Sanjeev Rathore

Congressional Testimony Memorandum

Tax Policy Seminar

November 6, 2005

Why Consumption Tax is Bad for the American Middle Class

Introduction

Perhaps there is no single issue that dominates our economic policies than tax policy. In recent history the most significant laws enacted were tax cut of 1981 and the tax reform of 1986[1] which broadened the tax base and closed down loopholes for the tax shelters. There have been several serious attempts to adopt progressive consumption tax[2]. In 1921, Rep. Mills of NY introduced a bill to replace income surtaxes with a graduated spending tax. In 1942, Treasury Secretary Morgenthau proposed to combine refundable war-time tax with graduated surtax on spending. In 1995, Senator Sam Nunn introduced a bill to replace income tax with Unlimited Savings Allowance (USA) Tax. In 1996, the tax reforms took the center stage when presidentialcandidate Steve Forbes introduced flat tax to replace the current income tax system.

This written testimony will provide information regarding consumption tax, including: a summary of different varieties of consumption taxes; an overview of effect of consumption tax on middle class; and discussion of most prevalent issues regarding consumption taxes today.

What is Consumption Tax ?

Consumption tax is a tax levied on the consumption of goods and services. It is an indirect tax on consumption including excise duties, wholesale or retail sales taxes, and value-added taxes. Perhaps we can defineconsumption tax better by defining consumption. Professor McCaffery defines consumption as amount remaining after deducting all savings and investments from taxpayer’s income[3]. We can also define what consumption is by using “Haig-Simons” definition of income[4]. According to Haig-Simons definition, consumption is income minus accumulation or algebraically expressed as C = I – A. Consumption tax is tax on goods and services that are purchased in business or consumer transactions in anticipation of utilizing them.

What is Middle Class?

In order to answer the question whether consumption tax hurts or helps middle class Americans, one has to first question what exactly constitutes the American middle class. Some may define[5] middle class as individuals who have at least high school education, health care, access to credit, and confident in their opportunities for economic advancement. The demographers[6] define the middle class as those whose annual income hovers around the median household income. Under this definition the poor are 20% of the population with the lowest household income. The low middle class would be the next quintile with household income of up to $32,000. The third quintile would make-up the median middle class with household income of up to $51,000. The fourth quintile would make-up the upper middle class with household income of up to $79,000. If none of the above definitions of middle class seem to be adequate then perhaps one could define middle class by defining what is not a middle class. From the US Census website a single person who makes $9,645 per year is living below the poverty line[7]. Therefore we can we reasonably be sure that person making above this wage is not a middle class American. The US Census does not officially define what constitutes the middle class.

The idea of who is in the middle class is more of a perception than reality. Studies[8] have shown that most upper-income American define themselves as middle class even though their income says otherwise. For example former congressman Newt Gringrich defines middle class as family with income of upward of $200,000 per year.

Different Types of Consumption Taxes

In general there are four different types of consumption taxes[9]: retail sales tax, value added tax, flat tax, and personal consumption tax. Although each of the tax types are grouped under the umbrella of consumption tax, they each have different effect on the middle class.

The retail sales tax is something that we all are familiar with because almost every state in the union has it. The retail sales tax is collected by businesses on services and products sold to consumers. By definition it excludes tax on goods and services sold to other businesses to produce their own products. This distinction[10] between consumer and business use of goods and services creates a problem in collecting retail sales tax.

The value added tax (VAT) is very similar to the retail sales tax except for the method of collecting the tax. The VAT collects tax money at every stage of the transaction along the production and the distribution chain. The VAT has been used by manyindustrialized countries around the worldto one degree or another but we don’t have thisform of taxes in America.

The flat tax is similar to the value added tax in many respects. Under the flat tax, businesses pay[11] taxes on their total sales minus the material input and the investment goods. Under the flat tax unlike the VAT the employer is allowed to deduct wages and salary. The difference is that these wages and salaries are taxed at same rate regardless of whether they are considered employer or employee tax. The flat tax system applies to both businesses and wage earner however the tax system has two separate tax forms. The business tax system not only includes corporation but also includes all types of business entities. Under the flat tax, all income would be taxed only once at a 19 percent rate.

The personal consumption tax goes by several different names[12], such as savings-exempt tax, or consumed income tax. Personal consumption tax defines consumption as income earned minus the savings[13]. This type of tax does not tax the savings but rather what the person consumes. Unlike some of the other types of consumption tax ideas, personal consumption tax would require the reporting of total savings not just the consumption.

Impact of Retail Sales Tax on Middle Class

Federal retail sales tax is not good for middle class. The federal retail tax is regressive form of tax on the middle class.Everybody has to buy subsistence items including the middle class regardless of their income. The federal retail sales tax is anonymous in nature and everything that one buysistaxed at same rate regardless of his income. The person who is in top 20% of earners pays the same amount of tax as compared to someone who is in 3rd quintile from the bottom.

Some people would counter that federal retail sales tax is not regressive because certain items will be exempt from this form of tax. I would think that even if some subsistence items were not taxed or taxed at a lower rate that this still would not eliminate the regressive nature of the tax. The rich and the high earners would also be able to buy subsistence goods at the same price as the middle class because of anonymous nature of the tax. In essence the rich are getting same benefits as the middle class therefore there is no net difference between the two types of taxpayers.

Problem with Implementing Retail Sales Tax

Having federal retail sales tax will cut off some revenue-raising options at the state and local levels. State and local governments' dependence on sales tax revenues will create severe policy problems for state and local tax authorities. Canadaexperienced similar problems when it adopted a VAT in 1991[14]. The federal sales tax will be very visible and very large incidence of tax on each and every transaction in goods and services. Taxpayers will be constantly reminded of the cost of government in a much more immediate way than income taxes. This will create political pressure for reductions in state and local sales taxes; administrative issues with federalism overtones if states are charged with administering the federal sales tax scheme.

The Congress’s Joint Committee on Taxation estimated that in order to generate current rate of federal revenue the sales tax would have to be 36% tax-inclusive[15]. Representative John Linder introduce bill (H.R. 25) to enact the national sales tax. Under this bill the assumption is that all consumption of goods and services are going to be taxed[16]. This means that your doctor bill for the emergency operation is going to be taxed. The house that a middle class American was planning to buy is going to be taxed at 36%.

Impact of Value Added Tax on Middle Class

The VAT is a regressive tax on the middle class. The middle class are the one who are least able to pay because higher percentage of their income is taxed by VAT as compared to high wage earner. The government can exempt certain items such as food and medicine but that will make the system more complex and difficult to administer.[17] The problems that has plagued other types of consumption tax also effects VAT. The reason that VAT is not good for the middle class is because it is regressive. The idea of having some food exemption may help but the overall scheme is still regressive. As in other types of regressive tax proposals the poor and the middle class are forced to spend more of their income on basic essentials as compared to high income earners.

Impact of Flat Tax on Middle Class

Under the flat tax proposal all the individual itemized deductions and credits would be eliminated. Therefore there would be no deductions for mortgage interest, state and local taxes, and no credit for child-care expenses for middle class working families. The flat tax would apply to employer paid fringe benefits. This would include employer-paid health insurance, company car, and other such benefits.

Consumption Tax and Buying Power

The middle class will have reduced buying power due to consumption tax. As compared to the income tax,the consumption tax immediately taxes you on what you buy. This has a net effect of reducing the buying power because the price of goods includes substantial tax. If the retailers increase the price by the amount of the tax increase then we are going to have inflation by that amount[18]. If the prices are not increase by the increase in tax amount then there is going to be a recession and low tax yield.

Problems of Transition from Income tax to Consumption Tax

The transition from the income tax system to the consumption tax will have a major impact on the middle class elderly and people who live on a fix income. Unless there is some transition period, the elderly will be paying twice in taxes. The elderly have been saving the money for the retirement and now due to the changes in the tax code they must pay additional tax on the goods that they buy.

Conclusion

I think having federal tax in a form of a consumption tax is not good for the middle class. Consumption tax is a form of a regressive tax therefore it penalizes the middle class on subsistence needs. The elderly who are also a middle class are penalized twice because they have to pay taxes on subsistence needs on an income that has already been taxed. The consumption tax reduces the buying power of the middle class because it immediately taxes the goods andthe services bought.

[1] Joel Slemrod, Jon Bakija, Taxing Ourselves – A Citizen’s Guide to the Debate Over Taxes, 1 (3rd ed., MIT Press 2004).

[2]Steven A. Bank, The progressive Consumption Tax Revisited, 101 Michigan L.Rev. 2238, 2239 (2005).

[3]Steven A. Bank, The progressive Consumption Tax Revisited, 101 Michigan L.Rev. 2238, 2240 (2005).

[4]Id.

[5]Susan D. Carle, Re-valuing Lawyering for Middle-Income Clients, 70 Fordham L.Rev. 719, 720 n. 2 (2001).

[6]Susan D. Carle, Re-valuing Lawyering for Middle-Income Clients, 70 Fordham L.Rev. 719, 721 (2001).

[7]

[8]Susan D. Carle, Re-valuing Lawyering for Middle-Income Clients, 70 Fordham L.Rev. 719, 720 n. 7 (2001).

[9] Slemrod, Taxing Ourselves – A Citizen’s Guide to the Debate Over Taxes at 233.

[10] Slemrod, Taxing Ourselves – A Citizen’s Guide to the Debate Over Taxes at 234.

[11] Slemrod, Taxing Ourselves – A Citizen’s Guide to the Debate Over Taxes at 238.

[12] Slemrod, Taxing Ourselves – A Citizen’s Guide to the Debate Over Taxes at 241.

[13]Id at 241.

[14] Eric J. Gouvin, Radical Tax Reform, Municipal Finance, and the Conservative Agenga, 56 Rutgers L. Rev. 409 (2004).

[15] Bruce Bartlett, A National Sales Tax No Vote, August 9, 2004 at

[16]Id.

[17] Robert W. McWee, Principles of Taxation for Emerging Economies: Lesson From, 12 Dickson Journal of International Law 29, 73 (1993).

[18] Bruce Barltett, A National Sales Tax No Vote, August 9, 2004 at