This is more than a technical tweak. A progressive consumption tax – where people who spend more face higher effective rates – can behave very differently from a progressive income tax. And according to economic research I co-authored with fellow researcher Carlos da Costa based on life-cycle behaviour, the consequences may be surprisingly large.
At first glance, taxing income and taxing consumption might look similar. If you earn £40,000 and spend £30,000, you could imagine taxing either amount and raising similar revenue. But people do not live one year at a time. They earn very unevenly over their lives – lower wages early in their career, higher wages later – and they tend to save in good years to stabilise their spending in leaner ones.
This basic feature of real life makes the choice between taxing income or taxing consumption much more important than it seems.
Progressive income taxes increase the marginal tax rate (the percentage applied within someone’s highest tax bracket) as earnings rise. This is designed to redistribute income towards lower earners. But it also creates an unintended effect: people are discouraged from working more in the years when they are most productive because those extra earnings are heavily taxed.
Over a lifetime, this discouragement flattens people’s earning patterns and reduces saving. When lots of people make these choices at once, the whole economy ends up with less investment, lower productivity and slower wage growth. These long-run effects are invisible in year-to-year statistics, but they matter greatly for overall prosperity.
What a progressive consumption tax does differently
A progressive consumption tax takes a different approach. It doesn’t penalise earning more in a particular year. Instead, it taxes people according to how much they spend overall. Someone who earns £70,000 but saves £25,000 would face a lower tax bill than someone who earns £50,000 and spends it all.
This creates an incentive to save in high-earning years. While higher saving might sound like it would slow the economy, in the long run it does the opposite. Saving provides the funds that businesses use to invest in new equipment, technology and expansion.
Over time, this raises productivity and – crucially – pushes wages up. This mechanism is particularly important for lower-income households, who depend almost entirely on their earnings rather than capital income (from things like property) or investment returns.
Our analysis suggests that switching from progressive income taxation to progressive consumption taxation could make households noticeably better off. This could be roughly equivalent to a permanent 10% increase in living standards as a result of rising wages and families being better protected when their incomes fluctuate.
A policy reform that both strengthens the economy and improves financial security is rare. From our analysis, it looks like this approach could do both.
A common concern is that consumption taxes are regressive. A flat tax on spending would indeed fall more heavily on low-income households who spend all or almost all of the money they have coming in. But progressivity can be built into a consumption-based system.
In fact, our work shows that a progressive consumption tax can redistribute as much as a progressive income tax, but with fewer of the distortions that slow growth.
Put simply, it is possible to design a consumption-based system that is both fair and efficient. And it wouldn’t necessarily require radical reform. It may sound like a major overhaul, but many of the benefits could be achieved with practical, incremental reforms.
At first glance, taxing income and taxing consumption might look similar. If you earn £40,000 and spend £30,000, you could imagine taxing either amount and raising similar revenue. But people do not live one year at a time. They earn very unevenly over their lives – lower wages early in their career, higher wages later – and they tend to save in good years to stabilise their spending in leaner ones.
This basic feature of real life makes the choice between taxing income or taxing consumption much more important than it seems.
Progressive income taxes increase the marginal tax rate (the percentage applied within someone’s highest tax bracket) as earnings rise. This is designed to redistribute income towards lower earners. But it also creates an unintended effect: people are discouraged from working more in the years when they are most productive because those extra earnings are heavily taxed.
Over a lifetime, this discouragement flattens people’s earning patterns and reduces saving. When lots of people make these choices at once, the whole economy ends up with less investment, lower productivity and slower wage growth. These long-run effects are invisible in year-to-year statistics, but they matter greatly for overall prosperity.
What a progressive consumption tax does differently
A progressive consumption tax takes a different approach. It doesn’t penalise earning more in a particular year. Instead, it taxes people according to how much they spend overall. Someone who earns £70,000 but saves £25,000 would face a lower tax bill than someone who earns £50,000 and spends it all.
This creates an incentive to save in high-earning years. While higher saving might sound like it would slow the economy, in the long run it does the opposite. Saving provides the funds that businesses use to invest in new equipment, technology and expansion.
Over time, this raises productivity and – crucially – pushes wages up. This mechanism is particularly important for lower-income households, who depend almost entirely on their earnings rather than capital income (from things like property) or investment returns.
Our analysis suggests that switching from progressive income taxation to progressive consumption taxation could make households noticeably better off. This could be roughly equivalent to a permanent 10% increase in living standards as a result of rising wages and families being better protected when their incomes fluctuate.
A policy reform that both strengthens the economy and improves financial security is rare. From our analysis, it looks like this approach could do both.
A common concern is that consumption taxes are regressive. A flat tax on spending would indeed fall more heavily on low-income households who spend all or almost all of the money they have coming in. But progressivity can be built into a consumption-based system.
In fact, our work shows that a progressive consumption tax can redistribute as much as a progressive income tax, but with fewer of the distortions that slow growth.
Put simply, it is possible to design a consumption-based system that is both fair and efficient. And it wouldn’t necessarily require radical reform. It may sound like a major overhaul, but many of the benefits could be achieved with practical, incremental reforms.
People on low incomes spend a far greater proportion of their
income – a progressive consumption tax could leave them
better off. 1000 Words/Shutterstock
One example is income averaging. Instead of taxing each year’s earnings in isolation, consumption tax could be based on a multi-year average. The idea is that a person’s average income over time is a good proxy for how much they consume, since people tend to smooth spending even when earnings fluctuate.
Under this approach, taxes would be administered through the income tax system, and people would pay tax in much the same way as they do now. The key difference is that tax brackets would be applied to an income average rather than a single year’s pay. This better reflects how people actually spend over their lifetimes, and it reduces the penalty for working more or earning more in peak years.
The information needed to do this already exists in social security records, which track people’s earnings over time. Rather than collecting new data, governments would continue to use these records as they do now, while also using them to calculate income averages across several years as a proxy for how much they spend. No new bureaucracy would be required – it is simply an additional use of information that is already held.
But why does this matter now? Most advanced economies face the same long-term pressures: ageing populations, rising fiscal demands, stagnant productivity and intense debate about how to tax “fairly” without discouraging work and investment. These pressures are unlikely to disappear.
Rethinking not just how much to tax, but how to tax, offers a different way forward. A system that taxes consumption rather than income is not a silver bullet. But progressive consumption taxation deserves a far more prominent place in the public conversation about how to design a fair and prosperous tax system for the future.
Marcelo R Santos, Senior Lecturer in Macroeconomics, University of Glasgow This article is republished from The Conversation under a Creative Commons license. Read the original article
One example is income averaging. Instead of taxing each year’s earnings in isolation, consumption tax could be based on a multi-year average. The idea is that a person’s average income over time is a good proxy for how much they consume, since people tend to smooth spending even when earnings fluctuate.
Under this approach, taxes would be administered through the income tax system, and people would pay tax in much the same way as they do now. The key difference is that tax brackets would be applied to an income average rather than a single year’s pay. This better reflects how people actually spend over their lifetimes, and it reduces the penalty for working more or earning more in peak years.
The information needed to do this already exists in social security records, which track people’s earnings over time. Rather than collecting new data, governments would continue to use these records as they do now, while also using them to calculate income averages across several years as a proxy for how much they spend. No new bureaucracy would be required – it is simply an additional use of information that is already held.
But why does this matter now? Most advanced economies face the same long-term pressures: ageing populations, rising fiscal demands, stagnant productivity and intense debate about how to tax “fairly” without discouraging work and investment. These pressures are unlikely to disappear.
Rethinking not just how much to tax, but how to tax, offers a different way forward. A system that taxes consumption rather than income is not a silver bullet. But progressive consumption taxation deserves a far more prominent place in the public conversation about how to design a fair and prosperous tax system for the future.
Marcelo R Santos, Senior Lecturer in Macroeconomics, University of Glasgow This article is republished from The Conversation under a Creative Commons license. Read the original article
5 comments:
Without slogging through the article , a nonsense. We already ghave 15% gst. How much more? 67% income tax at a low threshold as in the 1970s?All monies sent offshore would have to be taxed. When Labour regains power Inheritance tax is a certainty. Triple taxation; earnings , inheritance, spending.
Sounds like the latest idea from the “own nothing and be happy” brigade. The incentive would change from earn below a given tax threshold to consume/spend less. Instead of depressing income it would lower consumption. Would that be good, bad, or just different? Suspect there would be unintended consequences - e.g. less demand, lower growth, fewer jobs. Although with more automation and fewer workers expected in the future perhaps it wouldn’t be all bad? At the moment we tax both income and consumption. I’m no economist or tax expert, but think I prefer the balance and flexibility of the status quo.
It’s hard to imagine a more regressive tax system than this proposal.
Interesting idea. Many of the wealthiest people don't actually have any income (hence, they don't pay income tax) and instead they borrow money to spend, secured by their assets. Because they spend an awful lot, however, and poorer people less-so, consumption tax with zero income tax seems the best way to go. But it won't happen because the wealthy who would be less-well off won't let it.
This is typical academic nonsense from someone who clearly has no experience of operating a tax system in the real world. The fundamental flaw in Santos' argument is the impossibility of designing a system that accurately tracks every person's expenditure in a particularl year to identify their correct tax bracket. And he admits as much by proposing the use of average income as a proxy for expenditure. Data averaged is data estimated and an annual wash-up would then be needed to precisely assess the correct tax rate. And that offers all sorts of evasion opportunities. So why bother? Income is already taxed progressively and has built in collection mechanisms like PAYE and witholding tax. And the clincher is of course the fact that GST is already a very efficient tax on consumption that is effective in taking a lot more tax off the big spenders than middle income earners. So a progressive consumption tax is neither as efficient nor as effective as existing taxes and boils down to just another ill-considered lefty envy tax
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