Discussing The Progressive Consumption Tax

In early January 2003, a interesting bill was referred to the House Ways and Means Committee: H.R.269 Simplified USA Tax Act of 2003. This bill, sponsored by then-Representative of Pennsylvania Phil English, would, among other things, replace the federal income, estate, and gift taxes with a “progressive consumption tax.” In the other words, a tax on income less net savings and investments. The bill also sought to replace the corporate income tax with a tax on gross profits (value added tax), which is a similar to the current corporate income tax, but with a broader base (fewer deductions).

The progressive consumption tax concept was perhaps popularized by American economist Irving Fisher’s 1942 paper Constructive Income Taxation, which proposed this exact system placed in Congress-bill form a little over sixty years later. The basic idea is the incentivize people to make more money, and spend less (or in other words, produce more and consume less).

It’s worth noting that we have something at least resembling this system in place today with Americans allowed to deduct net savings into tax deferred retirement accounts up to a certain amount each year, and a tax on net corporate income. The difference of course is scale. A progressive consumption tax system would provide an unlimited deduction for net savings and investments (savings deposits minus withdrawals).

I find this sort of system very interesting and worth investigating. In the future, this system may very well distinguish the United States in a world of unique tax systems. Now, like any tax system, it can be implemented in one way or other. The question is whether or not a consumption-based tax system is ideal.

If you take the Keynesian perspective, the key determinant in economic output is aggregate demand. If we are essentially boosting the incentive of chiefly upper income people to save money (which they do a lot already), we could see a slowdown in personal consumption expenditures growth. Also, by taxing the gross profits of corporations, we may potentially (depending on how exactly we design the new tax) remove existing incentives for businesses to spend on R&D, and other indirect operating expenses.

On the other hand, if we maintain present levels of demand, increased saving and investment in the long-term could, according to mainstream economics, lead to a greater supply of capital, boosting GDP growth. I’m always learning more in economics and I am by no-means an expert, but do increased savings really translate into greater investment?

The general theory goes something like this: greater savings deposits allow banks to lend more money, and a greater stock market capitalization (and thus greater share prices) allows firms to raise more capital than they would otherwise be able to when issuing new shares. I have problems with this theory.

For one, the bank deposit theory would make sense if banks were running dry, but they’re not— banks consistently hold trillions more in deposits and cash than they lend out. This is especially true when we look a liabilities plus cash minus credit as a share of gross domestic product, which (in in part due to the pandemic), is at its highest level since the government and Federal Reserve started collecting data on it.

Taking another leg out from under the theory, despite a historically large supply of credit, interest rates (the price of credit) have fallen to their lowest point ever, indicating lack of demand, which could only be the case if firms lacked profitable investment opportunities. It seems that demand is too low to spur investment, leading to an overall under-utilization of economic resources in the economy (which is supported by the fact of historically low inflation and a decade of sluggish growth).

Opponents of this theory might point to the flow of corporate equity as evidence businesses are periodically raising capital to make investments, but if you add up these numbers over the decades, we find that for every dollar in corporate equity issued, a dollar and then some is bought back. From 1989 to 2019, $591 billion more was bought than issued; similar story from 2009 to 2019: $1.1 trillion more purchased than sold. The reality is further corroborated by direct investment data.

Firms are investing substantially less on a net basis as a share of gross domestic product than they were in the past. We can see that even at the height of the last growth period in 2014 we were still below our investment levels during the depths of the 1969-1970 and 1980 recessions, or really at any point during the growth phases of those business cycles. We reached only two-thirds the level of net private domestic investment reached during the 1991-2001 business cycle, and half our record high in 1966.

To sum up what we know: firms are not investing, banks are not lending, and despite historically high stock market capitalization, firms are buying shares instead of issuing them to raise capital. We have a shortfall of demand, not supply.

If demand really is our problem, creating a strong new incentivize for individuals and firms to reduce consumption will exacerbate the problem, not solve it. While exempting savings and investment from income taxation could be a good policy in different times, at the present I believe this policy could be damaging.

I am certainly open to new perspectives on the matter, but any new approach needs to answer the questions above, including how getting Americans to save and invest more is going to help an economy where historically high savings and investment are failing to drive growth. Increasing the savings rate and taxing corporate spending on research and development inhibits the fuel our economy needs to grow at past rates.

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