Question

In: Economics

Suppose the government of Mascolia is considering replacing its income tax system with a consumption tax....

Suppose the government of Mascolia is considering replacing its income tax system with a consumption tax. Assume that the government's revenue requirement would be the same under either system.

(a) How would the base of a consumption tax compare with the base of an income tax? Does this have implications for the magnitude of the tax rate on consumption versus the magnitude of the tax rate on income? Explain.
(b) Compare the income tax and consumption tax in terms of vertical equity, assuming that both tax all people at the same rate (for example, a 20% tax on income and a 20% sales tax).

Solutions

Expert Solution

a) The base of the consumption tax will always be greater than the base of the income tax. This is because, all the people do not pay income tax, by way of tax evasion, exemptions, etc. However, when there is a consumption tax, everyone has to pay the tax as they will have to consume one good or the other and hence, then they have to pay the tax. So, if the government wants to maximise the tax revenues, it should replace the income tax with a consumption tax. However, the tax rate of the consumption tax has to be lower since all the people are paying the tax. If the tax rate on consumption is high then the poor people wouldnt be able to afford it. So, the tax revenues will be a net effect of the increase in tax base and decrease in tax rates.

2. Assuming, both income tax and consumption tax are at 20%, the income tax has vertical equity while the consumption tax does not have vertical equity. Vertical equity means that as the income of a person increases, the tax he has to pay also increases. In the case of income tax, as incomme increases, the tax payer pays more and more tax as it is a proportion of his income. However, in the case of a consumption tax, the tax for all is fixed as it is based on the price of the product and has nothing to do with taxpayer's income. Hence there is no vertical equity in the case of consumption tax.


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