Consumption taxes reach a broader base than income taxes, including participants in black and grey market economies, illegal aliens, and tourists. A broader base means a lower consumption tax rate than the average outstanding income tax rate.
A consumption-based tax policy will reduce or eliminate filing, compliance assessments, and enforcement efforts. Taxpayers will have the option of pursuing the used goods loophole, though low and fixed income taxpayers will likely exercise that option most often. Taxpayers will recoup the time they now spend filing, possibly investing that time in starting a business or sweat equity in their house, or just enjoying their additional free time with friends and family. Taxpayers consequently also regain a large degree of financial privacy, currently sacrificed in the name of full disclosure and enforcement.
Corporations and people wealthy enough to manage their investments full time would no longer have to file income tax or even direct any effort at finding loopholes (because the loopholes would disappear along with the income tax), so they could focus their efforts on making money instead of avoiding taxes.
The secondary effect is perhaps more astounding. A corporate income tax policy, sets the after tax profit optimization goal closer to zero than it would be if consumption were taxed. Corporations use two mechanisms to compete for capital – dividends and growth in share price. If the corporation has all the capital it needs to execute the current tactical business plan, the need to attract capital is reduced, so reducing taxes increases in importance relative the need for capital. Now the corporate finance goal shifts toward tax minimization, away from profitability. Corporate income taxes thereby diffuse the profit objective.
In such an environment, lavish travel expenses for executives start making more economic sense because all of the money spent is above the taxable line at income tax time. People are principally driven by self-interest and corporate executives are undifferentiated from ordinary people in their motivations, though they do exercise control over expense policy. Where the two collide, you find corporation lavishing expense accounts on executives. The logic behind what looks like irrational corporate behavior makes perfect sense if you consider that the corporation’s travel expenses are above the income tax line, while similar expenses for an individual fall below the tax line. The logical optimization strategy is now to transfer as much of the personal travel and entertainment budget to the corporation.
If income tax disappeared and was replaced by consumption taxes, the tax advantage of shifting travel and entertainment expenses from individuals to corporations would be reduced to whose pocket the money was coming out of. Businesses would still have to grapple with what the acceptable expenses were, but it should be obvious that consumption taxes are revenue neutral to who is doing the consuming. Corporations that spend lavishly would pay more tax than those that are frugal, so consumption tax policy rewards economic efficiency, while income tax policy rewards profligate spending by setting the optimization goal at zero profitability (in the limiting case of complete indifference to attracting fresh capital).
So, how about that need to attract capital? What does that imply for growing companies (typically the ones that need fresh capital). Insufficient capital means a need to attract it, which means paying dividends or making a convincing case for share price growth. When you look at both cases, income tax is least avoidable by businesses that need capital and most avoidable by those that have plenty. Income tax therefore favors wealthy companies over ‘working class’ companies that need to grow share price and/or pay dividends in order to attract investors.
Legislators have attempted to eliminate ‘loopholes’, by excluding this and that type of expense in attempt to end around the tendency to optimize for zero taxes. Unfortunately, the end result is that the burden becomes ever more bifurcated, with higher marginal rates paid by companies who cannot escape the tax.
Consequently, the tendency is for income tax policy to place the heaviest economic burden on companies with the greatest need to attract capital. Need for capital stems from a desire for growth – income tax policy is therefore inimical to economic growth.
