The Progressive Consumption Tax
A win-win solution for reducing American income inequality.
The first part of this series described how growing income disparities have made it more expensive for middle-income families to achieve many basic goals, such as sending their children to a decent school. The second part explained why income inequality has grown so rapidly in recent decades. This final installment describes an opportunity to perform fiscal alchemy. By pulling a simple tax lever, we could reduce the costs of growing income disparities, while at the same time freeing up several trillion dollars of additional resources each year—more than enough to pay down the federal debt and rebuild our crumbling infrastructure—all without requiring painful sacrifices from anyone. This essay is adapted from Robert H. Frank’s recently published book, The Darwin Economy.
As I wrote yesterday, rising income inequality has been largely a consequence of two forces: changes in technology that have extended the reach of the most gifted performers in every arena, and increasingly open competition for the services of those performers. Finger wagging at corporate pay boards will not alter the strength of those forces. Regulatory reforms aimed at promoting better corporate governance are often desirable in their own right, especially in the financial services industry. But such reforms are also unlikely to alter the income growth trends we’ve seen in recent decades.
The good news is that we could pull a few simple policy levers that would greatly reduce the adverse effects of growing income gaps without threatening the benefits that have been made possible by improved technology and increased competition.
The simplest step would be to scrap the current progressive income tax in favor of a much more steeply progressive tax on each household’s consumption. Families would report their taxable income to the IRS (ideally under a tax code that greatly simplifies the calculation of taxable income), and also their annual savings, as many now do for IRAs and other tax-exempt retirement accounts. The difference between those two numbers—income minus savings—is the family’s annual consumption expenditure. That amount, less a large standard deduction—say, $30,000 for a family of four—is the family’s taxable consumption. Rates would start low and would then rise much more steeply than those under the current income tax.
Families in the bottom half of the spending distribution would pay lower or no higher taxes than under the current system. But high marginal rates on top spenders would not only generate more revenue than the current system, but would also reshape spending patterns in ways that would benefit people up and down the income ladder.
If top marginal income tax rates are set too high, they discourage productive economic activity. In the limit, a top marginal income tax rate of 100 percent would mean that taxpayers would gain nothing from working harder or investing more. In contrast, a higher top marginal rate on consumption would actually encourage savings and investment. A top marginal consumption tax rate of 100 percent, for example, would simply mean that if a wealthy family spent an extra dollar, it would also owe an additional dollar of tax.
That feature of the tax gives rise to what it would be no exaggeration to describe as fiscal alchemy. Consider, for example, how the tax would affect a wealthy family that had been planning a $2 million addition to its mansion. If it faced a marginal consumption tax rate of 100 percent, that addition would now cost $4 million—$2 million for the job itself, and another $2 million for the tax on it. Even the wealthy respond to price incentives. (That’s why they live in smaller houses in New York than in Seattle.) So the tax would be a powerful incentive for this family to scale back its plans. It could build an addition half as big, for example, without spending more than it originally planned.
The fiscal magic occurs because other wealthy families who’d also planned additions to their mansions would respond in a similar way. And since no one denies that, beyond some point, it’s relative, not absolute, mansion size that really matters, the smaller additions would serve just as well as if all had built larger ones.
The tax would have similar effects in other luxury domains. The amounts spent on multimillion-dollar coming-of-age parties would grow less quickly, as would the amounts spent on weddings, yachts, jewelry, and other items. And these changes would attenuate the expenditure cascades that have squeezed middle-class families.
A progressive consumption tax would not cure all ills. Although it would reduce inequality in consumption spending, it would likely have the opposite effect on wealth inequality, since the rich could better take advantage of the savings exemption. Because the wealthy would die with larger estates than before, it would be important to maintain a strong estate tax as part of the system.
With the unemployment rate still near 9 percent, now would be an inopportune moment to implement a progressive consumption tax. But if we passed the tax into law and scheduled it for gradual phase-in only after the economy had again reached full employment, we’d achieve three goals at once.
Robert H. Frank is an economics professor at Cornell University’s Johnson School of Management, an economics columnist for the New York Times, and a distinguished senior fellow at Demos. He is the author, most recently, of The Darwin Economy.