tax is that it would raise less revenue than income tax if both tax rates were the same.

Reporting complexity and lack of transparency lead the list of negatives of the income tax model. Additionally, there is ultimately less money saved since earnings on savings are subject to taxation. There is also an economic cost to businesses to collect and report corporate income taxes. Those who argue against income tax and in favor of consumption tax also believe that income tax reduces productivity since every hour worked is taxed – the only way to pay less tax in this system is to earn less money.

There will always be a need for taxes to offset the costs associated with public safety, infrastructure, and defense, to name a few. There are several European nations using a value-added tax (VAT), similar to consumption tax, which appears to raise adequate revenue without negatively impacting their economies. However, combining income and VAT certainly raises the overall tax burden.

With pros and cons to each system of taxation, Congress has a lot of homework to do in creating a reform to the current system.

Join Our Newsletter.