Taxing Consumption Rather Than Investment

Over the weekend I got a lot of negative feedback from my post on why investment income should be taxed at a lower rate than regular income. In discussing the issue, I found a lot of people were much more sympathetic to the same basic idea when it was framed the way Brad DeLong framed it in February as about the desirability of taxing consumption rather than investment:

We want to tax luck—heavily. We don’t want to tax enterprise and ingenuity. We do not want to create armies of accountants gaming our system. In a world that is as a whole still relatively poor we do not want to tax thrift. And we want to use our tax system to provide a substantial amount of social insurance: if you could ask us all as neonates whether we wanted a lump-sum, a flat, or a progressive tax, we would (if we could think and talk) nearly all call for a strongly progressive tax—and if you could ask us even earlier, before we had drunk from the Lethe when we all still faced the risk that we might not choose the right parents, that conclusion would be squared.

These considerations push in very different directions. The closest to a point of equipoise is a strong progressive tax on consumption, on net cash flow, on income minus savings—with then no distinction between whether the income comes from wages or dividends or capital gains: if the income is saved, it escapes tax, and if it is spent on consumption goods and services it is all taxed at the same rate.

This is a view that John Rawls seemed to espouse, and it’s something Robert Frank has written about extensively. And for a variety of administrative and enforcement reasons, I think it’s a better way to go.

But something most people don’t realize is that in the long run, using consumption as your exclusive tax base and using labor income as your exclusive tax base are theoretically equivalent. On a finite time scale, there’s still a big different here. If you’re 68, rich, and no longer working, then a progressive consumption tax will cost you a lot of money, and a progressive payroll tax will cost you no money. In administrative terms, they’re quite different, and that matters in the real world. But in principle the two ideas are the same, namely that at the margin it’s good to create incentives for savings and investment.

Last I’ll say that I was a bit surprised by some of the blowback simply because this is such standard practice. Not only have capital gains been taxed at a lower rate than ordinary income throughout almost all of American history (with the gap even bigger when you consider that investment income isn’t subject to Social Security tax), but the gap was particularly large during the postwar decades that progressives often cite as an example of a time when high tax rates were compatible with strong economic growth. In European countries with large welfare states, similarly, there’s a lot of reliance on consumption taxes as a finance base.