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The Economic Effects of Comprehensive Tax Reform July 1997

Moving to a consumption-based tax may affect the price level and will certainly affect the value of existing assets. The precise effects, however, depend on the details of the proposal.
 

The Price Level

Switching to an indirect tax such as a valued-added tax (VAT) or national sales tax will probably cause a one-time jump in the price level, with no permanent change in the inflation rate. By contrast, any consumption-based tax that levies taxes directly on households will probably have little or no effect on the price level.

A VAT or sales tax is likely to boost the price level because each one collects the tax on labor income from the firm or retailer. That treatment represents a change from the current income tax system, which collects tax on labor income directly from the worker. Because the cost of labor to the firm would include the new tax, real compensation paid to workers would initially have to fall to match the value of their so-called "marginal product" and keep them fully employed.

Real compensation can fall in two ways: nominal compensation can drop or the price level can rise. What happens will ultimately depend on the Federal Reserve. If it fixes the price level, nominal compensation will have to fall--an event that workers might accept because they would no longer have to pay income tax and hence would take home about the same pay as now. Most analysts note, however, that workers have resisted cuts in nominal compensation in the past. Those analysts expect that firms fearing morale problems or facing union contracts will hesitate to make such cuts. In that case, nominal compensation may fall slowly to its new level, leading to higher unemployment rates in the interim. To prevent that outcome, the Federal Reserve is expected to allow the price level to rise. For example, a VAT or sales tax of 10 percent would lead to a one-time jump of 10 percent in the price of consumer products.⁽¹⁾

Further price increases may ensue if compensation is indexed to inflation. In that case, the price rise will cause a corresponding rise in compensation, and real compensation will not drop enough to maintain full employment, requiring a further price rise--that is, a wage-price spiral. That problem occurred in the United Kingdom when it adopted a VAT in 1979, although the extent of indexing there was greater than it is in the United States.

In contrast, the flat tax probably has little effect on the price level. Although the total tax base of the flat tax is essentially the same as that of a VAT, compensation under the flat tax is taxed at the household level. In that case, firms do not face a new tax on labor, and thus their payroll is the same as before the reform. The flat tax may, however, lead firms to raise prices by about 2 percent to recoup their loss of deductions for payroll taxes and fringe benefits other than pension contributions.

The Unlimited Saving Allowance (USA) tax combines a subtraction-method VAT (an indirect consumption tax) with a personal cash flow tax (a direct consumption tax). The VAT is collected at the business level at a rate of 11 percent, but firms are given a credit for their payroll taxes--about 6 percent of compensation. Thus, if nominal compensation did not fall, a switch to the USA tax would raise the price of business output by about 5 percent. The personal portion of the USA tax, however, would fall directly on household consumption and would not affect the price level.

Although pure forms of comprehensive, single-rate, consumption-based taxes differ from each other in their effects on the cost of labor to firms, they have identical effects on the real after-tax compensation received by workers. Given pure forms, an indirect tax resulting in higher consumer prices leaves workers with the same purchasing power as a direct tax on consumption. But the various plans are not pure forms and impose taxes at different rates. Therefore, the plans will have similar, but not identical, results. Moreover, without legislation, the form of the tax will affect the purchasing power of recipients of government transfers (such as welfare payments) that are not indexed to the price level.
 

The Value of Existing Assets

Switching from a pure tax with an income base to one with a consumption base would by itself impose a new burden on current owners of existing assets. Owners in effect would pay a one-time levy on their assets at the new tax rate. But the net effect on asset prices is uncertain because neither the existing income tax nor all proposed substitutes are pure forms and because other factors would by themselves act to raise asset prices.

Switching Between Pure Forms Exacts a Levy on Existing Assets

A levy would apply under pure forms because existing assets would lose their tax basis. For instance, if a plan allowed expensing and imposed a business-tax rate of 20 percent, a firm would reduce its tax liability by $20 when it spent $100 on new capital and expensed it. But old capital that is otherwise identical would lose its basis because it would receive no deductions and yet would face a 20 percent tax rate. In effect, buying $100 of new capital would cost the firm only $80. Consequently, the value of otherwise equivalent old capital (or shares in the firm that owns it) would also fall to $80--a 20 percent drop. A sales tax would have the same effect in that the firm would lose its deductions for old capital, whose return would face the new tax when it was consumed.

The decline in the value of assets would be shared proportionately by owners and lenders if the price level rose to include the new tax. Such a price rise would reduce the real value of nominal claims, constituting a loss to the lender and a gain to the borrower. Except for the loss to holders of government debt, however, such gains and losses would cancel each other in the economy as a whole.

In addition to imposing a levy on real assets, the various plans would change the tax treatment of existing financial securities, such as bonds and mortgages. All consumption-based plans would eliminate deductions for interest paid, increasing the tax liabilities of borrowers and reducing their net worth. (The USA tax, however, would continue to allow deductions for mortgage interest.) The flat tax would eliminate any tax on interest income, reducing the tax liabilities of lenders and raising the value of their loans. Under the other plans, the tax would apply to interest income not when it was earned but rather when it was consumed. Other things being equal, the value to the holder would rise if the rate of the consumption tax fell below the rate of the income tax it replaced.

Departures from Pure Forms Counteract the Levy

Because the current income tax and some proposed consumption-based taxes are not pure forms, the levy on existing assets would fall short of its theoretical value under pure forms. First, owners of household assets--owner-occupied housing and consumer durable goods--would escape such a levy because the imputed yields of those assets are already taxed on a consumption basis under the current system. Thus, the levy would strictly apply only to existing business assets.

Second, much existing capital has been depreciated faster than it would have been under a pure income tax. Accelerated depreciation under current law in essence grants partial expensing and places old capital at a tax disadvantage in relation to new capital. Moreover, most past investment that firms made in their intangible property--such as buying advertising, conducting research and experimentation, or developing software--was fully expensed. Eliminating the income tax would abolish the tax disadvantage of such capital and intangibles, partly offsetting the levy.

Third, capital gains are now taxed when they are realized, even if the proceeds are reinvested. The switch in the tax base would free those gains from tax and directly benefit people who intended to realize them. In other words, the switch would eliminate the lock-in effect on capital gains.

Finally, granting relief to holders of existing assets during the transition would reduce the levy by allowing firms to retain a basis in their assets. For instance, the USA tax would allow firms to amortize existing assets.

Other Factors That Counteract the Levy

Several other factors might also work to counteract the levy. First, existing firms have a market advantage if investment incurs costs beyond the purchase of new capital. Such adjustment costs of investing may include retraining workers or disrupting other work. In that case, new firms would find it too costly to amass capital immediately and compete at the scale of existing firms. That situation temporarily allows existing firms to earn supernormal returns on their existing capital and previously planned investment, thereby raising their share value.

Second, a theory of dividends (the "new view") predicts that the new treatment of dividends and capital gains in isolation would raise the value of stocks. According to the new view, the value of corporations would rise because the effective tax rate on dividends currently exceeds that on capital gains, and a new tax treatment would equate the effective rate on each. Even though both are taxed at the same statutory rate, capital gains are currently taxed at a lower effective rate because taxes are deferred until realization. Switching to a consumption base would equate the two rates--at zero, for normal expected returns--and, according to the new view, raise stock values. The new view is controversial, however, and the traditional view holds that equating the effective tax rates on dividends and gains would not by itself affect the stock market.

Finally, reform would affect the demand for all assets. Total demand would rise if reform boosted private saving. Furthermore, the demand for business assets would rise in relation to that for household assets because reform would reduce or eliminate the tax bias against business assets. In addition, other things being equal, the value of most assets would increase if the market interest rate fell under reform. (Holders of municipal securities, however, would suffer a capital loss as the after-tax interest rate rose because interest on those securities is already tax-free.) Moreover, owners of existing assets would benefit from higher after-tax returns, although that benefit would mean more to the young than the old because the young would receive the higher net returns for a longer period of time.

1. A value-added tax would also lead to a jump in the price of producer products, but their effective price would remain as before because the VAT is rebated to producers.

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