Consumption Tax - Practical Considerations

Practical Considerations

Many proposed consumption taxes share some features with the current income tax systems. Under these proposals, taxpayers would be given exemptions and a standard deduction in order to ensure that the poor do not pay any tax. In a pure consumption tax, other deductions would not be permitted, because all savings would be deductible.

A withholding system might also be put into place in order to estimate the total tax liability. It would be difficult for many taxpayers to pay no tax all year, only to be faced with a large tax bill at the end of the year.

A consumption tax could also eliminate the concept of basis when computing the value of investments. All income that is put in investments (such as property, stocks, savings accounts) is tax-free. As the asset grows in value, it is not taxed. Only when the proceeds from the asset are spent is any tax imposed. This is in contrast with the current system where if one buys land for $10,000 and sells it for $15,000, one has a taxable gain of $5,000. A consumption tax taxes only consumption, so if one sells an investment to buy another investment, no tax is imposed.

Andrews notes the inherent problem with housing. Renters necessarily "consume" housing, so they will be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset).

The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent the home to others in exchange for money but instead chooses to live in the home to the exclusion of all possible renters. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home.

A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) and would not tax the increase in the value of the asset (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States, home ownership is subsidized by the federal government by permitting a deduction for mortgage interest expense and exempting a significant increase in value from the capital gains tax. Therefore, treating renters and homeowners identically under a consumption tax may not be feasible in there.

Also, a consumption tax could utilize progressive rates in order to maintain "fairness." The more that someone spends on consumption, the more that the person will be taxed. The rate structure could look like the current bracket system, or a new bracket system could be implemented.