The Progressive Consumption Tax: Fiscal Magic?

When all stand to get a better view at a concert or sporting event, none sees any better than if all had remained comfortably seated. Many forms of consumption spending are wasteful in analogous ways. Families spend more on their daughter’s wedding in the hope of staging a celebration that guests will remember as special. But special is a relative concept. When all families spend more, the standards that define special merely escalate. The good news is that a simple change in tax policy could eliminate this form of waste.

How much do parents feel they need to spend on their daughter’s wedding? They want guests to remember it as a special occasion, but “special” is a relative concept.

Standards differ from place to place and from era to era. In 1980, the cost of an average American wedding, adjusted for inflation, was $11,000; a princely sum in most parts of the world even today. But by 2014, that figure had escalated to $30,000, and in Manhattan the average wedding now costs more than $76,000.

How much do parents feel they need to spend on their daughter’s wedding? They want guests to remember it as a special occasion, but “special” is a relative concept.

Why are people are spending so much more? The short answer is that rising income and wealth inequality have sharply raised the bar that defines “special.” There is no evidence that higher wedding costs have made marrying couples any happier. On the contrary, increased expenditures on weddings actually appear to increase the likelihood of divorce, they are almost purely wasteful.

The good news is that a simple change in tax policy could free up a large share of the resources currently being wasted in similar ways. Specifically, we could scrap the current progressive income tax in favour of a much steeper progressive tax on each household’s consumption. Families would continue to report their taxable income and also their annual savings, as many now do for tax-exempt retirement accounts. The difference—income minus savings—is the family’s annual consumption expenditure. That amount, less a large standard deduction—say, 30,000€ for a family of four—is the family’s taxable consumption. Rates would start low and would then rise much more steeply than those under the current income tax.

Families in the bottom half of the spending distribution would pay lower or no higher taxes than under the current system. But high marginal rates on top spenders would not only generate more revenue than the current system, but would also reshape spending patterns in ways that would benefit people up and down the income ladder.

If top marginal income tax rates are set too high, they discourage productive economic activity. In the limit, a top marginal income tax rate of 100 percent would mean that taxpayers would gain nothing from working harder or investing more. In contrast, a higher top marginal rate on consumption would actually encourage savings and investment. A top marginal consumption tax rate of 100 percent, for example, would simply mean that if a wealthy family spent an extra dollar, it would also owe an additional dollar of tax.

If top marginal income tax rates are set too high, they discourage productive economic activity.

The incentive effects of a progressive consumption tax would be markedly different.

Consider, for example, how the tax would affect a wealthy family that had been planning a large addition to its mansion. If it faced a marginal consumption tax rate of 100 percent, that addition would now cost twice as much. Even the wealthy respond to price incentives (that’s why they live in smaller houses in New York than in Seattle). So the tax would be a powerful incentive for this family to scale back its plans. It could build an addition half as big, for example, without spending more than it originally planned.

The fiscal magic occurs because other wealthy families who’d also planned additions to their mansions would respond in a similar way. And since no one denies that, beyond some point, it’s relative, not absolute, mansion size that really matters, the smaller additions would serve just as well as if all had built larger ones. The tax would have similar effects in other luxury domains. Not a shred of evidence suggests that such a change would make top earners any less happy. If all mansions were a little smaller, all cars a little less expensive, all diamonds a little more modest, and all celebrations a little less costly, the standards that define “special” in each case would adjust accordingly, leaving successful people just as happy as before.

Conservatives have long favoured proposals to tax consumption instead of income. They generally favour a flat tax, but because flat taxes would make inequality dramatically worse, they are unlikely ever to be adopted. So a progressive consumption tax may be our only politically realistic hope for ending the downturn quickly and limiting the growth in consumption inequality that has made life so much more difficult for the 99 percent.

As economists are fond of saying, there’s no free lunch. An important exception to that rule, however, is that when existing arrangements are grossly wasteful, it’s possible for everyone to have more of everything. Growing income disparities, which are largely a consequence of market forces, have made it far more expensive for middle-income families to achieve many basic goals.