Consumption tax

What are the significant effects of tax reform - Consumption tax?


Nowadays, tax reform is a favor approach to broaden the tax base. According to Robert (2002), “Broadening the base means ridding the tax code of the special deductions, credits, exemptions, and allowances that currently shield about half of all income from federal income tax. ”(p.1). During in tough economic times, it can be difficult to save money; especially saving is diminished through taxes on capital gains and interest. Consumption tax is a tax on spending on goods and services. It can take various forms, such as sales tax, flat tax and value added tax (VAT). They represent a major source of revenue in form of indirect tax. Someone loves it, someone fears. In this research, we intend to study the impact of taxation on economic efficiency, labour and saving.

Thoughts on the Consumption

People are encouraged to shift their behavior if tax cut. When you are saving and not obstructed by taxes, people would like to spend more. A better alternative would be a progressive consumption tax. Many economists believe that consumption tax is better than income tax and easier to administer.

Tax cut makes macroeconomic sense. Tax reform can use the extra revenues from the larger base to reduce tax rates. As consumption tax is regressive on income, exemption and tax free on saving can make it more progressive. John (1995) concluded that economists have long recognized that taxing wages discourages work and taxing capital income discourages saving. (p.20).

Effect of Tax Reform on Saving

The economists concern on saving because saving provides resources for domestic capital formation, and hence raises labour productivity and standard of living. According to Edmund (2005), "Many economists believe that a consumption tax would be best from the perspective of promoting economic growth - particularly if one were designing a system from scratch - because a consumption tax is likely to favor saving and capital formation," (p.1). Why would saving increase if tax on consumption? Eliminating taxes on the saving, they would reduce future consumption compared with the current consumption. With the neutral revenue from the reform, the tax rate would become higher. Garner &Merfeld (1987) stated that cuts in marginal tax rates are an effective way to stimulate domestic person saving. (p.12). As a result, peoples would like to save more for the future. Saving encourages investment and investment causes growth.

Effect of Tax Reform on Labour

Labour supply would also be reduced, especially in the early years during transition. With the marginal tax rate, directly reduce the after tax wages and hence reduce the cost of leisure. Finally, people would have less incentive to increase income and be encouraged to work less. In such situation, tax reform lead to decrease in the supply of labour. In contrast, if tax preferences eliminated during reform, the tax base would be broaden and tax rate on labour would then be reduced.

Besides, some labor force participants are more likely to experience unemployment due to economy adjusts. The Congress of the United States Congressional Budget Office (1997) stated that the reallocation of resources to capital intensive production may well lead to the permanent displacement of certain types of workers. (p.30). For example, displacement can occur if industries use labours who have prized skills from those used in shrinking industries. According to Gilbert (1998), “labor supply effects can occur in other dimension human capital investment, effort, retirement, nonwage compensation” . (p.401). And, productivity and wages would also be affected. Dale & Peter (1997) stated GDP would increase in first year relative to the case and decline to a long run level almost identical to the initial value. (p.15). Most economists believe that wages would be reduced and might cause many workers to leave their job as resistant to have wage cut.

Effect of Tax Reform on Economic

Eventually, increased economic efficiency and growth must be the goal of consumption tax. Either income or consumption is being taxed is irrelevant to the amount output of a tax system - money. However, it altered the spending habits and the balance between income and consumption. People would not prefer saving rather than consumption if their income taxed. Moreover, tax burden on current assets because the assets accumulated in the past would have consumption tax on. Thus, purchasing power would suffer and the value of the assets would be become lower than before. Alan (2005) stated that consumption tax could raise the capital stock and real output per person over the long run with respect to economic efficiency. (p.24). In view of investment, it might increase the capital stock and hence increase the size of the economy. The most important effect of consumption tax is to reduce the value of existing capital relative to new capital. It would hurt the richer who own much of this capital. However, tax on existing assets helps lower the tax rate.


The degree to which there are economic outputs and welfare improvement s following tax reform depends on the responsiveness of saving to the change in the tax system. Tax on consumption would tend to have a greater impact on lower income households than income tax does.The main downside is that consumption tax is a greater burden for the poor. It would hurt the poor more than the rich. Although it can be have some exemption or rebate to the low income peoples, they spend a relatively high amount of their income. Over period of time with a high rate of economic growth, it would improve everyone's standard of living, rich as well as poor.

Consumption taxes are more conducive to economic growth than are taxes on the return to savings or source-based capital taxes. Replacing the income tax with consumption based tax would greatly simplify the tax collection process. In other words, the decline in consumption spending would slow the economy down. With lower marginal tax rates would increase employment. Labour force participation is related to a different tax rate than hours worked.


The effects of tax reform on the economy are unpredictable. The increase in long run output depends importantly on the comprehensiveness of the tax base and the extent of the tax rate. Replacing income tax system with comprehensive consumption tax may lead to increase economic efficiency. Under consumption tax, reduction in cost of capital should lead to an increase in investment. This makes the capital flows as this is an efficient way to increase tax revenue in global economy. Interest rates would also be lower. In addition, consumption tax would encourage saving in the long run. And consumption tax could cause the supply of labour to increase or decrease, depending on the substance of the reduction in marginal tax rate. And in long run, consumption tax could increase the Gross Domestic Product (GDP).

Reference List

Auerbach, Alan J (2005, August). A Consumption Tax. The Wall Street Journal. Retrieved Jan 21, 2010, from

C. Alan Garner (2005). Consumption Taxes: Macroeconomic Effects and Policy Issue Retrieved February 1, 2010, from

Dale W. Jorgenson & Peter J. Wilcoxen (January 1997). The Effects Fundamental Tax Reform and the Feasibility of Dynamic Revenue Estimation. Retrieved Jan 29, 2010, from

Edmund L. Andrews (2005, March). Fed's Chief Gives Consumption Tax Cautious Backing. Retrieved Jan 21, 2010, from

Garner, C. Alan,&Merfeld, Thomas J..(1987). Tax Reform and Personal Saving. Economic Review - Federal Reserve Bank of Kansas City,72(2),8.

Retrieved February 1, 2010, from ABI/INFORM Research. (Document ID:394871).

Gilbert E Metcalf. (1998). Economic Effects of Fundamental Tax Reform. National Tax

Journal,51(2),399-404. Retrieved February 1, 2010, from ABI/INFORM Research. (Document ID:30091829).

John E. Golob (1995). How Would Tax Reform Affect Financial Markets? Retrieved Jan 21, 2010, from

Robert Shapiro (2002, November). The Flat Tax, Flat-Lined. Retrieved Jan 20, 2010, from

The Congress of the United States Congressional Budget Office (1997, July). The Economic effects of comprehensive tax reform. Retrieved Jan 28, 2010, from

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