Low tax rate spur calls for tax reform. I propose a new form of taxation called progressive consumption taxes.

The recent Pro Publica report on the low incomes taxes paid by American billionaires at the same time that their net wealth has been increasing by very large amounts has sparked a lot of discussion about reforming the tax code. Some people would like to redefine what counts as income, and others would like to follow Elizabeth Warren’s suggestion about taxing wealth rather than income.

My preference would be to tax consumption and not income. Typical consumption taxes are sales taxes which cannot be made progressive. That is you can not raise the marginal tax rates as total consumption increases beyond certain defined limits. In order to keep track of total consumption of and individual it would be necessary to keep track of their net financial worth. As an example let us consider and individual whose wealth is entirely in financial instruments of various kinds and whose ‘work’ consist entirely of managing his or her financial assets. Suppose that at the beginning of a tax year a certain individual has a net financial world of 1 billion dollars. When this individual files a tax return in the following year their financial income turns out to be 80 million dollars. In my imagined tax system it does not matter what form this incomes takes. Interest, dividends, and capital gains all go into the income bucket. However, income is not taxed. In order to determine the taxes we examine the net financial worth at the end of the year which turns out to be $1,040,000,000. Taking the income minus the increase in net worth give us the presumed personal spending for consumption which in this case is 40 million dollars.

If the marginal tax rate on consumption over 1 million dollars is 60% then our presumed billionaire pays a very health amount of tax indeed. Note that in this presumed tax system losses in net wealth do not free a person from paying consumption taxes. If the billionaire’s net worth at the end of tax years is 900,000,000 and their market losses for the year are 60 million dollars then they still owe taxes on 40 million dollars of personal spending. This necessity might seem unfair to some people, but remember that in this system savings are not taxed. I you save money for a rainy day tax free, then when the rainy day comes and you spend down you savings then it is perfectly appropriate that you should pay taxes at that time.

In reality, of course, the tax code would be much more complicated that is indicated by the above example. Various adjustments to personal consumption would be required. For example if we want to continue to allow deduction for contribution to charity then such contributions would have to be subtracted from the nominal personal consumption. In this case of a rich person lives like a monk and gives away all of the wealth to charitable causes then they will pay taxes just like a poor person. Of course this tax avoid comes at the cost of not getting any substantial benefit from their wealth other perhaps than a feeling of security and the satisfaction of being a philanthropist. If the rich person lives like a monk and passes on their financial wealth to their children then the children avoid high taxes only if they also live like monks. If, on the other hand they decide to enjoy the substantially the material benefits of being rich then they will pay substantial taxes.

This tax system would require people to account for the totality of their personal wealth. If you moved large amounts of money offshore without accounting for it on your tax forms then you end up paying consumption taxes on this ‘vanishing’ wealth.

I have no intention in this brief post of proposing a detailed system of progressive consumption taxes, but one special case in addition to charitable contributions requires mention even in a brief discussion. The materials used to build housing are a substantial and significant form of consumption yet there are obvious problems with counting the purchase price of a house as personal consumption. For one thing part of the purchase price (and in certain markets a very large part) is the value of the land. Owing land is not a form of consumption. Secondly even if we separate the value of the house from the land the consumption of the materials constituting the house take place over a long period of time. Counting this full value as consumption in the year in which the purchase is made is unfair to the purchaser. Furthermore if the home owner lives in the house for just a few year and then purchases another house they will be charge will full consumption taxes for the materials in two house in a very short period of time. Therefore including housing costs as part of consumption taxes will require special procedures.

My suggestion is consumption taxed for housing should be collected on a yearly basis in a manner similar to property taxes. Some kind of consumption tax assessment would be made on a periodic basis based on an inspection. At minimum this inspection would take place a every time a house changes hands (as already happens at present) but conceivably additional inspections could take place at specified intervals. Because the home owner pay year consumption taxes the purchase price of the house can be deducted from yearly personal consumption. The homeowners only pay taxed on the value of the house that they ‘consume’ during their time living there. This procedure eliminates the problem of over payment and double payment of consumption taxes.

Of course the consumption of materials in housing is an ongoing process. Periodic major maintenance such as putting on a new roof, replacing pipes etc. are required to maintain the house in working order. For major repairs whose purpose is only maintenance a procedure should exist for deducting the cost of these repairs from yearly personal consumption. Upgrades to the house which increase the living area should results a new increased consumption tax assessment, but the direct immediate cost should be deductible from the yearly personal consumption. Again the home owners pay taxes for that part of the upgrades which consume during their stay in the house and not for the full lifetime consumption value.

Landlords who buy real estate in order rent housing to other people should be directly responsible for paying consumption taxes on this property. Of course the tenant will indirectly pay these taxes via their rent so that they should be able to deduct rent from their personal consumption. The people who own and maintain the physical structure formally pay the consumption taxes. Procedures should exist for petitioning for lower consumption taxes if certain kinds of building upgrades are made which tend to lower resource consumption required to maintain the building in the long term. I know that the idea of any government entity voluntarily reducing taxes may seem strange to some people, but encouraging shoddy construction because it brings in more stimulates the economy by creating more work for the construction industry is a form insanity which must be resisted.

Similar inducements might be used to induce individual private owners to adopt certain kind of environmentally friendly construction practices in the ongoing maintenance of their home. Obviously though, such inducements will be more effective for people who plan to stay in their homes for the long term. I also have some more radical ideas about how to encourage sustainable housing construction methods which I outline in my book Eight Economic Truths

Since the subject of land value came up during the discussion of housing I might as well say a few words about it here. Buying land is not a form of consumption and money so spent should not be taxed as such. If you buy land you would have to declare this fact on your tax forms so that it would be clear that the decrease in you financial wealth due to such purchases was not used for personal consumption. Again this fact demonstrates that a system of progressive consumption taxes requires that the taxpayer should account for changes in net wealth rather than for income.

The idea of progressive consumption taxes may not appeal to some people who see the huge increase in wealth driven by huge a increase in the value of stocks in recent years and who are itching to get their hands on some of this wealth as quickly as possible. I am not going to comment on the wisdom of the short term strategy of financing important infrastructure using this form of wealth. However, in the long term I have concerns about whether the recent run up in stock value represent a real sustainable increase in wealth. In a stock market crash a lot of this apparent wealth could vanish. If some of the stock owners are prescient about the coming crash, they can get out of stocks ahead of time, but then they will liable to capital gains taxes. The progressive marginal tax rates for capital gains are much lower than for income so these tax rates should be a target for income tax reformer. Also for inherited wealth the cost basis for capital gains is reset to the fair market value at the time of death, which means no one pays taxes on the capital gains that occurred in the life time of the original owner of the stocks. Again this change in cost basis should be a target for income tax reformers.

So far I have talked only about taxes on individuals or families and have not discussed corporate taxes. I do not think it makes sense to tax corporate consumption insofar as that consumption is directed at producing salable products. Of course corporations put huge demands on the earth’s material resources, but they do so in order to pass finished products on to end users. Taxing both the corporation and the end users for this consumption would be double taxation. Corporations like individuals pay property taxes which are direct payments for the consumption of public goods and services. However if additional taxes need to be collected from corporations then traditional income taxes (or taxes on profit) seem like the best choice.

In one case, however, corporations should be taxed for consumption. If a part of the cash reserves of a company mysteriously disappear without having been used for some legitimate business purpose it should be assumed that the funds have been used for consumption and they should be taxed at a high marginal rate. This procedure would prevent money from flowing offshore and then being used for hidden consumption.

It is not clear how much corporate income tax would be required in a system of progressive consumption taxes on private individuals. Consumption is the economic bottom line. If we do not consume what we produce people start losing their jobs. If consumption taxes can be made progressive and if we can implement wealth accounting systems which prevent significant portions of our consumption to be hidden, then I see no reason why they cannot be made the basis of a stable system of taxes. If corporate profits do not pass into private consumption then they remain invested in the financial system helping to provide the credit which keeps the economy working. Therefore it is conceivable that a tax system with very low or even zero corporate income taxes could be made to work effectively, but the key to producing such a result would be to make sure that there is not a large amount of hidden consumption (e.g. money being spent out of unreported offshore financial havens).

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