CRS EXPLAINS DIFFERENCE BETWEEN CONSUMPTION AND WAGE TAX.

                       CRS REPORT FOR CONGRESS

Given that the nuances of consumption taxes are not well known outside the economics community, these proposals have produced a great deal of confusion over the inter-relationships of the various tax bases, including the relationship between a tax on consumption and a tax on wage income. While economists recognize that under certain circumstances these two taxes are economically equivalent, this concept has led some to conclude that the two taxes are interchangeable. In practice, however, the two taxes would be quite different.

In essence, a tax on consumption is a tax on wages plus a tax on old capital (capital in existence at the time a consumption tax is adopted). In contrast, a wage tax simply taxes the return to labor (wages). Based on this relationship, it can be seen that if there was no capital stock in existence or from the perspective of individuals with no capital assets at the time a consumption or wage tax is adopted, then the two taxes are, indeed, equivalent. ¹

For instance, consider the case of a two-period model where an individual earns $100 in wages in the first period and no wages in the second period during his retirement. Assume that the market interest rate is 10% and that the consumption tax rate is 50%. Under this scenario, in the first period, if the individual consumed $33.33 worth of goods then he would owe $16.66 in tax ($33.33 times the 50% tax rate) which would leave him $50 to invest at 10% interest ($100 wages less $33.33 in consumption and $16.66 in taxes).

In the second period, the individual would have $55 of capital income ($50 of savings plus $5 interest earnings) and could consume $36.66. This would produce a tax liability of $18.33 ($36.66 in consumption times 50% tax rate) and just uses up his entire store of savings at which time, in order to keep the example simple, he promptly dies.

Now consider what would happen under a wage tax that yields the same amount of revenue. In the first period, the individual's entire wage income of $100 is subject to tax. However, since the wage tax base is larger than the consumption tax base, the tax rate can fall to 33.33% and still produce the same revenue. The individual would pay $33.33 in taxes ($100 wages time 33.33% tax rate) and have $66.66 left over. If he keeps his consumption equal to the previous example, he will consume $33.33 and save the remaining $33.33 at 10%. In the second period, the $33.33 in savings would grow to $36.66, all of which he could consume tax-free.

Hence, from the perspective of a person with no capital assets, an equal yield wage tax and consumption tax are economically equivalent. They both allow the individual to achieve the exact same level of consumption and, in present value terms, pay the same amount of total tax over his lifetime.

From the government's perspective, the two taxes on this individual are also equivalent because they both yield, in present value terms, the same amount of tax revenue. Under the wage tax, the government would simply save the excess revenue collected in the first period, $16.66 (which is the revenue from the wage tax, $33.33, less the revenue that would have been collected under the consumption tax, $16.66) at 10% for a year. This would then grow to meet the government's revenue needs of $18.33 in the second period.

It should be noted, however, that only under very stringent assumptions such as those used in the previous example are a wage and consumption tax equivalent. In the real world, a consumption and wage tax would be very different animals. The existence of wealth at the time the tax is adopted would introduce substantial differences between wage and consumption based taxes.

Specifically, in the presence of existing capital, the incidence of the two taxes is quite different. Under a consumption tax, where consumption financed by old capital is included in the tax base, more of the tax burden would fall on the elderly, who presumably own a larger percentage of the existing capital stock, than would fall on young wage earners with no capital. Conversely, under a wage tax, the tax burden on the elderly owners of existing capital would be lower than under a consumption tax, while the tax burden on younger wage earners would be higher.

The theoretical similarities between consumption and wage taxes have led some to suggest that if the current income tax system is to be replaced, then it would be simpler to replace it with a wage rather than a consumption tax. Since a wage tax would be easier to implement and administer and, under certain circumstances, is economically equivalent to a consumption tax, why not adopt a wage tax? As the preceding discussion makes clear, only under very stringent assumptions are the two taxes equivalent while in actual practice there would be significant distributional differences between the two taxes, which in turn would lead to different economic consequences.