Consumption tax

Definition

A consumption tax is a tax imposed by a government or regulatory authority on consumption, i.e., on the purchases made for consumption. It could take two forms:

• Sales tax: A sales tax is a tax imposed on the final purchase, i.e., the purchase by the consumer. It is typically determined as a percentage of the retail price.
• Value-added tax: This is a tax imposed at each intermediate stage of the production process for the value added during that stage of the production process. Value-added tax (VAT) is therefore collected at many stages rather than simply at the final point of sale.

Purposes of a consumption tax

Raising revenue

Consumption taxes are a source of revenue.

Affecting decision to consume versus save

Since a consumption tax applies only to that fraction of income that one spends on consumption, it affects people's propensity to consume. An increase in the consumption tax thus provides an incentive to reduce the propensity to consume, while a decrease in the consumption tax provides an incentive to increase the propensity to consume.

Affecting decisions of what to consume

Another purpose of a consumption tax is to shape consumption decisions for individual buyers. A tax levied for this purpose is sometimes called a sumptuary tax. One rationale for this is to affect people's consumption decisions for their own good, for instance, discouraging people from smoking through higher tobacco taxes.

Another rationale is that of a Pigouvian tax: a tax intended to raise money to cover the external costs imposed by the purchase or use of the good or service.