Making Consumption Taxes More Progressive

One issue that naturally arises on the subject of consumption taxes is whether you can’t act to make them progressive. For example, Paul Holmes says:

There’s no reason a consumption tax has to be regressive. You can exempt certain goods (I would start with foodstuffs and children’s clothing, certain health-related products from tampons to cough medicines) on which poorer people spend a disproportionate part of their income, and make a consumption tax that is far more progressive than our current tax system, and far easier to evade. I’ve never been quite sure why American liberals are resistant to this kind of VAT.

I spent a healthy chunk of January playing around with Consumer Expenditure Survey tables to try to devise just this sort of clever scheme. It turns out to actually be really hard. The problem is that if you look at spending by household income quintile the bottom quintile actually spends a larger share of its income on every CES category of goods and services than does the top quintile.

This, in turn, is because the bottom quintile spends $22,304 a year but only earns $10,263 in pre-tax income. Poor people, in other words, are liquidating savings or going into debt (the bottom two quintiles are older than the top three, suggesting that many low-income households are actually retirees). The top quintile, by contrast, earns $158,652 and spends $97,003. So while you can use exemptions of certain types of goods to make a consumption tax somewhat less regressive, fundamentally regressivity is built into the system in virtue of the much higher consumption:income ratio of the poor.

One thing you might say to that is: Who cares? Part of the point of consumption taxes is to encourage savings and investment that boost growth over the long-run. So maybe the right thing to do is to structure a system that’s progressive with respect to consumption and not worry about non-consumed income. In that case, if you exempt non-restaurant food and cheap clothing from taxation, you’ll have a system where taxes are a smaller share of poor households’ consumption, though still a larger share of their income. It’s worth noting that utilities are a quite high share of poor households’ incomes, so that policies that increase the price of electricity (cap-and-trade, carbon tax) are the reverse of the spirit of this proposal.

Another thing you might say is that it’s fine to have a regressive as long as you have a progressive tax system. Which is to say that you could raise 70 percent of your revenue through a regressive consumption tax and then go get the remaining 30 percent from a sharply progressive income tax. That would create a system that’s progressive in its overall impact, but still features lower marginal income tax rates than our current system.