The Phantom Line Between Consumption and Production

Matt Yglesias has some thoughts on the (complicated) virtues of a consumption tax:

The great egalitarian political philosopher John Rawls wrote that he preferred the idea of a consumption tax to an income tax “since it imposes a levy according to how much a person takes out of the common store of goods and not according to how much he contributes.”

The idea of a consumption tax sounds beautiful and, on the surface, it’s moral virtues are clear. The economic argument rests on the belief that such a tax promotes saving and investment which is, in the long-run, better.

Granted this is true, the argument behind such a tax still requires some work. And this is also assuming that the tax is implemented in a progressive fashion. Otherwise, there might be perverse consequences. Let’s think of value in a closed economy (or the world as whole). Economic output is, of course: Consumption (C) + Investment (I) + Government Purchases (G).

Let’s further divide this as: C + I + Government Consumption (GC) + Government Investment (GI). The lines here really aren’t clear, especially with things like education. When government subsidizes education there’s both consumption (“an end in and of itself”) as well as investment (“as a means to an end”).

There’s nothing inherently valuable about education, except its promise of increased future consumption. Consumption is the only activity from which we derive any value, we just hope that with solid investment our future consumption would compound exponentially against the nominal amount deferred. But herein lies the problem.

Rawls, in his argument of a consumption tax, thinks “it imposes a levy according to how much a person takes out of the common store of goods and not according to how much he contributes.” He makes the mistake of believing there is something ipso facto valuable about “contribution”. This is wrong. The value of production is predicated on consumption. There’s an artistic (if Marxist) sense in which there’s dignity and value in the process of contribution itself. (anyway, I would, impersonally, argue that this is a form of consumption).

Regardless, we measure contribution in terms of its dollar value, not by unit. Ten light-bulbs are not as valuable as two MacBooks. If I’m giving to society a useless good, I’m contributing nothing at all. Therefore, there’s nothing specifically “better” – in the moral sense he argues – about taxing outflow over inflow. Of course, the way his words are framed, one pictures a common pot from which people freely take, but any such consumption is financed only by earned value from previous contribution. So there’s also a cyclical sense in which the distinction between production and consumption is vague.

Scott Sumner has some nice remarks on this column here, but this bit caught by eye:

I absolutely do not assume the economy is at full employment when advocating consumption taxes.  And “financial saving” is a meaningless term, so I won’t comment on that.  Saving is saving; it is defined in all the textbooks as the funds that go into investment.

If you buy my argument that there’s nothing by the fact better about investment (only that it can increase future consumption more than the amount by which it defers present value, or that there are positive returns) then this will be tough to accept, without qualification. Vanishingly low interest rates imply that investors don’t believe there are many worthwhile interest rates. Which is why companies and rich people are sitting on piles of cash. If the rate of return is low, it would be better to employ the resources to finance present consumption, especially for the needy. Indeed, smart spending on roads or education would both direct these funds toward future returns, but also serve as valuable consumption today.

Taxing capital might serve a bad precedent (but why, then, are some people okay with inflation – just an implicit tax), but I think it could be valuable if constitutionally capped to a certain proportion of government revenue. Any serious disincentives to save would be mitigated by ensuring the tax only applies to extremely large levels of cash.

This would also incentivize corporations like Apple to find productive venues of investment, as savings would earn a negative return (above a very, very high level). This is inefficient in the classical sense that Apple is not investing because there are no good investments to make. But in times of recession, which is usually when individuals or corporations find themselves sitting on cash, it might be an effective way to spur employment. Edit: Sumner notes that I haven’t defined my terms very clearly. And because income equals output, savings and investment really are the same thing. When I talk about taxing capital I mean highly liquid assets, as are many corporate cash piles, incentivizing investment in riskier and less-liquid projects. Like a factory. Or huge R&D endeavor.

And, really, this is no different than the Fed aggressively using government mandate to keep interest rates down.

Don’t get me wrong, I think a consumption/payroll tax is a much better system than what we have today. America needs to save more, and not just in the economic sense. Larger savings provides a sense of security which would better allow us to tolerate frictional unemployment. It also has the huge benefit of being ridiculously simple. The real immorality of our income taxation, as anyone who’s met a tax lawyer knows, is its complexity.

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