When discussions about tax fairness arise, the spotlight often falls on income. Debates center around how much the wealthy earn, the degree to which their income should be taxed, and strategies to protect lower earners. However, an older concept is quietly resurfacing: what if we taxed what people spend rather than what they earn?
This idea, known as a progressive consumption tax, represents more than a mere technical adjustment. It proposes that individuals who spend more face higher effective tax rates, which can function quite differently from traditional progressive income taxes. According to economic research co-authored by myself and fellow researcher Carlos da Costa, based on life-cycle behavior, the implications of such a shift could be substantial.
Understanding the Differences: Income vs. Consumption Taxation
At first glance, the concepts of taxing income and taxing consumption may appear similar. Consider an individual earning £40,000 and spending £30,000; taxing either amount could ostensibly generate comparable revenue. However, people do not live financially isolated from year to year. Their earnings fluctuate significantly throughout their lives, often earning less in the early stages of their careers and more in later years, while saving during prosperous times to stabilize spending during leaner periods.
This fundamental aspect of real life underscores the significance of choosing between taxing income or consumption. Progressive income taxes increase the marginal tax rate as earnings rise, aiming to redistribute income towards lower earners. Yet, this system inadvertently discourages individuals from working more during their most productive years due to the heavy taxation of additional earnings.
“When many individuals make these choices simultaneously, the entire economy faces reduced investment, lower productivity, and slower wage growth. These long-term effects, though invisible in year-to-year statistics, are crucial for overall prosperity.”
The Benefits of a Progressive Consumption Tax
A progressive consumption tax adopts a different approach by not penalizing individuals for earning more in a particular year. Instead, it taxes people based on their overall spending. For example, someone earning £70,000 but saving £25,000 would incur a lower tax bill than someone earning £50,000 and spending it all.
This system incentivizes saving during high-earning years. While increased saving might seem counterintuitive to economic growth, it ultimately fosters the opposite effect. Savings provide the capital businesses need to invest in new technologies, equipment, and expansion, which over time enhances productivity and drives up wages. This mechanism is especially crucial for lower-income households, who primarily rely on earnings rather than capital income or investment returns.
“Switching from progressive income taxation to progressive consumption taxation could potentially raise living standards by approximately 10%, as rising wages and financial stability protect families from income fluctuations.”
Addressing Concerns and Implementing Reforms
A common concern is that consumption taxes are inherently regressive, disproportionately affecting low-income households who spend most of their income. However, progressivity can be integrated into a consumption-based system. Our research indicates that a progressive consumption tax can redistribute wealth as effectively as a progressive income tax, but with fewer growth-inhibiting distortions.
Designing a consumption-based tax system that is both fair and efficient is feasible and does not necessitate radical reform. Many benefits could be realized through practical, incremental changes, such as income averaging. Instead of taxing annual earnings in isolation, a consumption tax could be based on a multi-year average, reflecting a person’s spending habits over time.
This approach would utilize existing social security records, which already track individuals’ earnings over time. By calculating income averages across several years as a proxy for spending, governments could administer taxes through the current income tax system without creating new bureaucracies.
The Urgency of Tax Reform
Why does this matter now? Advanced economies face long-term pressures, including aging populations, rising fiscal demands, stagnant productivity, and ongoing debates about fair taxation that does not discourage work and investment. These challenges are unlikely to dissipate.
Rethinking not just the amount but the method of taxation offers a new path forward. While a system that taxes consumption rather than income is not a panacea, progressive consumption taxation deserves a more prominent place in public discourse as we strive to design a fair and prosperous tax system for the future.
