Published: May 4, 2022

Income Tax vs Consumption Tax


Tax Revenue Trends

Income Tax vs Consumption Tax. According to the US Census Bureau, in 2021 the states collected taxes totaling $1.338 trillion.1 Most of this revenue was derived from two sources: income taxes (individual and corporate) and sales taxes.

Income and Sales Tax Distribution

For 2021, this amounted to $626 billion in income tax ($523 billion individual and $103 billion corporate) and $481 billion in sales tax, with other revenue sources making up the difference.2

Challenges with Income Tax

Most states levy both taxes. One of the key problems with this longstanding model is the volatility of income tax collections. Personal and corporate income taxes are among the most volatile, and hence unreliable, general fund sources for state governments.

When companies have losses, they (theoretically at least) pay little to no income tax. Certain aspects of personal income taxes are inextricably linked to the stock market. We all know how much of a rollercoaster that can be.

Shift to Consumption Taxes

The volatility in both tax regimes can be attributed to any number of factors. For example, the pandemic that we are collectively still trying to put in the rear-view mirror, foreign conflict, etc.. As a result of the volatility and over-reliance on these specific tax revenue streams, state governments often find it impossible to even reasonably forecast their future tax revenues.

Consequently, some states are starting to see the wisdom of what tax policy analysts have been saying for years. They are beginning to realize that a tax structure predicated on consumption can be a much fairer and more stable source of tax revenue. By eliminating income taxes and implementing a broad-based consumption tax, these states can realize greater economic efficiency. They can grow more than is probable under their current tax regimes.

Benefits of Consumption Taxes

Progressivity of Consumption Taxes

Income taxes are often employed as a method of progressive taxation and redistribution. Taxing consumption may offer similar benefits over time. In the long term, wealthier taxpayers consume more than poorer ones do, moderating the supposed regressive element of consumption taxes. This scheme can be augmented using targeted credits and deductions to reduce the burden on lower-income taxpayers. Compensating for their higher spending on necessities relative to total income.

Alternative approaches to increasing the progressivity of consumption taxes such as blanket exceptions for necessities or the imposition of luxury taxes are either self-defeating or introduce unnecessary distortions. General exemptions on categories of essential goods provide relatively less relief to the taxpayers they are supposed to help.

Both general exemptions and luxury taxes distort consumer and business spending patterns, decreasing the efficiency of resource allocation. Such approaches are rife with opportunities for the intrusion of special interests, distorting and eroding the original intent of the policy. They also complicate compliance and enforcement.

A broad-based approach that includes services ensures sufficient revenue while further reducing distortion by disincentivizing a shift away from goods. It also increases equity by taxing items that are typically utilized more heavily by higher-income consumers.

Simplified Compliance and Enforcement

By shifting taxation to the point of sale for final consumption, the burden of compliance and enforcement can be reduced. The removal of intermediate taxation on goods and services simplifies taxation of business activity by reducing the number of points at which tax must be collected and eliminates myriad complexities of determining what tax must be paid.

For consumers, focusing taxation on consumption shifts the burden of determining what is owed to businesses, further consolidating the points at which this must be done. This helps reduce the disadvantage of lower-income taxpayers in an income-based system due to their proportionately higher cost of compliance and reduces the ability of wealthier payers to leverage loopholes and other methods of evasion to cut their own tax bills.

At the same time, the overall simplicity of the scheme does not unduly increase the burden on businesses and tax agencies; to the contrary, it should result in a substantial net reduction.

Encouragement of Saving and Investment

Focusing taxation on final consumption encourages saving and investment. Taxpayers would be free to allocate a larger portion of their earnings as they see fit. Greater workforce engagement may also manifest through higher take-home earnings. Business inputs should also be tax exempt. This will make business activity more flexible and responsive to the desires of consumers, resulting in more efficient allocation of resources.

The cost of production would be reduced, disincentivizing cost-cutting at the expense of workers and potentially lowering prices. A flat and broad-based tax structure limits the potential influence of government and special interest groups. In the long run, this approach should produce greater and more equitable economic growth, realizing efficiency in a way that is mutually beneficial.

State Policy Responses

Several states have begun implementing portions of these policy proposals, such as cuts to income taxes and modifications of consumption taxes. These reforms aim to generate greater economic growth while reducing compliance burdens and economic distortions.

Examples of State Initiatives:

  • Iowa, Kentucky, Georgia, Minnesota, Ohio, Arkansas, North Carolina, Indiana, Idaho, and others have cut or are considering cuts to income taxes.
  • Georgia’s H.B. 1459 proposes the repeal of graduated income and corporate net worth taxes while introducing a broad-based sales tax.
  • Kentucky has adopted H.B. 8, reducing the state’s income tax rate and expanding the sales tax to include certain services.
  • Idaho has cut income taxes and is considering further reform, including a sales tax increase.

Conclusion of Income Tax vs Consumption Tax

States should be encouraged to continue adopting policies that prioritize consumption taxes over income taxes. These reforms promise greater economic growth, efficiency, and equity while reducing administrative burdens and economic distortions. If you have any further questions on Income Tax vs Consumption Tax please contact Clarus Partners.

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