This paper addresses a case study on a debate on the benefits of personal consumption versus personal income tax.
When taxes induce people to change their behavior—such as inducing Jane to buy less pizza—the taxes
cause deadweight losses and make the allocation of resources less efficient. As we have already seen, much
government revenue comes from the individual income tax in many countries. In a case study in Chapter 8,
we discussed how this tax discourages people from working as hard as they otherwise might. Another
inefficiency caused by this tax is that it discourages people from saving.
Consider a person 25 years’ old who is considering saving $1,000. If he puts this money in a savings account
that earns 8 percent and leaves it there, he would have $21,720 when he retires at age 65. Yet if the
government taxes one-fourth of his interest income each year, the effective interest rate is only 6 percent.
After 40 years of earning 6 percent, the $1,000 grows to only $10,290, less than half of what it would have
been without taxation. Thus, because interest income is taxed, saving is much less attractive.
Some economists advocate eliminating the current tax system’s disincentive toward saving by changing the
basis of taxation. Rather than taxing the amount of income that people earn, the government could tax the
amount that people spend.
Under this proposal, all income that is saved would not be taxed until the saving is later spent. This
alternative system, called a consumption tax, would not distort people’s saving decisions.
Various provisions of the current tax code already make the tax system a bit like a consumption tax.
Taxpayers can put a limited amount of their saving into special accounts—such as Individual Retirement
Accounts and 401(k) plans—that escape taxation until the money is withdrawn at retirement. For people
who do most of their saving through these retirement accounts, their tax bill is, in effect, based on their
consumption rather than their income.
European countries tend to rely more on consumption taxes than does the United States. Most of them raise
a significant amount of government revenue through a value-added tax, or a VAT. A VAT is like the retail
sales tax that many U.S. states use, but rather than collecting all of the tax at the retail level when the
consumer buys the final good, the government collects the tax in stages as the good is being produced (that
is, as value is added by firms along the chain of production). Various U.S. policymakers have proposed that
the tax code move further in direction of taxing consumption rather than income. In 2005, economist Alan
Greenspan, then Chairman of the Federal Reserve, offered this advice to a presidential commission on tax
reform: “As you know, many economists believe that a consumption tax would be best from the perspective
of promoting economic growth—particularly if one were designing a tax system from scratch—because a
consumption tax is likely to encourage saving and capital formation. However, getting from the current tax
system to a consumption tax raises a challenging set of transition issues.”
Q1: What should be taxed – Personal Income or Personal Consumption and why? Provide your opinion
based on the case given below. (200 words) [2.5 Marks]
Q2: How may it affect Saudi Economy if an income tax is imposed in KSA? (200 words) [2.5 Marks]