Income vs consumption taxes: What’s the difference

Posted by: Matt Nolan on: September 19, 2008

• In: Government Policy | Political economy
• 6 Comments

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 😛 ). 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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