Consumption Taxes: An Overview

January 14, 2016 – January 24, 2023 R44342

Consumption Taxes: An Overview
January 24, 2023
Some argue that the current U.S. income tax code is overly complicated and unfair, restrains
economic growth, and is in need of reform. One option for tax reform would be to tax
Donald J. Marples
consumption instead of income, which would represent a fundamental change in how taxes are
Specialist in Public Finance
collected in the United States. In the 118th Congress, H.R. 25 would replace the current federal

income, payroll, and estate and gift tax systems with a national retail sales tax, often referred to
as a “fair tax.”

Within the current income tax structure, an individual’s tax liability is determined as a function of total income. Under a
consumption tax, however, an individual’s tax liability would be determined as a function of total expenditures on goods and
services. Consumption taxes can take many different forms—which differ in when the tax is collected, how the tax is
calculated, and who is responsible for remitting the tax—but they all share the common tax base of consumption. Common
consumption tax designs include a value added tax (VAT), a national sales tax (NST), and a flat tax.
Taxes are necessary for the government to raise revenue to provide necessary and desired goods and services. However, taxes
also tend to introduce distortions into a market economy and can hinder economic efficiency. Proponents of consumption
taxes argue that a broad-based consumption tax could replace the federal income tax, raising requisite revenue while
improving economic efficiency, and increasing economic output.
Broadly, taxes tend to distort individual decisions by altering price signals within the economy. Taxes can affect individual
behavior in a number of ways, including labor participation decisions, and saving and investment decisions. As discussed in
the report, the effects on labor supply from switching to a consumption tax are expected to be small, if any. However, there is
evidence that transitioning to a consumption tax may increase individual saving. Increased individual savings could
contribute to increased economic output.
Effects on the distribution of the tax burden are also often considered in tax policy debates. When comparing a hypothetical
pure consumption tax to a hypothetical pure income tax, consumption taxes place a greater tax burden on lower income
individuals. Additionally, in this stylized comparison, consumption taxes place a greater tax burden on younger and older
individuals, especially retired individuals drawing down their savings.
Congressional Research Service

Consumption Taxes: An Overview

Introduction
Fundamental tax reform is an oft-cited policy priority among legislators, and appeals for tax
reform seem to achieve broad support across political parties. The basis of this appeal may be
grounded in views that the current U.S. income tax code is overly complicated, unfair, a drag on
the economy, and in need of reform. Disagreements, however, often surface when discussing the
specifics of tax reform. Previous legislative debates have focused on changes to the current
income tax code, such as changing marginal income tax rates or altering how different types of
income are taxed. Although these debates reflect important policy considerations, they focus
largely on changes within the current income tax.
Alternative discussions around tax reform have suggested fundamentally altering the federal tax
base, shifting towards taxing consumption instead of income. Within the current income tax
structure, an individual’s tax liability is determined as a function of total income. With a
consumption tax, however, an individual’s tax liability would be determined by total expenditures
on goods and services. Income not spent on goods or services, or “savings,” would not be taxed.
Consumption taxes can take many different forms—which differ in when the tax is collected, how
the tax is calculated, and who is responsible for remitting the tax—but they all share the common
tax base of consumption. Common consumption tax designs include a value-added tax (VAT), a
national sales tax (NST), and a flat tax.
Consumption taxes are commonplace across the developed world. Among countries in the
Organisation for Economic Co-operation and Development (OECD), the United States is the only
country without a broad-based national-level consumption tax.1 However, many states have their
own consumption taxes in the form of sales taxes. In fact, the OECD encourages countries to shift
away from income taxes and towards consumption taxes.2 The European Union even requires its
member countries to implement a VAT.3 Many of these countries also include personal and
corporate income taxes alongside their VATs.
In the 118th Congress, H.R. 25 would replace the income tax, as well as other federal taxes (such
as corporate taxes and payroll taxes) with a national retail sales tax, often referred to as a “fair
tax.”
This report will provide a survey of consumption taxes and their basic structures, including the
VAT, the NST, and the flat tax. After an overview of these tax structures, the report will discuss
the effects of consumption taxes on economic efficiency, the distribution of the tax burden, and
tax administration.
Taxation Fundamentals
In order to provide goods and services, a government must raise revenue. Generally, there are
three tax bases from which governments can raise this revenue directly from individuals: income,
wages, and consumption. The United States implements taxes on all three of these bases. The first

1 Many of the excise taxes implemented by the U.S. government could be considered consumption taxes, but are not as
broadly applied as those in other OECD countries. Organisation for Economic Co-operation and Development
(OECD), Consumption Tax Trends 2022, November 2022, p. 14, https://www.oecd.org/tax/consumption-tax-trends-
19990979.htm.
2 OECD, Tax policies for inclusive growth in a changing world, July 2018, p. 15, https://www.oecd.org/g20/Tax-
policies-for-inclusive-growth-in-a-changing-world-OECD.pdf.
3 Ben Terra and Julie Kajus, A Guide to European VAT Directives 2021 (2021).
Congressional Research Service

1

link to page 8 Consumption Taxes: An Overview

tax base, income, includes all income from both labor and capital (e.g., wages and interest on
investments). In the United States, income is taxed through a federal income tax, which applies
differential tax rates on income from labor and capital. The second tax base, wages, includes all
income that results from labor. The payroll tax, which in part funds the Social Security program,
is a type of wage tax. The third tax base, consumption, includes all money spent on goods and
services. A number of narrow consumption taxes exist at the federal level, such as the gasoline
excise tax. Broader consumption taxes are popular at the state level in the form of sales taxes.
State sales taxes are a commonplace consumption tax in the United States. There are differences,
however, across states regarding the base to which state sales taxes are applied. For example,
many state sales taxes exempt certain necessities from their sales tax base, though the specifics
vary by state.4
A broad and comprehensive consumption tax could be applied to all money spent on goods and
services for final consumption. Examples of broader consumption taxes can be found in Europe,
where many countries implement national-level consumption taxes referred to as value-added
taxes (VATs). These taxes generally do not have as many exemptions as consumption taxes in the
United States, and therefore have a broader tax base. A broader tax base, other things equal,
allows more revenue to be collected with lower tax rates.
A consumption and income tax with broad bases can be similar depending on an individual’s
saving behavior. An individual who saves no money at all would experience no difference
between an income and a consumption tax. Without savings, consumption is equal to income. A
consumption tax distinguishes itself from an income tax when taxpayers save a portion of their
income. For example, under a consumption tax, a taxpayer who makes $100,000 and saves
$10,000 a year would only pay taxes on the $90,000 that was spent on goods and services.
However, under an income tax the same taxpayer would pay taxes on the full $100,000, whether
it was saved or spent.
Tax Inclusive vs. Tax Exclusive
Tax rates can be characterized in two different ways, tax-inclusive and tax-exclusive. A tax-exclusive rate
describes the amount of tax paid as a percentage of the pre-tax price of the good or service. Alternatively, a tax-
inclusive rate describes the amount of tax paid as a percentage of the post-tax price of the good or service. Most
sales tax rates are discussed in tax-exclusive rates, while income tax rates are often discussed in tax-inclusive
terms. For example, a $10 book subject to a 10% tax-exclusive rate would cost $11. The corresponding tax-
inclusive rate would be 9% ($1/$11).
Proponents of a consumption tax argue that by allowing savings to be carried forward tax-free,
taxpayers will choose to save more of their income. Economic theory suggests that with a higher
level of savings, the productivity of the economy could increase and improve living standards in
the long run if the savings are used to finance productive domestic investments. The potential
economic effects of switching from an income tax system to a consumption tax system are
discussed further below (see the “Alternative Tax Bases: Economic Considerations” section).
Alternative Consumption Tax Designs
Consumption taxes often differ in how they are implemented, but they all share a common tax
base. The implementation of consumption taxes can differ with respect to when the tax is

4 Nikki Nelson, “Sales tax exemptions exist in every state,” Wolters Kluwer, December 26, 2020,
https://www.wolterskluwer.com/en/expert-insights/sales-tax-exemptions-exist-in-every-state.
Congressional Research Service

2

Consumption Taxes: An Overview

collected, how the tax is calculated, and who is responsible for remitting the tax. Three common
consumption tax designs include (1) a value-added tax (VAT); (2) a national sales tax (NST),
sometimes referred to as a “fair tax”; and (3) a flat tax.
Value-Added Tax
The value added of a firm is the difference between a firm’s sales and a firm’s purchases from all
other firms. In other words, a firm’s value added is simply the amount of value that a firm
contributes to a good or service by applying its factors of production (land, labor, capital, and
entrepreneurial ability). A value-added tax is a tax levied at each stage of production on a firm’s
net value added.
There are three accounting methods to calculate and keep track of a VAT throughout the
production process. The credit-invoice method is the most popular accounting method for VATs.
Under the credit-invoice method, a firm would calculate and collect the VAT on its sales. Next,
the firm would compute its VAT liability by subtracting the VAT paid on its inputs from the VAT
collected on its sales, and remit the difference to the federal government to satisfy its tax liability.
Other accounting methods include the subtraction and addition method.5
How Does a VAT Work?
An example is often helpful to understand how a VAT would work in practice. In the il ustration below, a bakery
purchases ingredients from a supplier for $100. The bakery then produces bread, using the purchased raw
materials in combination with its other factors of production (land, labor, capital, and entrepreneurial ability), and
sells the bread to a grocery store for $250, increasing the value of the inputs by $150. The grocery store then
sells the bread for $350 at the retail level, increasing the value of the inputs by $100. Under the credit-invoice
method with a 10% VAT, the bulk supplier would col ect and remit $10 in taxes from the sale of the raw
ingredients to the bakery (10% of $100). The bakery would then col ect $25 when selling the bread to the grocery
store (10% of $250). The bakery remits $15 to the government after claiming a credit for the $10 in VAT paid to
the bulk supplier ($25 less the $10 credit). The grocery store would then col ect $35 dol ars when selling the
bread at the retail level (10% of $350). The grocery store remits $10 to the government after claiming a credit for
the $25 in VAT paid to the bakery ($35 less the $25 credit).

5 Under the subtraction method, the firm calculates its value added by subtracting its cost of taxed inputs from its sales.
Next, the firm determines its VAT liability by multiplying its value added by the VAT rate. Under the addition method,
the firm calculates its value added by adding all payments for untaxed inputs. The firm then multiplies its value added
by the VAT rate to calculate VAT to be remitted to the government.
Congressional Research Service

3

Consumption Taxes: An Overview

Figure 1. Illustration of How a VAT Works

Source: CRS.
VATs can differ in their tax treatment of capital purchases (plant and equipment). The consumption-
type VAT treats capital purchases the same way as the purchase of any other input, which excludes
all capital goods purchases from the tax base (i.e., it is equivalent to expensing under an income
tax). Two other types of VATs are the income VAT and the gross product VAT. Under an income-
type VAT, the VAT paid on the purchases of capital inputs is amortized (credited against the firm’s
VAT liability) over the expected life of the capital inputs. Under a gross product-type VAT, no
deduction for the VAT on purchases of capital inputs is allowed against the firm’s VAT liability.
Most countries use a consumption-type VAT.6
National Sales Tax
A national sales tax (NST), sometimes referred to as a “fair tax,” would be a federal consumption
tax collected only at the retail level by vendors. The NST would equal a set percentage of the
retail price of taxable goods and services. Retail vendors would collect the NST and remit the tax
revenue to the federal government.
The retail price of a good or service equals the sum of the value added at all stages of production.
Consequently, a value-added tax and a national sales tax with the same tax rate and tax base
would yield the same amount of revenue. Both policymakers and economists generally assume
that both types of taxes are fully shifted forward onto consumers; that is, the price to the
consumer increases by the full amount of the tax.7
In the 118th Congress, H.R. 25 would implement a NST. This proposal would replace the current
federal income, payroll, and estate and gift tax system with a 23% tax-inclusive sales tax rate in
2025 (30% tax-exclusive rate), with adjustments to the rate moving forward.

6 For further information on the alternative structures of a VAT, see OECD, Consumption Tax Trends 2022, November
2022, https://www.oecd.org/tax/consumption-tax-trends-19990979.htm.
7 Dora Benedek, Ruud A. de Mooij, and Philippe Wingender, Estimating VAT Pass Through, International Monetary
Fund, September 30, 2015, https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Estimating-VAT-Pass-
Through-43322.
Congressional Research Service

4

Consumption Taxes: An Overview

Flat Tax
The flat tax is commonly associated with systems based on a proposal originally formulated by
Robert E. Hall and Alvin Rabushka.8 Their proposal would have two components: a wage tax and
a cash-flow tax on businesses taxed at a single “flat” rate. Under this system, businesses would
generally pay cash-flow taxes on their sales minus deductions for wages, pensions, material costs,
and capital investments. Individuals would generally be responsible for paying taxes on the wages
that had been deducted by businesses, in excess of an exemption level. The resulting system is
essentially a modified VAT.9
Consumption Taxes Abroad
Across the world, consumption taxes are common, with more than 170 countries using a VAT as a
major source of revenue.10 Among OECD countries, VATs accounted for 20% of total tax revenue
in 2020.11 The United States is the only OECD country without a broad-based consumption tax at
the national level.
Alternative Tax Bases: Economic Considerations
Taxes allow governments to provide desired goods and services for its citizens; however, taxes
also tend to distort individual and business economic decisionmaking. In a perfectly competitive
market, it is expected that individuals and businesses will decide to spend their money and time in
the most valuable manner possible, resulting in the most efficient economy possible. Taxes distort
these decisions by interfering with prices. Beginning the policy discussion with the understanding
that taxes generally impede economic efficiency, one goal is then to design a tax structure that
minimizes distortions, allowing the market to operate as efficiently as possible.
It is important to note that a “perfectly competitive market” is a purely theoretical concept in
economics, which requires several very strict assumptions to achieve economic efficiency. For a
perfectly competitive market to function according to economic theory, the market must consist
of many buyers and sellers such that no individual can exert market influence independently,
firms can freely enter or exit the market (i.e., there are no barriers to entering a market), the good
being sold by producers is homogenous, and buyers and sellers have access to all information
related to their economic decisions. Few markets, if any, achieve all of these characteristics. Still,
the perfect competition framework provides a benchmark against which economic outcomes and
tax systems can be compared.
There are also situations where a tax, or subsidy, can improve economic efficiency, by correcting
for a market failure. Market failures can occur for a number of reasons, but result in an inefficient
allocation of resources, either producing too little or too much of a good than the optimal
quantity. For example, the current income tax code contains a number of tax benefits to support
education. Education generates positive externalities, as there are benefits to society that

8 Robert E. Hall and Alvin Rabushka, The Flat Tax (Stanford, CA: Hoover Institution Press, 1985).
9 Under a standard VAT, a business would not subtract its wage and pension contributions when calculating its tax
base. In addition, some wage income would not be included in the tax base of the flat tax because of exemptions that
would be included under a standard VAT.
10 Cristina Enache, 2022 VAT Rates in Europe, Tax Foundation, January 25, 2022, https://taxfoundation.org/value-
added-tax-2022-vat-rates-in-europe/.
11 OECD, Consumption Tax Trends 2022, November 2022, https://www.oecd.org/tax/consumption-tax-trends-
19990979.htm.
Congressional Research Service

5

Consumption Taxes: An Overview

individuals do not consider when making education consumption choices. Thus, absent
intervention, markets would tend to result in an allocation of resources for education that is below
socially optimal levels.
Taxes are thought to introduce distortions into individual work decisions and saving decisions,
and impact the performance of the economy overall. Replacing the federal income tax with a
consumption tax has been offered as a means to reduce distortions caused by taxation within the
economy. The following sections will discuss the potential impact and relative merits of
consumption taxes compared to income taxes with respect to impacts on work choices, savings,
and the economy.
Impact on Work Choices
As discussed above, taxes are generally expected to alter individual decisions away from their
optimal choices by distorting price signals. One of the main concerns voiced when discussing tax
policy is its potential impact on individual work decisions. Taxes can impact individual work
decisions through two avenues, (1) by reducing the real value of work, known as the income
effect, and (2) by changing the relative value of work in relation to other activities, known as the
substitution effect. The impact of these effects is discussed below.
Income Effect
As individuals are subject to either an income or consumption tax, their ability to pay for goods
and services will decrease. Under an income tax, an individual’s take-home salary is reduced by
the amount of the tax. Under a consumption tax, an individual’s purchasing power is reduced
either through increased prices or reduced wages.12 For example, consider an individual whose
total monthly expenditures equal $1,500, and who has a job that pays $10 per hour. He would
have to work 150 hours a month to cover his expenditures. However, if an income tax of 20% is
implemented, his effective wage is reduced to $8 per hour, and he would have to work 187.5
hours a month to cover his expenses. Similarly, under a 20% consumption tax, assuming the tax is
passed on completely to consumers through higher retail prices, the effective cost of his monthly
expenditures increases to $1,800, and he must now work 180 hours to cover his monthly
expenditures.
In response to the decreased value of work due to an income or consumption tax, individuals are
expected to increase how much they work to make up for some of the lost consumption power.
This response to taxation is referred to as the income effect. If a consumption tax proposal were
revenue neutral, the income effect produced from switching to a consumption tax is likely to be
similar to the income effect under the income tax.
Substitution Effect
In addition to decreasing an individual’s purchasing power, taxes also decrease the relative value
of work in relation to leisure. Individuals have to make numerous decisions about how to spend
their time each day, allocating time between work, friends, family, and numerous other activities.
With the implementation of a tax on income or consumption, the value of spending an hour at
work is reduced in relation to these other activities. Under an income tax, this occurs because the
tax reduces an individual’s income for a given level of work by the tax rate. Whereas under a

12 A consumption tax can either increase prices or decrease wages, based on a number of factors. It is generally
expected that under a consumption tax, policymakers would attempt to accommodate a one-time increase in prices
rather than a decrease in wages.
Congressional Research Service

6

Consumption Taxes: An Overview

consumption tax, this occurs because the tax decreases the amount an individual can purchase for
a given level of work by increasing the price of goods or reducing his or her wages. As taxes
reduce the real value of work, the relative value of leisure and other activities increases and
individuals are expected to decrease the amount of time they spend working. This response,
referred to as the substitution effect, works in opposition to the income effect discussed above.
The degree to which the substitution effect impacts individual work decisions is largely a function
of the tax rate. A higher tax rate is expected to increase the substitution effect, and therefore
increase the disincentive to work by making leisure relatively more valuable. A consumption tax
is likely to have a higher tax rate than an income tax if the taxes are to be revenue neutral,
because the tax base under a consumption tax is necessarily smaller than the tax base under an
income tax.13 A higher tax rate under a consumption tax would be expected to decrease the
relative value of work to a greater degree than under an income tax, and therefore decrease work
effort to a greater degree. However, in practice, a lower consumption tax rate can be used while
remaining revenue neutral because the lump sum tax on old capital generates additional tax
revenue. In addition, this lump sum tax raises revenue without introducing distortions into the
economy. The result is that the anticipated substitution effect under a consumption tax may not be
significantly larger than under an income tax when the tax plans are revenue neutral.
There is, however, an important feature inherent in the transition to a consumption tax that limits
the need for higher rates, thus limiting changes in behavior arising from the substitution effect.
While transitioning to a consumption tax, there would be an additional implicit tax placed on
savings and assets owned before the transition to a consumption tax is complete. Under the
current income tax, individuals purchase assets and save a portion of their income to finance
consumption later in life. These savings and assets have a certain value under an income tax, but
with the implementation of a consumption tax, the real value of these assets and savings would
decrease. The value declines because when individuals begin to consume (by drawing down their
savings) their purchases would now be subject to the consumption tax. The real value of assets
and savings is reduced by the amount of the consumption tax rate.14 The decrease in value arising
from the transition to a consumption tax is often referred to as a tax on old capital.
As discussed earlier, most taxes tend to distort individual behavior and reduce economic
efficiency. There are a number of exceptions to this rule however, and the inherent tax on old
capital under a consumption tax is one such example. The tax on old capital is not expected to
distort individual behavior because there is no legal way for individuals to alter their behavior in a
way to reduce their tax burden. All decisions to purchase assets or save income occurred in the
past, and because individuals cannot travel back in time to reduce their asset purchases or saving
behavior, individuals cannot alter their behavior to avoid the tax on old capital. This kind of tax is
referred to as a lump-sum tax, and is not expected to distort the economy because individuals will
not alter their behavior in response to it.
Empirical Discussion
While economic theory suggests that taxes have two opposing effects on an individual’s work
decisions, the net impact on work is ambiguous in theory. Researchers have sought to determine

13 Theoretically, consumption is income less savings. Thus, the tax base for a comprehensive income tax would be
larger than the tax base for a comprehensive consumption tax. In practice, both income and consumption taxes may
have exemptions and other tax preferences that reduce the size of the tax base.
14 Joseph Bankman and Barbara Fried, “Winners and Losers in the Shift to a Consumption Tax,” Georgetown Law
Journal, vol. 86, no. 3 (January 1998), pp. 539-568.
Congressional Research Service

7

Consumption Taxes: An Overview

how the income and substitution effects play out in reality, and have produced varying estimates.
In empirical work, economists attempt to quantify the responsiveness of workers to changes in
after-tax wages—the “labor supply elasticity.” These estimates yield the percentage change in
hours worked arising from a percentage change in after-tax wages.
Estimated elasticities range between zero and 1.3, but elasticities tend to bunch at the low end.
Numerous studies have found elasticities between zero and 0.3.15 An elasticity of 0.3 suggests that
a 10% decrease in after tax-wages would decrease hours worked by 3%. Some researchers have
critiqued the work finding low elasticities, citing poor methodological choices. These critics
believe the response would likely be higher once these methodological shortcomings are
accounted for, suggesting a larger decrease in hours worked in response to the same decrease in
after-tax income.16
According to the empirical literature, increased taxes tend to result in decreased work effort.
Therefore, empirically, the substitution effect is larger in magnitude than the income effect. While
increasing taxes will likely decrease individuals’ work effort, it is unlikely that there would be a
significant difference in work effort under a revenue neutral consumption tax compared to an
income tax. The additional lump sum tax on old capital under a consumption tax is the principal
reason for the anticipated minimal impact on work effort. One study found that a consumption tax
is likely to decrease labor participation more than an income tax, but the difference is expected to
be relatively small.17
Impact on Savings
A key difference between an income tax and a consumption tax is in how individual savings are
treated. Individuals generally earn income through two avenues: the first is through their labor,
for which they receive a wage, and the second is capital income, which results from interest,
dividends, or capital gains earned on savings and investments. A generic income tax would be
applied to both income earned from labor and capital. In addition to the impact on work choices
discussed previously, an income tax is expected to affect individuals’ saving behavior by reducing
the after-tax return to savings. By reducing the after-tax return to savings, an income tax is
expected to change individual saving behavior.
In contrast, under a consumption tax, the return to saving is not taxed. Therefore, under a
consumption tax, no disincentive to saving is introduced and individuals would not be expected to
make tax-induced changes in savings behavior. All else equal, this results in the returns to saving
being higher under a consumption tax compared to an income tax. The mechanism through which
taxes impact saving decisions is discussed further below.

15 Michael P. Keane, “Labor Supply and Taxes: A Survey,” Journal of Economic Literature, vol. 49, no. 4 (2011), pp.
961-1075, and Robert McClelland and Shannon Mok, “A Review of Recent Research on Labor Supply Elasticities,”
Congressional Budget Office, October 2012.
16 Michael P. Keane, “Labor Supply and Taxes: A Survey,” Journal of Economic Literature, vol. 49, no. 4 (2011), pp.
961-1075.
17 Eric Engen, Jane Gravelle, and Kent Smetters, “Dynamic Tax Models: Why They Do The Things They Do,”
National Tax Journal, vol. 50, no. 3 (September 1997), pp. 657-682.
Congressional Research Service

8

Consumption Taxes: An Overview

How does an income tax reduce the return to saving?
An example is often helpful to understand how alternative tax bases can impact the return on investments. Two
individuals each place $100 into savings accounts, which earn 15% interest annually. One individual is subject to a
10% income tax, while the other is subject to a 10% consumption tax. After one year, both individuals would have
earned $15 in interest. The individual subject to an income tax must remit 10% of his earnings due to the income
tax. Thus, the after tax return on the investment under an income tax is 13.5%, while the return on investment is
15% under a consumption tax.
Economic theory does not provide a definitive answer on how individuals will respond to
increased returns to investing. Similar to the impact taxes have on work decisions, the impact of
rising returns to saving results in two opposing effects on saving behavior. The income effect is
expected to result in individuals saving less. In contrast, the substitution effect is expected to
result in individuals saving more.
Income Effect
The income effect is expected to diminish individual savings and investment because as the rate
of return to saving increases, individuals have to save and invest less of their income to achieve a
given level of income in the future. For example, if an individual has a target savings goal for
retirement, an increase in the rate of return to saving allows an individual to save less and still
reach that target goal for future consumption during retirement.
Substitution Effect
In opposition to the income effect, as the return to saving increases, individuals are expected to
increase the amount they save. This is referred to as the substitution effect. As the return to saving
increases, the price of current consumption increases in relation to future consumption, and
individuals substitute current consumption for future consumption.
Empirical Discussion
Economic theory suggests that an increased rate of return to saving and investment will have two
opposing effects on an individual’s saving behavior—one pushing them to save more and the
other to save less. Therefore, due to the expected increase in the return to saving under a
consumption tax, individual saving may actually decrease, increase, or remain unchanged based
on the magnitude of these oppositional responses compared to saving under an income tax.
A small body of literature estimated the response of the interest rate on saving, and found small
effects that could be either positive or negative.18 A significantly larger body of work examined
the effect of interest rates on the substitution of consumption over time. Analysis of the literature
suggests that on average, a 1 percentage point increase in the real return to savings will tend to
decrease consumption by about 5%.19 There is some evidence that this substitution effect is
overstated due to publication bias (the tendency of only studies with positive findings to be

18 The real interest rate is measured as the market interest rate less inflation. These studies are reviewed in Jane G.
Gravelle, The Economic Effects of Taxing Capital Income (Cambridge, MA, MIT Press, 1994), p. 27. The most recent
study was Jonathan Skinner and Daniel Feenberg, “The Impact of the 1986 Tax Reform on Personal Saving,” in Do
Taxes Matter? The Effect of the 1986 Tax Reform Act on the U.S. Economy, ed. Joel Slemrod (Cambridge: MIT Press,
1989).
19 Tomas Havranek, Roman Horvath, and Zuzana Irsova, et al., “Cross-Country Heterogeneity in Intertemporal
Substitution,” Journal of International Economics, vol. 96, no. 1, (May 2015), pp. 100-118.
Congressional Research Service

9

link to page 14 Consumption Taxes: An Overview

published).20 This effect reflects the substitution effect, and for an exogenous change in rate of
return, it would be more than offset by the income effect. In a revenue-neutral shift to a
consumption tax, however, the income effect is from a tax change that is not a direct change in
income but is distributed across taxpayers in different stages of their lives. The significant
increase in savings with a shift from an income tax to a consumption tax predicted by some
models is due in part to the shift in who pays taxes and when, as discussed in the next section.
Impact on the Economy
One of the main arguments for a consumption tax is that in comparison to an income tax, a
consumption tax would lead to an improved standard of living over the long run. Or, in economic
terms, switching to a consumption tax would lead to an increase in the level of gross domestic
product in the long run. The expected increase in standard of living is due to a number of factors,
including increased personal savings, but also the inherent lump sum tax on capital that occurs
while transitioning to a consumption tax. The inherent lump sum tax allows policymakers to use a
lower consumption tax rate than without the lump sum tax, while raising similar amounts of
revenue to those under an income tax. The anticipated increase in economic welfare from
switching to a consumption tax is largely due to a combination of these two factors, increased
private saving and the lower effective tax rate afforded by the lump-sum tax on capital.
Transitioning to a consumption tax is expected to increase economic welfare in part due to an
increase in private saving. As noted above, the increase in return due to lower taxes increases
savings through the substitution effect. The redistribution of taxes between savers and nonsavers
(in a stylized model, the young and the old) also contributes to a saving effect. Younger
individuals pay less tax because they save more of their income, while older individuals pay
more. The young will have to pay more tax in the future and save for their payments. An increase
in private saving would theoretically increase the amount of capital available for firms to borrow
and use for investments in improved facilities, machines, and workers. Increases in the amount of
capital available to firms are expected to increase productivity and lead to increased economic
output in the long run, according to economic theory.
Additionally, the lump-sum tax on old capital allows for additional tax revenue without
introducing significant distortions into the economy.21 As discussed earlier, individuals tend to
save part of their income while young, investing in capital to finance consumption in retirement.
They then draw down that savings to finance consumption when they are retired. As such, older
individuals with retirement savings would own a significant amount of old capital, and would
therefore bear a larger burden from the lump-sum tax when transitioning to a consumption tax.
Researchers have produced varying estimates of the potential impact on the economy of
transitioning to a consumption tax.22 These estimates vary for a number of reasons including the
type of model, assumptions, and parameter estimates used. Researchers have found that switching
to a consumption tax could increase total economic output by 5% to 10% in the long run

20 Tomas Havranek, “Measuring Intertemporal Substitution: The Importance of Method Choices and Selective
Reporting,” Journal of the European Economic Association, vol. 13, no. 6 (December 2015), pp. 1180-1204.
21 Joseph Bankman and Barbara Fried, “Winners and Losers in the Shift to a Consumption Tax,” Georgetown Law
Journal, vol. 86, no. 3 (January 1998), pp. 539-568.
22 As implemented in most European countries, VATs are generally used as a supplementary source of tax revenue in
addition to income tax revenues. The economic implications of an add-on VAT are discussed in the section
“Supplemental Consumption Tax Options” below.
Congressional Research Service

10

Consumption Taxes: An Overview

compared with a stylized income tax.23 The projected increase in economic output occurs over a
long period of time, often in the range of 100 years, meaning that the change in annual GDP
growth is very small. It should also be noted that to achieve these economic gains under a
consumption tax, near-term consumption spending necessarily decreases.
The burden the lump-sum tax on old capital would impose on the elderly with retirement savings
may motivate policymakers to look for policy remedies to ease the tax burden on this cohort.
However, this sort of policy intervention would reduce the expected increase in economic output.
Estimates suggest that by compensating the owners of old capital, the efficiency gains of
switching to a consumption tax could decrease by 60% to 90%.24 This occurs in part because any
structure to compensate owners of old capital will require a higher tax rate under the consumption
tax to maintain revenue neutrality. The higher tax rate distorts individuals’ decisionmaking more
significantly, thus inducing a larger impact economic efficiency.
Supplemental Consumption Tax Options
The majority of economic research tends to estimate the economic benefits of a full transition to a
consumption tax, even though this is rarely the policy prescription that is implemented. Instead,
governments often incorporate an additional tax on an alternative tax base to raise further
revenue, as is the case in most countries within the Eurozone. For this reason, it is worth
discussing two potential alternative consumption tax schemes, including a partial replacement of
the income tax with a consumption tax, and an additional consumption tax on top of the current
income tax.
There is limited research on the economic effects of replacing a portion of income tax revenue
with a consumption tax. However, it is likely that economic benefits similar to those of full
replacement would be seen, but of a smaller magnitude. The CBO estimated the economic effects
of replacing a quarter of the income tax in the United States with a consumption tax in the form
of a VAT. The beneficial impacts highlighted above are all diminished when partially replacing
the income tax with a consumption tax. According to a 1992 CBO study, the saving rate would
increase by 0.5 percentage points, consumption would increase by 1.2%, and overall output
would increase by 1.5% in the long run.25 The expected increase in overall output from partial
replacement is 8.5 to 3.5 percentage points lower than the estimate for full replacement of the
income tax with a consumption tax.
Similarly, there is limited evidence on the impact of implementing a VAT on top of an income tax.
The limited empirical work on the subject has focused on changes to the VAT rate after the tax
has been established. However, given these limitations, the literature suggests that increasing the
VAT rate, in economies which also have an income tax, tends to decrease consumption and

23 Lawrence Summers, “Capital Taxation and Accumulation in a Life Cycle Growth Model,” The American Economic
Review, vol. 71, no. 4 (September 1981), pp. 533-544; and Jane Gravelle, “Income, Consumption, and Wage Taxation
in a Life-Cycle Model: Separating Efficiency from Redistribution,” The American Economic Review, vol. 81, no. 4
(September 1991), pp. 985-995; and David Atlig, Alan Auerbach, and Laurence Kotlikoff, et al., “Simulating
Fundamental Tax Reform in the United States,” The American Economic Review, vol. 91, no. 3 (June 2001), pp. 574-
595.
24 Jane Gravelle, “Income, Consumption, and Wage Taxation in a Life-Cycle Model: Separating Efficiency from
Redistribution,” The American Economic Review , vol. 81, no. 4 (September 1991), pp. 985-995, and David Atlig, Alan
Auerbach, and Laurence Kotlikoff, et al., “Simulating Fundamental Tax Reform in the United States,” The American
Economic Review, vol. 91, no. 3 (June 2001), pp. 574-595.
25 U.S. Congressional Budget Office, Effects of Adopting a Value-Added Tax, February 1992, pp. 49-65,
http://www.cbo.gov/publication/20769.
Congressional Research Service

11

link to page 13 link to page 16 link to page 16 Consumption Taxes: An Overview

increase saving as well. The impact appears be of a smaller magnitude however, suggesting that a
1 percentage point increase in the VAT rate will reduce consumption between 0.4 and 1% in the
near term, with a larger decrease in the long term.26 This decrease in consumption would likely be
accompanied by an increase in savings, which could contribute to greater economic output in the
long term through the processes discussed in the “Impact on the Economy” section.
Alternative Tax Bases: Distributional
Considerations
In addition to considerations of economic efficiency, policymakers often consider how the tax
burden is distributed when crafting tax policy. The following discussion will compare some of the
potential distributional implications of transitioning from an income tax to a consumption tax. It
is important to note that the following sections examine the impact of a revenue-neutral switch
from a stylized income tax to a stylized consumption tax, and not the current income tax as
implemented in the United States.
The discussion is complicated because the distributional implications of a tax structure can be
changed by altering specific parts of the tax. For example, under an income tax the first $10,000
earned could be exempted, thereby increasing the progressivity of the tax. Similarly, under a
consumption tax certain staple goods, such as groceries, could be exempted, which would make
the tax more progressive. To simplify the discussion, this section will consider a pure income and
a pure consumption tax structure, both with a flat 20% tax rate and similarly sized tax bases.
Tax Burden across Income Classes
A common critique of consumption taxes is that they tend to be regressive, where an individual’s
average tax rate decreases with income. Estimates of the distribution of the tax burden are
sensitive to how income is measured. When observing individuals’ average tax rates with respect
to annual incomes, a consumption tax tends to be regressive, since higher-income individuals
tend to save a greater proportion of their income than lower-income individuals. Therefore, a
larger portion of income from lower-income individuals would be subject to a consumption tax.
For example, Figure 2 shows that individuals in the second quintile of the income distribution
had a savings rate of negative 23% in 2019, meaning they spent more money on consumption
than they earned, while individuals in the fourth quintile of the income distribution had a savings
rate of 24%.27 Given these differential savings rates, under a 20% consumption tax an individual
in the second income quintile would tend to have an average tax rate of about 25% with respect to
their annual income, while an individual in the fourth quintile would have an average tax rate of
about 15% with respect to their annual income as shown in Figure 2.

26 James Alm and Asmaa El-Ganainy, “Value-Added Taxation and Consumption,” International Tax and Public
Finance, vol. 20 (March 28, 2012), pp. 105-128, and Ray Barrell and Martin Weale, “The Economics of a Reduction in
VAT`,” Fiscal Studies, vol. 30, no. 1 (April 16, 2009), pp. 17-30.
27 U.S. Bureau of Labor Statistics, Consumer Expenditure Survey, Table 1101, 2019.
Congressional Research Service

12

link to page 17

Consumption Taxes: An Overview

Figure 2. Savings and Average Tax Rate by Income Quintile
Assuming a 20% consumption tax with no exemptions

Source: CRS calculations based on the Consumer Expenditure Survey, Table 1101, 2019.
Notes: Income before taxes is used to calculate savings and average tax rates. The average tax rate is calculated
as a proportion of pre-tax annual income. Expenditure levels for the lowest income quintile may suffer from
measurement error.
When using lifetime income as a measure of ability to pay, instead of annual income, the burden
of a consumption tax tends to be more equitably distributed. This is because over an individual’s
lifetime, lifetime consumption tends to approximate lifetime income.28 Since lifetime
consumption tends to equal lifetime income, an individual with a higher lifetime income will
likely spend more on consumption and therefore have to pay more through a consumption tax.
Therefore, a consumption tax will generally approach proportionality across lifetime income
levels.
Under the stylized income tax with a single tax rate of 20%, the tax burden is spread
proportionately across income classes. With no exceptions or deductions, all individuals would
have a 20% average tax rate regardless of their income level. As income rises, individuals would
pay a larger absolute amount in taxes, but as a percentage of income everyone would pay the
same amount. Under such an income tax, the use of annual versus lifetime income has no effect
on the distribution of tax burdens—it remains proportional regardless.29
Tax Burdens across Generations
Tax burdens also tend to differ across generations. At different points in their lifecycle,
individuals tend to have different consumption and saving behavior, contributing to differences in
their tax burden.
Under the stylized income tax, an individual’s tax burden is independent of their age, and
individuals would face a proportional tax rate throughout their lives of 20%. Under the stylized
consumption tax, middle-aged individuals will tend to have the smallest tax burden as a
percentage of annual income because they save a larger portion of their income. As shown in
Figure 3, individuals between the ages of 35 and 44 had an average savings rate of 28%, in

28 In the absence of bequests, this will hold true. If an individual receives bequests, consumption can be greater than
income. If an individual gives bequests, consumption can be less than income.
29 To remain proportional, bequests must be treated as consumption and include the present value of future taxes paid
by heirs.
Congressional Research Service

13

link to page 17

Consumption Taxes: An Overview

comparison with individuals under 25, who had an average savings rate of -4%, and individuals
above 75 years old, who had an average savings rate of -2%. Due to the differing savings rates of
individuals over their lifetimes, differing average tax rates are produced under a consumption tax
as shown in Figure 3. An individual under the age of 25, who has an average savings rate of -4%,
would have an average tax rate of 21% with respect to annual income, while an individual
between the ages of 35 and 44, who has an average savings rate of 28%, would have an average
tax rate of 14%. Assuming that this distribution of savings rates would prevail under a
consumption tax, middle-aged individuals would have the lowest average tax rates, as a function
of their income, while older and younger individuals would have the highest average tax rates, as
a function of their income.
Figure 3. Savings and Average Tax Rate by Age
Assuming a 20% consumption tax with no exemptions

Source: CRS calculations based on the Consumer Expenditure Survey, Table 1300, 2019.
Notes: Income before taxes is used to calculate savings and average tax rates. Average tax rate is calculated as a
percentage of annual income, assuming no behavioral changes. Average tax rates are also calculated assuming
there are no exemptions to the consumption tax base.
Alternative Tax Bases: Administrative
Considerations
Tax Code Complexity and Administrative Cost
Proponents of a consumption tax often tout the potential for increased simplicity.30 Although a
consumption-based tax could be designed to be very simple, a consumption-based tax is not
inherently simpler than an income-based tax. An income-based tax could also be designed to be
simpler and more manageable than the current income tax code. The complexity of the current tax
code is not a result of using income as the tax base, but rather additions and revisions to the tax
code and the temporary nature of some tax provisions, which create uncertainty for taxpayers.

30 Jake Miller, “Could Americans Someday File Their Tax Returns on a Postcard?,” CBS News, April 15, 2015,
http://www.cbsnews.com/news/could-americans-some-day-file-their-tax-returns-on-a-post-card/.
Congressional Research Service

14

Consumption Taxes: An Overview

While complexity is not necessarily inherent to either of these tax bases, consumption or income,
limited evidence shows that some consumption-based taxes tend to have lower administrative
costs. For example, European countries with VATs have average administrative costs of 3 to 5
cents per dollar collected in VAT revenue, compared with 13 cents per dollar of income tax
revenue in the United States.31 Another study found that VAT administration costs in the United
Kingdom were estimated to be 0.55% of revenue collected, compared with 1.27% in the United
States for the federal income tax.32 As discussed earlier, most European countries have introduced
VATs to supplement their income taxes. If the United States were to follow this example,
administrative costs associated would likely increase, as a new or expanded agency would be
required to administer the new consumption tax.
Transitional Monetary Policy Considerations
With the implementation of a VAT or NST, certain decisions around monetary policy could have
significant impacts on either wages or the consumer price level. Under a VAT or NST, the relative
price of consumer goods and services would necessarily increase with respect to production costs
and wages as the new tax is applied to goods and services.33 Because the price increase is relative
to production costs and wages, assuming production costs cannot be lowered, the relative increase
in prices can be achieved either by price increases or wage decreases. Whether prices or wages
are impacted depends on “the institutions of wage- and price-setting and on monetary policy.”34
Policy analysts generally believe that a one-time increase in consumer prices would be
accommodated through an increase in the price level, in part because workers are reluctant to
accept lower wages and could cause many workers to leave their jobs if wages were lowered.35
Additionally, if inflation expectations remain well-anchored, a one-time price adjustment might
not lead to any subsequent changes in inflation, in which case monetary policy would not need to
be modified.36
Interactions with State Tax Codes
State tax codes and the federal tax code interact in a number of ways, which could complicate the
implementation of a broad consumption tax in the United States. As discussed earlier, a number
of states have consumption taxes in the form of retail sales taxes. If the federal government were
to implement a broad-based consumption tax as well, states might object that the federal
government is encroaching on their tax base.

31 President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax
System, November 2005, p. 201.
32 U.S. Government Accountability Office, Value-Added Taxes Lessons Learned from Other Countries on Compliance
Risks, Administrative Costs, Compliance Burden, and Transition, GAO-08-566, April 2008, p. 4, http://www.gao.gov/
products/GAO-08-566.
33 C. Alan Garner, Consumption Taxes: Macroeconomic Effects and Policy Issues, Federal Reserve Bank of Kansas
City, Second Quarter 2005, pp. 5-29.
34 David E. Bradford, “Consumption Taxes: Some Fundamental Transition Issues,” in Frontiers of Tax Reform
(Stanford: Hoover Institution Press, 1996).
35 Alan Garner, “Consumption Taxes: Macroeconomic Effects and Policy Issues,” Economic Review—Federal Reserve
Bank of Kansas City, Second quarter 2005.
36 George R. Zodrow, “Transitional Issues in the Implementation of a Flat Tax or a National Retail Sales Tax,” in
United States Tax Reform in the 21st Century (Cambridge, UK: Cambridge University Press, 2002).
Congressional Research Service

15

Consumption Taxes: An Overview

Additional implementation hurdles arise due to the inconsistent tax bases across states. Many
states have exempted certain items and entities from their sales tax. With the implementation of a
consumption tax, such as the NST, businesses would have to keep track of two separate lists of
taxable items based on the federal tax code and the tax code of any state in which they operate.
Businesses would be tasked with managing a tax structure in which either one, both, or neither
tax is applied to certain items at the point of sale. This sort of added complexity reduces the
administrative efficiency gains that could be achieved under a consumption tax. However, under
the current income tax structure similar complexity exists due to alternative income tax
deductions available at the state and federal level.
Interactions with the Business Cycle
Both income- and consumption-based taxes are countercyclical to the business cycle. Under a
progressive income tax, as the economy expands and individuals’ incomes grow, individuals’ tax
burdens also grow, which some believe has a stabilizing effect on the economy. Similarly, under a
consumption tax, as the economy expands, individual demand for goods grows, which will
increase individuals’ tax burdens and decrease demand. It is a matter of debate whether
countercyclical tax policy helps promote stability of the business cycle or potentially leads to
further destabilization of the business cycle.

Author Information

Donald J. Marples

Specialist in Public Finance

Acknowledgments
Jeffrey Stupak, former CRS Analyst in Macroeconomic Policy, contributed to this report.

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan
shared staff to congressional committees and Members of Congress. It operates solely at the behest of and
under the direction of Congress. Information in a CRS Report should not be relied upon for purposes other
than public understanding of information that has been provided by CRS to Members of Congress in
connection with CRS’s institutional role. CRS Reports, as a work of the United States Government, are not
subject to copyright protection in the United States. Any CRS Report may be reproduced and distributed in
its entirety without permission from CRS. However, as a CRS Report may include copyrighted images or
material from a third party, you may need to obtain the permission of the copyright holder if you wish to
copy or otherwise use copyrighted material.

Congressional Research Service
R44342 · VERSION 14 · UPDATED
16

Download PDF

Download EPUB

Revision History

Jan. 24, 2023

HTML · PDF

55% changed

Jan. 14, 2016

HTML · PDF

Metadata

Topic areas

Economic Policy

Report Type: CRS Report

Source: CRSReports.Congress.gov, EveryCRSReport.com

Raw Metadata: JSON