Would a Consumption Tax Reduce Interest Rates?

Abstract

Although there is substantial professional and public interest in the recent proposals to replace the existing personal and corporate income taxes with a consumption tax, there has been little attention to the effect of such a tax change on pre-tax interest rates and other pre-tax factor incomes. Despite the general absence of formal analyses, some economists have concluded that shifting to a consumption-type tax would lead, because such a tax would exempt interest income and encourage additional saving, to lower pre-tax interest rates. The most widely cited such statement is by Hall and Rabushka (1995), who say that long-term interest rates would decline by 20 percent if the existing U.S. tax system were replaced by a consumption tax of the type that they advocate. Hall (1996) presents the only formal analytic model of the effect on the interest rate of shifting to a consumption tax. His analysis deals with an economy of infinite-lived individuals in which the net-of-tax interest rate would be a constant determined by the time preference parameter of the representative individual. Eliminating the interest income tax in such an economy would therefore reduce the pre-tax interest rate to the equilibrium net interest rate. In this paper, I explain why the opposite may well be true: substituting a consumption tax for the existing personal and corporate income taxes may raise pre-tax interest taxes. The analysis indicates that whether the pre-tax rate of interest rises or falls depends on the strength of the personal saving response and the nature of the capital-market relation between debt and equity yields. With plausible parameter values, the analysis suggests that the shift from an income tax to a consumption tax is more likely to raise interest rates than to lower them. An important common feature of all the current consumption-tax proposals is to eliminate the tax on corporate profits. Corporations would, under some proposals, continue to make tax payments, but the tax collected from the corporations would become either a tax on the firm's non-cash labor compensation or a consumption-type value-added tax. The failure to take the elimination of the corporate tax into account has led much of the discussion of consumption taxes to wrong conclusions about the impact on interest rates of shifting to a consumption tax. Although there appear to be several different types of consumption taxes--consumed income taxes that permit a deduction for all net saving but continue to tax investment income, taxes that exclude investment income but do not allow a deduction for saving, value-added taxes, and national retail sales taxes--all of these different variants are in fact equivalent in the sense that after the transition they all define the same consumption opportunities for individuals who have the same wage income (i.e., they imply the same lifetime budget constraints). This equivalence is demonstrated explicitly in Appendix A to this paper. The paper itself uses the term consumption tax to refer to a tax that excludes all investment income at the corporate and personal level, but exactly the same conclusions would follow for a consumed-income tax, a national retail sales tax, or a value-added tax. The paper begins in section 1 by discussing the effect that shifting from the existing income-tax system to a consumption tax would have on the rate of interest if individual saving remained unchanged. Section 2 then extends the analysis to an economy in which the saving rate responds to changes in the net of tax rate of interest. The analysis of these two sections emphasizes that the shift to a consumption tax would eliminate the corporate tax on investment income as well as the personal tax on interest and dividends. Eliminating the corporate tax raises the capital income available at the company level to pay interest and dividends. Section 3 examines the sensitivity of the results to the assumed relation between debt and equity yields. Section 4 introduces the role of inflation. The fifth section then brings together these separate analyses to discuss the effects of changing the tax structure in a growing economy with inflation and with interest-sensitive saving behavior. There is a brief concluding section that comments on the generalization of this analysis to recognize international capital flows and different types of domestic borrowers and lenders.