The Progressive Consumption Tax

A win-win solution for reducing American income inequality.

Illustration by Rob Donnelly.

The first part of this series described how growing income disparities have made it more expensive for middle-income families to achieve many basic goals, such as sending their children to a decent school. The second part explained why income inequality has grown so rapidly in recent decades. This final installment describes an opportunity to perform fiscal alchemy. By pulling a simple tax lever, we could reduce the costs of growing income disparities, while at the same time freeing up several trillion dollars of additional resources each year—more than enough to pay down the federal debt and rebuild our crumbling infrastructure—all without requiring painful sacrifices from anyone. This essay is adapted from Robert H. Frank’s recently published book, The Darwin Economy.

As I wrote yesterday, rising income inequality has been largely a consequence of two forces: changes in technology that have extended the reach of the most gifted performers in every arena, and increasingly open competition for the services of those performers. Finger wagging at corporate pay boards will not alter the strength of those forces. Regulatory reforms aimed at promoting better corporate governance are often desirable in their own right, especially in the financial services industry. But such reforms are also unlikely to alter the income growth trends we’ve seen in recent decades.

The good news is that we could pull a few simple policy levers that would greatly reduce the adverse effects of growing income gaps without threatening the benefits that have been made possible by improved technology and increased competition.

The simplest step would be to scrap the current progressive income tax in favor of a much more steeply progressive tax on each household’s consumption. Families would report their taxable income to the IRS (ideally under a tax code that greatly simplifies the calculation of taxable income), and also their annual savings, as many now do for IRAs and other tax-exempt retirement accounts. The difference between those two numbers—income minus savings—is the family’s annual consumption expenditure. That amount, less a large standard deduction—say, $30,000 for a family of four—is the family’s taxable consumption. Rates would start low and would then rise much more steeply than those under the current income tax.

Families in the bottom half of the spending distribution would pay lower or no higher taxes than under the current system. But high marginal rates on top spenders would not only generate more revenue than the current system, but would also reshape spending patterns in ways that would benefit people up and down the income ladder.

If top marginal income tax rates are set too high, they discourage productive economic activity. In the limit, a top marginal income tax rate of 100 percent would mean that taxpayers would gain nothing from working harder or investing more. In contrast, a higher top marginal rate on consumption would actually encourage savings and investment. A top marginal consumption tax rate of 100 percent, for example, would simply mean that if a wealthy family spent an extra dollar, it would also owe an additional dollar of tax.

That feature of the tax gives rise to what it would be no exaggeration to describe as fiscal alchemy. Consider, for example, how the tax would affect a wealthy family that had been planning a $2 million addition to its mansion. If it faced a marginal consumption tax rate of 100 percent, that addition would now cost $4 million—$2 million for the job itself, and another $2 million for the tax on it. Even the wealthy respond to price incentives. (That’s why they live in smaller houses in New York than in Seattle.) So the tax would be a powerful incentive for this family to scale back its plans. It could build an addition half as big, for example, without spending more than it originally planned.

The fiscal magic occurs because other wealthy families who’d also planned additions to their mansions would respond in a similar way. And since no one denies that, beyond some point, it’s relative, not absolute, mansion size that really matters, the smaller additions would serve just as well as if all had built larger ones.

The tax would have similar effects in other luxury domains. The amounts spent on multimillion-dollar coming-of-age parties would grow less quickly, as would the amounts spent on weddings, yachts, jewelry, and other items. And these changes would attenuate the expenditure cascades that have squeezed middle-class families.

A progressive consumption tax would not cure all ills. Although it would reduce inequality in consumption spending, it would likely have the opposite effect on wealth inequality, since the rich could better take advantage of the savings exemption. Because the wealthy would die with larger estates than before, it would be important to maintain a strong estate tax as part of the system.

With the unemployment rate still near 9 percent, now would be an inopportune moment to implement a progressive consumption tax. But if we passed the tax into law and scheduled it for gradual phase-in only after the economy had again reached full employment, we’d achieve three goals at once.

First, by committing ourselves to a larger revenue stream in the future, we’d reassure those who worry, justifiably, that the government cannot forever spend more than it takes in. Second, by encouraging additional investment, we’d foster more rapid growth in productivity and income. Third, and most important, knowledge that the tax was coming would stimulate a burst of private spending that would help get the economy back on its feet. Anyone who was thinking about buying a bigger yacht or building a bigger mansion would rush to do so before the tax took effect.

Of course, that’s hardly the best way to stimulate a depressed economy. Far better would be for the government to spend hundreds of billions of dollars on desperately overdue infrastructure repairs. But conservatives in Congress have consistently demonstrated their ability and willingness to block such measures.

In contrast, conservatives have always been responsive to proposals to tax consumption instead of income. They generally favor a flat tax, but because flat taxes would make inequality dramatically worse, they are unlikely ever to be adopted.

So a progressive consumption tax may be our only politically realistic hope for ending the downturn quickly and limiting the growth in consumption inequality that has made life so much more difficult for the 99 percent.

In my recent book, The Darwin Economy, I defend the claim that taxes on activities that cause undue harm to others could generate more than enough revenue to end our budget woes once and for all. The progressive consumption tax is such a tax. The wealthy family that builds a bigger mansion or stages a more lavish wedding celebration almost surely had no intention of harming others. But its actions nonetheless harm others, by shifting the frames of reference that shape what they must spend in those domains. The progressive consumption tax creates an incentive to take those external costs into account.

For exactly analogous reasons, we should tax congestion, noise, and pollution. We should tax passenger vehicles by weight. In contrast, our current system generates most of its revenue by taxing useful activities. The payroll tax, for example, discourages hiring. The income tax discourages savings. As every mature adult realizes, we have to tax something. Every dollar we can raise by taxing activities that cause harm to others is a dollar less we must raise by taxing beneficial activities.

Many on the right are quick to denounce taxes on harmful activities as “social engineering”—which they usually define as using the tax code “to control our behavior, steer our choices, and change the way we live our lives.” But that’s what virtually all laws do. Stop signs are social engineering, as are prohibitions against theft and homicide. Laws restrict behavior because individuals often choose to behave in ways that cause harm to others. For someone who cares about personal liberty, discouraging harmful behavior by taxing it should be far less objectionable than prohibiting it outright.

As economists are fond of saying, there’s no free lunch. An important exception to that rule, however, is that when existing arrangements are grossly wasteful, it’s possible for everyone to have more of everything. We must not allow mindless anti-tax rhetoric to prevent us from implementing tax reforms that would create enormous benefits for citizens all along the income scale.

Growing income disparities, which are largely a consequence of market forces, have made it far more expensive for middle-income families to achieve many basic goals. The OWS movement has performed an invaluable service by helping to focus public attention on this problem.  Members of the movement have wisely refrained from making specific policy demands for the moment. But now that inequality has reached the top of the agenda, it’s time to discuss what to do about it.