Impose a Tax on Consumption

Background

A consumption tax generally applies to spending on goods and services. There are different forms of such taxes, including value-added taxes (VATs), retail sales taxes, and excise taxes. A VAT is a type of consumption tax levied on the incremental increase in the value of a good or service that occurs at each stage of the supply chain until the final point of sale. For example, a retailer would pay a VAT on the difference between the value of goods it sold to consumers and the value of those goods when it purchased them from manufacturers; the manufacturers would pay a VAT on the difference between the value of the materials used to produce a good and the value of the finished good it sold to retailers. Like a VAT, a retail sales tax is a form of consumption tax collected on the purchase of goods and services, but it is only collected when a consumer purchases the final product. An excise tax, unlike a VAT or a retail sales tax, is generally levied on a smaller set of goods and services and is usually assessed on each unit purchased rather than on the value of the purchase.

The United States does not currently have a broad consumption-based tax at the federal level, although it does impose federal excise taxes on purchases of several types of goods and services, including gasoline, air travel, alcohol, and cigarettes. In addition, most states impose a retail sales tax on many goods and services. By contrast, more than 160 countries—including all members of the Organisation for Economic Co-operation and Development (OECD) other than the United States—have adopted broad-based VATs. In 2020, the average standard VAT rate for OECD countries was 19.3 percent, ranging from 4.5 percent in Andorra to 27 percent in Hungary. Because a VAT is the most common form of broad consumption-based tax, this option focuses on approaches to reduing the deficit by imposing a consumption tax in the form of a VAT.

Key Design Choices

There are many ways to design a VAT. Key design choices include:

• Which goods and services to tax,
• Whether to apply a uniform VAT rate or different rates to different sets of goods and services,
• How to implement the VAT, and
• Whether to exempt small businesses from the tax.

Goods and Services to Tax. A VAT generally does not apply to all purchases of goods and services. Most countries exclude certain categories of goods and services from a VAT, either because they serve a social interest (such as education and health services) or because their value added is difficult to measure (as with financial services). In addition, because a VAT is designed to tax domestic consumption, goods and services produced domestically and exported to other countries are generally excluded from the tax; by contrast, goods and services produced abroad and imported from other countries are generally subject to it. Goods and services excluded from the VAT can be either "zero-rated" (that is, taxed at a rate of zero percent) or exempt from the VAT. If a purchased item is zero-rated, the seller can claim a tax credit for the VAT that is paid on the purchased inputs—such as materials and equipment—used to produce the good or provide the service. By contrast, if a purchased item is exempted, the seller cannot claim a credit for the VAT paid on inputs purchased to produce that item. As a result, the value of those purchased inputs remains subject to the VAT.

Tax Rates. Although a standard rate usually applies to most goods or services, some are taxed at lower rates. That subset of goods and services generally includes those that represent a larger share of total consumption for households with lower income, such as food and public transportation services. Many countries impose those lower rates to promote equity, but lower VAT rates can also be applied to encourage consumption of goods and services considered to have a social benefit, including books and cultural and entertainment services, or to stimulate employment in specific economic sectors like hospitality and tourism.

Implementing the VAT. There are two primary ways to implement a VAT: the credit-invoice method and the subtraction method. Under the credit-invoice method, the tax is calculated for each transaction. A business remits the VAT collected on the total value of its sales of a particular good or service and claims a credit for the taxes paid on the purchased inputs. Under the subtraction method, the tax is calculated using information about a business's total activity. A VAT applies to the difference between the value of all taxable sales and the sum of all taxable purchases. Differences in how the VAT is administered can affect its budgetary effects. Because the credit-invoice method is generally easier to administer and enforce, it has been adopted in almost every country currently administering a VAT.

Exempting Small Businesses From the Tax. Most countries exempt small businesses (those with total sales below a specified threshold) from VATs because the tax would impose administrative and compliance costs larger than the revenue that would be raised from those businesses. The exemption threshold varies by country and by sector of the economy. However, small businesses that predominantly sell intermediate goods and services to businesses that are subject to the VAT often voluntarily register and collect the VAT. They do so because businesses that are required to remit the VAT cannot claim a credit for the VAT paid on purchases from VAT-exempt businesses.

Option

This option consists of two alternatives. Each alternative would use the credit-invoice method and go into effect on January 1, 2024—a year later than the other revenue options presented in this volume—to provide the Internal Revenue Service time to set up and administer the tax.

The first alternative would apply a 5 percent VAT to a broad base that would include most goods and services. Certain goods and services would be excluded from the base because their value is difficult to measure. Financial services without explicit fees and existing housing services would be exempted. (Existing housing services encompass both the monetary rents paid by tenants and rents imputed to owners who reside in their own homes. Although existing housing services would be excluded under this alternative, a tax on the purchase of new residential housing would cover all future consumption of housing services.) Primary and secondary education would be zero-rated, as would some other services provided by government agencies and nonprofit organizations for a small fee or at no cost. Expenditures for health care reimbursed by the government—primarily costs paid by Medicare and Medicaid—would also be zero-rated. After accounting for those exclusions, the tax base would encompass approximately 59 percent of household consumption in 2024.

The second alternative would apply a 5 percent VAT to a narrower base. In addition to the items excluded under the broad base, the narrow base would exclude certain goods and services that are considered necessary for subsistence or that provide broad social benefits. Specifically, new residential housing, food purchased for home consumption, health care, and postsecondary education would be zero-rated. After accounting for those exclusions, the tax base in this alternative would encompass about 37 percent of household consumption in 2024.

Effects on the Budget

The staff of the Joint Committee on Taxation (JCT) estimates that the first alternative would reduce the deficit by $3.05 trillion from 2024 to 2032, and the second alternative would reduce the deficit by $1.95 trillion over that same period. The reduction in the deficit under the second alternative would be lower than under the first alternative because the VAT would apply to a smaller tax base.

The VAT, like an excise tax, would reduce taxable business and individual income. The resulting reduction in income and payroll tax receipts would partially offset the revenues raised by the VAT. The estimates for the option reflect that income and payroll tax offset. The estimates also account for taxpayers' noncompliance with a VAT, which would reduce the revenues raised. Additionally, because certain goods are excluded from the VAT, consumers might substitute untaxed goods for taxed goods. However, that substitution is likely to be small for a 5 percent VAT.

The incentives for noncompliance and substitution would probably increase with the VAT rate. As a result, significantly higher VAT rates would probably be associated with less than proportional decreases in the deficit.

Uncertainty About the Budgetary Effects

The amount of revenues raised by a VAT is uncertain because future consumption is uncertain. Another source of uncertainty in the estimate is how taxpayers would respond to a VAT, particularly with regard to compliance. Their compliance would depend on how the tax was implemented and might differ from the responses considered here. In addition, there is uncertainty about how consumers would replace taxed goods and services with those not subject to the tax.

Distributional Effects

A consumption tax would not affect households uniformly. Because families with lower income generally consume a greater share of their income than higher-income families do, a tax on consumption would probably be more burdensome for lower-income households than those with higher income. However, because many households with lower income receive government benefits in the form of means-tested transfers (that is, their eligibility for benefits is tied to income), which are adjusted for changes in prices, those households would be partially protected from the burden of the tax.

Because the burden of a VAT is based on when during their lifetime households consume their income, how the distributional effects of the VAT are determined depends significantly on how households with different economic resources are ranked. The burden of a VAT in relation to households' annual consumption or a measure of their lifetime income—which would account for both life-cycle income patterns and temporary fluctuations in annual income—would appear less regressive than the burden of a VAT in relation to a measure of their annual income, which does not account for those patterns and anomalies. For example, elderly-headed households spend out of accumulated savings and are likely to consume a larger share of their income than nonelderly households. Those elderly-headed households would be ranked higher in the income distribution if their economic resources were measured using their lifetime rather than their annual income.

A VAT would reduce the purchasing power of households' wealth accumulated before the tax went into effect, either because of an increase in the overall price level or, absent changes in the overall price level, because of a reduction in asset values. As a result, the tax would place a higher transitional burden on people with assets that exceed their liabilities than it would place on people with fewer assets than liabilities. Older people, who are more likely to have assets that exceed their liabilities, would probably face a greater burden than other cohorts.

Economic Effects

In addition to having the behavioral effects reflected in conventional budget estimates, such as the ones shown above, a consumption tax would affect households' and businesses' incentives in several ways that would reduce economic growth. That reduction in economic growth would be smaller than it would be for an income tax raising the same amount of revenues. First, a consumption tax could reduce saving and investment, although those effects would probably be small because a consumption tax would reduce the returns from saving and investment by a limited amount. Unlike an income tax, a consumption tax does not reduce the "normal" return on saving (that is, the return that could be obtained from making a risk-free investment) because the tax does not affect households' decisions about whether to consume now or in the future. A consumption tax can reduce returns in excess of a risk-free investment, but a reduction in those returns is less likely than a reduction in the normal return to affect households' and businesses' decisions about how much to save and invest.

Second, a new tax on consumption would probably reduce individuals' labor supply, although the magnitude of that effect is uncertain. On the one hand, it would create an incentive for people to work fewer hours because the reduction in real wages would make time spent on nonwork activity more attractive. On the other hand, it would reduce individuals' purchasing power and the value of their existing wealth, which might result in their increasing the number of hours they worked. The latter effect would probably be smaller.

Other Considerations

As with any new tax, implementing a VAT would impose administrative costs on the federal government and compliance costs on businesses. The magnitude of those costs would vary depending on the tax's design and implementation method. Administrative costs to the federal government are not included in the estimates for this option. Implementing a VAT would require the federal government to establish a new system to monitor compliance and collect the tax. Research has shown that at least some countries that have implemented a VAT devote significant resources to addressing and enforcing compliance.

Although existing consumption taxes typically apply to the purchase of goods and services, a broad consumption-based tax could also be designed as an individual income tax with an exemption for income received on past savings (such as dividends, capital gains, and interest income) or a deduction for the current year's savings. Alternatively, it could include a business cash flow tax and a tax on wages and salaries. A cash flow tax on businesses would apply to the difference between a business's cash receipts and its expenses. Expenses for current investments paid for by income saved in prior years would be fully deductible in the year those expenses were incurred. Because those investments would not be taxed, a cash flow tax on businesses would be economically equivalent to a consumption tax on their incomes. Similarly, a tax on wages and salaries would be economically equivalent to a consumption tax on workers.