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Saving Grace

  Individual demands are heavily shaped by the social environment. As the economist Richard Layard has written, for example, "In a poor society a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses." For the last three decades, virtually […]



Individual demands are heavily shaped by the social environment. As the economist Richard Layard has written, for example, "In a poor society a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses." For the last three decades, virtually all income gains in the United States have gone to top earners. Recipients have spent most of their extra income on positional goods, things whose value depends heavily on how they compare with similar things bought by others. Like mutually offsetting weapons in a military arms race, consumption of this sort is largely wasteful. Many of the most spectacular increases in high-end consumption in recent years appear to have been driven almost entirely by positional forces. If people acted in tandem, resources could be diverted from positional consumption at little sacrifice.

Although there is scant evidence that middle-income families in America resent the spending of top earners, they are nonetheless affected by it in tangible ways. Additional spending by the rich shifts the frame of reference that defines what the near-rich consider necessary or desirable, so they too spend more. In turn, this shifts the frame of reference for those just below the near-rich, and so on, all the way down the income ladder. Such expenditure cascades help explain why the median new house built in the U.S. is now about 50 percent larger than its counterpart from thirty years ago, even though the median real wage has risen little since then.

Higher spending by middle-income families is driven less by a desire to keep up with the Joneses than by the simple fact that the ability to achieve important goals often depends on relative spending. Because of the link between housing prices and neighborhood school quality, for example, the median family would have to send its children to below-average schools if it failed to match the spending of its peers on housing. Instead, middle-income families have opted to save less, borrow more, work longer hours, and commute longer distances than ever before, all in an effort to keep pace with escalating consumption standards.

Although additional outlays for positional consumption goods—such as houses beyond a certain size—don't accomplish much, they crowd out other forms of spending that would produce real improvements in the quality of life. If houses grew less rapidly, for example, we could invest in mass-transit systems that would yield shorter, less stressful commutes that would free up more time to spend with friends and family. Or we could support medical research and safety investments that would reduce premature death. The list goes on.

Wasteful positional arms races occur because people take too little account of the costs that certain types of consumption impose on others. When one job applicant spends more on an interview suit, for example, others must spend more as well, or else accept lower odds of getting a callback. Yet when all spend more, no one's odds of landing the job are any higher than before.

If we had perfect information, the ideal remedy for positional waste would be to tax different goods in proportion to the extent to which their use generates negative side effects. In practice, we lack the detailed information necessary to implement this remedy. But a steeply progressive tax on each family's total annual consumption would serve almost as well.

The amount a family consumes each year is simply the difference between what it earns and what it saves. Under a progressive consumption tax, people would report their income to the Internal Revenue Service as they do now and also their annual savings, much as they currently document contributions to 401(k) and other retirement accounts. The difference between these two amounts, less a large standard deduction—say, $30,000 for a family of four—would be the family's taxable consumption. Rates would start low, perhaps only at 10 percent. In this illustration, a family that earned $50,000 and saved $5,000 would have a taxable consumption of $15,000 and pay only $1,500 in tax. By comparison, it would pay about twice that amount under the current income tax.

As taxable consumption rises, the tax rate on additional consumption would also rise. With a progressive income tax, marginal tax rates cannot rise too far without threatening incentives to save and invest. Under a progressive consumption tax, however, higher marginal tax rates actually strengthen those incentives.

To see why, consider a family that currently spends $10 million a year and is debating whether to add a $2 million wing to its mansion. If the top marginal tax rate on consumption were 100 percent, the project's cost (including tax) would be $4 million. Alternatively, the family could scale back, building only a $1 million addition. Then it would pay $1 million in additional tax and could deposit $2 million more than before in savings. Federal revenue would rise by $1 million, and the additional savings would stimulate investment, promoting growth.

Either way, the nation would come out ahead, and the wealthy family would have made no real sacrifice. Because the tax would induce most other wealthy families to scale back, it would lower the bar that defines an acceptable mansion for families in their circle. In effect, it would create real resources out of thin air.

Even more striking gains would result from the tax's indirect effect on the expenditure cascades that have made life more difficult for middle-income families. If the rich spent less on housing, gifts, and other things, the near-rich would spend less as well, and so on, all the way down. All told, a progressive consumption tax could easily boost the nation's effective income by several trillion dollars a year.

Some may worry that tax incentives for reduced consumption might create or prolong an economic downturn. But it is total spending, not just consumption, that determines output and employment. If a progressive consumption tax were phased in gradually when the economy was at full employment, its main effect would be to shift spending from consumption to investment, causing productivity and incomes to rise faster.

Activities that cause congestion and pollution are another major source of private-sector waste. Like the waste caused by positional arms races, private waste occurs because people take too little account of how their actions affect others. Fuel use decisions, for instance, are driven primarily by concern about personal costs and benefits, and only secondarily, if at all, by concern about the costs that additional carbon emissions, smog, and congestion impose on others.

The simplest way to induce consumers to take such external costs into account is by taxing the activities in question. The cost of eliminating acid rain, for example, fell dramatically once government began charging for the right to emit sulfur oxides into the atmosphere.

Existing efforts to curtail environmental waste have barely scratched the surface. A carbon tax, in tandem with higher taxes on gasoline, could sharply curtail traffic jams, smog, suburban sprawl, greenhouse gases, and various other harmful effects associated with fossil fuel consumption. Taxes of this sort generally turn out to be much less burdensome than people expect. Europeans, for instance, have responded to gasoline taxes of more than two dollars per gallon by driving more fuel-efficient vehicles whose operating costs, including tax, are no higher than most Americans now pay. There is no evidence that Europeans are less happy with their cars than Americans are with theirs.

Conservatives complain that higher taxes make the economic pie smaller. But taxes on harmful activities have precisely the opposite effect. And when the economic pie grows larger, it's always possible for everyone to have a larger slice than before. By eliminating waste, these taxes free up resources for things we actually value.

With the economy in the midst of the deepest downturn since the Great Depression, now is not the time to impose these taxes on low- and middle-income households. Yet national renewal on the scale Obama has proposed will require major sources of new revenue in the long run. We can't borrow money from the Chinese to pay for universal health care, expanded investment in education and infrastructure, increased scientific research, and more. Future taxes will clearly have to rise by more than suggested in the president's recent budget proposals. But raising taxes has always been the third rail of American politics. If we postpone decisions about how to raise more revenue until after the economy has regained its footing, we are likely to remain saddled with our current dysfunctional system.

Recent research in behavioral economics shows a way to structure tax increases to avoid reflexive opposition. Studies suggest that tax resistance is rooted in loss aversion—according to which a loss of any given magnitude causes much more pain than the pleasure from a gain of the same size. Adding any new tax right now would mean further cuts in consumption, which would trigger additional paroxysms of loss aversion. New taxes would be much easier to accept if they required not an absolute reduction in current consumption but rather only a smaller increase in future consumption.

Evidence for this claim comes from experience with Save More Tomorrow, a program devised by the economists Richard Thaler and Shlomo Benartzi, PhD '94. Under their program, employees of a company can commit now to divert some portion of their next pay raise into their 401(k) account. Employees with this option save dramatically more than those whose only option is to save more right away.

In the same spirit, Congress could enact Tax More Tomorrow legislation. That is, it could enact legislation today calling for new taxes to begin phasing in only after economic growth has resumed in earnest—for example, only after the unemployment rate has again fallen below a suitable target, perhaps 6 percent. Loss aversion would thus be sidestepped, because the typical family's income net of tax would still be higher each year than the year before. Consumers and producers can adapt to new taxes more efficiently if they are phased in gradually. Gasoline taxes, for example, could be increased by ten cents per gallon for each of the twenty months after the target unemployment rate is reached.

It is time to discard childish ideas. It is not true, as we were urged to believe in recent years, that an invisible hand driven by greed serves up the greatest good for all.The same unemployment rate could trigger launch of the progressive consumption tax. At first, we could collect income taxes as before and levy a progressive surtax only on consumption in excess of some high threshold—say, $500,000 annually. The threshold could then be lowered gradually until the consumption tax completely replaced the income tax. Or, as the economist Larry Seidman has proposed, we could retain the current income tax permanently and supplement it with a progressive surtax levied only on extremely high levels of consumption. Since this surtax would apply to less than 1 percent of households, Seidman's approach would be administratively far simpler and hence likely to provoke less political resistance. In either form, such legislation would calm the bond market's fears of lingering deficits and deter speculative attacks on the dollar.

Adopting a progressive consumption tax that would take effect only when the economy again reached full employment would promote both short-term stimulus and long-run fiscal balance in a single stroke. Any family that was contemplating a large purchase in the coming years would have a powerful incentive to spend that money right away to avoid the future consumption levy. A strategically implemented progressive consumption tax is thus a conspicuous exception to the general rule that tax policy decisions confront us with painful tradeoffs between short- and long-term objectives.

Should a recession occur, a temporary cut in consumption taxes would actually provide a much more powerful stimulus than the traditional temporary cut in income taxes. People would benefit from a temporary consumption-tax cut only if they spent more right away. In contrast, consumers who fear that they might lose their jobs in a recession are often reluctant to spend a temporary income-tax cut.