The Ultimate Tax on Harmful Activity?

Why not tax consumption rather than income?

When the dollar, US treasury bills, and stock prices slumped yesterday because of growing concerns about the U.S. government’s debt rating, Treasury Secretary Tim Geithner hastily reassured nervous investors that the Obama administration has clear plans to reduce the country’s massive budget deficits going forward. But as I argued in a recent post, accomplishing that will require significant new sources of revenue. And if new taxes are indeed necessary, by far the best ones are those that discourage harmful activities.

But new taxes on congestion and pollution will probably not be enough. The president has already proposed to allow the Bush tax cuts for top earners to expire as scheduled in 2010. Many economists caution against even further increases in top marginal income tax rates, which would discourage effort and savings.

Fortunately, there is a compellingly attractive alternative: abandon the income tax in favor of a much more steeply progressive consumption tax. Doing so would generate more than enough revenue to balance the federal budget without requiring painful sacrifices from anyone. Under a progressive consumption tax, each family would report its income to the IRS and also its annual savings, much as many now document their annual contributions to 401(k) and other similar accounts.

A family’s income minus its annual savings is its annual consumption, and that amount minus a large standard deduction—say, $30,000 for a family of four—would be its taxable consumption. Rates would start low, perhaps 20 percent, then rise gradually with total consumption. For example, a family that earned $60,000 and saved $10,000 would have annual consumption of $50,000, which, after subtracting the standard deduction, would mean taxable consumption of $20,000. It would owe about $4,000 in tax, about the same as under the current income tax.

With savings tax-exempt, top marginal tax rates on consumption would have to be significantly higher than current top rates on income. But that’s not problematic, because higher top rates would actually encourage saving.

Consider, for instance, how the tax would affect a specific high-end spending decision. The Smiths, a wealthy couple approaching their 25th wedding anniversary, are trying to decide what kind of party to throw. Their close friends, the Joneses, recently spent $2 million to stage a gala celebration of their own silver anniversary. The Smith would prefer not to spend that much, but one of their goals is for their family and friends to share a memorable celebration, and they understand a memorable occasion is an inherently relative concept. So they reluctantly decide to stage a $2 million party of their own.

But the same decision would have almost surely played out differently under the incentives inherent in a progressive consumption tax. If the top marginal rate on consumption was, say, 100 percent, the after-tax cost of what would have been a $2 party under the current income tax would instead be $4 million. Facing that extra cost, couples like the Smiths and Joneses would typically scale back, spending perhaps only half as much as they might have. If the pre-tax cost of the party they chose were $1 million, the after-tax cost would be $2 million. The government would get $1 million in additional revenue, which could be used to pay down debt.

By staging a lavish party, a couple typically has no intention to harm its friends and relatives. Yet the bar that defines how much one must spend to mark a special occasion is an inescapably social construct. When some spend more, others must follow suit or be seen as having failed to grasp the magnitude the occasion. The rub is that when all spend more, the occasions seem no more special than before. As in the familiar stadium metaphor, all stand to get a better view, yet no one sees better than if all had remained seated.

Like a tax on congestion or pollution, a progressive consumption tax is thus a tax on harmful activity. The real attraction of all such taxes is that they essentially create real resources out of thin air. The less expensive mansions people build, the cleaner, lighter vehicles they drive, and the less costly parties they stage are just as satisfying as the more elaborate versions would have been.

Some worry that by discouraging consumption spending, a progressive consumption tax as politically unrealistic. But in a future post, I’ll cite evidence that this tax enjoys support from across the political spectrum.

Author: Robert Frank

Robert H. Frank is the Henrietta Johnson Louis Professor of Management and Professor of Economics at Cornell's Johnson Graduate School of Management and the co-director of the Paduano Seminar in business ethics at NYU’s Stern School of Business. His “Economic View” column appears monthly in The New York Times. He is a Distinguished Senior Fellow at Demos. He received his B.S. in mathematics from Georgia Tech, then taught math and science for two years as a Peace Corps Volunteer in rural Nepal. He holds an M.A. in statistics and a Ph.D. in economics, both from the University of California at Berkeley. His papers have appeared in the American Economic Review, Econometrica, Journal of Political Economy, and other leading professional journals. His books, which include Choosing the Right Pond, Passions Within Reason, Microeconomics and Behavior, Principles of Economics (with Ben Bernanke), Luxury Fever, What Price the Moral High Ground?, Falling Behind, The Economic Naturalist, and The Darwin Economy, have been translated into 22 languages. The Winner-Take-All Society, co-authored with Philip Cook, received a Critic's Choice Award, was named a Notable Book of the Year by The New York Times, and was included in Business Week's list of the ten best books of 1995. He is a co-recipient of the 2004 Leontief Prize for Advancing the Frontiers of Economic Thought. He was awarded the Johnson School’s Stephen Russell Distinguished teaching award in 2004, 2010, and 2012, and its Apple Distinguished Teaching Award in 2005.