The Progressive Consumption Tax: Is It Left? Is It Right? Or Both?

by Reihan Salam

Recently, Robert Frank made the case for a progressive consumption tax in Slate, arguing that it might mitigate the dispersion of household incomes:

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.

After poking fun at Nobel laureate economist Edward Prescott, Slate’s Matt Yglesias:

Ed Prescott came up with the absolute most banal idea imaginable for a conservative economist and Taylor just asserted that it was dramatic and exciting! What’s that? Tax cuts? How “dramatic.” If only the Bush administration had thought of that we wouldn’t even be in this situation. For substantive commentary on Taylor see Noah Smith. For smart ideas on taxes see Robert Frank. [Emphasis added]

The relevant proposal from Prescott relates primarily to reforming old-age pensions by transitioning to a wealth-building defined contribution system from pay-as-you-go. I briefly referenced Prescott’s views on this matter a few months ago:

My ideal approach, however, would involve reforming Social Security and the Social Security payroll tax along the lines Edward Prescott proposed several years ago. Basically, the system would become a defined contribution system. Between 18 and 35, contributions would steadily increase, thus facilitating consumption smoothing. Among other things, a prefunded system of this kind — which, of course, raises the question of transition costs — would address Myrdal’s contradiction, and it might give family formation and fertility a significant boost.

My speculative claims aside, it’s not obvious to me that this is a banal proposal, even for a conservative economist. Broadly understood, conservative economists tend to favor relatively modest tweaks to the existing Social Security system. 

Moreover, Yglesias is deriding “tax cuts,” suggesting that the Bush administration tried tax cuts without much success. The trouble is that in the 2003 tax cuts on capital-gains and dividend income, the Bush administration pressed for … cuts in the tax burden on savings and investment, an idea that is also implicit in any progressive consumption tax. 

And who else advocates a progressive consumption tax? As we noted earlier this fall, a number of right-of-center economists, including Alan Viard, Scott Ganz, and Robert Carroll and Glenn Hubbard. A version of the progressive consumption tax was seriously considered by President Bush’s tax reform panel, and the modified Growth and Investment Tax, a progressive consumption tax plus a 15 percent tax on capital-gains and dividend income, was among the panel’s recommendations. 

According to Yglesias’s mental model, if I understand it correctly, conservatives advocate for measures like the progessive consumption tax because there is profit to be made in doing so — this is also an argument that protectionists have levied against free-traders, curiously enough — while left-of-center thinkers advocate it because, well, it’s a good idea. This is certainly an interesting view. Yet the evidence I’ve seen suggests that many people on the right happily advocate for a progressive consumption tax for free, merely because they find the idea intellectually compelling and politically attractive.

Could it be that left-of-center neoliberals face strong incentives to sharply differentiate their views from right-of-center neoliberals in order to signal the intensity of their partisan loyalty — to avoid being on the wrong side of symbolic exclusion? That seems at least possible to me, particularly as left-of-center neoliberals are often harshly condemned by more traditional social democrats who tend to be suspicious of market mechanisms. To these social democrats, left-of-center neoliberals are seen as in some sense worse than right-of-center neoliberals, because at least the latter are (in their view) unapologetic defenders of privilege, etc., and thus easily dismissed.

I doubt that people think about these incentives self-consciously. And similarly, it is possible that Yglesias’s mental model works on some subconscious level, e.g., people are subtly and unbeknownst to them kowtowing to the rich, because doing so is in the ether. Suffice it to say, we’re probably not going to persuade anyone who isn’t already convinced on these matters.