Heidelberg Congress on Taxing Consumption

A major objective of setting up this congress was to further the academic and public debate on taxing consumption, but I especially hope that this congress will contribute to a more intensive consideration in the debate on the German tax reform of the opportunities, and of course risks, connected with the different approaches towards a consumption-based tax system.

Debate over the “correct” tax base is of long standing and my assignment is to view it in its historical perspective¹. The literature is endless, and a variety of approaches may be distinguished². Since they overlap in time, no neat sequential story can be told. I therefore present a brief review of each of the key approaches, keeping in mind their significance for the current debate over income versus expenditure tax.

Tax reform seems to be a perpetual item on the policy agenda of governments around the world, reflecting the fact that we still do not seem to have it “right”. There are many reasons for this. One is simply that judgments about what is the right tax system vary immensely across observers, even well-informed ones. This is inevitable given the value judgments involved. Another is that the reform process is itself potentially painful. Although tax reform may improve the efficiency of the economy and lead to some net gains, it is almost always the case that it also involves a reallocation of the tax burden among taxpayers with some gaining and others losing. Moreover, it also often involves transitional or short run windfall gains and losses. Governments apparently place great weight on these transitional effects. One of the main purposes of this paper is to investigate the interaction of these transitional gains and losses with longer run effects from a dynamic welfare economics point of view.

If Hobbes were alive today, he would be required to express himself somewhat differently. Consider two individuals, one of whom laboureth much, supplying labour l_m, while the other, living idlely, supplies l_i. Both face the same wage, w, while m but not i spares a fraction s of the fruits of his labour.

During the 1970s and 80s public finance economists devoted increasing attention to the taxation of consumption and wages as an attractive alternative to the existing income tax systems, which are widely believed to discourage savings and capital formation. Despite the ongoing internationalization of the western economies, most of these studies of the macroeconomic effects of tax reform have assumed a closed economy. As Slemrod (1988) has noted, economists have only recently begun to realize that the effects of tax policy may change markedly as the economy is opened up to international trade in goods and assets.

Economists have emphasized a number of possible advantages of consumption taxation over income taxation.¹ One of the most important of these has to do with dynamic efficiency. It is often asserted that increased reliance on consumption taxation would result in welfare gains.² However, from the perspective of the policymaker, it may not suffice merely to assert that consumption taxation is better. In order to have much chance of overcoming the inertia of the political system, it may be necessary for economists to show that the efficiency gains are, in some sense, large.

This paper uses consumption taxation as a vehicle for examining questions of political process and constitutional order. The fiscal politics of consumption taxation is my main concern here; I do not seek to contribute directly to any of the predominant streams of economic literature on consumption taxation, but rather seek to refract this literature through some public choice principles regarding the operation of political processes.¹ The theory of public choice seeks to apply an economic logic to political processes, and this paper seeks to apply that logic to consumption taxation in particular. According to that logic, tax policy is the outcome of what can be called a “market” for tax legislation, and the operation of this market is constrained by a set of constitutional rules within which fiscal and political processes operate and through which tax programs emerge.²

In all States with developed tax systems is a widespread wish to carry out fundamental tax reforms. In 1985, the President of the United States tried to enlist support with the programme “Reduce tax rates, reduce complexity, increase fairness, and increase growth”¹; with it, he created not only a national, but also an international trend towards fundamental reforms².

One of the most important fiscal developments of the past twenty years has been the worldwide growth in reliance on the value-added tax (VAT). Following its adoption by the European Common Market in the 1960s, the VAT has become the “workhorse” of fiscal systems throughout the world. At least forty countries now levy VATs, and many others use other forms of broad-based general sales taxes, as well as more selective taxes on consumption.¹

The debate about the theoretical and practical advantages of taxing income or consumption will no doubt outlive us all. In this paper I shall not try to resolve — or even advance — that debate. Rather I shall focus on a subsidiary question. If it is decided that consumption is a more appropriate tax base than income, how would administrative considerations influence the choice among alternative ways to tax consumption? Judgments about the administrative ease of shifting from income to consumption taxation would bulk large even if the theoretical debate were resolved. Absent such a conclusive outcome, they are likely to be dominant.

An expenditure tax has been endorsed at various times by a respectable number of most notable scholars such as Thomas Hobbes, John Revans, John Stuart Mill, Eduard Pfeiffer, Alfred Marshall, Francis Ysidro Edgeworth, Arthur Cecil Pigou, Irving Fisher, Luigi Einaudi, Joseph A. Schumpeter, Nicholas Kaldor, and James Edward Meade, to name only the most prominent ones. Over the years several motions have been proposed to enact an expenditure tax, or to consider it for possible enactment. Such proposals include John Stuart Mill’s famous suggestion to the Select Committee on Income and Property Tax in 1861¹, the considerations of the Colwyn Committee on National Debt and Taxation², Congressman Ogden L. Mills’ motion of a spending tax bill put before the U.S. House of Representatives in 1921³, Mr. Morgenthau’s proposal of an expenditure tax to pay for the war submitted to the Finance Committee of the Senate of the United States in September 1942⁴, the suggestion of an expenditure tax by the Danish Commission on Tax Reform in 1958⁵ and by the Swedish Government Commission on Taxation in 1972⁶, by the British Meade Committee in (1978), the Blueprints of the U.S. Treasury (1977/1984), the Information Report of the U.S. Advisory Commission on Intergovernmental Relations (1974), and - let us not forget — the discussions within the Royal Commission on the Taxation of Profits and Income, appointed in 1950⁷, which provided much of the material leading to Kaldor’s well-known book published in 1955. None of these numerous attempts at establishing an expenditure tax was ever adopted, save for rather short interludes of expenditure tax enactment in India and Sri Lanka⁸.

Worldwide interest in consumption taxation in recent years has largely been focused on domestic considerations of growth, efficiency, revenue, equity, and stabilization [Miesz-kowski (1980); Hall and Rabushka (1983); Bradford (1984); Aaron and Galper (1985); McLure (1987a)]. To the extent that international considerations have been included in the discussion, it has largely been by way of effects on the balance of payments or on the competitive trade position of the country contemplating adoption of a consumption-based tax. For instance, among the reasons given on behalf of adoption of value-added taxes in the United States and Japan has been the desire to gain comparable competitive advantage with the European Common Market [Aaron (1981); Weidenbaum et al.(1989)]. Thus the adoption of consumption-based taxation has rarely been seen in the context of an international tax order within which differences in fiscal systems might be coordinated to mutual advantage. Since the European Community has been for long involved in a process of fiscal coordination, it is appropriate and perhaps not surprising that this conference should be the first, so far as I know, to give some attention to the problem of the international coordination of consumption taxes.

There are many arguments pro and contra a change from income to consumption taxation. In what follows, attention is given only to aspects connected with the fact that economies have international economic relations.

The eighties showed a worldwide discussion of tax reform scenarios, based on the theoretical and empirical evidence that national income tax regimes suffered from major shortcomings. The criticism is not new that the system of direct taxes needed adaptation in order to achieve the goals of an equitable distribution of tax burdens and net personal income, of avoiding allocative distortions and welfare losses for the society and of low costs of information, compliance, administration and control. All this has led to changes in the tax systems in the past. In the last three decades major reform steps have included measures to integrate corporate and personal income taxes, indexation rules to mitigate inflationary distortions or the introduction of assignment rules for household income in order to escape undesirable progressivity effects.