The Aches and Pains of Transition to a Consumption Tax: Can We Get There From Here?

This article discusses probably the most significant obstacle to the adoption of a consumption tax: the negative effects on existing wealth that the transition from the income tax to most forms of a consumption tax would have. The Congressional Budget Office in its 1997 study posed the question, “How to Get There from Here.” The difficulty with transition and the changes in the tax law since the CBO study, however, prompt the more basic question: “Can we get there from here?” This article deals with this question by examining the effects of transition on existing wealth under a variety of consumption tax systems and the likely responses of transition relief under each of the systems. The consumption tax proposals considered and analyzed include direct consumption taxes (like a consumed income tax and yield exemption tax), indirect consumption taxes (like a retail sales tax and various forms of value added taxes), and combinations of the two (like the Flat Tax, X Tax, and E Tax proposals), which involve a two-tier tax structure. The article explains that, as a general proposition, a consumption tax in the form of either a consumed income tax or a VAT reduces the tax on newly invested capital to zero. In contrast, a consumption tax in the form of a yield exemption tax reduces the tax on all capital – including existing capital – to zero. The difference, then, is in the treatment of existing or “old” capital. This important proposition, as well as its significance for purposes of transition, provides a substantial obstacle to the adoption of any form of consumption tax other than yield exemption, and to the extent that the current system already incorporates large elements of yield exemption, makes it less likely that any other form of consumption tax can garner sufficient support for adoption. It is possible that a gradual, phase-in approach could overcome the obstacle of the additional tax on existing wealth. The forces of reform, however, may be working against any shift to a consumption tax (other than yield exemption) even with transition relief in the form of gradual phase-in. As the income tax gradually becomes a yield exemption, wage and business tax, existing wealth owners may view the consumption tax battle as having already been won without cost and without the need to make compromises. Possessors of existing wealth may be reluctant to support an alternative consumption tax system that would erode the consumption purchasing power of some of their wealth. Reform in other consumption tax directions may then be elusive, because it would lack the group that would be its natural supporters.