Compare and contrast consumption tax and income tax. Analyze the effects of each on the economy.
Ans: Consumption, or current expenditure, is an alternative to income as a tax base. A general tax on consumption is equivalent to an income tax that allows savings to be excluded from the tax base. Taxable consumption would be calculated directly from data on income simply by excluding that portion of income that is saved rather than spent. Income can be given as :
Income = Consumption + Consumption Tax
An interesting difference between an income tax and an expenditure tax lies in the treatment of borrowed funds. Under the consumption tax, loans are taxed when they are spent. Under an income tax, loans are never added to the taxpayer’s income, but interest payments on the loan are often deductible from taxable income. The consumption tax includes the loan proceeds in the tax base as they are spent and allows the deductions from consumption as the loan is paid off.
A blanket comparison of these two types of taxes is challenging because either one can be progressive or regressive and more or less efficient depending on the tax rate(s) and tax base. The current US income tax is progressive in nature, but not entirely comprehensive; some forms of income are exempted from taxation or are taxed at lower rates, which others are taxed twice. A similar situation would likely occur with a nation-wide consumption tax. Certain types of consumption (food, housing, medicine) would likely be excluded from taxation. However, it is unlikely that double taxation would occur with a consumption tax.
In general, consumption is income minus savings. So if both taxes were to include a broad base, shifting to a consumption tax is equivalent to removing taxes on saving and investment. Consumption taxes shift preferences away from spending and on to saving since the additional income gained from the investment (interest) is tax-free. The percentage of income spent on consumption each year decreases as income rises, so a broad base would create a regressive tax system and benefit tax payers fortunate enough to have left-over money to invest after expenses.
Sales, exercise, turnover and value-added tax are all consumption taxes. Sales tax are taxes accessed to a purchase of tangible goods unlike the exercise taxes. An exercise tax is a tax on specific activiites, but is generally designed to discourage consumption of certain activities. Turnover tax is multistage sales tax that charged a fixed rate on transactions during stages of production. Turnover taxes are very similar to value added tax, but it isnt a general tax it is accessed to the final price of higher goods. Value-added tax is tax on the consumption when value is added to a product during the production process. I think exercise taxes affect the economy the most. The tax serves to police and discourages consumption of a particular activity, but the typically behaviour for people is to do things that arent good for them. As a result the government generates income of of the program. If you truely wish demonize a negative activity make it illegal. This practice is evident with the consumption and sales of liquor.
Consumptions taxes are accessed on the purchase of goods and services. Income tax is accessed on the income earned. The two taxes are quite different but relative. Income minus savings is equals consumption. Consumptions taxes indicate the difference in the amount consume and saved during period of time. The effects of consumption identifies if an economy is growing if consumption is high than people are spending money and vice versa. If income rates are high than people generally have more to spend or save. Individuals choices change and this is based on tax rates.
David N. Hyman (2010). Public Finance. 10th Edition.