Tackling Wealth Disparity with a Consumption Tax

What are the limitations of the current tax system and how could a progressive consumption tax change this?

The current tax system in the UK has several limitations. Firstly, households at the bottom of the income distribution pay a higher proportion of their income on essential goods, resulting in them paying more in indirect taxes. This raises questions about the equity of the system. Secondly, the current system of income tax, National Insurance contributions, VAT and corporation tax is complex and administratively burdensome. Additionally, income tax only covers some sources of income and there are several forms of tax penalties based on employment types. The implementation of a progressive direct consumption tax could address some of these limitations, but it raises several transition issues, such as how to deal with imported goods, double taxation for pensions and registered assets, and different capital taxes. Phasing in the consumption tax gradually and allowing for exemptions could help with the transition.

What tax policies did NIESR simulate?

NIESR simulated three tax policy scenarios using a microsimulation model and data covering approximately 40,000 individuals from 20,000 households, representative of the UK population. The scenarios include replacing VAT and consumption duties with a 15% flat-rate tax on consumption (simulation 1), replacing the current tax system with a flat-rate direct consumption tax rate of 41.3% (simulation 2), and replacing the current tax system with a progressive flat-rate direct consumption tax rate of 78% with a tax-free threshold of £100 per week (simulation 3). The analysis aims to achieve budget neutrality, distributional neutrality, and focus on inequality of adult equivalised consumption while studying behavioural effects.

What was the outcome of the study?

Simulation 1: Negligible impact on consumption, employment and wealth effects. Limited behavioural effects overall

Simulation 2: Increased inequality of equivalised consumption, with the introduction of the direct consumption tax leading to a decrease in lifetime consumption for the bottom quintile of the income distribution and an increase for the top quintile

Simulation 3: Improved welfare by allowing households to smooth consumption, incentivising employment, and increasing savings and wealth accumulation for all income groups