Consumption Tax vs. Income Tax

    Today, I saw a post on Finshots about consumption tax vs. income tax. The article succinctly describes the advantages of consumption-based taxes (GST in our case) over income tax. But I want to bring forward an essential argument because of which economists’ support consumption-based taxes.   

    Let’s consider this simple example. A person receives 100₹ today and decides to consume 50₹ today and saves 50₹ for next year's consumption. Now, for simplicity, we assume both consumption tax and income tax are set at 50% and interest rate in economy at 10%.     

     In the case of consumption tax, this means that if you buy a good for 50₹ then, 25₹ will go to government, and product worth of only 25₹ will be delivered to you. 50% consumption tax is like 100% of GST on a good sold at 25₹. Now, we will see what happens in our example by considering two following scenarios (Note that we will consider only a single tax in a single scenario) –
 

1. In the income tax regime, the person will be taxed by 50₹ (50% of 100₹) this year. And a total of 50₹ is remained in his account. Now, he goes and buys a product worth of 25₹ this year. (on which he won’t pay any taxes according to our assumption).
He invests the remaining 25₹ in his bank account and gets 2.5₹ of interest next year. But, in the income tax regime, this additional income in the form of interest will be again taxed by 50% that means he now has 25₹+2.5₹ -1.25₹ (tax on interest) = 26.25₹. And he takes this money and consumes it entirely next year. 

2. In second scenario of consumption tax, the person will pay 50₹ out of which 25₹ (50% of 50₹) will go to government, and he receives product worth of 25₹. Then, he invests remaining 50₹ in the bank, gets an additional interest of 5₹. Now, he has a total of 55₹. When he consumes 55₹ in next year, as discussed earlier, 27.5₹ (50% consumption tax on 55₹) will go to government, and he will get a product worth of remaining 27.5₹. So, if you compare both scenarios, person will get a product worth 25₹ in current year for both the scenarios but for the next year, the consumption of person will reduce from 27.5₹ to 26.25₹ because of additional income tax which is levied on his accumulated interest. 

As seen in the above example, income tax, as opposed to consumption tax, tends to penalize the person when he tries to save his money and consume it next year. In this way, future consumption becomes more and more expensive to the person compared to consumption today. And this could lead to various effects on interest rates.
 

To find a detailed graphical-based proof of this problem, one can read Chapter 15 in Prof. Hirshleifer’s book on Price Theory and Applications: Decisions, Markets, and Information.