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Expenditure Cascades

In an earlier post, I argued that a progressive consumption tax could free up the resources needed to avoid economically crippling budget deficits in future years.  But because the United States is notoriously tax-phobic, many view any major new tax as little more than a political pipedream.   

The initial reaction to my proposal in the comments was distinctly skeptical, not to say hostile.  But as the conversation unfolded in the comments on a subsequent post, opposition has gradually softened.  From having had hundreds of conversations about this issue over the course of many years, I can report that this pattern is typical.  As the details of how a progressive consumption tax would work become more clear, its appeal grows, not only to the middle-class families that constitute a decisive electoral majority, but also to the wealthy, whose political influence far exceeds their number.

First, the middle-class:  Although the tax would have little effect on how much the government collects from low- and middle-income families, it would reduce the growing financial pressures confronting these families. The greatest income gains over the last three decades and the lion’s share of income tax cuts have gone to top earners.  Finger-wagging social critics have been quick to denounce the lavish spending of this group, but top earners have been building larger houses and throwing more expensive parties simply because they have more money. That’s what people of all income groups do. 

Such spending has had little direct impact on people in the middle.  To the extent they pay any attention to it at all, they look on with bemused admiration.  But the spending of top earners shifts the frame of reference of the near-rich, leading them to spend more as well.  (Perhaps the bigger mansions of the rich have made it the custom to host their daughters’ wedding receptions at home, rather than in hotels and country clubs.)  So the near-rich, who travel in the same social circles, are moved to build bigger too, and so on all the way down the income ladder.  The resulting expenditure cascade has affected families at every income level. 

For example, the median new house in the United States now has over 2,300 square feet, over 40 percent more than in 1979, even though real median family earnings have risen little since then.  And many middle-income children now take it for granted that their birthday party guests will be entertained by a professional clown or magician.  These spending changes are a consequence of the pressure middle-income families feel to keep up with the spending patterns of their peers.

If the only cost of failing to keep up were hurt feelings, that would be one thing.  But many middle-income families feel pressure to spend beyond their means because more expensive neighborhoods tend to have better schools. That means a family that spends less than its peers on housing must send its children to lower-quality schools.  In the short term, a progressive consumption tax would slow the growth of high-end spending that has made it increasingly difficult for middle-income families to make ends meet.  Longer term, increased investment would spur income growth, raising living standards for families at all income levels.

How would the wealthy be affected by a progressive consumption tax?  The attractions of the tax for low- and middle-income families are clear enough.  Perhaps more surprising, in light of its high marginal rates on high levels of consumption, is the attraction of this tax for high-income consumers. 

Evidence suggests that, beyond some point, across-the-board increases in many types of consumption spending deliver little increase in consumer satisfaction.  As the economist Richard Layard has written, “In a poor country, a man proves to his wife that he loves her by giving her a rose, but in a rich country he must give a dozen roses.” 

The upshot is that when the wealthy all increase the size of their mansions from 50,000 square feet to 60,000 square feet, the main effect is to raise the bar that defines how big a mansion a wealthy family needs.  So across-the-board increases in house size beyond some point yield little gain.  Indeed, given the hassles involved in recruiting, training, and supervising the staff to take care of a larger mansion, the wealthy might well be happier with smaller mansions, even neglecting the extra security they’d enjoy from the extra money they saved. 

In short, the spending incentives confronting the wealthy resemble those confronting rival nations embroiled in a military arms race.  It would be good to build fewer bombs, but only if everyone did it.  By creating incentives for across-the-board reductions in high-end purchases that deliver little value, a progressive consumption tax helps solve this collective action problem.

Conservatives often complain that if we raise the top marginal tax rates on income, the wealthy will move away.  Although that sometimes happens in countries whose tax rates are high relative to rates elsewhere, it is not a practical worry for the US, whose marginal tax rates are among the lowest anywhere.   

But under a progressive consumption tax, higher marginal rates on top consumption levels would actually make a country more attractive to the wealthy, because it would help them avoid squandering resources on unproductive spending arms races.