GST as a neutral tax?

I was reading a quick little post on Econlog. In it they say that you should not tax income, you should tax consumption. Ergo we should remove income taxes and replace them with a higher rate of GST.

The main criticism I often hear about this is that GST is regressive. Now I used to spout that line as well, after all poor people have a lower marginal propensity to save then wealthy people, as a result they spend more of their income, and so more is taxed.

However, then I was told to think about it a different way. Over our lifecycle we should spend all our money, so that we are on the boundary of our budget constraint. As everyone spends all their income over their lifetime, GST must be a flat tax.

Now you could make GST a progressive tax by having a higher rate of tax on luxury items (although that distorts the market by changing the relative price of goods). As a result, changing from income taxes to GST seems to make sense, if you think it is more efficient.

In the above article they said that income=consumption+savings+charity. They said that savings and charity should not be taxed, and that is why we need a GST tax. Now, as we have said that savings become consumption over time, that doesn’t hold, and you can get tax rebates on charity. As a result, the only reason I can see to switch to an only GST tax will be if it is easier and cheaper to administer, and I seriously doubt that setting up a progressive GST schedule will be easy or cheap to administer.

Note: The labour market distortion still exists with a GST tax, since even though your disposable income is higher, the cost of everything is also high, so the real return for an hour worked is the same.

  • rauparaha

    Well, this ignores the effect of discounting on the NPV of future spending. Even without thinking about utility, the discount rate and interest rate on savings must be the same in order for the NPV of savers and non-savers (with identical wealth) to be equal. That doesn’t even take into account the behavioural results concerning hyperbolic discount rates and the likely difference between the utility functions of poor and rich people. I think this analysis makes a few more assumptions than I’d be comfortable with in order to justify a flat tax.

  • Matt Nolan

    I think the fundamental difference in our arguments here is what constitutes a flat tax.

    Now I think you are saying that a flat tax should ‘disadvantage everyone equally’, ergo the the dis-utility they suffer from the tax should be directly (and linearly) proportional to their income. However, if that is how we described a flat tax, then a ‘flat income tax’ would not we flat, as people have diminishing marginal utility.

    The way I see it a flat tax implies that people pay the same proportion of their income in tax. Now, whether you tax someone when they are payed, or when they are consuming shouldn’t matter, as over a persons lifecycle they exhaust their entire income on consumption. As a result, a flat GST tax works just like a flat income tax, over an individuals lifecycle.

    Now even if we thought their should be a flat tax (I’m sure neither of us do) one issue is, that if we scrap income tax now, and put in a flat GST, people who have saved are taxed twice.

  • rauparaha

    Sorry, I was quite unclear about what I meant. I was suggesting that a flat tax should mean that the monetary cost of the tax should be borne by everyone equally. We can tell that it is borne equally if the imposition of the tax on a previously untaxed, risk neutral person doesn’t cause them to change their behaviour. If the interest rate on savings is different from the discount rate that the person applies to future consumption then the imposition of the tax will change their behaviour.

    Certainly, the sum of lifetime tax paid will be the same but I wouldn’t consider that a good measure of whether a tax is ‘flat’ or not. Taking the possible variation in utility functions and risk aversion into account would complicate things beyond the scope of a blog post comment so I haven’t thought about that much.

  • Matt Nolan

    But, we have increased the persons income by x%, while also increasing the price of goods now and in the future by x%. Now a person will save until the MU of spending a dollar now is the same as the MU of saving the dollar and spending it in the future. As we have increased the persons income, but also increased the price of goods now and in the future by the same amount, then the individuals behaviour would not change.

    I do agree that if the person was currently a saver their would be a problem. In fact I thought my tone in the post was that it wasn’t a good idea in practice, however I can’t write properly so that probably didn’t happen.

    However, I do think, that for a person with no savings or borrowing, that believed that what ever tax arrangement was around would stay the same into the future, the switch of the tax from income to consumption would not change behaviour.

    With the utility function thing, I reckon it would be cool to look at optimal progressiveness, in a model with multiple agents with different utility functions. Getting labour supply into that could be pretty cool.

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