In the late 1980s and early 1990s, when I was an economist at the Institute for Research on the Economics of Taxation, my boss and tax policy mentor, the late Norman Ture, had a favorite saying: “People aren’t taxed. Activities are.” It is this proposition, that taxation of any kind always has the effect of penalizing some activities relative to others, that lies at the heart of the economic analysis of taxation.

Obviously the income tax is a tax on people’s income-generating activities. What this means is that it penalizes these activities relative to activities that do not generate income. In a market setting, income-generating activities are those that lead to the production of goods and services. So the income tax penalizes work relative to leisure, and saving and investment relative to consumption. It is the latter that tends to be least understood and therefore will be the focus of this essay.

Consume or Invest?

The broad choice facing an individual in choosing to allocate his or her income is to either spend it or save and invest it. This consumption/saving choice is distorted by the income tax in favor of consumption.

Using the traditional terminology, the income tax double-taxes saving relative to consumption. It should be noted that this terminology is somewhat misleading. As will be demonstrated, the tax does not explicitly double-tax saving but reduces the returns to saving twice, while reducing the returns to consumption just once.

This can be shown with a simple example. Start with an individual who has $100 of pretax income. In the absence of taxation this person has $100 for either consumption — the purchase of goods and services — or saving. If the interest rate is a simple 10 percent per year, then the person can decide whether he prefers to spend $100 or save the $100 and have $110 available for spending a year from now. The decision will be based on his preference for satisfaction now relative to satisfaction in the future. This is what economists call time preference.

Now assume that the individual faces a 10 percent income tax. His $100 is reduced to $90, cutting the amount available for consumption by that rate. Likewise, the tax implicitly reduces his returns to saving by 10 percent. In other words, by taxing the principal the government is simultaneously reducing the entire stream of returns from the investment. So if he saves the $90, because of the tax his interest income is reduced from $10 to $9.

The Returns to Waiting

In the absence of further taxation the individual’s choice is between spending $90 now or waiting a year and having the opportunity to spend $99. Returns to consumption spending and returns to saving have both been reduced equally by the tax. But under a standard income tax, the returns to saving are reduced yet again. The $9 in interest also is taxed 10 percent, leaving $8.10.

So the tax reduces the returns to savings twice: first from $10 to $9 when the initial $100 is taxed, and second from $9 to $8.10 when the interest is taxed.

Note that the return from consumption is only reduced once, from the level of satisfaction that could be obtained with $100 to the level that could be obtained with $90. The tax on interest or other returns to investment, including dividends and capital gains, biases decisions against saving, investment, entrepreneurship, and business expansion, and in favor of consumption spending.

In addition the government, at both the federal and state levels, further punishes investors with a separate corporate income tax. The corporate tax, which at the federal level is 35 percent, adds a third layer of tax on both dividends and capital gains.

Exempt Returns from Saving

The most straightforward way to remove the bias is to exempt from taxation all returns from saving. This is the approach that has been taken by those who advocate the flat tax, for example, Steve Forbes. From this perspective, saving and consumption are treated symmetrically.

An alternative way of remove this bias is by eliminating all saved income in the current time period from the tax base, taxing it only when it is withdrawn for consumption purposes. A tax that deals with the bias against saving in this way is called a “consumed income tax.” The idea would be to treat all savings and investment in the same way that IRA and 401k retirement investment plans are treated, except that there would be no penalties for withdrawing funds before any legally specified age.

In reference to our example, if the person decided to spend his $100 in pretax income, he would be subject to the 10 percent tax immediately and would have $90 available for consumption. If instead he decided to save or invest the $100 for a year, he would not be taxed on it until it was taken out of savings and used for consumption. At the end of a year, if he chose to withdraw the money from savings or to cash in his investment, the original $100 and the return of $10 would be taxed 10 percent. This would leave him with $99 for consumption, or the equivalent of a full 10 percent return on $90. The point here is that only income that is used for consumption is taxed, hence the name “consumed-income tax.” It should also be noted that this gives the same result as the flat tax, which would exempt the interest income from the tax base. The individual would save $90 ($100 minus the 10 percent tax) and earn $9 in interest.

Full Exemption of Expenses

The consumed-income tax suggests that all expenses incurred to generate future income, which is the definition of investment, should be eliminated from the tax base. This implies that all work-related expenses, including commuting expenses, educational expenses incurred to enhance future income, and day-care expenses, should be excluded from the tax base. These expenses are analytically equivalent to saved income. They represent forgone current consumption in an attempt to generate future income. This approach also implies that all business expenses (labor, plant, and equipment) should also be deducted in the year they are incurred rather than depreciated over time. This insures that the full cost of the investment, rather than a time-discounted cost, is realized in the tax deduction.

A word of warning is in order. It needs to be made clear that there is no such thing as a tax that does not damage productivity and economic growth. To invoke a term often used by economists, a “neutral tax” does not exist. At the very least, all taxation transfers the control of productive resources from the free market to government control, that is, from an institutional setting that will generate a more efficient use of resources to one that will generate a less efficient use of resources. What this means is that overall the economy, and therefore human welfare, always suffers as a result of taxation.