The visible hand in economics

Income vs consumption taxes: What’s the difference

Posted on: September 19, 2008

Although my personal knowledge of taxes is relatively sketchy, tax is an issue that this blog has spent a little time discussing:

  1. Financial transations tax,
  2. Fiscal policy and tax (diminishing marginal utility), (Flat taxes and fairness), (fiscal responsibilities), (tax free threshold), (income splitting), (tax cuts and timing),
  3. GST taxes (relative price), (GST neutrality),
  4. Externalities (Fat tax), (cut GST on fruit/veg), (overestimation), (bridge too far),
  5. Taxes and inflation (tax cuts and interest rates), (GST and inflation), (petrol tax).

Ok, so we have talked a bit about tax (and I’ve skipped about a million other externalities posts :P ). But there is one thing I don’t think we have transparently covered – the difference/similarity between consumption taxes (GST) and income taxes (PAYE). Lets see what we can do:

The taxes, and the markets!

To start with, lets put the idea of “progressive taxation” to one side (we will touch on it at the end).

One common way to look at consumption and income taxes is to look at the separate markets they work from. This works well as a starting point, but as we will discuss later – its not completely appropriate.

In this case, a consumption tax is assumed to hit the “goods market” while a income tax lands in the “labour market”. According to standard economic theory (Ramsey pricing) it is socially optimal to have a higher tax in markets where demand is relatively price inelastic – as you can get the same amount of revenue for a lower deadweight loss.

As a result, if we believed that labour demand was more inelastic than demand for goods and services, we may want to set a higher income tax than we would a consumption tax.

Is it that simple?

No, it is not nearly that simple. Fundamentally, this partial equilibrium view of consumption vs income taxes misses one important element – the income you earn from working is used for consumption, therefore all taxes fundamentally work as consumption taxes. Another way to view this problem is as follows:

Income=consumption+savings (where savings are effectively deferred consumption). Assuming that wealth is zero and that income in the future is also zero we could effectively state Income=consumption+future consumption.

When we put it this way the difference between an income and a consumption tax should make NO DIFFERENCE to the incentives of agents – as a result, the decision should be based on whichever method able to generate the revenue more easily and cheaply.

As a result, trying to state whether we should place the tax on consumption or income based on elasticities is a bit silly – as they are one in the same.

Think of it this way. If consumption taxes rise and income taxes are cut (both flat rates) on average your income will rise by the same amount as the general price level and presto nothing has happened.

Just a sec, income taxes are a tax on savings, consumption taxes aren’t!

As long as the consumption tax still exists in the future, then consumption taxes are also on “savings” – given that savings is deferred consumption. In the end, it all gets taxed.

But, how do we know that the increase in prices from the consumption tax will mirror the increase in income from the income tax?

Good question.

The placement of a consumption or a income tax could have different distributional consequences, based on the relative elasticities of demand for different types of labour and different types of products.

However, these elasticities are not necessarily independent. A firm with a high elasticity of demand for its product will change the quantity it produces a lot following an increase in consumption taxes – which in turn implies it will need a lot less labour. As a result, this firm effectively has a high price elasticity of demand for labour as well! This implies that, whether you increase consumption or income taxes, this firm would respond by laying people off and reducing production.

This is why we expect the impact to be relatively equivalent.

So what do you think

Independent of any “progressive notion” (which I will get to) I think that the goal should be to establish a tax system where the effective tax on different types of income is equivalent. If there is any way to focus the tax system to burden those with inelastic labour demand a little more – then maybe we should try to do that as well (however, this will depend on our societies conception of fairness).

When we want to add a redistributive element, income tax appears to be the easiest way to do it. Doing it through GST will create a much more costly system, while the a preferable tax on wealth (which hits to the bone of what redistribution really is) appears difficult to implement.

Interestingly, a progressive income tax system does share some of the advantages of the Ramsey tax rule – if we believe that people that earn high incomes are in jobs where labour demand is relatively price inelastic. Very interesting.

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6 Responses to "Income vs consumption taxes: What’s the difference"

One thing that jumped out on me here when you talked about both forms of taxation being a tax on savings

As long as the consumption tax still exists in the future, then consumption taxes are also on “savings” – given that savings is deferred consumption. In the end, it all gets taxed.

From an individual’s perspective wouldn’t you prefer a tax on consumption then? This is becasue with an income tax you pay the tax now where as with a consumption tax you defer paying the tax till later? Thus all other things being equal, the present value your liftime tax liability would be lower.

Haven’t thought this through much, interested in your thoughts.

“From an individual’s perspective wouldn’t you prefer a tax on consumption then? This is becasue with an income tax you pay the tax now where as with a consumption tax you defer paying the tax till later?”

No, because the value is derived from the final product with is consumed in the further in either case. Fundamentally, your level of real savings (and the therefore the amount you buy with savings) is the same in either case – so the individual will not prefer either situation.

but wouldn’t you have more money in the future and thus be able to consume more in the future with a consumption tax? I must be missing something here.

By not paying the tax now you can invest that money and earn interest leaving you with greater real income in the future.

I’ve only just purchased my second coffee of the day so you’ll have to excuse me if I’m missing something obvious;)

“By not paying the tax now you can invest that money and earn interest leaving you with greater real income in the future.”

Starting at the same interest rate, then if you are a net saver yes. If you are a net borrower it is the opposite. At any point in time these groups cancel out don’t they. This implies that the interest rate adjusts to set them equal.

If the interest rate is adjusting to set these groups equal, then any “gain” in real income will net out, thereby making GST and income taxes equivalent again. I guess that will influence the distribution of the tax burden though wouldn’t it.

Does that sound right?

“By not paying the tax now you can invest that money and earn interest leaving you with greater real income in the future.”

I’ve just been thinking about it again. And I think I got too excited with the interest rate in the previous comment.

If income taxes fall and consumption taxes rise (making your true real income now the same) you will have to save “more money” in order to buy the same number of goods in the future.

Prices in the future will be higher, and as a result even if the interest rate does stay the same, the amount of real goods you can buy won’t be any different.

For example, you make $100 net of tax and spend $50 now and $55 in the future (with a 10% interest rate) your intertemporal budget constraint is satisfied. If we increase income by 20% but increase prices by 20% you now make $120, but the cost of consuming the same bundle now is $60 the same bundle we would have purchased earlier is $66 (again consistent with a 10% interest rate). As a result, the change in tax structure does not provide you with a greater net income – as any nominal lift is canceled out by higher future prices.

Ultimately, the tax structure change does not change the budget constraint, regardless of the interest rate as we have had an equivalent income and intertemporal price shift in opposite directions. Given that the indifference curve (the intemporal preference) is no different, the fact that our budget constraint is the same ensures that the consumer will make the same choice in real terms – as a result there should be no change in savings or borrowing behaviour from a position where the person is neither a borrower or a lender.

If you are ALREADY a net saver you suffer- as your savings are worth less. If you are ALREADY a net borrower you suffer, as you are made better off – as you brought before the lift in the price level. This is a distributional issue associated with the change in tax structure – however, it does not remove the long-run equivalence between the two.

Do you agree – or am I still on crack ;)

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