Last Friday, the President Bush issued his annual Economic Report. Press coverage focused heavily on the chapter relating to taxation. The lead was that President Bush favors a shift toward consumption taxation.
As is so often the case, the news stories gave the barest hint of what the report actually said. And the spin was designed to frighten voters into thinking that a new tax was being imposed on top of all the others, one that will be especially injurious to the poor.
In fact, the Economic Report was more of a philosophical discussion than a concrete proposal. But the points that it makes will be central to any effort at fundamental tax reform.
The idea of taxing consumption rather than income has been around for almost 500 years. In 1651, the philosopher Thomas Hobbes wrote in his book, Leviathan,” that taxing what people consume is more fair than taxing what they earn. The former, he thought, represented what people take out of society, while the latter showed what they contributed. Hobbes asked, why should a rich man who saves much and consumes little be more heavily taxed than one of modest means who consumes all he earns and more by going into debt? The first is giving something to society by saving, while the second makes society poorer.
At almost the same time, Sir William Petty also made a strong case for taxing consumption on the grounds that the goods and services that people consume is a truer measure of their well being than what they earn. “Every man should pay according to what he actually enjoyeth,” Petty wrote in 1662. And taxes should be light on those “who please to be content with natural necessities.”
In the 18th century, the great Scottish philosopher David Hume argued that a principal benefit of consumption taxes is that they are to a certain extent voluntary, because people can choose whether or not to consume the taxed commodity. This view was endorsed by Alexander Hamilton in Federalist No. 21. Consequently, he thought that taxes on consumption were less likely to become excessive.
I bring this history up only to indicate that taxing consumption, rather than income, is not a radical new idea, but one that has a long and distinguished pedigree. It fell out of favor in the 20th century because of Keynesian economics and the popularity of income redistribution as a central tenet of liberalism. Keynes saw saving as bad for growth and income taxation discourages saving by including it in the tax base, which would not be the case under a consumption tax. And income taxation also supported liberalism by justifying heavy taxes on forms of income mainly accruing to the wealthy, such as capital gains and dividends.
Unfortunately, the 20th century’s greatest champion of taxing consumption, economist Irving Fisher , got the reputation of being a bit of a crank and thus did not have the influence that those favoring income taxation had. The latter had their greatest success in the 1960’s when the tax-expenditures concept was developed. Henceforth, all deviations from a theoretically perfect income tax would be considered illegitimate and Congress often abolished them when looking for new revenue.
The case for taxing consumption had a revival in 1977, when the Treasury Department issued a study entitled, “Blueprints for Basic Tax Reform.” However, since it was a Ford Administration initiative that came out just three days before Jimmy Carter took office, it went nowhere legislatively. But it did have a profound impact on those who think about tax policy and really made the idea respectable again. The principal author of the study, economist David Bradford of Princeton, has continued to write extensively in favor of its basic outlines.
Consumption-based taxation would have made more progress in the years since except that a few eccentrics got the idea that the entire tax system needed to be rooted out and replaced with a retail sales tax like those at the state level. This is a silly idea that never had any chance of enactment and would be impossible to implement if it were ever tried.
What the Bush administration proposes is something much more sophisticated and workable. It wants to work within the existing tax system to get rid of taxes that burden saving and investment. If this were done consistently, we would have a tax system that falls only on consumption without the administrative and political problems inherent in trying to tax sales directly.
Supplementing the effort to explain this initiative, President Bush has included a section in his new budget detailing specific deviations from a consumption tax base. (Look on page 130 in the Analytical Perspectives volume.) Taken together with the Economic Report, these constitute the most powerful case for consumption taxation since the 1977 Blueprints study, and the first to come out of the White House itself.