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Income inequality vs. consumption inequality

A post today by Kevin Drum reminded me of an issue that arose in the media a few months back that I've meant to address. Some economists (I gather mainly conservative ones) argue that focusing on income inequality is misguided. Thus, according to Michael Cox and Richard Alm some months back:

"Looking at a far more direct measure of American families? economic status ? household consumption ? indicates that the gap between rich and poor is far less than most assume, and that the abstract, income-based way in which we measure the so-called poverty rate no longer applies to our society."

Given the view I've expressed elsewhere (even if with qualifications and reservations) that a consumption tax is superior to an income tax, not just on efficiency grounds but also as a distributional measure of relative wellbeing, why wouldn't I agree with this?

In a word, because it's wrong, and wrong in a way that is consistent with viewing the consumption tax (if suitably progressive) as the superior instrument.

The case for a consumption tax is NOT that this year's consumption provides a better measure of one's wellbeing than this year's income or wealth. Much the contrary. What makes the consumption tax potentially an appealing instrument for measuring relative wellbeing is that it is neutral between present and future consumption. Hence, it is a wealth tax in the sense that the present value of the tax one would pay if one consumed all of one's wealth immediately is not reduced by deferring some of the consumption to future years (or even indefinitely).

So if we have a 40% consumption tax that will be in place forever and I earn $1 million this year but consume only $100,000, then, while I pay only $40,000 of tax this year, the increase in the present value of my long-term tax liability is indeed $400,000.

So a consumption tax gets it right (if one accepts this line of argument) not because current consumption is the metric of interest, but because of how the tax unfolds in imposing liability over time.

If wealth-holding gets more uneven but current consumption doesn't, the society has indeed grown more unequal. People's opportunity sets and budget lines have diverged. A consumption tax would automatically adjust for this, but using annual consumption as one's measure of inequality gets it wrong.

Full post as published by Start Making Sense on October 31, 2008 (boomark / email).