A Discussion of the Consumption Tax: An Inquiry Into the Excess Burden of Taxation

By Robert Schiener

In 1996, Richard Lugar campaigned on restructuring the federal tax code by advocating a national sales tax, or consumption tax. Although widely respected for his professionalism in the Senate, Lugar was a virtual unknown due to his inability to raise requisite campaign funds for election. Nevertheless, he initiated a debate over the means of federal taxation that rages in the diverse geographical spatial arenas of today.

This debate is partly centered on the benefits and costs of a consumption tax levied by national officials. Advocates argue that it could simplify the tax code, enabling a liberalization of labor from the accounting offices and into more productive enterprise. True too is the fact that such a tax could tax some products and not others, thereby discriminating among products. Furthermore, the rich would pay more in absolute tax dollars, continuing to place the burden on those most able to pay. Opponents of this latter theme point out that such an argument is folly since an ad valorem tax on labor would produce a similar result on burden. It would produce an average tax rate equal to the marginal tax rate as well.

Opponents of the consumption tax enlighten the opinion that the tax is clearly unfair on those earning far below the median income. Currently, an individual can earn up to $6,950 in income and be tax-exempt assuming one exemption and a utilization of the standard deduction. Even then, individuals often qualify for a tax subsidy which could send their tax liability into negative territory. A sales tax, they claim is regressive. But, opponents need to specify the taxable base before assuming this. If the base is consumption, then their argument is wrong. But, assuming they are referencing income, then it is generally regressive.

Regardless, much of the current debate surrounding the consumption tax centers on equity. Of course, equity is a varied term for fairness. But what is fair? Unfortunately, this feelings and emotional angle tends to dominate public discussion regarding public policy. It would be a tremendous benefit to the societal voter if a discussion of efficiency were discussed as well. Such an efficiency discussion is a necessary ingredient into formulating a guided policy of taxation of wealth.

The severity of such taxation of wealth is dependent upon the means and rates of taxation. Let us thus examine the means of taxation found in the consumption tax and its potential hindrance to the achievement of maximizing social surplus. For if we intend to implement effective public policy, it would serve us good to realize the full impact of our actions on the normative criterion of efficiency as well.

Currently an uninformed constituency has settled for the taxation of labor, capital, and product, all of which produce a deadweight loss or excess burden upon its respective market. The excess burden is a loss in efficiency that can never be recaptured. In summary, a government can tax labor and raise revenue. The revenue raised lessens consumer and producer surplus in most transactions depending on the relative values of elasticity. However, this fails to constitute a welfare loss. The rationale extends from the fact that if political officials desired to, they could merely redistribute the tax revenue to the taxed parties and allow the respective parties to recapture their respective loss in surplus. On the contrary, the full impact of a tax on labor creates a deadweight loss that is composed of a loss in social surplus. The reason for such a loss is due mainly to the substitution effect of this price-distorting tax.

We can apply the aforementioned analysis to the similar impact of a tax on products, that being indicative to a consumption tax. This means of taxation produces both income and substitution effects and thus results in an excess burden. Such a taxation reduces the consumer's real income and provides impetus for the consumer to substitute for the taxed product.

A national sales tax can be depicted graphically utilizing the theory of consumer behavior. The result of an implementation of a consumption tax is shown below:

Here, the consumption tax acts like a price-distorting tax, thereby reducing the quantity consumed of the taxable product. Initially, the consumer has an indifference equilibrium at the tangency between the indifference curve I' and the budget constraint depicted by UF (Unabridged Freedom from government). Upon its implementation, however, the indifference curve is swiveled inward and results in a lower consumer equilibrium which implies less utility. Specifically, utility curve I'' tangents the budget constraint UD. In effect, quantity consumed declines from Quf to Qpd. This is in consequence to both the income and substitution effects that a potential consumption tax would create. The reasons why the consumption tax resembles a price-distorting tax are twofold: Such a tax raises the relative price of the taxed product and decreases the consumed quantity. It further prevents the marginal social benefit of the good from equating with its corresponding marginal social cost (contingent on an initial optimal market allocation).

Thus, it is helpful to identify the consequence to an implementation of the consumption tax on social welfare levels by isolating the substitution effect through a comparative analysis of a tax implementation creating only income effects. We can show this through a head-tax collecting the identical amount of tax revenue, T. A lump-sum tax (head-tax) would merely tax an individual T dollars and collect it independent of market activity. This is shown as a parallel decline in the budget line from UF to LS (Lump-Sum). Indeed, it reduces the consumer's income by T but fails to create a substitution effect. This principle is most important for the political official to realize upon a vote on taxation. The lump-sum tax lessens income and therefore the demand for the product (normal product). It thus alters price. But, referring to the above diagram, it shows us that although quantity consumed falls, it is only a result of income effects. Thus, quantity consumed is more under a lump-sum tax than under a consumption tax.

The above analysis is necessary in order to identify the excess burden of a consumption tax. This welfare loss is a loss in utility. When the lump-sum policy prevails, the indifference equilibrium is the tangency between I''' and LS. The indifference curve illustrated by this form of taxation is higher than that of the price-distorting tax. Thus, the difference in utility constitutes the excess burden of a consumption taxation. The difference in quantity consumed illustrates the distortion in behavior a consumption tax provokes: [(Qls - Qpd) > 0 ].

Thus, should we necessarily undermine the feasibility of the consumption tax and, instead, consider the tenants of a lump-sum tax? Not necessarily. Although the consumption tax could produce an excess burden on the market for a taxable product, the lump-sum tax could prove difficult to administer and could require these same accountants to pack their bags from the private sector to Washington. Further, the lump-sum tax, if implemented in its simplest form, would tax all consumers a fixed sum. This would certainly be regressive with respect to the Haig-Simmons definition of income and increase the marginal benefits to lump-sum tax evasion.

In the end it is desirable, though, that political officials consider the social welfare loss of a consumption tax in formulating good public policy. Implementation of a popular tax movement may not increase either efficiency or "equity" without a detailed analysis of its long-term effects on consumer and producer behavior. Nevertheless, the debate on the consumption tax may end on the equity front, since there are many interest groups and individuals who stand to benefit or lose upon such implementation.

Eric Seymour

Robert Schiener

Joel Corbin

Bryant Lewis