Is Consumption Tax Desirable?

Whether the increase of consumption tax is needed is now one of the hottest debates in the Diet. It is said that the system of social welfare is at present unsustainable due to increasing elder retired people and decreasing younger working people. That is, the public expenditure for medical care for the elder is increasing whereas the tax revenue from the workers is decreasing. So more tax revenue is needed to maintain the social welfare.

To finance the medical care for increasing aged people, some politicians advocate the high rate of consumption tax. Others oppose the policymakers increasing tax on consumption on account of its countereffect on the aggregate demand of the economy. What is the impact of consumption tax on the economy? This question seems to be very empirical and is just a controversial topic in the field of economic policy.

N.Gregory Mankiw, a prolific Harvard economics professor and my favorite economist, mentioned the effect of consumption tax in his blog;

Ideally, I would use consumption, rather than income, as the tax base for purposes of raising revenue and redistribution. The benefit of consumption taxes over income taxes is that they do not distort the intertemporal allocation of consumption.

The bottom line is the "intertemporal allocation of consumption". What does it mean? Mankiw told us what it does. Here's the excerpt:

If we are looking at the decision to work today in order to consume today, consumption and income taxes have similar effects. Both discourage work effort.

Consider, however, another margin of adjustment: Work today in order to save (consume in the future). So under a consumption tax, there is a greater incentive to work and save today in order to consume in the future.

Let W be the real wage(the wage in terms of goods or leisure), r be the (real) interest rate, and t be the tax rate.

Suppose I work today in order to save and consume in 1 year. Under an income tax, the amount of consumption I get for one hour of work is:

(1-t)W×[1+(1-t)r] .....(1)

Under a consumption tax, the amount of consumption I get is:

(1-t)W×[1+r] .....(2)

Now compare these after-tax relative prices to the before-tax relative price.

And suppose I work today in order to save and consume in 2 years. Under an income tax, the amount of consumption I get for one hour of work is:

(1-t)W×［1+(1-t)r］×［1+(1-t)r］ .....(3)

Under a consumption tax, the amount of consumption I get is:

(1-t)W×［1+r］×［1+r］ .....(4)

You can see that the consumption tax creates a constant gap: the after-tax relative price is 1-t times the before-tax relative price, regardless of years. However, an income tax creates a growing gap. As years go by, it becomes greater between the before-tax and after-tax relative price.

In other words, a consumption tax taxes current and future consumption at the same rate, whereas an income tax in effect taxes future consumption at a higher rate than current consumption.The bottom line: Both consumption taxes and income taxes discourage work, but income taxes discourage saving(future consumption) as well.

In sum, increasing a consumption tax discourages working and doesn't discourage saving. Higher rate of income tax discourages both working and saving. That is, an increase in a consumption tax gives no influence on future consumption and its utility, but a rise in a rate of income tax influences both future consumption and its welfare negatively. In the viewpoint of macroeconomics, increasing an income tax affects saving and then capital accumulation inversely. And so it affects the growth of economy and the standard of living and the welfare of future generations negatively.