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What Are Consumption Taxes?

Aug 01, 2011

Posted by Jaimie McFarlinOn July 26th, I attended a Ways and Means Committee hearing on consumption taxes. It comes at a time when the future of tax reform is certainly part of the federal debt ceiling negotiations. In this blog entry, I will break down a few of the issues and arguments regarding two types of consumption taxes: the FairTax and the Value Added Tax (VAT).

About Consumption Taxes
There were two panels of witnesses at this last hearing. The first panel included the former presidential candidate and governor Mike Huckabee, economic experts, Larry Kotlikoff and David G. Tuerck, and former policy advisor, Bruce Bartlett. They discussed the FairTax, a proposal to replace existing federal income taxes with a national retail sales tax. The second panel, including multiple economists and policy advisors, discussed the VAT. While the FairTax only taxes the end consumer, the VAT is a consumption tax that would tax the buyers of goods even if they are not the end consumer. In essence, the VAT would tax a good little by little as it progresses through the supply chain.

The Main Obstacles
The allure of a simpler, more efficient tax code is a tantalizing goal for U.S. lawmakers. However, the path to getting there is littered with obstacles. One of the main obstacles is the issue of regressive taxation. At the hearing, Democrats in the Ways and Means Committee expressed this as one of their main concerns with consumption taxation.
Critics consider consumption tax methods to be regressive taxation: lower socioeconomic groups pay more, as a percentage of their income, than the rich. However, proponents of consumption taxes say they are proportional taxes, as those with higher income pay more taxes because they are taxed at the same rate that they consume. Huckabee also argued that the current method of taxation through income is an arbitrary standard without incentives for economically smart behavior.

The progressiveness or regressive-ness of the VAT system or the FairTax system can be affected when different classes of goods are taxed at different rates. To maintain the progressive nature of total taxes on individuals, countries currently implementing VAT have reduced income tax on lower income-earners, as well as instituted rebates or direct transfer payments to lower-income groups, resulting in lower tax burdens on the poor.

The FairTax or the VAT
Even if you are a proponent of consumption taxes, the question then becomes: which system?

Economically, both proposals have the same effects. The key differences would be the administration of these tax reforms and their incentives for compliance. The VAT would probably create more accounting procedures, as a business would have to measure the value-added during the production, distribution, and sales processes. Generally, “value added” is measured as the difference between the price for which a business sells a good or service and the costs of the inputs the businesses incurred to produce it.

Opponents of the VAT believe that it is a confusing tax system with extra accounting required by those in the middle of the supply chain. Proponents counter that this disadvantage of VAT is balanced out by the application of one tax rate. Each member of the production chain would be taxed the same rate, regardless of its position in the supply chain and the position of its customers, reducing the effort required to check and certify statuses and tax rates.

Because the VAT is imbedded in the supply chain, it creates stronger incentives to collect than the FairTax or federal sales tax codes. Now, both types of consumption tax create an incentive for end consumers to avoid or evade the tax. However, the sales tax creates simpler mechanisms to avoid or evade the tax. Two evasion methods were discussed by panelists: purchase the good off-the-books or persuade the seller that he (the buyer) is not really an end consumer, and therefore the seller is not legally required to collect the tax. Overall, the pros and cons of consumption taxes make for an interesting debate of tax reform proposals. 

Definitely feel free to contact us here at the NASE with your thoughts or concerns on tax reform. As advocates for small business, we understand the complications of the tax system and are always looking for ideas to simplify the tax system for small business owners and the self-employed. Our Tax Resource Center offers focused tools and resources that help micro-business owners manage and compete more effectively. You can reach out to us via Twitter or on Facebook!
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