On April 18th, Rep. Buddy Carter (R-GA) offered remarks on the House floor in support of the FairTax Act of 2023, of which he is a sponsor. One of his arguments was that the FairTax would do a better job of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ing the underground economy than the income tax it is intended to replace.
His argument went as follows: many practitioners of underground or illegal activities do not report their income to the Internal Revenue Service (IRS) or pay income tax on those activities even though they are legally obligated to do so. However, they do consume plenty of legal goods and services. Therefore, while an income tax fails to tax them, a consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. —like the retail sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. under the FairTax—would succeed.
It’s laudable to broaden tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. s in this manner, from the standpoint of both fairness and economic growth, but consumption taxes won’t necessarily solve the problem.
The most obvious reason is that consumption taxes create a different horizontal inequity: legal goods and services are taxed, while illegal ones are not. Presumably, if you’re the sort of illegal activity practitioner who doesn’t file income taxes, you aren’t going to remit the FairTax to the appropriate authorities either.
But more subtly, Rep. Carter’s argument is based on assumptions about tax incidenceTax incidence is a measure of who ultimately pays a tax, either directly or through the tax burden. This burden can be split between buyers and consumers, or different groups in the economy. , or who bears the burden of the tax. In his argument, the FairTax comes out of consumers’ pockets, while the income tax comes out of earners’ pockets.
Though an intuitive reading of the names “consumption tax” and “income tax,” these terms of art pertain more to the treatment of saving and investing, or to cross-border trade, than to whether consumers or income earners bear the final burden.
Income and Consumption Broadly Overlap
Consider the simplest sort of transaction in an economy—Alice creates something and sells it to Bob. In most systems, Alice is responsible for remitting the tax. Under a 20 percent income tax, for example, she might sell an item for $1, withhold $0.20 in tax, and pocket $0.80 after tax. However, under a 25 percent sales tax, she might charge $0.80 and remit a $0.20 sales tax. In either case, Bob pays $1 and Alice takes home $.80. (If you’re curious why the rates are different, it is a question of whether the value of the tax itself is included in the denominator when calculating the percentage; under income taxes, it is included, while under most consumption taxes, it is excluded.)
Given that these two scenarios are effectively identical, it would be extraordinarily odd if Alice graciously offered more generous terms to Bob under one scenario than the other, just by virtue of the tax having a different name. Both taxes are worth 20 percent of the value of Alice’s labor, as measured by the final amount charged to Bob.
Extending the example further still generally results in identical accounting for the income tax and the consumption tax. For example, imagine Bob is not a final consumer, but a producer who uses Alice’s product as an intermediate good, improves it to double its value, and sells it to Charlie for $2. The tax base becomes 20 percent of the total value of Alice and Bob’s combined labor, as determined, ultimately, by the amount charged to Charlie.
Under a 20 percent income tax, Alice might have $1 in income and $0.20 in tax. Bob has $2 in revenue with $1 cost of goods sold, for $1 in income and $0.20 in tax. They each take home $0.80 after tax, and the government collects $0.40 in tax.
Under a 25 percent consumption tax, Alice could charge $0.80 and Bob could charge $1.60. The government would collect $0.40 in taxes, with Charlie still paying $2. (Some consumption taxes are structured such that Bob would remit the whole tax on behalf of the whole production chain, whereas some are structured such that Alice and Bob split the responsibility.)
Once again, everyone’s after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. s are the same under both scenarios. Renaming the tax doesn’t shift the burden dramatically between Alice and Charlie.
But consumption and income tax bases do have a few important differences. The first is in the treatment of saving or investment. People and businesses both have many ways to save or invest, but, broadly speaking, an income tax falls in part on capital goods like factories or equipment as that creation happens, while a consumption tax only falls on the returns to capital goods after they begin yielding final products. This matters to individuals and firms because of the time value of money.
The second difference is in the treatment of trade. A consumption tax falls on imports but not exports. An income tax falls on the incomes of exporters but does nothing to imports, which generate income for people in other countries. While this might sound like it has significant implications for trade, exports in the long run enable imports (and vice versa), so the effects cancel out once trade has made a full “round trip.”
The distinctions between the income tax base and the consumption base absolutely do matter for economic efficiency—but they have limited distributional implications about how consumers and producers share the burden.
Holes in the Tax Base Matter for Distribution
Broad theoretical claims and stylized examples are one thing. The actual taxes that exist in the world are another. They’re far messier and have all sorts of holes in them. For example, the U.S. income tax fully excludes worker health-care benefits, even though an economist would call them income. And consumption taxes in the U.S. are often sales taxes, assessed on goods but not on most services. Value-added taxes, used in many other countries, are sometimes broader but have exclusions of their own.
Holes in the tax base matter significantly for distribution, and they are argued over regularly. For example, in 2014, a substantial debate occurred in Washington, D.C., over an expansion of the sales tax base to include some services, such as gym memberships. The result was staunch institutional opposition from gyms and yoga studios. This is at least circumstantial evidence that producers believed a consumption tax on their products would hurt their pocketbooks—a belief expressly contradicting the assumption that consumers are the ones who pay consumption taxes.
Distributional consequences are far from the only important property of tax policies. But if one is interested in the distributional consequences of consumption or income taxes as practiced in real life, the distinction between producer-side and consumer-side incidence is a bit of a red herring. Instead, the largest distributional consequences are determined by what economic activities the taxes—as implemented in practice—fail to capture.
In this respect, Rep. Carter’s instincts to try to bring illegal activities into the tax base are good ones. Unfortunately, the FairTax likely does little to shift more of the tax burden to people who do illegal activities. It is true that they typically don’t pay income tax, giving them an unfair (and illegal) tax break. But they are unlikely to remit FairTax on their sales either, giving them a helpful tax advantage under Rep. Carter’s preferred system as well—in fact, the very same tax advantage that gyms and yoga studios in Washington, D.C., were so desperate to keep.
The fundamental problem under either system is that taxes are remitted when legal purchases of goods or services occur, but typically not illegal ones. The FairTax won’t fix that.
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