Advantages and disadvantages of a pure consumption tax system

In this paper we discuss and analyze the effects of a pure consumption tax system. A consumption tax (also known as a cash-flow tax, expenditure tax, consumed income tax, or consumption-based direct taxation) is imposed on goods and services, but unlike standard sales tax or value added tax (VAT), in its purest form it has no regressive efect. For instance, if we raise the standard VAT rate, it would lead to regressive effects of consumption taxes, which would increase poor households’ budget share of taxes compared to better off households. In the US, the most common consumption taxes are sales taxes, while the EU imposes VAT as a broad-based consumption tax. The advantages and disadvantages of a pure consumption tax system are generally quite the opposite to the advantages and disadvantages of a pure income tax system or orientation. It is up to governments to choose which one to use, and to which extent, for achieving goals of economic policy. The incidence of taxes depends on how individuals and firms respond to a change in relative prices. And then, of course, it is not the same if somebody else, and not the taxpayer, bears the tax burden. Then the achieved effect could be quite different than expected, which depends on income elasticity. Thus, the effects of taxation on income distribution are connected to equity and economic growth. If we simplified the very complex analysis of determinants of income-based and consumption-based tax models or their variants, we could deduce that if a tax system is more income oriented, it is easier to achieve non-fiscal goals, but a pure consumption tax system could promote growth.

Keywords: consumption tax system, income tax system, regressive effect, economic growth

JEL classification: E62, H24, H25, H30