Types
Value-added tax
A value-added tax applies to the market value added to a product or material at each stage of its manufacture or distribution. For example, if a retailer buys a shirt for twenty dollars and sells it for thirty dollars, this tax would apply to the ten dollar difference between the two amounts.
A simple value-added tax is proportional to consumption but is regressive on income at higher income levels, as consumption tends to fall as a percentage of income as income rises. Savings and investment are tax-deferred until they become consumption. A value-added tax may exclude certain goods to make it less regressive against income. It is common in European Union countries.
Value added tax is a consumption based tax and is levied each and every time the value of a good gets increased in the process of manufacturing to the point of sale.
In Australia, Canada, India, New Zealand and Singapore, it is instead called a "Goods and Services Tax." In Canada, it is also called Harmonized Sales Tax when it is combined with a provincial sales tax.
Sales tax
Sales tax is a consumption tax applicable to sales of goods and services. A sales tax typically applies to the sale of goods, and sometimes includes the sales of services. The tax is applied at the point of sale. The tax amount is usually ad valorem, that is, it is calculated by applying a percentage rate to the price of a sale. When a tax on goods or services is paid to a governing body directly by a consumer, it is usually called a use tax. Often, laws provide for the exemption of certain goods or services from such taxes.
Laws may allow sellers to itemize the tax separately from the price of the goods or services, or they may require it to be included in the price.
Excise tax
An excise tax is a sales tax that applies to a specific class of goods, typically alcohol, tobacco, gasoline (petrol), or tourism. The tax rate varies according to the type of good and quantity purchased and is typically unaffected by the person who purchases it.
Sin taxes, are a type of excise tax imposed on items that are considered harmful to society, in an effort to decrease their consumption by increasing their prices.
Expenditure tax
A direct, personal consumption tax may take the form of an expenditure tax, that is, an income tax that deducts savings and investments, such as the Hall–Rabushka flat tax. [1] A direct consumption tax may be called an expenditure tax, a cash-flow tax, or a consumed-income tax and can be flat or progressive. Expenditure taxes were briefly implemented in the past in India and Sri Lanka. [2]
This form of tax applies to the difference between an individual's income and any increase/decrease in savings. Simple personal consumption taxes are regressive with respect to income. However, because this tax applies on an individual basis, it can be made progressive. Just as income tax rates increase with personal income, progressive consumption tax rates increase with personal consumption. Economists from Milton Friedman to Edward Gramlich and Robert H. Frank supported a progressive consumption tax. [3] [4] [5]
History
Consumption taxes, specifically excise taxes, have featured in several notable historic events. In the United States, the stamp tax, the tax on tea, and whiskey taxes produced revolts, the first two against the British government and the latter against the federal government. In India, an excise tax on salt led to Mohandas Gandhi's famous Salt March, a major event in the Indian Independence Movement.
United States
In the early United States, taxes were levied principally on consumption. Alexander Hamilton, one of the two chief authors of the anonymous The Federalist Papers , favored consumption taxes in part because they are harder to raise to confiscatory levels than income taxes. [6] In The Federalist Papers (No. 21), Hamilton wrote:
It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess. They prescribe their own limit, which cannot be exceeded without defeating the end proposed—that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty that, "in political arithmetic, two and two do not always make four." If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them. [7]
Although personal and corporate income taxes provide the bulk of revenue to the federal government, consumption taxes continue to be a primary source of income for state and local governments. One of the first detailed proposals of a personal consumption tax was developed in 1974 by William Andrews. [8]
Japan
The Liberal Democratic Party government of Masayoshi Ōhira attempted to introduce a consumption tax in 1979. Ohira met opposition within his own party and gave up on his attempt after his party suffered badly in the 1979 election. Ten years later, Noboru Takeshita successfully negotiated with politicians, bureaucrats, business, and labor unions to introduce a consumption tax, [9] which was introduced at a rate of 3% in 1989.
In April 1997, [10] under the government of Ryutaro Hashimoto [11] the rate increased to 5%. [12] The 5% is split between the national and local governments, which receive 4% and 1%, respectively. [13] Shortly after the tax was introduced Japan fell into recession, [14] which was blamed by some on the consumption tax increase, [15] and by others on the 1997 Asian financial crisis.
Prime Minister Junichiro Koizumi said he had no intention of raising the tax during his government, but after his massive victory in the 2005 election, he lifted a ban on discussing it. [16] Over the following years LDP politicians discussed raising it further, including prime ministers Shinzō Abe, [17] Yasuo Fukuda, [18] and Tarō Asō. [19]
The Democratic Party came to power in the August 2009 elections with a promise not to raise the consumption tax for four years. [20] The first DPJ prime minister, Yukio Hatoyama was opposed, but Naoto Kan replaced him and called for the consumption tax to be raised. The following prime minister, Yoshihiko Noda "staked his political life" on raising the tax. [21] Despite an internal battle that saw former DPJ leader and co-founder Ichirō Ozawa and many other DPJ diet members vote against the bill and then leave the party; on June 26, 2012, the lower house of the Japanese diet passed a bill to double the tax to 10%. [22]
Despite considerable opposition and an attempted no-confidence motion from minor opposition parties the bill was successfully passed through the upper house on August 10, 2012, with the result that the tax increased to 8% in April 2014 and to 10% in October 2019 (twice postponed from the original date of October 2015). [23] [24]
Savings effect
Consumption taxes do not tax savings, which allows invested assets to accumulate untaxed. If, in the absence of taxes, one dollar of savings is put aside for retirement at nine percent compound interest, the balance grows to $7.91 after twenty-four years. Alternatively, by assuming a thirty-three percent tax rate, the same dollar is reduced to about sixty-seven cents after taxes when earned. The effective interest rate, thereafter, is reduced to six percent, since the rest of the yield is paid in taxes.
After twenty-four years, the balance increases only to $2.73. The cumulative taxes in the latter case are $1.02. The other $4.16 is not lost by the economy in any sense, as the $4.16 is what the government would make in interest, if it had invested its tax revenue in the same investment. If the initial invested amount is not taxed when earned, but the earnings are taxed thereafter, the cumulative taxes paid are the same, but are spread more evenly across the period. These results are primarily sensitive to the rate of return; for example, with a three percent return most of the tax receipts come from the tax on the initial dollar.
To the extent that taxing something results in less of it (whether income or consumption), taxing consumption instead of income should encourage both work and capital formation, which increases economic growth, while discouraging consumption. [3] [4] Secondly, the tax base is larger because all consumption is taxed.
Flat consumption taxes are regressive (shift the tax burden to the less well-off). The ratio of tax obligation to income tends to shrink as income increases because high-earners tend to consume proportionally less of their income. [25] An individual unable to save will pay taxes on all his income, but an individual who saves or invests a portion of his income is taxed only on the remaining income.
Practical considerations
Many proposed consumption taxes share some features with income tax systems. Under these proposals, taxpayers are typically given exemptions and/or a standard deduction in order to ensure that the poor do not pay any tax. In a flat consumption tax, these other deductions are not permitted. [3]
A withholding system may be put into place in order to approximate the average tax liability, smoothing payments. It is difficult for many taxpayers to pay no tax all year, only to face a large year-end tax bill.
Andrews notes the inherent problem with housing. Renters necessarily "consume" housing, so they would be taxed on the expenditure of rent. However, homeowners also consume housing in the same way, but as they pay down a mortgage, the payments are classified as savings, not consumption (because equity is being built in an asset).
The disparity is explained by what is known as the imputed rental value of a home. A homeowner could choose to rent the home to others in exchange for money, but instead chooses to live in the home. Therefore, the homeowner is also consuming housing by not permitting renters to pay for and occupy the home. The amount of money that the homeowner could receive in rent is the imputed rental value of the home.
A true consumption tax would tax the imputed rental value of the home (which could be determined in the same way that valuation occurs for property tax purposes) but not the increase in the asset value (the home). Andrews proposes to ignore this method of taxing imputed rental values because of its complexity. In the United States, home ownership is subsidized by the federal government by permitting limited deductions for mortgage interest expense and capital gains. Therefore, treating renters and homeowners identically under such a consumption tax may not be feasible there.
This issue would not arise under an expenditure tax, since all withdrawals of funds from a pre-tax investment account are treated as taxable consumption, whether these funds are used to pay rent, buy a house, or pay down mortgage principal. A person may buy a house within a pre-tax account, but would not be allowed to live there.
Also, a consumption tax could utilize progressive rates in order to maintain "fairness". More consumption means disproportionately more tax liability.
Economic impact
The temporal neutrality of a consumption tax, however, is that consumption itself is taxed, so it is irrelevant what good or service is being consumed in terms of allocation of resources. The only possible effect on neutrality is between consumption and savings. Taxing only consumption should, in theory, cause an increase in savings. [3]
Many economists and tax experts favor consumption taxes over income taxes for economic growth. [26] [27] [28]
Depending on implementation (such as treatment of depreciation) and circumstances, income taxes either favor or disfavor investment. (On the whole, the American system is thought to disfavor investment. [3] ) By not disfavoring investment, a consumption tax would increase the capital stock, productivity, and therefore increase the size of the economy. [3] [4] Consumption also more closely tracks long-run average income. [4] The income of an individual or family can often vary dramatically from year to year. The sale of a home, a one-time job bonus, and various other events can lead to temporary high income that will push a lower or middle income person into a higher tax bracket. On the other hand, a wealthier individual may be temporarily unemployed and earn no income.
Impact on work choices
Consumption taxes, like other taxes, alter individual decisions away from optimal choices. An important concern is potential impact on individual work decisions. Two possible impacts are known as income effect (taxes reduce the real value of work) and substitution effect (changes in relative value of work in relation to other activities).
Income effect
Under a consumption tax, an individual's purchasing power decreases, either through increased prices (producers pass the tax along to the consumer) or through decreased wages (taxing authorities directly tax the consumer based on a measurement of their consumption). Assuming the former case, of increased prices, if an individual had monthly expenses of $1,000 and an hourly wage of $10 per hour, they would have to work 100 hours a month to cover the expenditures. However, under a 10% consumption tax and assuming the tax is passed completely on to consumers, the monthly expenditures would be $1,100 meaning the individual would have to work 110 hours to cover them. It is expected that individuals increase their amount of work to compensate for the loss of consumption power as a response to increased taxation. [29]
Substitution effect
Along with decrease in purchasing power, taxes also decrease the relative value of work in relation to leisure time. If a tax is implemented on consumption, the value of spending an hour at work decreases in relation to different activities because the tax decreases the actual amount of goods and services an individual can purchase for a given level of work. This subsequently increases the relative value of leisure time and decreases amount of working time, effectively working opposite to the income effect.
If the consumption tax is to be revenue neutral, the tax rate is likely to be higher in comparison with an income tax, because of the smaller tax base. While the tax base for income tax includes all of personal income, the tax base for consumption tax include only income less savings, thus being necessarily smaller. The higher tax rate might then result in an increased substitution effect. However, the consumption tax is levied also on past savings consumed later in individual's life, e.g. during retirement. The tax on this capital is not expected to distort one's behavior, because there is no legal way to avoid this tax burden. The consumption tax on past savings is thus an example of a lump-sum tax. As a consequence, the consumption tax rate does not have to be that much higher than income tax rate in order to preserve revenue neutrality. One possible disadvantage is a higher burden among elderly, consuming primarily their past savings. [29]
Empirical evidence
According to theory, taxes have two opposing effects on individual's work decisions, the net impact might thus be unclear. Empirical evidence shows that increased taxes cause a decrease in work effort, meaning the substitution effect is larger than the income effect. A study shows that a consumption tax is likely to decrease work effort more than an income tax, although the difference is expected to be minor. [29]
A tax is a mandatory financial charge or levy imposed on a taxpayer by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax compliance refers to policy actions and individual behavior aimed at ensuring that taxpayers are paying the right amount of tax at the right time and securing the correct tax allowances and tax relief. The first known taxation occurred in Ancient Egypt around 3000–2800 BC. Taxes consist of direct or indirect taxes and may be paid in money or as labor equivalent.
A flat tax is a tax with a single rate on the taxable amount, after accounting for any deductions or exemptions from the tax base. It is not necessarily a fully proportional tax. Implementations are often progressive due to exemptions, or regressive in case of a maximum taxable amount. There are various tax systems that are labeled "flat tax" even though they are significantly different. The defining characteristic is the existence of only one tax rate other than zero, as opposed to multiple non-zero rates that vary depending on the amount subject to taxation.
Taxation in Japan is based primarily upon a national income tax (所得税) and a residential tax (住民税) based upon one's area of residence. There are consumption taxes and excise taxes at the national level, an enterprise tax and a vehicle tax at the prefectural level and a property tax at the municipal level.
A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, so that the average tax rate exceeds the marginal tax rate.
A tax cut represents a decrease in the amount of money taken from taxpayers to go towards government revenue. Tax cuts decrease the revenue of the government and increase the disposable income of taxpayers. Tax cuts usually refer to reductions in the percentage of tax paid on income, goods and services. As they leave consumers with more disposable income, tax cuts are an example of an expansionary fiscal policy. Tax cuts also include reduction in tax in other ways, such as tax credit, deductions and loopholes.
FairTax is a single rate tax proposal which has been proposed as a bill in the United States Congress regularly since 2005 that includes complete dismantling of the Internal Revenue Service. The proposal would eliminate all federal income taxes, payroll taxes, gift taxes, and estate taxes, replacing them with a single consumption tax on retail sales.
In a tax system, the tax rate is the ratio at which a business or person is taxed. The tax rate that is applied to an individual's or corporation's income is determined by tax laws of the country and can be influenced by many factors such as income level, type of income, and so on. There are several methods used to present a tax rate: statutory, average, marginal, flat, and effective. These rates can also be presented using different definitions applied to a tax base: inclusive and exclusive.
In the United Kingdom, taxation may involve payments to at least three different levels of government: central government, devolved governments and local government. Central government revenues come primarily from income tax, National Insurance contributions, value added tax, corporation tax and fuel duty. Local government revenues come primarily from grants from central government funds, business rates in England, Council Tax and increasingly from fees and charges such as those for on-street parking. In the fiscal year 2023–24, total government revenue was forecast to be £1,139.1 billion, or 40.9 per cent of GDP, with income taxes and National Insurance contributions standing at around £470 billion.
Haig–Simons income or Schanz–Haig–Simons income is an income measure used by public finance economists to analyze economic well-being which defines income as consumption plus change in net worth. It is represented by the mathematical formula:
Although the actual definitions vary between jurisdictions, in general, a direct tax is a tax imposed upon a person or property as distinct from a tax imposed upon a transaction, which is described as an indirect tax. There is a distinction between direct and indirect taxes depending on whether the tax payer is the actual taxpayer or if the amount of tax is supported by a third party, usually a client. The term may be used in economic and political analyses, but does not itself have any legal implications except in the United States of America, where the term has special constitutional significance because of two provisions in the U.S. Constitution that any direct taxes imposed by the national government be apportioned among the states on the basis of population; and in the European Union, where direct taxation remains the sole responsibility of member states.
An indirect tax is a tax that is levied upon goods and services before they reach the customer who ultimately pays the indirect tax as a part of market price of the good or service purchased. Alternatively, if the entity who pays taxes to the tax collecting authority does not suffer a corresponding reduction in income, i.e., the effect and tax incidence are not on the same entity meaning that tax can be shifted or passed on, then the tax is indirect.
A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The amount of the tax is in proportion to the amount subject to taxation. "Proportional" describes a distribution effect on income or expenditure, referring to the way the rate remains consistent, where the marginal tax rate is equal to the average tax rate.
In France, taxation is determined by the yearly budget vote by the French Parliament, which determines which kinds of taxes can be levied and which rates can be applied.
The tax system of the Russian Federation is a complex of relationships between fiscal authorities and taxpayers in the field of all existing taxes and fees. It implies continuous communication of all its members and related objects: payers; legislative framework; oversight authorities; types of mandatory payments. The Russian Tax Code is the primary tax law for the Russian Federation. The Code was created, adopted and implemented in three stages.
The Fair Tax Act is a bill in the United States Congress for changing tax laws to replace the Internal Revenue Service (IRS) and all federal income taxes, payroll taxes, corporate taxes, capital gains taxes, gift taxes, and estate taxes with a national retail sales tax, to be levied once at the point of purchase on all new goods and services. The proposal also calls for a monthly payment to households of citizens and legal resident aliens as an advance rebate of tax on purchases up to the poverty level.
The Fair Tax Act is a bill in the United States Congress for changing tax laws to replace the Internal Revenue Service (IRS) and all federal income taxes, payroll taxes, corporate taxes, capital gains taxes, gift taxes, and estate taxes with a national retail sales tax, to be levied once at the point of purchase on all new goods and services. The proposal also calls for a monthly payment to households of citizens and legal resident aliens as an advance rebate of tax on purchases up to the poverty level. The impact of the FairTax on the distribution of the tax burden is a point of dispute. The plan's supporters argue that it would decrease tax burdens, broaden the tax base, be progressive, increase purchasing power, and tax wealth, while opponents argue that a national sales tax would be inherently regressive and would decrease tax burdens paid by high-income individuals.
Goods and Services Tax (GST) in Singapore is a value added tax (VAT) of 9% levied on import of goods, as well as most supplies of goods and services. Exemptions are given for the sales and leases of residential properties, importation and local supply of investment precious metals and most financial services. Export of goods and international services are zero-rated. GST is also absorbed by the government for public healthcare services, such as at public hospitals and polyclinics.
Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints. The social welfare function used is typically a function of individuals' utilities, most commonly some form of utilitarian function, so the tax system is chosen to maximise the aggregate of individual utilities. Tax revenue is required to fund the provision of public goods and other government services, as well as for redistribution from rich to poor individuals. However, most taxes distort individual behavior, because the activity that is taxed becomes relatively less desirable; for instance, taxes on labour income reduce the incentive to work. The optimization problem involves minimizing the distortions caused by taxation, while achieving desired levels of redistribution and revenue. Some taxes are thought to be less distorting, such as lump-sum taxes and Pigouvian taxes, where the market consumption of a good is inefficient, and a tax brings consumption closer to the efficient level.
Taxation in Norway is levied by the central government, the county municipality and the municipality. In 2012 the total tax revenue was 42.2% of the gross domestic product (GDP). Many direct and indirect taxes exist. The most important taxes – in terms of revenue – are VAT, income tax in the petroleum sector, employers' social security contributions and tax on "ordinary income" for persons. Most direct taxes are collected by the Norwegian Tax Administration and most indirect taxes are collected by the Norwegian Customs and Excise Authorities.
A value-added tax is a consumption tax that is levied on the value added at each stage of a product's production and distribution. VAT is similar to, and is often compared with, a sales tax. VAT is an indirect tax, because the consumer who ultimately bears the burden of the tax is not the entity that pays it. Specific goods and services are typically exempted in various jurisdictions.
