Tax Reform: The Effects of a Flat Tax or Consumption Tax on Individuals

There has been much talk about tax reform. There are two popular ideas being promoted: the flat tax and the consumption tax. Proponents of these ideas insist that these tax methods are simple and fair. Proponents of the consumption tax claim that the consumption tax will encourage savings.

We will demonstrate below that:

  1. The Flat Tax is not intrinsically fair. The flat tax will not burden citizens equally.
  2. The consumption tax is not intrinsically fair. The consumption tax will burden lower incomes more.
  3. The consumption tax will not encourage savings. In fact, the consumption tax will actually reduce savings for the majority.

 

Last Updated 5/27/2009

 

Introduction: What are the opportunity costs of taxes?

To review the fairness of a tax system we need to look at the opportunity costs of the taxes. That is, we must look at what a person will have to give up to pay the tax. This will require a review of necessities, comforts, luxuries, and investments.

We all need necessities to live. The necessities we require have no correlation to income. It's about the same for all of us. The variations that result from health issues have nothing to do with income. (Actually, the need for medical support tends to be greater amongst the poor.)

Comforts are like necessities, they're just a little more comfortable. For example, everybody needs transportation to get to work, and to buy, sell, or trade. In most parts of America transportation it would be hard to find transportation for less than $1,000 per year. In those same neighborhoods, $3,000 each year would get a more comfortable transportation and $10,000 each year would provide very comfortable transportation. More than that would provide luxurious transportation.

Similarly, it's very hard to find basic rooming for less than $400 a month. This would be the necessity cost. More comfortable housing can be found for under $1,000 per month, and luxurious housing can be found for about $3,000 per month.

A person can cook himself a balanced meal for about $2. They can eat fast food for about $7, or the individual can eat a rather nice meal for about $20. Meals for more than that would be somewhat luxurious. And a person can be rather comfortable eating out only occasionally.

In each of these examples, we find that comforts are like necessities. Comforts give you the same basic items as necessities, just a little more comfortable. Comforts rarely cost more than 10 times their corresponding necessity. So as a rule of thumb, total spending on comforts will not really go above 10 times spending on necessities. Spending above that would be spending on luxuries.

Related Discussion

 

Comparing Four Examples at Different Incomes

Now lets compare how four sample people might spend their income. Our first person will be a wage earner at the poverty line, the second will be a middle class worker earning roughly twice the poverty line, third a more comfortable person earning roughly 10 times the poverty line, and last, a CEO earning roughly 300 times the poverty line. In year 2000 dollars, these four workers are earning about $15K, $30K, $150K, and $5M.

 
Part 1: The no tax model: How would people spend their money if they had no taxes to pay?

Our poverty line worker spends all of his income on necessities. He has to! He will fall behind if he spends money on anything else.

Our middle class worker, spends half his wages on necessities. He makes himself a little more comfortable by spending the most of the rest on comforts. But he tries to become a little more secure by investing a little.

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So if the low wage worker gets taxed what will he have to give up to pay the tax? He only has one thing to give up - his necessities.

And what will our middle class worker do when he is taxed? He will probably give up more of his investments than his comforts. He will probably give up a little of both . But he won't have to give up his necessities.

 
The wealthy (10x) earner has most of the comforts he could want. He's investing more than he spends on necessities, and still can acquire some luxuries. Since he can pay taxes out of the money he would invest, he can pay a significant tax without sacrificing any of his comforts.
The CEO (300x PL) spends only a fraction of a percent on his necessities. He only spends about 1/3 of his income on comforts. In fact, he can have a rather luxurious life and still spend less than half his earnings. He can invest nearly half of his earnings. A very large tax will not really impact his lifestyle at all.
 

Part 2: The flat tax model

For a flat tax with no deductions to cover the same amount the tax rate would have to be about 15%. So how would a 15% tax impact the lives of our three examples?

For the low wage worker any tax is a tax on his necessities. That is all he has to give up. For the low wage earner, any tax pushes him into poverty. A flat tax with no deductions (15%) leaves him with less money than he needs to survive. His taxes constitute a serious burden on his survival.  
What will the middle class worker give up to cover his taxes? He will probably want to keep most of his comforts. As a result he will pay the taxes mostly out of his potential for investing. He will probably want to invest some, so the tax will impact his comforts a little.  
The wealthy wage earner will not need to sacrifice any comfort to pay the flat tax. He will have to give up part of his investments, and he might chose to give up part of his luxuries. Even with this sacrifice, he will still be investing more than twice what he will need for his necessities.  
Similarly, the CEO will make no real sacrifices to pay his taxes the way. He will probably reduce his luxuries a little so that he can keep his investments high. He will still be able to spend more than four times what he needs for necessities on luxuries, and more than 8 times what he needs for necessities on investments.  
So what does this show us? The flat tax is a tax on necessities for the poor, and tax on comforts for the middle class. The flat tax impacts the lifestyle of the middle class and poor, but has no real impact on the rich. How can we call a tax that forces one group of people into poverty, but doesn't even impact the lifestyle of another group of people "fair?"
 

Part 3: Consumption tax model

Many are now proposing that we replace the income tax with a consumption tax. They claim this will be fairer and encourage savings. Is this true? Let's see how a consumption tax will affect our 4 examples. First, we should note that to raise the same amount of revenue that the income tax raises a consumption tax rate would have to be set at over 50%. This is not a surprise since the graphs above showed those with higher incomes putting a significant amount into investments. Currently, those paying the higher taxes are paying out of their investments, not out of their consumption

For the CEO fully half of his income will go untaxed, since he does not need to spend it. The consumption tax might encourage him to spend a little less on luxuries, so that he can keep his investments high. Regardless of the choices he makes he will have no reason to give up any comforts.
The wealthy wage earner will probably give up some comforts, and luxuries to pay the consumption tax. But to maintain his high level of comfort, he will probably simply invest less.

As the graphs above show, the consumption tax will have to be high because unlike the income tax, the rich will have less than half of their income taxed.

Since the middle class worker spends most of his income on consumption, and the tax rate has to be higher, his tax rate will be significantly higher than it is under the current system and higher than it would be under a flat tax. What will he give up to pay this high tax? He can't give up his necessities. He won't want to give up all his comfort. So he will give up his savings.

The consumption tax will hit the low wage earner rather hard. Since all of his income is spent on the consumption of necessities, he will be forced deeply into poverty by a consumption tax. After taxes he will barely be able to pay for 65% of what he needs to survive.

 

This review shows two things. A consumption tax will actually lower savings for the bottom 70%. This would be the opposite of one of the stated goals. Even worse, consumption tax will force the bottom 30% deeper into poverty.


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