The Case for a Consumption Tax By Cameron Davis
The following is an article I wrote for my school newspaper: The Politik Press.
This week the Commerce Department announced that the economy grew at a 2.5% annual rate in the first quarter. While this represents strong growth relative to the languid state of the economy of the last five years, it certainly is not justification for complacency. At a 2.5% annual GDP growth rate, China is zipping by at a rate of 7.5% as is India at 6.5%. However, the United States can spark a new era of robust economic growth if it can reform part of its tax system to promote investment.
Over the past few years, one of the few things that the parties have been able to agree on is that the country needs sweeping tax reform, but there has been far too little consideration of a consumption tax. Similar to a federal sales tax in a way, a consumption tax would be a tax on the calculated value of consumption: income minus savings. Conservatives such as Harvard Professor Jeffrey Miron and many Bush administration advisers support a consumption tax. Some Democrats oppose a consumption tax because it is regressive in nature. However, as supporter Robert Frank points out, it can be made progressive by setting an exemption amount of consumption below which consumption is not taxable, which he estimates would lead to the bottom half of the income distribution paying less than or about the same as now and top earners paying slightly more. The consumption tax thus represents an opportunity for a major compromise between the parties. The consumption tax has support from many other eminent voices in the economics community such as Princeton economist Alan Kruger, former Fed Chairman Alan Greenspan, and the OECD. By promoting savings and investment and discouraging exorbitant consumption, the consumption tax is the key to solving the United States’ consumption mindset: a cultural problem that has become an economic one.
There are three main components of the economy: consumption, investment, and government expenditure. There is a tradeoff between consumption spending on consumer goods in the present and investment, which is spending by businesses on new plants, equipment, and research on new technologies, which all directly increase or have the potential to increase the productive capacity of the economy and thus its GDP. This tradeoff exists because each dollar of personal income is either spent on consumer goods or saved in a financial institution, which theoretically responds by loaning it out—often to a business that wants to invest[K1] . Because the growth rate is dependent on increases in the capital stock, investment spending promotes economic growth. Consumption represents the desire for short-term gratification, while investment spending represents prudent preparation and sacrifice for a better future.
The greatest obstacle to robust US economic growth is a consumption mindset. A common misconception is that consumption itself is important to driving the economy. In actuality, spending—consumption or investment—is. If every dollar of consumption was replaced by investment, businesses would still produce goods and accrue the same amount of income. When businesses invest, they buy new capital from other businesses. Of course, zero consumption would be devastating as quality of life would plummet and there would be no point to investment if consumption couldn’t be expected in the future. However, the US would benefit from a somewhat higher level of investment at the expense of consumption because investment goods allow greater levels of production and thus consumption in the future. On the list of countries sorted by fixed investment as a percentage of GDP, the United States holds spot 143 of 152 with only 12% of production going to new fixed capital. Near the top of the list are mostly some of the fastest growing countries in the world: Singapore, China, Vietnam, India, etc. This correlation certainly is not unassailable evidence of a causal relationship, but it is worth considering since the possibility of a causal relationship makes economic sense.
It has become somewhat of a platitude to say that Washington—mostly the Republican Party—needs to put aside politics and return to an embrace of the facts, but that truth nonetheless applies to the issue of economic growth as well as any other. With the economy experiencing lackluster growth, a consumption tax, which would encourage savings and investment, is the key to restoring the healthy consumption levels and strong growth.
P.S. After publishing this article, I realized my argument has a major flaw. Investment spending is already as cheap as possible because the Fed has artificially kept interest rates so low. A consumption tax would do little to stimulate investment spending. My argument can be salvaged, however, by the qualification that a consumption tax should be implemented within the next few years, after the economy has recovered further and the Fed stops increasing the money supply so quickly and keeping interest rates so low.
This week the Commerce Department announced that the economy grew at a 2.5% annual rate in the first quarter. While this represents strong growth relative to the languid state of the economy of the last five years, it certainly is not justification for complacency. At a 2.5% annual GDP growth rate, China is zipping by at a rate of 7.5% as is India at 6.5%. However, the United States can spark a new era of robust economic growth if it can reform part of its tax system to promote investment.
Over the past few years, one of the few things that the parties have been able to agree on is that the country needs sweeping tax reform, but there has been far too little consideration of a consumption tax. Similar to a federal sales tax in a way, a consumption tax would be a tax on the calculated value of consumption: income minus savings. Conservatives such as Harvard Professor Jeffrey Miron and many Bush administration advisers support a consumption tax. Some Democrats oppose a consumption tax because it is regressive in nature. However, as supporter Robert Frank points out, it can be made progressive by setting an exemption amount of consumption below which consumption is not taxable, which he estimates would lead to the bottom half of the income distribution paying less than or about the same as now and top earners paying slightly more. The consumption tax thus represents an opportunity for a major compromise between the parties. The consumption tax has support from many other eminent voices in the economics community such as Princeton economist Alan Kruger, former Fed Chairman Alan Greenspan, and the OECD. By promoting savings and investment and discouraging exorbitant consumption, the consumption tax is the key to solving the United States’ consumption mindset: a cultural problem that has become an economic one.
There are three main components of the economy: consumption, investment, and government expenditure. There is a tradeoff between consumption spending on consumer goods in the present and investment, which is spending by businesses on new plants, equipment, and research on new technologies, which all directly increase or have the potential to increase the productive capacity of the economy and thus its GDP. This tradeoff exists because each dollar of personal income is either spent on consumer goods or saved in a financial institution, which theoretically responds by loaning it out—often to a business that wants to invest[K1] . Because the growth rate is dependent on increases in the capital stock, investment spending promotes economic growth. Consumption represents the desire for short-term gratification, while investment spending represents prudent preparation and sacrifice for a better future.
The greatest obstacle to robust US economic growth is a consumption mindset. A common misconception is that consumption itself is important to driving the economy. In actuality, spending—consumption or investment—is. If every dollar of consumption was replaced by investment, businesses would still produce goods and accrue the same amount of income. When businesses invest, they buy new capital from other businesses. Of course, zero consumption would be devastating as quality of life would plummet and there would be no point to investment if consumption couldn’t be expected in the future. However, the US would benefit from a somewhat higher level of investment at the expense of consumption because investment goods allow greater levels of production and thus consumption in the future. On the list of countries sorted by fixed investment as a percentage of GDP, the United States holds spot 143 of 152 with only 12% of production going to new fixed capital. Near the top of the list are mostly some of the fastest growing countries in the world: Singapore, China, Vietnam, India, etc. This correlation certainly is not unassailable evidence of a causal relationship, but it is worth considering since the possibility of a causal relationship makes economic sense.
It has become somewhat of a platitude to say that Washington—mostly the Republican Party—needs to put aside politics and return to an embrace of the facts, but that truth nonetheless applies to the issue of economic growth as well as any other. With the economy experiencing lackluster growth, a consumption tax, which would encourage savings and investment, is the key to restoring the healthy consumption levels and strong growth.
P.S. After publishing this article, I realized my argument has a major flaw. Investment spending is already as cheap as possible because the Fed has artificially kept interest rates so low. A consumption tax would do little to stimulate investment spending. My argument can be salvaged, however, by the qualification that a consumption tax should be implemented within the next few years, after the economy has recovered further and the Fed stops increasing the money supply so quickly and keeping interest rates so low.