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As we have seen in our study of human progress, technological advancements have brought humanity unprecedented wealth. By default, however, this “bounty” tends to be distributed disproportionally, a trend that will likely worsen in the coming years. While not a problem in itself, we know that if the economic system is allowed to become extractive, future growth is threatened. Taxation is core to this discussion but the balance is delicate. Can we raise revenue for vital public functions and uplifting public services without suffocating the engines of wealth creation? I believe the answer is yes.
Wealth Taxation
As the distribution of wealth between capital owners and the laborers they employ elongates, many are clamoring for higher income, corporate income, and wealth taxes to correct the balance. Yet, there is almost an inverse relationship between tax policy popularity and what is ultimately best for them. I am here to convince you that the better approach to achieving this, counterintuitively, is to tax everyone’s consumption instead. Before we begin, you should know that I did not set out to arrive at this conclusion. This essay was written and rewritten five times; the conclusion I present here comes from evaluating the evidence and theory, not from trying to make any specific argument.
On the surface, if the goal is to level wealth distribution, a “wealth tax” sounds intuitive. Those with more wealth (capital) can “afford” to have a small portion siphoned away for redistribution. A “wealth tax” is a broad term describing a set of possible policies such as taxing “unrealized gains,” or the value of shares in companies that have not yet been sold or “realized.” It may include taxes on property, like yachts, mansions, artwork, and jewelry. The problem with all wealth taxes is that they are difficult to administer, requiring mountains of paperwork and armies of agents tracking down jewelry, artwork, and other property stored around the globe. There is also the challenge of valuation, how do we value a particular work of art or jewelry, especially when that value changes from one month to the next? Capital is highly elastic and therefore tax evasion, is relatively easy. For this reason, wealth taxes generally raise very little revenue at a very high cost. Most countries that had a wealth tax have since abandoned the concept.
Perhaps you agree that a wealth tax is not the way to go. Instead, we could raise the corporate and personal income tax rates to collect wealth from high earners. The problems here are many. Corporate income taxes will tend to be shifted downward onto the employees who work at those corporations. Much of the tax incidence (the burden) is ultimately shouldered by labor anyway, who also have to pay personal income tax. Alternatively, we could raise income taxes on high earners, such as people making $400k+ a year, but again the trade-offs here are problematic. First, high-income taxes on this cohort will mostly miss the “capital” owners, the multimillionaires and billionaires that reap the benefits of wealth elongation. Second, it depresses earning and saving incentives, making all of us poorer.
Consumption Taxes
We ultimately use our earnings in two ways: savings or consumption. While it may be “intuitive” to believe that consumption is what drives economic growth, the reality is more complex.
described it this way:…long-run economic growth isn't determined by how much we consume or by aggregate demand more broadly. Rather, it's constrained by our economy's productive capacity—what economists call long-run aggregate supply. Simply consuming more doesn't expand this capacity. What does expand it is saving and investment in new capital formation, which increases what our economy can produce in the future.
In other words, savings/investments drive growth by providing the capital needed for future expansion. Most of the wealth of billionaires and millionaires is kept in these productive assets, not yachts or property. This is why a wealth tax fails or, if it succeeds, is counterproductive. By the same token, when we tax corporate and personal incomes, we tax away money that would have been used for savings and investment. Money that would have been recycled into the economy for the benefit of all. We are better served devising a tax that targets consumption only and exempts savings. For this reason, “consumption” taxes have long been considered more “optimal” by economists.
Consumption taxes are exactly what they sound like; levies on things people buy. Most economists prefer consumption to income taxes because, by default, they exempt the taxation of savings/investments, and minimize economic distortions, with minimal work disincentives. Consumption taxes come in three primary flavors, excise, sales, and VAT. Excise taxes are levied on specific goods, such as cigarettes or sugar-sweetened beverages, often intended to counteract negative externalities. On the other hand, sales and VAT, are broad-based levies on goods and services.
A key advantage of consumption taxes is that they exempt the “normal” returns to capital. In other words, they target profits larger than necessary for a firm to remain in business. In a perfect market with perfect competition, such returns are only temporary. But because markets are imperfect, these “supernormal returns,” called “rents” in economic parlance, are a great tax base. Supernormal returns emerge when companies enjoy unusual market power or other non-reproducible advantages. This can include rents derived from natural monopolies, government lobbying, industry concentration, and other market inefficiencies and imperfections. Wealthy individuals receive a larger proportion of their wealth through these supernormal returns, thus a consumption tax is better targeted, and because the “normal” returns to capital are exempt, they are more conducive to overall economic growth.
Consumption taxes are much easier to administer than wealth taxes and can capture activities that otherwise might escape scrutiny. Take the “borrow-and-die” strategy, whereby wealthy individuals borrow against appreciating property, paying no income tax, and dying before incurring any tax liability. A consumption tax catches the fruits of this gain. Consumption taxes reduce the value of wealth, just as a wealth tax does, but do not disincentivize savings and investments, thereby having minimal impact on growth. Consumption taxes achieve the general aims of a wealth tax without the baggage. Imagine three wealthy individuals; one investing in companies that create jobs, one doing philanthropy, and another living a hedonic lifestyle of yachts, mansion parties, and private jets. Most would agree the latter should be taxed more than the former; this is precisely what a consumption tax does!
This will become more important soon as the nature of the economic system evolves. A new paper by Vincent Glode and Guillermo Ordoñez suggests that the growing wealth “spread” created by new technology is incentivizing economic actors to “appropriate” rivals’ surpluses instead of generating their own. They use the example of High-Frequency Traders (HFTs) who utilize technology to “electronically front run” institutional investors on the stock market for profit. HFTs generate profits but no social surplus…nothing of any benefit to humanity. The rise of “appropriation” over “surplus generating” activities may help explain slowing economic growth in recent decades and the apparent reduced sensitivity of growth to technological progress. Proper tax design can, partially, restore the balance by capturing those gains when they’re consumed.
Implementing a Consumption Tax
There is more than one way to tax consumption. One rather unusual approach is the clunkily-named DBFCT, or Destination-Based Cash Flow Tax which is seen as a replacement for the corporate income tax even though it is functionally similar to a VAT. The DBCFT targets business/corporate “cash flow,” the total revenue coming into a company less the immediate and complete deduction of total expenses, including wages, the costs of purchasing long-term assets, and the cost of research and development. Under the current corporate tax, these expenses are often not immediately deductible. Taxing cash flow exempts normal returns to capital, in essence, the government becomes a non-voting equity partner (shareholder) in the venture, giving the company part of the capital it needs upfront, in hopes of future profits and tax revenue.
For example, take a company that makes $1000 of taxable income. Taxed at 50 percent, it will owe $500 to the government. If that company invests $200 to build a second factory, it can take that $200 as an immediate deduction, leaving $800 of taxable income. Thus, the company now owes $400, not $500, a reduced tax burden in reward for job creation. Nothing would have been different had the government collected the full $500 first and mailed a check of $100 to fund the new factory. In essence, the government paid for 50 percent of the new facility, and in exchange, it hoped that the second factory would be profitable and lead to greater tax revenues in the future.
The DB of the DBCFT acronym means that the tax is “destination-based.” Currently, the US tax code is origin-based and attempts to tax the business activity of American companies worldwide. This creates immense confusion as companies abroad typically also have to pay taxes to foreign governments. It’s sometimes unclear how much tax is owed and to whom; this may lead to double taxation. Thus, the current tax code incentivizes American companies to incorporate in “tax havens” and hide their assets from the US government. A destination-based tax code solves this by only taxing business activity within the United States. A DBCFT would tax profits from importing goods, but not exports or activity abroad, which would be deducted. Some have incorrectly compared this to a tariff. The DBCFT is not a tariff, it merely levels the playing field by taxing profits derived from imports and domestic production equally.
For projects that earn economic rents, becoming an equity partner is a valuable proposition. The government can raise enough revenue to cover its initial “investment” as well as capture some future returns. It does this without discouraging or distorting investment decisions because taxing supernormal profits does not disincentivize investment in the first place. Instead of “confiscating wealth” the government becomes a partner, sharing in both the upside and downside risk. For example, if a startup invests $1000 into R&D whilst having no revenue, the government will still apply the 50 percent tax ($0), and carry over the loss where it can be deducted from future profits.
A DBCFT would apply to all businesses, including “pass-through” entities like LLCs, simplifying and equalizing their tax treatment. Ultimately, the amount of revenue that could be raised would be determined by the tax rate, but since we are taxing economic rents, the rate could be higher than the current CIT. The problem is that the higher the rate, the greater the risk that the tax depresses the incentive to innovate. After all, one of those “supernormal returns” are fruits of innovation and new ideas. We want innovators to collect those rents because this encourages more innovation. If we tax away the gains, we risk deterring the “social supercomputer” from…solving problems. For that reason, I fear that the DBCFT may not raise enough revenue on its own. It may make sense to go one step further and implement a full VAT instead.
Enter the VAT
A VAT is a consumption tax and operates much like your standard sales tax. It differs, however, in that the tax is collected at each stage in a product or service’s lifecycle, from production to consumption, rather than only at a final sale. This gives the VAT some key advantages over a sales tax. To understand how VAT works, imagine a chair manufactured and sold subject to a 10 percent VAT. The lumber company sells the raw material to a manufacturer for $100, which becomes a purchase price of $110 including VAT. The $10 tax is remitted to the government. The manufacturer then fashions the lumber into a chair, selling it to a retailer for $300, which becomes $330 with VAT. Instead of remitting the full $30 tax to the government, the manufacturer can deduct the $10 tax they already paid, remitting $20 to the government. The retailer then sells the product to the end consumer for $500, or $550 with VAT. The retailer remits $20 to the government, the total tax collected less the $30 they already paid when they purchased the chair from the manufacturer.
VAT is superior to sales tax because it avoids “tax pyramiding,” when products are taxed multiple times before they are sold. This cannot happen with a VAT due to its deduction mechanism. In addition, the desire of each party at every stage of production to obtain that deduction makes the VAT largely self-enforcing. This has the added benefit of making it easier and cheaper to collect and much more difficult to evade than a sales tax. In addition, compared with income tax, VAT has proven to be a more stable and reliable source of revenue. Corporate and household incomes can fluctuate wildly from year to year, but consumption fluctuations are much more muted. The VAT, therefore, can generate huge sums of revenue. In the average OECD country, about 1/3 of government revenue comes from VAT alone.
Detractors will counter that the VAT has one significant weakness: regressivity. Low-income individuals spend proportionally more of their earnings on goods and services with less left over for savings and investment. Consequently, the VAT appears to have the greatest proportional impact on those with the least financial resources. But this isn’t quite correct. When evaluating the VAT in the near term, it appears regressive because wealthy individuals invest/save a greater proportion of their income. Over a lifetime, however, those savings will ultimately be consumed, thus incurring the VAT like everyone else. Studies have found that the VAT burden is ultimately roughly proportional. Of course, there is a “time value of money” argument we should consider here too, so perhaps we do need to address this concern more directly.
A Better VAT
To counter the VAT’s perceived regressivity, many governments lower the rate or exempt certain goods and services, such as groceries, education, and healthcare. Exemptions and varying rates, however, create administrative complexities and economic distortions. These are so problematic that VAT’s inventor, Maurice Laure, described them as a “cancer.” When designing a VAT, we best resist the urge to do this. Instead, we should look to broaden the tax base as wide as possible, including business sectors previously considered too complex to tax, namely financial transactions and housing. We could, for example, levy VAT on the spread between lending and borrowing interest rates, the implicit charge for financial services provided by banks. Similar levies could be used in insurance and other financial services.
A single, broadly applied, low tax rate, has the advantage of improved simplicity, equivalent revenue, reduced economic distortions, and reduced deadweight loss. As I previously discussed, deadweight loss is a function of the square of the tax rate; doubling the rate quadruples the loss. Therefore, keeping the rate as low as possible is advantageous for everyone. Granted, many will remain unconvinced, holding that the apparent regressivity of VAT remains a deal breaker. Some tax designs, like the FairTax proposal, address this by offering a “prebate.” Essentially, this “prebate” is a check given to every household at the beginning of the month that roughly equates to the value of taxes that will be paid on essentials. Other schemes, like the “X-Tax” try to solve this problem by splitting the VAT in two; a “cash flow tax” (much like the DBCFT) on businesses and a separate income tax on households. This sounds like an “income” tax but is really a consumption levy and allows for graduated (progressive) rates on income.
That said, our goal should be to design policies that are as simple as possible and to eliminate all redundancies. In my opinion, therefore, the X-Tax and FairTax designs, while superior to the status quo, become needlessly complex as they try to solve a problem that isn’t there. So long as VAT revenue is used for social good, to fund “progressive” policies that uplift people, any perceived regressivity is a non-issue. In what is known as “progressive revenue recycling,” we could, for example, designate VAT funds for a universal healthcare scheme or universal education vouchers. Designed correctly, VAT becomes a near-perfect instrument of policy, especially when used to replace payroll, corporate, and income taxes that depress growth. A 15 percent VAT on all goods and services would generate substantial revenue alongside LVT, aiding our goal of building a pro-growth and inclusive economy.
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J.K., your article does a good job of touching a lot of bases in the economic theory of taxation. Sadly enough, I must push back on some of the conclusions you reach.
Full disclosure: I am a member of the pro bono advisory board for FairTax.org, the main organization responsible for creating, researching, and promoting H.R. 25 The Fair Tax Act, which is a bill introduced into every Congress since 1999. https://www.congress.gov/bill/118th-congress/house-bill/25.
All who have interest in efficient, fair taxation that promotes economic growth can easily learn why the FairTax offers the best way to finance our federal government by visiting this link: https://fairtax.org/articles/the-chairmans-report-january-24th-2025.
The ONLY reasonable complaint about a national retail sales tax to replace ALL OTHER SOURCES OF FEDERAL REVENUE is the allegation that a sales tax is regressive. The FairTax, as proposed by H.R. 25 is NOT regressive. Period. In fact, it is progressive. That's the top, bottom, and both sides of it.
So why don't we just put that red herring to bed and learn about the exceptional benefits of repealing the 16th Amendment to get rid of income taxation forever, replacing tens of thousands of pages of the U.S. Tax Code with H.R. 25, a bill you can read this afternoon in its entirety?
You are correct, J.K.; nearly all professional economists who specialize in public finance agree that tax on the base of consumption spending is best. Good job outta' you for knowing and publicizing that fact.
I invite anyone who has questions about why the FairTax is the best consumption tax to send them to me in a note on the 'stack: @davidlkendall. Answer I will.
Fair tax or VAT. Either would be better than what we have. As for regressivity, we've got to be able to explain to taxpayers of limited means that there is a price to pay. However, they should be willing to accept something akin to $50 worth of benefits for every $20 they pay. I'd take that deal all day long. We haven't marketed tax changes well at all.