Is Consumption Tax better than Income Tax?

Last updated on January 31, 2022

A “consumption tax” is a tax charged on goods and services whereas income tax is charged on income. Today, consumption tax sounds foreign, but before the passage of the 16th Amendment to the Constitution, taxes were levied primarily on consumption. It was only in 1913 that Congress was allowed to charge tax on income. The apprehension against income tax was that it could be abused by those in power.

Both consumption tax and income tax has limitations that can be exploited. The challenge is to counter those limitations and create a tax system that is fair to taxpayers and best for economic growth.

A major flaw of consumption tax is that poor and middle-income groups will be paying more taxes than the higher income groups. However, this problem can be countered by including additional features, such as exemptions for basic living necessities, and rebates and deductions on certain goods and services.

Income tax includes taxing of savings whereas consumption tax excludes taxing of savings. Under the income tax, all income is taxed including, interest, dividends, rent, or capital gains. Under the consumption tax, all goods and services are taxed.

Economists favor consumption tax over income tax because consumption tax increases savings and investment. People have more money to spend because their income is not taxed. That increases their purchasing power, but as taxes are charged on goods and services, it encourages savings, and increased savings result in more investment.

While Republican governors are weighing which tax system is better, especially in states with less revenue from income tax and more from sales tax, taxpayers must also be informed about the consumption tax and what it can achieve.