The US political system continues to debate the merits of income versus consumption taxes. The current US income tax is a hybrid with many consumption tax elements (e.g. exempt capital income, immediate expensing of many investments). Thus, it is like the Zonkey pictured above: half zebra, half donkey. Most hybrid animals are infertile. Similarly, hybrid tax systems are also difficult to sustain politically.
The House Republican’s 2016 Better Way tax plan was designed to move toward a consumption-based tax in the guise of a business income tax. Thus, it had border adjustments consistent with a destination-based value-added tax, while claiming to fall only on economic “rents” of business owners. Although based along the lines of David Bradford’s X-Tax, which was designed to be a more progressive consumption tax with a business cash-flow tax combined with a progressive wage tax, the House Republican proposal only included the business cash-flow tax in combination with the current hybrid personal income tax. Thus, it was a Zonkey proposal and wasn’t sustainable politically.
Michigan’s former Single Business Tax (SBT) is another example of political unsustainability of a Zonkey tax. The State of Michigan replaced its state corporate income tax (and six other business taxes) with an additive method value-added tax imposed on all forms of business entities, the SBT, in 1976. The SBT, similar to other consumption taxes, provided no business deduction for employee compensation, which usually accounts for 70% of value-added. Labor-intensive businesses didn’t like the SBT because they couldn’t deduct employee compensation, which they argued was inconsistent with income taxation. Companies complained that they had to pay SBT when not earning profits, which is to be expected with a consumption tax. Michigan’s use of both a retail sales tax and an entity-level VAT created another political tension. Michigan politicians were whip-sawed between consumption tax and income tax arguments, so provided generous deductions for certain labor-intensive businesses. While the tax was operational in different forms for 45 years, the mixture of consumption tax and income tax concepts, combined with the uniqueness of the tax, made it increasingly difficult to defend. It was repealed in 2007 and Michigan returned to a business income tax in combination with a modified gross receipts tax.
The current US tax reform debate has resulted in confusion about how to tax business income. The debate about the “border adjustment tax” and proposals to eliminate interest deductions reflect the Zonkey nature of many hybrid tax proposals. A general limitation on business interest deductions is consistent with consumption taxation, but inconsistent with income taxation, except in narrow cases of excess leverage in multinational subsidiaries or debt financing of tax-favored investments.
Most tax systems have some hybrid features, but the political debates and economic analyses underpinning them would be clearer if purer income and consumption taxes were debated. Almost all other countries have both income and consumption taxes, and can adjust the relative mix by modifying the tax rates rather than Zonkifying either tax base.
The US’ aversion to politically considering a federal general consumption tax, such as a value-added tax, results in veiled attempts to adopt variants of indirect or entity-level consumption taxes with income tax sounding names, or further eroding the income tax base. Instead of trying to back into a consumption tax by destroying fundamental features of the corporate and individual income tax, federal policymakers should specifically debate the merits of a general consumption tax and a broad-based income tax. The initial 1984 US Treasury tax reform proposal concluded that a broad-based, lower-rate income tax was preferred to a consumption tax, which was the end result in the 1986 Tax Reform Act. Thirty years later with growing long-term fiscal deficits and a more competitive global economy, a broad-based consumption tax may be needed, in addition to a broader-base lower-rate income tax.
Loading the current income tax up with consumption tax features (expensing of capital investment, lower tax rates on capital income, a general interest disallowance or a VAT-like border adjustment) is a Zonkey tax policy with undesirable consequences.
Tom Neubig and Bob Cline