The hottest tax idea in Washington is actually terrible
People are falling over themselves to endorse a consumption tax. Don't believe them.
Something called the "consumption tax" has become one of those rare policies that transcends political divides in Washington. The core idea is that instead of taxing wealth or income, the government should encourage people to save by taxing only their spending. Republican Senators Marco Rubio (Fla.) and Mike Lee (Utah) like this idea. So does Democratic Senator Ben Cardin (Md). Even Bill Gates is a fan!
Too bad they're all wrong.
Despite being surprisingly broad, the consensus is mistaken. Here are four big reasons why:
1. Saving is something wealthy people do.
The theoretical arguments in favor of consumption taxes are typically based on the injustice of penalizing thrift by the poor. But those are just fables: Saving is overwhelmingly a pastime of the rich.
Economists Emmanuel Saez and Gabriel Zucman show that definitively in their 2014 paper on wealth inequality in the United States. The saving rate for the bottom 90 percent of Americans who pay taxes is less than zero, meaning these folks are taking on debt. Meanwhile, the saving rate for the top 1 percent is north of 35 percent. Such savings inequality is a huge driver of rising wealth inequality overall. The rich continuously grow their pile, while what was once the wealth-holding middle class has eaten through its seed corn. Since saving is something the wealthy do, exempting saving from taxes would amount to a huge tax cut for the wealthy.
To some extent, this could be solved by making a consumption tax progressive. But how progressive? Consider the case of progressive consumption tax enthusiast Bill Gates.
According to Forbes, Gates' fortune is $78.1 billion as of 2014. Suppose that his annual income is a conservative 4 percent return on that fortune. Now, it's impossible to know how much he spends per year, but let's take a rough proxy: his house. While most proposals for taxing consumption exempt the cost of a personal residence, let's just suppose that Bill Gates repurchases his home in Medina, Washington, with cash every year. Its assessed value is $147.5 million.
In this scenario, Gates' rate of saving (the portion of his income that would be tax-exempt) is therefore 96.2 percent. Assuming that he currently pays the extraordinarily low effective tax rate of 20 percent on his income, under the progressive consumption tax regime he prefers, the rate he pays on the remaining 3.7 percent of his income that goes to consumption would have to be 430 percent in order to maintain his current tax bill.
Now, suppose Bill Gates goes to McDonalds and orders a Big Mac. When his $5 order is rung up for $26.47, he turns to the guy nearby who just got his food and asks "how much for that $5 Big Mac?"
In other words, a progressive consumption tax might sound great in theory, but one that would be revenue and distributionally neutral would create tremendous smuggling opportunities and thus be impossible to enforce. Meanwhile, a consumption tax that isn't progressive would be a massive windfall for the rich.
2. Exempting savings doesn't make people save more.
The question of whether tax exemptions actually induce people to shift toward saving is a long and fraught one in the academic literature. But a preponderance of the evidence shows that tax incentives don't actually increase savings. A 2010 study by the U.S. Congressional Research Service found that was true of proposed capital gains tax cuts: They don't increase saving. They just transfer wealth from the government to the wealthy.
In a paper about savings behavior and wealth accumulation in Denmark, Raj Chetty and his co-authors find that mere tax incentives to save are startlingly inefficient. Each additional dollar spent by the government on inducing individuals to save more for retirement generated one cent worth of additional saving.
3. Capital accumulation increases inequality.
The "pro-growth" argument for consumption taxes is that if people save more, the economy will grow and workers will be more productive thanks to capital accumulation. But Thomas Piketty's Capital in the 21st Century takes a much darker view of savings and capital accumulation. It says that as the capital stock grows, the share of income that accrues to the owners of capital grows, too. And since the owners of capital are disproportionately already wealthy, a rising capital share increases inequality. In Piketty's vision of the high-inequality future, the accidents of birth or strategic marriage matter more than individual initiative.
Capital in the 21st Century is dismissed by many economists on the ground that even if capital accumulates, the share of income paid to the owners of capital will not increase because additional capital will be so abundant that it becomes useless. Leaving aside dueling estimates of the Marginal Elasticity of Substitution between capital and labor — the economic concept that determines how valuable additional capital is in the standard macroeconomic model — note what this anti-Pikettian argument implies: if more capital doesn't threaten rising inequality because it's useless, then what's the point of incentivizing more capital accumulation via the tax code?
4. The economy doesn't actually 'want' any more saving.
Since the global financial crisis, interest rates on pure cash have been near zero in almost every major developed economy. This phenomenon, the so-called Zero Lower Bound , implies that there's an excess supply of savings in the global economy. In other words, there's a lot of money sitting around with not a lot to do. Over an even longer time horizon, since the early 1980s, interest rates have been on a downward march. Whether that is related to rising inequality or not is an open question, but, at the very least, it implies that the global economy increasingly doesn't lack for savings. What it needs are things to do with those savings, i.e. profitable investment opportunities. And those come from healthy aggregate demand, of which consumption is the major component.
So, there are at least four reasons to be skeptical of supposedly serious-minded proposals to tax consumption and exempt savings or the income that comes from savings. It's time for policymakers, billionaires, and especially economists to take a fresh look at the evidence.