10/3/22

When I was a student of economics, Keynesian economics was the coin of the realm. I saw it as somewhat of the holy grail largely because it offered a logical framework with which to view the world, enabling one to devise straight-forward solutions to profoundly significant problems. The Keynesian remedy to address inflation, for example, is simple: contractionary economic policies — both fiscal and monetary. These policies are designed to curb spending and thereby lessen the pressure for pushing prices higher. Viola! Problem solved.

On the fiscal side, contractionary policy means reducing government spending, increasing taxes, or some combination of the two. Lower government spending directly dampens aggregate demand by the government sector, which represents roughly two-fifths of the US economy. Higher taxes reduce spending by consumers and businesses, indirectly, by lowering disposable income. Tight monetary policy slows the growth of the money supply thereby ratcheting up interest rates and again tamping down consumer and business spending particularly by those for whom purchases are conditional upon borrowing money.

My reservation about these Keynesian anti-inflationary remedies is that they give little or no consideration to the demographic considerations as to who bears the brunt of these economic policies. The divide between those whose income barely covers living expenses and those who operate with a larger financial cushion is stark. Under an inflationary regime, those at the bottom of the economic ladder are forced to do without for at least some critical purchases necessary for maintaining basic health and well-being. With the kind of inflation we’re experiencing, those who are better off can more easily accommodate to higher prices, at least for a time, without seriously impacting their quality of life. Keynesian economics has nothing to say about this dichotomy.

I’ve struggled with the question of what can be done to fight inflation without imposing this disproportionate burden on the most vulnerable of our society. I’m pleased to be able to report, however, that I’ve just read a piece authored by Ezra Klein, a podcaster and frequent op-ed contributor to the NY Times, that may well untie this Gordian knot for me. Klein is suggesting that a tax on consumption may be the way to go. The idea isn’t without its problems; but conceptually, I think Klein’s suggestion is worthy of consideration.

Some definitional foundation is needed: Income is money that is earned over some span of time, and it gets divided between consumption and saving. Mathematically, Income = Consumption + Saving.

In this context, consumption includes any purchases of non-financial goods or services, including the purchases of real assets such as real estate, commodities, art, etc. Saving, on the other hand, is comprised of purchases of financial assets including additions to savings accounts and money market deposits — i.e., any income not spent on consumption.

The rationale for a consumption tax is straight forward. If we want to disincentivize spending on those items that impact inflation, we should do so by making consumption more expensive. Put another way, we shouldn’t tax saving. In his recent opinion piece in the Times, Klein points out that those in the top quintile by income are responsible for 40 percent of aggregate consumption expenditures, while the bottom quintile contributes only 10 percent of that total. Thus, if we want to impose the tax where it would have its greatest effect on consumption, we should concentrate the effort with higher income households.

To that end, Klein calls for a progressive tax on consumption (i.e., higher tax rates for higher levels of consumption), with a “hefty” standard deduction. I’m relying on Klein’s research here, but he credits Cornell Professor Robert Frank who had written about instituting a progressive consumption tax as early as 2005, for the genesis of this idea.

I’m especially impressed by Klein’s suggestion of using the consumption tax as an automatic stabilizer, whereby it would work as an adjunct to our current income tax structure. Consumption taxes could be phased in and out as inflation surpasses or recedes from some prescribed critical level. In this way, consumption taxes would play an incremental role in fighting inflation, as opposed to being the primary source of funding government expenditures. But, again, the tax on consumption is an anti-inflationary tactic that is sensitive to the idea of equity.

A number of practical considerations would have to be worked out, but none are all that different from those that had to be settled in connection with our current income tax regulations. First, the measure of consumption used as the basis for the consumption tax would likely be derived residually. That is, we would first determine income and then subtract from that value any new acquisitions of financial assets.

The determination of income, however, is itself problematic. Taxable income for income tax purposes excludes a host of exclusions and deductions. It’s not clear that those same deductions and exemptions should apply in the calculation of consumption relevant to the determination of a consumption tax; but whatever the formula enacted for calculating income and consumption for this purpose, we’d want to make one critical carveout. Assuming we include realized gains or losses from the sale of any financial asset in the calculation of income in the general case, because our intent is to tax consumption, per se, we’d want to exempt income from the sale of a financial asset when the proceeds of that sale are reinvested into a different financial asset. That is, capital gains or losses would affect this income measure if and when the proceeds from the sale were used to buy goods or services; but otherwise, if those proceeds were rolled over into a new financial asset position, the realized gains or losses would not be included in income, thereby leaving consumption unaffected by the substitution.

I’m envisioning three basic criticisms about the implementation of the consumption tax: (1) The idea of taxing something that can’t be readily and directly measured may foster a lack of consistency in the way the consumption taxes would be calculated across taxpayers. (2) The timing of when these taxes would be paid matters. With annual payments, it’s not clear that taxpayers will plan ahead and respond as we might like to the intended spending disincentives. And (3) taxes are already too high. Our fiscal effort to combat inflation should rely exclusively on cutting government spending, and we shouldn’t increase taxes at all.

My response to each: (1) It’s hard to give all that much credence to the concern that this particular calculation for consumption is too complicated or difficult for the public to understand. It’s certainly no more difficult than the rules and regulations that pertain to the current practice of collecting income taxes. (2) The concern about timing is legitimate. It would be ideal to have any consumption tax collected on a concurrent basis, but that would be next to impossible. Whether this deficiency should be overriding, however, is another issue. I would hope that with the aid of public service announcements, the support of the community of tax preparers, and perhaps some adjustability built into the way we assess payroll taxes and estimated income tax requirements, we may be able to mitigate some portion of this problem. (3) My expectation is that of the three concerns listed, the resistance to any higher taxes is probably the most significant impediment to the implementation of a consumption tax.

I find it ironic that, often, those with the shrillest voices demanding fiscal action to tame inflation are the same voices that argue most vociferously against raising taxes. Most disturbing to me is that theirs is an extreme position allowing for no compromise. Any tax increase is too big, irrespective of their purported concern about the level of inflation. That posture makes no sense to me. Perhaps even more disturbing than that, the insistence to resist any compromise or accommodation with “the other side” is emblematic of the worst of America today. I wish it weren’t so. Institution of some form of a consumption tax seems to me to be worth a try.