Consumption Tax vs. Income Tax
At the law and econ lunch yesterday we had a vigorous discussion of the effect on savings of having a sales tax instead of a income tax. It is an old theoretical question, but we were starting from the basics. In a world with a zero return on capital, switching to a consumption tax should not change anything. You can escape being taxed today if you save instead of consuming today, but since you will consume tomorrow what you saved today, you will end up paying the consumption tax anyway. So in that case, there is no incentive to change more.
When you earn interest on your savings, though, the situation changes. Now, the delay in paying the tax given you by the consumption tax lets you earn more interest, since you are earning interest on some money that would have been taxed away under the income tax. You end up paying the consumption tax on that extra interest too when you spend it, but the consumption tax rate is less than 100%, so you gain overall. This makes saving have a higher return than under the income tax. (The higher return could conceivably actually reduce savings. If someone had a target future consumption rate, for example, the higher return would allow him to reach it with lower savings. But that is not the case we’d expect.)
The intuition is very slippery, though, and I still might not have it right. If you do want to get it right, formal modelling will help.
September 7th, 2007 at 7:24 pm
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