Question

uppose 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).

Answer 1

Answer,

(a) The tax base of a consumption tax would be smaller, because rather than taxing both consumption and savings, a consumption tax would tax only consumption. To make up for the smaller tax base, the government of Mascolia would have to tax consumption at a higher rate than it was taxing income to raise the same amount of revenue. (b) Vertical equity refers to equity between those with high incomes and those with lower incomes. Those with low to moderate incomes will probably spend all their income over their lifetime. However, rich people are much less likely to spend all their income over their lifetime and are more likely to leave large bequests. Consequently, under a consumption tax in which estates are not taxed, rich people may pay a smaller fraction of their total lifetime income in taxes than would poorer people. For that reason, the consumption tax may be less desirable than an income tax in terms of vertical equity.