How Should Consumption Be Taxed?

Spencer Bastani

Higher taxes on consumption combined with lower taxes on labor would benefit the economy in a number of ways. This is argued by tax scholar Spencer Bastani in a new SNS report in which he, among other things, proposes a unification of VAT rates and a broadened VAT base.

How Should Consumption Be Taxed? (english summary) 50.0 KB PDF

Taxes on consumption, mainly VAT and various excise taxes, currently account for approximately 30 percent of Swedish tax revenues. VAT is by far the most important. VAT typically means that goods and services become 25 percent more expensive for consumers. However, many goods and services are subject to a reduced VAT rate, such as food (12 percent), books and transportation services (6 percent). In addition, several industries are exempt from VAT, such as housing, insurance and financial services.

“This leads to costs for society in terms of distorted consumption choices and production decisions, distorted competition, administrative hassle, delineation problems and arbitrary redistribution between individuals and sectors,” says Spencer Bastani, researcher at the Institute for Evaluation of Labour Market and Education Policy (IFAU).

In his SNS report How Should Consumption Be Taxed? Bastani argues that consumption represents a broader tax base compared to labor and can therefore be more efficient to tax. Consumption is not only financed by labor income, but also by wealth, capital income, undeclared work, tourism and border shopping.

Bastani also points out that increasing the relative importance of consumption taxes in the tax system can have equalizing redistributive effects, since consumption taxation, in contrast to labor income taxation, targets consumption financed by various forms of low-taxed capital income concentrated among high income individuals (in the context of the Swedish “dual” income tax system where the taxation of labor income is separated from the taxation of capital income).

Increasing the importance of consumption taxes relative to labor income taxes in two steps

Bastani proposes a two-step process of increasing the tax burden on consumption relative to labor. As a first step, the reduced VAT rates are proposed to increase from 12 percent and 6 percent to 25 percent, at the same time as individuals and firms are compensated through, for example, reduced payroll taxes, reduced labor income taxes for low and middle income earners and increased transfers. As a second step, Bastani suggests abolishing VAT exemptions.

“VAT exemptions are often perceived as given by EU rules, but even if no changes are implemented at the EU level, it is still possible to broaden the VAT base at the national level,” says Spencer Bastani.

Excise taxes, ROT and RUT*

According to tax research, there are two exceptions to the recommendation that consumption should be taxed in a uniform fashion. The first concerns excise taxes, the aim of which is to improve economic efficiency by correcting for so-called negative externalities affecting, for instance, people’s health and the environment.

Unfortunately, according to Bastani, rather than focusing on reducing negative externalities, which should be the main purpose of such taxes, several excise taxes are to a great extent used as sources of tax revenue.

He proposes that in the long term, excise taxes on energy should be replaced by a higher VAT rate and a higher tax on carbon dioxide in a revenue and climate-neutral manner. He also proposes that symbolic taxes, such as the Swedish aviation tax and the tax on plastic bags, should be abolished and replaced by taxes targeting the underlying environmental problems.

The second exception to uniform consumption taxation concerns goods and services that contribute to a greater labor supply and labor effort, such as child care and household services.

“ROT and RUT deductions are well-motivated elements of the tax system as they help counteract the distortions caused by Sweden’s high marginal tax rates on labor. Hence, they can contribute to more hours worked, more labor effort, and an increased level of specialization,” says Spencer Bastani.

This report is published within the framework of the SNS research project Taxes in a Globalised World.

About the author

Spencer Bastani is a researcher at the Institute for Evaluation of Labour Market and Education Policy (IFAU). He is affiliated with the Uppsala Center for Fiscal Studies, Uppsala University, and the Research Institute of Industrial Economics (IFN).