Thursday , November 21 2019
Home / S. Sumner: Money Illusion / Time neutral consumption taxes

Time neutral consumption taxes

Summary:
The field of economics is regressing. We are forgetting what we knew about monetary policy back in 2007, and we are also forgetting what we knew about public finance back in 2007. This is incredibly discouraging. For non-economists, I’ll start with a simple thought experiment to explain the basic principles of public finance. Imagine a country where everyone earns exactly the same wage income, ,000/year from age 25 to 65. No one inherits any money. The only investment is a safe asset that earns a 5% rate of return. Assume no inflation. Some people like to save a lot for future consumption, while others spend their money today and save very little. What do we know about this world? 1. There is substantial income inequality. 2. There is lots of inequality in measured

Topics:
Scott Sumner considers the following as important:

This could be interesting, too:

Scott Sumner writes Could’ve fooled me

Scott Sumner writes Bartleby the central banker

Menzie Chinn writes Making America Great Again (in Indebtedness): Net International Investment Position

Scott Sumner writes Instrumental beliefs, prediction and reality

The field of economics is regressing. We are forgetting what we knew about monetary policy back in 2007, and we are also forgetting what we knew about public finance back in 2007. This is incredibly discouraging.
For non-economists, I’ll start with a simple thought experiment to explain the basic principles of public finance.

Imagine a country where everyone earns exactly the same wage income, $80,000/year from age 25 to 65. No one inherits any money.

The only investment is a safe asset that earns a 5% rate of return. Assume no inflation.

Some people like to save a lot for future consumption, while others spend their money today and save very little.

What do we know about this world?

1. There is substantial income inequality.
2. There is lots of inequality in measured wealth.
3. Actual wealth is identical, in the sense that every single person has identical lifetime consumption in present value terms.

(Wealth, properly measured, is supposed to represent the present value of future expected consumption, for you and those to whom you give money.)

The society that I described does not have any economic inequality, in any meaningful sense. Everyone has exactly the same amount of resources to work with over their lives; they simply choose to spend their money at different points in time.

[I’ve seen people argue that a lack of patience is a disability, like being born without a right arm. I view preference for current goods over future goods as being no different from preference for strawberries over blueberries. Maybe that’s because I made the mistake of consuming too little when I was young.  I don’t view myself as being better off than those who enjoyed life while young

ALL TAXES ARE CONSUMPTION TAXES!

All taxes are 100% consumption taxes.  That’s public finance 101.  The burden of a tax is its impact on consumption.  Saving and investment are simply a way of generating future consumption, for you or the person you give the money to.

When economists like me use the term “consumption tax” we are referring to taxes that tax current and future consumption at the same rate.   We actually mean, “time neutral consumption taxes”.  Examples include VATs, payroll taxes, and income tax systems with unlimited 401k privileges.  (I.e., no limit on contributions and no mandatory withdrawal date.)

An ordinary income tax system does tax capital income, as do corporate income taxes, capital gains taxes, etc.  These are also consumption taxes in a sense, but they are not called consumption taxes because they tax future consumption at a higher rate than current consumption.

In my imaginary example above, an income tax would tax those who preferred future consumption at a higher rate than those who prefer current consumption.  At first pass, that looks distortionary.

Now it’s perfectly OK to say that the simple public finance theories do not work in the real world.  Some “capital income” is disguised labor income.  Maybe for that reason we should tax capital income.  I’ve argued that when in doubt, capital income should be treated as labor income.  But you’d have to be completely insane to believe that all capital income is disguised labor income.

Unfortunately, the profession seems to be completely insane, as I see more and more economists making nonsensical comments such as claiming that the super rich pay a lower rate of tax than the middle class.  In making that claim, they are treating “income” as the correct base to use when evaluating tax incidence, not consumption.  That’s a freshman level error, completely unacceptable.  If you see an economist doing that, just stop reading.  Nothing they have to say will have any value.  In fact, income is a meaningless concept.  The tax rates faced by billionaires are meaningless numbers.

Progressives should be advocating a progressive consumption tax.  This tax system would tax current and future consumption at the same rate, but would tax high levels of consumption at much higher rates than low levels of consumption.

There are many ways to get there, and undoubtedly many compromises that must be made.  Perhaps “second best” options need to be considered.  But if you don’t even understand the proper destination, what chance is there of developing a sound strategy?

PS.  Tim Peach recently pointed out to me that Estonia is the country whose tax system is closest to being time neutral.


Tags:

 
 
 
Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

Leave a Reply

Your email address will not be published. Required fields are marked *