What is the Consumed Income Tax?

August 6, 2014

Since the 1940’s the United States has relied most heavily on the individual income tax, which accounts for 40 to 50 percent of total federal revenue. Income is currently defined as consumption plus change in net worth – also known as the “Haig-Simons” definition of income. This definition of income leads to the double taxation of saving and investment while it taxes current consumption only once, making our tax code non-neutral.

Our current tax base requires $775 billion dollars of tax expenditures to move toward tax neutrality. Even with such large modifications to the tax base we still double tax capital gains and many types of interest income, among others. Piecemeal modification of the tax code through tax expenditures is an imperfect remedy because it introduces unnecessary complexity and further distortions.

In contrast to our current tax system, a consumed income tax achieves neutrality between current consumption and future consumption (savings and investment) by taxing each dollar of income once. A consumed income tax redefines the tax base to tax only consumption.

All income is either current consumption or future consumption. By not taxing future consumption (savings), individuals are able to invest their saving until they are ready to spend it. The investment of savings puts that money in the hands of the productive economy, whether in the form of a loan for a home or the purchase of a piece of equipment for an agriculture business.

IRAs and Roth IRAs provide a good example of the structure and function of a neutral consumption tax. Individuals using Roth IRA retirement accounts pay taxes on earned income whether it is spent or saved. When the investor withdraws their savings, the gains from investment are not taxed.

Traditional IRAs provide the same economic treatment but the equation is flipped. Under traditional IRAs, an individual pays no taxes when the income is earned, but instead pays taxes on any withdrawal from their account, including taxes on any gains from investment.

In both cases, the tax treats saving and investment neutrally in regard to consumption. Giving all income the same treatment as IRAs would create a consumed income tax.

Our current tax regime discourages future investment and incentivizes current consumption. Taxing all economic activity neutrally would remove the disincentive to save and result in more saving and investment.

Saving and investment are the engine that grows the economy by supplying the tools for future innovation and productivity. The consumed income tax would be a boon for economic growth.

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