Quiz on the Consumption Tax

August 25, 2005

True or false: Shifting to a consumption-based tax system could boost U.S. GDP by some 9 percent in the long run?

True, according to UC Berkeley’s Prof. Alan Auerbach. That’s just one of several consumption tax lessons in Auerbach’s excellent piece in this morning’s Wall Street Journal (subscription req.):

Q.1: A shift to a consumption tax could increase GDP in the long run by as much as 9%.

A: True. In a pair of studies published in 1996 and 2001 (the second with several co-authors) I estimated the effects on the economy of an immediate switch to a low-rate, broad-based consumption tax that would raise the same amount of revenue as the current tax system. We found that lower marginal tax rates would increase employment and therefore expand production somewhat in the short run. Over a longer period of time, production would increase even more as the result of stronger capital accumulation induced by the more favorable tax treatment of savings…

Q.6: Adopting a consumption tax would hit the underground economy.

A: False. Drug dealers and others engaged in illegal economic activity currently evade income taxes but would have to pay taxes on their purchases under a consumption tax. The same is true for those engaged in legal economic activity who currently fail to report or pay taxes on their income. But the tax evaders also have customers, who currently pay income taxes before using their after-tax income to make purchases. Under a consumption tax, purchasers of illegal drugs would no longer have to pay income tax but would evade the consumption tax. The increased taxes on producers in the underground economy would be offset more or less by the reduced taxes on consumers in the underground economy.

Read the full piece here.

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