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What is a Direct Expenditure Tax?
Phil Hanratty
Economics, Commerce and Industrial Relations Group
Taxation reform is back on the political agenda of many sections of
the community. Discussion of measures to bolster household saving are
also receiving increased attention. Proponents of a Direct Expenditure
Tax (DET) often put it forward as a taxation reform which will substantially
raise household saving.(1) However, no advanced market economy has yet
introduced a DET.
The Nature of a DET
The core feature of a DET is that it uses the direct taxation system
(i.e. that dealing with the taxation of income) but only taxes consumption
expenditure. Personal saving is tax-exempt. A DET is different in nature
from indirect taxes on consumption such as the wholesale sales tax (WST)
or a goods and services tax (GST); these do not operate through the direct
tax system but are levied whenever an item of taxable consumption spending
is made.
One significant advantage of a DET over a WST or a GST is that it can
be levied progressively so that average taxation rates increase with the
level of a person's consumption spending. This is possible because a DET
taxes aggregate personal consumption spending together in one bundle,
whereas the others tax each item of consumption spending individually.
Two Versions
There are two main versions of a DET.(2) The first is an income-based
form of a DET in which the starting point is roughly the definition of
income currently in use by the taxation authorities. Personal saving made
within any financial year is then subtracted from this income measure.
Since consumption is, by definition, equal to income minus saving this
gives a measure of personal consumption which is then subject to a progressive
taxation schedule as in the current income tax.
The second is a cashflow-based form. Here the starting point is not
just income (although this is a crucial component) but all net cashflows
which can finance either consumption or saving. Thus, cash income, receipts
of gifts and inheritances and receipts of borrowings are added together.
From this total is subtracted saving and this net measure is again subject
to progressive taxation rates.
Tax-Exempt Assets
A crucial design feature of a DET, whether of an income-based or cashflow-based
form, is the choice of those assets in which tax-exempt personal saving
can take place.
Arguments about economic efficiency point to having the widest possible
array of tax-exempt assets, both in order to encourage personal saving
and to avoid distorting personal preferences about the composition of
assets in which saving takes place.
Arguments about administrative feasibility point to restricting tax
exemption to assets which can be easily monitored by the taxation authorities,
in order to minimise operational costs and the dangers of tax avoidance
and evasion. Assets such as deposits with banks, building societies and
credit unions, and contributions to insurance and superannuation funds,
are relatively easy to monitor. But loans to friends or family and property
assets located overseas, for example, are much more difficult to keep
track of, and thus more open to abuse. DET designers would need to choose
a set of tax-exempt assets which balanced these conflicting considerations.
Effects on Personal Saving
The current income tax entails what is usually called the 'double taxation
of saving'. Saving is taxed once when the underlying income is taxed,
and any income derived from such saving is again taxed when it is generated.
A DET avoids both these levies on saving since consumption, and not
income, is now the base for the personal taxation system. Proponents of
a DET argue that this abolition of the taxation burden on saving will,
in turn, increase personal saving levels since the real after-tax (inflation
adjusted) return on savingthe incentive to savewill now be higher. Analysis
of formal models of consumption/ saving shows that saving will not fall
after the introduction of a DET, and will increase so long as persons
do not have fixed 'target' levels of saving to which they aim.(3)
Reforms to Company Taxation
DET proponents usually also argue that company taxation should be reformed
to accord with the economic principles underlying the DET system.
One option would be to abolish company taxation. This would accord with
the treatment of the profits of unincorporated enterprises (those not
registered under the company law) under a DET. Under the current income
tax, the earnings of unincorporated enterprises are notionally allocated
to their owners and then subject to the relevant personal taxation rates.
Under a DET, such profits would not be taxed until they were spent on
consumption. With the abolition of company tax, earnings retained by the
company would be free of taxation (thus encouraging company saving) while
dividends distributed to shareholders would only be taxed when spent (thus
replicating the situation with unincorporated enterprises).
A second option would retain the company tax on grounds, for example,
that incorporation bestows valuable benefits such as limited liability
which should properly be paid for through taxation. It entails replicating
the cashflow version of a DET in the case of companies. Here, just as
with persons, the net monetary inflow of companies (their cashflow) would
be subjected to separate company taxation rates. All revenue and loan
receipts would be added in together while all operating and investment
costs, debt, interest and dividend payments would be subtracted. The net
measure, excluding share transactions, would be the new base for company
taxation. Alternatively, the 'real' and financial transactions of companies
might be separated and the net cashflow outcome of the 'real' account
would be the tax base.(4)
Problems with a DET
The main issues of debate around a DET have centred on whether there
would be any net gain in terms of economic efficiency from its introduction,
and whether the increase in household saving would be sufficient to justify
the costs of its introduction and operation.
A DET could increase effective taxation rates upon work effort and this
extra burden will be more likely the higher the rate of household consumption
spending.(5) Tax rates on working spouses of higher income earners would
also be increased as couples sought to minimise their overall tax burden.
These effects dissipate the economic efficiency gains from abolishing
the double taxation of saving.
There are also questions about whether a DET would increase household
saving by any substantial extent. Many statistical studies have not found
household saving to be very responsive to real rates of return on saving.(6)
However, these studies may not fully replicate the economic situation
facing persons making consumption and saving choices after the introduction
of a DET.(7)
Problems of tax evasion are likely to be greater under a DET compared
to the current income tax. This is because of the greater range of tax
deductions entailed in the latter, since saving would be tax-deductible,
unless the DET's range of tax-exempt assets was quite restricted.(8) Issues
of possible financial compensation for high consumption groups, such as
the retired and those with large families, also add to the DET's administrative
complexity.
Endnotes
- Laurence Seidman, 'Boost Saving Through a Personal Consumption Tax',
Challenge, November/December, 1989: 44-50; and his more recent
article: 'A Better Way to Tax', Public Interest, Winter, 1994:
65-72. See also the DET proposals in: Access Economics, Unscrambling
Saving Signals, Report for the Life, Investment and Superannuation
Association of Australia Inc., December, 1996.
- Richard Goode, 'Should Reformers Aim at an Improved Income Tax or
at an Expenditure Tax?', Australian Tax Forum, 8(4), 1991: 440-444.
Goode also discusses a third option (tax exemption for capital income)
which is not actually a DET.
- Mathew Benge and Robert Albon, 'Saving and Taxation' in Peter Stemp
(ed.), Saving and Policy, Canberra: Centre for Economic Policy
Research, Australian National University, 1991: 161-191.
- Institute of Fiscal Studies, The Structure and Reform of Direct
Taxation (The Meade Report), London, Allen and Unwin, 1978.
- A.R. Prest and N.A. Barr, Public Finance in Theory and Practice,
London, Weidenfeld and Nicolson, 7th edition, 1985: 78.
- For example, see: Adrian Blundell-Wignall, Frank Browne and Alison
Tarditi, 'Financial Liberalisation and the Permanent Income Hypothesis',
The Manchester School, no. 2, June, 1995: Table 3. For somewhat
more positive statistical results, see: Paul Masson, Tamim Bayoumi and
Hossein Samiei, 'Saving Behaviour in Industrial and Developing Countries',
Staff Studies for the World Economic Outlook, International
Monetary Fund, September, 1995: Table 2.
- Lawrence Summers, 'Capital Taxation and Accumulation in a Life Cycle
Growth Model', American Economic Review, 71(4), September, 1981:
533-544; and the Seidman articles cited in endnote 1.
- Richard Goode, op. cit: 441. The DET proposals of Access Economics
(endnote 1) entail restricting tax exemption to financial assets which
are linked to the Tax File Number (TFN) system. This implies tax discrimination
against 1) other financial assets within Australia, 2) physical assets
within Australia and 3) assets located overseas, where all such assets
are not indirectly owned by Australian taxpayers through TFN-linked
accounts with Australian financial institutions.
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