NCPA - National Center for Policy Analysis


September 6, 2005

As the President's Advisory Panel on Federal Tax Reform works on its report (due by the end of September), one of the measures under consideration is switching to a low-rate, broad-based consumption tax.

According to Alan J. Auerbach (University of California, Berkeley), a consumption tax could raise the same amount of revenue as the current tax system:

  • A shift to a consumption tax could increase Gross Domestic Product (GDP) in the long run by as much as 9 percent.
  • Lower marginal tax rates would increase employment and therefore expand production somewhat in the short run.
  • Over a longer period of time, production would increase even more as the result of stronger capital accumulation induced by the more favorable tax treatment of savings.

Critics argue that adopting a consumption tax would raise asset values, but Auerbach says a consumption tax would actually reduce asset values somewhat in the short run:

  • A consumption tax eliminates the burden on saving and investment, a key reason why capital accumulation would rise; however, a consumption tax would actually increase the tax burden on existing assets because those who have accumulated assets in the past would face consumption taxes when selling their assets in order to consume goods and services.
  • The purchasing power of accumulated assets would suffer, meaning the real (price-level adjusted) values would be lower than before; this feature of the consumption tax is sometimes referred to as a levy on "old" capital.

Auerbach says not all consumption taxes are equal. Significant gains are possible even if the tax system retains its current degree of progressivity, though not if the tax reform also fully shields existing assets.

Source: Alan J. Auerbach, "A Consumption Tax," Wall Street Journal, August 25, 2005.

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