Friday, August 13, 2004

The Consumption Tax and the Current Account

Apparently our preznit has been making noise about eliminating income taxes and switching to a consumption tax. While Angry Bear has correctly pointed out that a switch to consumption tax from income tax would impose a huge double taxation burden on those currently with large reserves of savings (retirees) and thus be politically infeasible in the US, a consumption tax is still worth examining. Specifically, the question of the interaction of an income to consumption tax switch with the current account deficit (or possibly surplus in other theoretical locales).

Outside the possibility of default, no effects could be predicted by theory. The increase in the amount required for a borrower to achieve a given level of consumption due to the consumption tax would be offset in the borrower’s higher income due to elimination of income tax. However, there is a material difference when the possibility of default is introduced. With in the case of default under income tax, the creditor shares the burden with government in the form of unpaid tax on income the borrower was supposed to earn to pay off the loan. In the case of a consumption tax, the creditor has paid out the taxes owed on the consumption to the government immediately upon making the loan. The government loses no revenue by the default of the borrower as it would under income tax. This should cause an interest premium for a given amount of borrower consumption at a given level of risk.

The most obvious advantage of this would be to impose an implicit tariff on a current account deficit. There can also be an advantage for a government to ensure that its own expenditures are proportional to the expenditures of its constituents. In a small developing country, if a powerful native NGO receives a loan and begins to spend it on security equipment (that also happens to double as paramilitary gear), it could create a volatile fluctuation in the relative power of that NGO to the government. A consumption tax would mitigate this fluctuation by ensuring the government was able to spend (on a police force build-up) while these NGO’s are spending (on their private armies).

In addition, we must consider that a consumption tax in a period of national dissavings (current account deficit) acts like a loan to the government. If a revenue neutral switch is made from income to consumption tax during a time of dissavings, it probably would cause government deficits to widen as the current account returns to the long run average of zero net surplus/deficit.

That being said, I wouldn’t trust the Bush administration to implement a speed limit increase let alone overhaul the tax system. Someone should come out with an ad saying “Bush thought increasing taxes on seniors X billion dollars is an interesting idea that deserves to be explored seriously.”


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