Balancing Equality and Growth: Evaluating the Transition from Income to Consumption Taxation

By Ness Kotecha

Taxation plays a predominant role in the stabilization of an economy through revenue generation and economic regulation. However, with growing wealth inequality worldwide, governments must adapt to foster support for low-income households while maintaining stable revenue streams. Historically, the impact of income inequality has been dampened through the redistributive effects of progressive income tax, but many nations are adopting a larger reliance on consumption taxes, such as value-added tax (VAT) and general sales tax (GST). Although these tax structures have potential as they stimulate productivity, savings, and capital investment, they also disproportionately impact low-income households. This essay discusses the impacts of transitioning to consumption taxes on both wealth distribution and long-term economic growth.

Impact on Inequality

Income taxes enable nations to redistribute wealth among their citizens and provide additional support to vulnerable groups. The system fundamentally redistributes wealth by incrementally taxing larger percentages on higher income levels, on average reducing Gini coefficients by 10% (Bourguignon, 2018). Furthermore, the revenue from income taxes allows the government to improve public infrastructure and services, including healthcare and education (The World Bank, 2024). This improves the standard of living for all citizens, especially disadvantaged groups (Inchauste & Lustig, 2017).

In most countries that administer income tax, support programs are implemented and make a significant difference; in the US, programs like the Child Tax Credit (CTC) and Earned Income Tax Credit (EITC) provided $200 billion in 2022 alone (York et al., 2024). In the short term, income taxes aid vulnerable groups, especially low-income households. Over time, this can significantly impact educational levels and the labor force, as a greater proportion of individuals, especially those from low-income backgrounds, have access to quality education supported by taxation. Overall, income tax systems worldwide have made substantial progress, with EU countries like Ireland and Belgium reducing income inequality by nearly 40% in the last two decades through progression and rebates (Hasell & Roser, 2023).

Consumption taxes are inherently regressive, as they disproportionately tax low-income households who spend a higher percentage of their income on necessities like rent and utilities. In the UK, the lowest-income decile spends about 12% of its disposable income on VAT, compared to 5% for the highest-income decile (Bourquin, Joyce, & Keiller, 2020). Retirees are impacted as their fixed incomes, from which they sustain costs for basic necessities, don’t provide flexibility during price changes (Ruppert, Schön, & Stähler, 2023). Furthermore, unlike income tax systems, consumption is not directly based on the individual’s ability to pay, limiting progression and wealth redistribution. Young adults entering the labor force, especially those with low-paying jobs, also struggle to build savings, as more of their income is spent on necessities (Blasco, Guillaud, & Zemmour, 2023). Though low-income households face a similar burden, wealthier individuals can accumulate more assets as they have a larger proportion of income available after consumption and tax, possibly having a lower burden than before from the lack of progressive taxation. 

This trend is evident in the reduction of Gini coefficients across taxation systems. Finland and Denmark, which rely on income taxation, achieve substantial reductions in inequality after taxes and benefits. In contrast, Australia and New Zealand, emphasizing consumption taxes, show lower reductions, averaging 25%. Mixed systems like Germany and the Netherlands fall in the middle, achieving around 30%. These patterns highlight how income taxation more effectively reduces inequality than consumption or mixed systems.

Although they are regressive, shifting to consumption taxes has broadened the tax base in some countries, alleviating the negative impact (Marples, 2023). Consumption taxes apply to purchases made by any person in the country, including low and high-income individuals, tourists, and informal businesses. This broadens the tax base and removes dependency on any single group, leading to the tax burden being divided more equally among taxpayers. In the short run, there is a substantial increase in income inequality due to the regressive nature of consumption taxes. However, by relieving pressure off vulnerable groups, the expanded broad tax base works towards mitigating disparity in the future.

Overall, progressive income tax systems substantially reduce income inequality and support the most vulnerable groups. A shift to a consumption tax could exacerbate the disparity, making it imperative for governments to expand the tax base and mitigate the negative impact. Besides social equality, economic growth is fundamental, making it imperative to analyze consumption tax’s impact on it. 

Economic Growth

Through progressive income taxation, countries have historically increased disposable income and consumer purchasing power as the support for low-income individuals stimulates demand and capital investment (Steindel, 2001). Furthermore, by raising the average education level, lower-income households can acquire more skilled and higher-paying jobs, fostering labor force productivity and participation in the long run (Khattar, Weller, & Correa, 2023). Lastly, income taxes comprise a large proportion of government revenue, which directly improves public infrastructure like healthcare and the overall standard of life in the future. These factors directly contribute to foreign direct investment (FDI) and strengthen international relations over time, as income, education, and public infrastructure are key indicators of growth for foreign investors (Haudi, Wijoyo, & Cahyono 2020). 

Shifting to consumption taxes could dampen these impacts and growth. Historically, countries that have transitioned to VAT or GST have often encountered inflation shocks that exacerbate inequality in the short run (York et al., 2024). For example, when Latvia introduced a VAT in 1992, consumer prices rose by approximately ten percentage points in the following quarter (Bird & Gendron, 2007). Preemptive consumption, fueled by anticipatory behavior regarding price changes, often leads to high demand and surged prices. This forces retirees and low-income groups, reliant on fixed incomes and limited disposable income, to adapt to the drastic decrease in purchasing power. 

Though challenging, these negative impacts associated with consumption taxation can be mitigated and even reversed. Singapore’s implementation of GST mirrored historical transitions, with high inflationary pressure soon after implementation. However, through effective policies like the GST Voucher Scheme, which funded direct cash payments to low-income households, and the Workfare Income Supplement (WIS), which aided low-wage workers, Singapore successfully mitigated inflation, which overall lasted only for a short term (Australian Treasury, 2003). Another effective countermeasure is applying progression, where essential goods are taxed at lower rates than luxury items, reducing the burden on low-income households. Other countries have also developed similar programs that capitalize on maximum economic growth derived from consumption tax, like Japan’s reduced consumption tax rate for necessities that support low-income households (Gole, 2024).

Eliminating double taxation is another key advantage of consumption taxes. Under an income tax system, individuals who invest their after-tax income are taxed again on their capital gains, resulting in a higher overall tax burden than those who spend immediately (York et al., 2024). A consumption tax system ensures that all taxpayers, regardless of whether they save or spend immediately, bear equivalent burdens, as taxes are applied only at the point of spending (Kagan, 2024). Ultimately, consumption taxes eliminate the savings and investment stigma associated with income taxation, enhancing both capital investment and technological innovation in the long run. 

A broad tax base also simplifies tax administration for the government by removing the need to regulate individual taxpayers, a requirement that is associated with income taxes (Gale, 2001). Although consumption taxes make individual rebates substantially more complex, streamlining tax collection has a direct impact on higher compliance and leads to greater government revenue. They also incorporate the tourism industry and informal economy into a country’s tax base  (Bird & Gendron, 2007). Mexico further leveraged this by integrating informal sectors into the fiscal framework, excising unnecessary administrative costs and benefiting businesses that gained tax credits in exchange for compliance. Additionally, transparent and predictable tax systems are often perceived as more stable for foreign investors, as reflected in Mexico’s increased FDI in the years after implementing GST (Cuevas, Messmacher, & Werner, 2005). Lastly, many groups, including the OECD and EU, view consumption taxes as more efficient and effective than their counterpart; by adopting consumption taxes, nations can foster trade benefits and strengthen international relations (OECD, 2024).

Conclusion

Determining whether to transition to a consumption tax system requires a comprehensive analysis of its impacts on inequality and economic growth. This essay argues that while consumption taxes present significant economic advantages, a full transition is not without risks. Income taxes historically reduce inequality and support government revenue. However, consumption taxes are substantially more efficient, as they increase government revenue, simplify administration and strengthen international relations. Furthermore, broadening the tax base, as seen in Mexico, reflects the potential for governments to capitalize on consumption taxes to integrate informal sectors and increase FDI (Cuevas, Messmacher, & Werner, 2005). 

Still, the regressive nature of consumption taxes could exacerbate inequality, further reflected in the UK’s relatively increased income inequality after implementing VAT. Therefore, the answer lies not in a complete shift but in adopting a balanced approach (Bourquin, Joyce, & Keiller, 2020). Utilizing the redistributive characteristics of income taxes and the growing potential of consumption taxes is imperative in a dynamic world. Germany exemplifies this balance through its hybrid tax system, enabling it to maintain equality and a robust economy concurrently (Hasell, 2023). Overall, the decision to transition must account for the unique economic and social context of each country, ensuring that no group disproportionately bears the tax burden while promoting economic growth in the long term.

References

Adam, Stuart, Tim Besley, Richard Blundell, Stephen Bond, Robert Chote, Malcolm Gammie, Paul Johnson, Gareth Myles, and James M. Poterba. 2010. Dimensions of Tax Design: The Mirrlees Review. Oxford: Oxford University Press.

Australian Treasury. 2003. “Preliminary Assessment of the Impact of the New Tax System | Treasury.gov.au.” Treasury.gov.au. https://treasury.gov.au/publication/economic-roundup-autumn-2003/preliminary-assessment-of-the-impact-of-the-new-tax-system.

Bachas, Pierre, Ruth Hill, Mariano Ernesto Sosa, and Matthew Wai-Poi. 2023. “In Many Countries, Taxes and Transfers Make the Poor Poorer, It Doesn’t Have to Be This Way.” World Bank Blogs. May 4, 2023. https://blogs.worldbank.org/en/developmenttalk/many-countries-taxes-and-transfers-make-poor-poorer-it-doesnt-have-be-way.

Bird, Richard, and Pierre-Pascal Gendron. 2007. The VAT in Developing and Transitional Countries. Cambridge University Press. https://doi.org/10.1017/cbo9780511619366.

Blasco, Julien, Elvire Guillaud, and Michaël Zemmour. 2023. “The Inequality Impact of Consumption Taxes: An International Comparison.” Journal of Public Economics 222 (June): 104897–97. https://doi.org/10.1016/j.jpubeco.2023.104897.

Bourguignon, François. 2018. “Spreading the Wealth.” IMF Finance & Development Magazine, March 2018. https://www.imf.org/en/Publications/fandd/issues/2018/03/bourguignon.

Bourquin, Pascale, Robert Joyce, and Agnes Norris Keiller. 2020. “Living Standards, Poverty and Inequality in the UK: 2020.” Institute for Fiscal Studies. https://ifs.org.uk/publications/living-standards-poverty-and-inequality-uk-2020.

CEFP. 2018. “Evolución Y Perspectiva Del ISR E IVA, 1990 – 2019.” Centro de Estudios de las Finanzas Públicas.

CFR. 2023. “Why Do Taxes Matter?” CFR Education by Council on Foreign Relations. May 2, 2023. https://education.cfr.org/learn/reading/why-do-taxes-matter.

Crandall-Hollick, Margot L., Gene Falk, and Jameson A. Carter. 2020. “The Impact of the Federal Income Tax Code on Poverty.” Congressional Research Service. https://crsreports.congress.gov/product/pdf/R/R45971.

Cuevas, Alfredo, Miguel Messmacher, and Alejandro Werner. 2005. “Foreign Direct Investment in Mexico since the Approval of NAFTA.” The World Bank Economic Review. Vol. 19. https://doi.org/10.1093/wber/lhi015.

Dhamani, Ishita. 2008. “Income Inequality in Singapore: Causes, Consequences and Policy Options.” ResearchGate, January. https://www.researchgate.net/publication/242593839_Income_Inequality_in_Singapore_Causes_Consequences_and_Policy_Options.

Gale, William G. 2001. “Tax Simplification: Issues and Options.” Brookings. July 17, 2001. https://www.brookings.edu/articles/tax-simplification-issues-and-options/.

Gole, Aradhana. 2024. “Japan to Reform Consumption Tax Refunds 2025.” VAT Calc. August 16, 2024. https://www.vatcalc.com/japan/japan-to-reform-consumption-tax-reforms-2025/.

Hasell, Joe. 2023. “Income Inequality before and after Taxes: How Much Do Countries Redistribute Income?” Our World in Data, July. https://ourworldindata.org/income-inequality-before-and-after-taxes.

Hasell, Joe, Max Roser, Esteban Ortiz-Ospina, and Pablo Arriagada. 2023. “Poverty.” Our World in Data. https://ourworldindata.org/poverty?insight=the-rapid-progress-seen-in-many-countries-shows-an-end-to-poverty-is-possible#key-insights.

Haudi, H, Hadion Wijoyo, and Yoyok Cahyono. 2020. “Analysis of Most Influential Factors to Attract Foreign Direct Investment.” Journal of Critical Reviews 7 (13). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3873718.

Ikhsan, Mohammad Fajar, Norsyuhada Azwin Aziz, and Emil Mahyudin. 2022. “CASE STUDY on the IMPLEMENTATION of GOODS and SERVICES TAX (GST) in MALAYSIA and SINGAPORE.” Journal of International Studies 18 (October): 159–89. https://doi.org/10.32890/jis2022.18.6.

Inchauste, Gabriela, and Nora Lustig. 2017. “How Do Taxes and Transfers Impact Poverty and Inequality in Developing Countries?” World Bank Blogs. September 18, 2017. https://blogs.worldbank.org/en/developmenttalk/how-do-taxes-and-transfers-impact-poverty-and-inequality-developing-countries.

Kagan, Julia. 2024. “What Is Double Taxation.” Investopedia. October 30, 2024. https://www.investopedia.com/terms/d/double_taxation.asp.

Khattar, Rose, Christian Weller, and David Correa. 2023. “Investing in Workers Can Further Ease Inflation and Boost Economic Growth.” Center for American Progress. August 30, 2023. https://www.americanprogress.org/article/investing-in-workers-can-further-ease-inflation-and-boost-economic-growth/.

Krueger, Alan B., and Mikael Lindahl. 2000. “Education for Growth: Why and for Whom?” SSRN Electronic Journal 39 (4). https://doi.org/10.2139/ssrn.223589.

Marples, Donald J. 2023. “Consumption Taxes: An Overview.” Congressional Research Service. https://crsreports.congress.gov/product/pdf/R/R44342.

OECD. 2024. “Consumption Tax Trends 2024.” 2024. https://www.oecd.org/en/publications/consumption-tax-trends-2024_dcd4dd36-en.html?utm_source=chatgpt.com.

Ruppert, Kilian, Matthias Schön, and Nikolai Stähler. 2023. “Consumption Taxation to Finance Pension Payments.” Economic Modelling 130 (October): 106570. https://doi.org/10.1016/j.econmod.2023.106570.

Steindel, Charles. 2001. “The Effect of Tax Changes on Consumer Spending.” SSRN Electronic Journal 7 (11). https://doi.org/10.2139/ssrn.711385.

The World Bank. 2024. “Taxes & Government Revenue.” World Bank. April 10, 2024. https://www.worldbank.org/en/topic/taxes-and-government-revenue.

York, Erika, Garrett Watson, Alex Durante, and Huaqun Li. 2024. “How Taxing Consumption Would Improve Long-Term Opportunity and Well-Being for Families and Children.” United States Tax Foundation. September 9, 2024. https://taxfoundation.org/research/all/federal/us-consumption-tax-vs-income-tax/#_ftnref17.