Consumption Taxes

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Consumption Taxes

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois at Urbana-Champaign

Econ 415 Fall 2001
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Topics for today

• Consumption as a tax base
• Types of consumption taxes
• Value added taxes
• Methods of collection
• Rate structure
• Treatment of capital
• Comparison with a retail sales tax
• Incidence of the VAT
• Comparison with a Flat Tax

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Consumption as a tax base

• A proportional consumption tax, a proportional
  wage tax, a flat tax, and a value added tax are
  equivalent taxes. All are equivalent to taxing
  lifetime income assuming no inheritances or
  bequests.
• C0 W0 - SC1 W1 S(1 r)C0 C1/(1r) Y
  W0 W1/(1r)

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Types of consumption taxes

• Direct consumption taxes
• Expenditures tax
• Flat tax
• Indirect consumption taxes
• Excise taxes
• Sales taxes

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Direct consumption taxes

• Expenditures (cash flow) tax
• Applied to the difference between income and
  saving in qualified accounts
• Can apply progressive rates
• Should include imputed rental value of housing
• Flat tax
• Individual tax on wage income and a business tax
  on sales minus wages, materials purchases, and
  purchases of new capital equipment

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Indirect consumption taxes

• Excise taxes
• Apply to one or a few commodities
• May be unit or ad valorem
• Important source of revenue in LDCs
• Sales taxes
• Apply to wide range of commodities
• Single stage (retail or manufacturing sales tax)
• Multiple stage
• Turnover tax t sales
• VAT t (sales - purchases)

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Turnover tax

• Raises much revenue with a low rate, but has
  several disadvantages
• 1. It artificially encourages vertical
  integration of industries, eliminating stages in
  order to minimize the tax.
• 2. It results in very different effective tax
  rates across commodities depending on the number
  of sales transactions involved in the production
  and distribution process.
• It is expensive to administer because it must be
  collected from a large number of firms.
• 4. Results in cumulative taxation of goods as
  they move through successive stages of production
  and distribution (cascading).

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Value-added tax

• Tax on the value added to intermediate products
  at each stage of production
• Used in more than 50 countries of the world, but
  not the US

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Value Added Tax Example
How would this VAT compare with a retail sales
tax of equal yield?
What rate turnover tax would raise the same
revenue as the 20 VAT?
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VAT vs. retail sales tax

• The VAT collects a substantial part of the tax
  revenue (80 or more) at import, manufacturing,
  and wholesale levels, while the retail sales tax
  puts the entire impact on the retail sector.
• The potential for evasion with a retail tax is
  greater unless retailing is highly
  commercialized, records good, and a strong audit
  program established.

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VAT Treatment of Capital
Consumption-type VAT
Income-type VAT
Capital is depreciated over the service life of
the asset.
Capital is expensed (written off fully in year of
purchase).
VAT t(sales - purchases of materials -
depreciation of capital)
VAT t(sales - purchases of materials -
purchases of capital)
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VAT Methods of Collection
Subtraction method
VAT t (S - P)
Credit (invoice) method
VAT tS - tP
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Administration of VAT

• Relatively expensive (.5 to 1 of revenues) to
  administer
• Exempting small firms lowers administrative costs
• Multiple rates and zero rating increases
  administrative costs

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VAT rate structure
May be single rate or differential rates. Many
countries apply reduced rates to food and other
necessities. Several impose high rates on
luxuries. VAT is generally rebated on export
sales.
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VAT Exemption vs Zero-Rating
Exemption
Zero-Rating
Firm pays no tax but receives credit.
Firm pays no tax and receives no credit.
VAT 0
VAT -t purchases
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Incidence of a VAT

• Partial equilibrium
• General equilibrium

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Partial Equilibrium Incidence of a VAT
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General Equilibrium Incidence of a VAT
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Flat Tax and the VAT
Individuals IFT t(Wages Pension and
Retirement benefits) - I where I
exemption   Businesses BFT t(Sales - Purchases
- Wages - Pensions - Purchases of capital
equipment)   Flat tax FT t(Sales Purchases
Purchases of capital equipment)
I consumption VAT - I
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Flat Tax and the VAT
Flat tax
VAT
Earnings
I/t
Earnings
I
Flat tax tE I VAT tE
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Effect on investment
Effect of replacing a comprehensive income tax
with a equal yield comprehensiveconsumption tax
Yield
S
rG
r
rN
D
IY
IC
Investment
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Effect on work
Effect of replacing a consumption tax with a
equal yield income tax
Wages
S
Note tC gt tY for equal yield taxes
DWG
WG (1-tC)
WG(1-tY)
HC
HY
Labor hours
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Consumption tax elasticities

• Measure the responsiveness of consumption tax
  revenue to changes in GDPln TC a b ln GDP
• Can be decomposed into the tax-to-base and
  base-to-income elasticitiesln TC c d ln Cln
  C e f ln GDP
• Expectation b df

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Advantage of high tax to base elasticity

• Base-to-income elasticities are largely
  determined by the way in which the structure of
  the economy changes with economic growth.
• Tax-to-base elasticities indicate revenue growth
  within control of tax authorities.
• High tax to base elasticities may be raised by an
  improvement of tax administration.

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Lab 10

• Estimate the tax-to-base and base-to-income tax
  elasticities for goods and services taxes using
  your country data
• Include a dummy variable to control for major
  discretionary tax changes
• Test to see whether elasticities are greater than
  one

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Next Time
Lab 10 Consumption Tax Elasticities Chat If
Mr. Ramsey were here to give advice on the design
of the rate structure of the VAT, what advice
would he give? Would you agree with him? Why or
why not? Next week Trade taxes
Sunday Oct 28 7-9 pm Halloween Party!