Consumption taxes are taxes levied on purchases of goods and services. As opposed to income, dividend, and capital gains taxes (which are taxes on earnings), consumption taxes are collected when individuals purchase or consume goods and services.
Examples of consumption taxes include excise taxes, value-added (VAT) taxes, and tariffs, all of which function a bit differently. Here, you’ll learn how consumption taxes work, the benefits and disadvantages of each, and the impact they may have.
Definition and Examples of Consumption Tax
A consumption tax is a tax levied on goods and services consumed or purchased. Essentially, consumption taxes tax people when they spend money rather than when they earn money. Examples of consumption taxes include excise taxes, VAT taxes, sales taxes, and taxes on imported goods.
An excise tax is a common form of consumption tax levied on items not considered healthy or wholesome.
Let’s look at a specific example to get a better understanding of how consumption taxes work. In the U.S., a special tax—specifically an excise tax—is levied on tobacco products.
Because of the government-imposed tax, a pack of cigarettes at the local convenience store costs more than it would without that tax. These tax rates depend on the state you live in, and there are often local excise taxes, too.
In New York, for example, the state excise tax rate is $4.35 for a pack of 20 cigarettes, and the New York City local excise tax is $1.50 for the same amount. That means you’ll pay $5.85 in taxes on top of the retail price, bringing the retail price to about $10 for a pack of cigarettes.
How Consumption Taxes Work
Consumption taxes were first introduced in the U.S. in the 1800s and have since been an integral part of the tax system. Globally, though, consumption taxes have a stronger presence and are a very popular form of revenue generation for governments. The United States is unusual in that there is no federal consumption tax on goods and services; it is up to state and local entities to set it up.
Revenue from consumption taxes makes up less than 20% of total tax revenue in the U.S. In comparison, as of 2019, consumption taxes make up 32.3% of tax revenue in OECD countries.
Nevertheless, consumption taxes do play a role in raising government funds in the U.S. In the U.S., consumption taxes usually are designed as sales taxes, excises taxes, and taxes on imported goods.
Types of Consumption Taxes
Consumption taxes come in several forms, including excise taxes, sales taxes, VAT taxes, and taxes on imported goods. Let’s dive into how they all work.
Excise taxes—also known as “sin taxes”—are taxes levied on specific categories of goods or services. Excise taxes can be imposed on the producer, retailer, or consumer, and are often used to discourage behaviors considered detrimental. The tax rates vary depending on the state. Examples of excise taxes include taxes on alcohol, tobacco, coal, and gambling.
Sales taxes are taxes levied on the retail sale of goods or services. Unlike excise taxes, sales taxes are not designed to target vices. In the U.S., retail sales taxes are a significant revenue source for state governments, and many allow local counties, cities, and municipalities to add their own separate taxes to the state rate, too. Some governments exempt necessities such as groceries from sales taxes.
Some states, but not many, have little to no sales tax. As of 2020, there are just five states with no sales tax at all: Alaska, Delaware, Montana, New Hampshire, and Oregon.
The value-added tax, or the VAT tax, is a very common consumption tax in European countries. The VAT is very similar to the sales tax in that the tax is ultimately levied at the retail level. The tax, however, is determined by calculating the value added at every stage of production of the product.
Taxes on Imported Goods
Tariffs are taxes levied by one country on goods or services imported from another country. Tariffs are usually paid on raw materials at the producer level, or for finished goods at the distributor level. Tariffs differ from import duties, which are consumption taxes paid by retail consumers for imported finished goods.
Benefits of Consumption Taxes
The U.S. government generates most of its revenue via income taxes, payroll taxes, and corporate income taxes. In other words, most revenue is generated on money earned. This model poses several problems.
First, income is very difficult to measure, especially when complex financial calculations such as capital gains and depreciation are taken into account. Consumption taxes, on the other hand, are relatively easy to quantify: Any time an individual spends money, a portion of the expenditure is remitted to the government.
The consumption tax can also encourage saving. Under the current income-based model, individuals and households are subject to a tax whether or not they are careful to set aside funds for the future. The consumption tax model reverses this paradigm, as money is only taxed when spent, which can encourage people to spend less and save more.
A consumption tax may also be more fair than an income tax. Since income is difficult to measure, it is also easier to hide income and to avoid potential taxes therein. Consumption is more difficult to conceal, and since the wealthy generally spend more on goods and services, they are liable to pay more taxes.
Criticisms of Consumption Taxes
The consumption tax can present several drawbacks, too. For example, many people with very low incomes pay no income tax under the current system because of the current threshold. If a consumption tax were to be implemented, low-income people would suddenly have to pay taxes on every purchase.
Since low- and middle-income households spend more of their income than wealthy households, the consumption tax can prove regressive. Research further suggests that even with a switch to a consumption model, savings would not increase significantly.
- Consumption taxes are taxes on the purchase of goods and services designed to tax individuals when they spend money rather than when they earn it.
- Examples of consumption taxes include excise taxes, VAT taxes, sales taxes, and taxes on imported goods.
- Consumption taxes may be fairer and simpler than the income tax since it is easy to conceal income.
- Consumption taxes may also encourage saving since it discourages spending.
- Some studies indicate that consumption taxes do not encourage saving and adversely affect low-income households.