Consumption Tax Definition

You pay income tax on money you’ve earned but what is consumption tax? This is a tax levied on items purchased or consumed, from cigarettes to retail sales tax, and rates vary widely depending on your location. We’ll discuss the differences between consumption tax vs income tax below.

What is consumption tax?

As its name suggests, a consumption tax is a tax you pay when you purchase a good or service. This category includes things like sales tax, excise tax, and import duties. Consumers who are willing to pay more for retail items can expect to pay higher consumption taxes. However, tax rates are dependent on the type of item consumed as well. Necessary items like groceries are taxed at a far lower rate than luxury items like jewelry and designer handbags. The retailer or vendor collects consumption tax at the point of sale, and then submits this to the government.

While most countries impose federal consumption taxes, there’s no such system within the United States. Individual states have the right to decide whether to charge consumption tax.

Types of consumption tax

There are several types of consumption taxes you might come across, depending on the country.

• Value-Added Tax (VAT) – Also referred to as a goods and services tax, VAT is a tax that covers the mark-up between production cost and the cost of the finished item. In other words, it’s levied on the value added to the product.

• Excise Tax – Excise taxes are charged on specific categories of products, such as hotel rooms, gas, alcohol, and tobacco. They might be used to discourage consumer spending on those categories, as with alcohol and tobacco.

• Import Taxes – Import duty is charged on importers when they bring consumable products into the country. While the importer is responsible for paying the tax, they’ll pass the costs on to the final consumer.

• Sales Tax – A sales tax is usually applied as a percentage of the total sale and applies to retail items rather than necessary goods like food and housing.

Consumption tax vs income tax

We’ve discussed the various types of consumption taxes you might come across, but how do they compare to income tax? While consumption tax is applied to items that you purchase, an income tax is levied on money you’ve earned. You could look at it this way: one tax is for adding money to the economy, and one is for taking money out of the economy in the form of capital gains, earnings, and dividends.

There are arguments for both consumption tax vs income tax. Those who support consumption taxes believe that it encourages consumers to save rather than spend, while those in favor of income tax believe it can penalize the poor for necessary purchases. By contrast, income is taxed progressively with higher earners paying their proportional share.

Understanding consumption tax rates

While consumption tax is paid around the world, the United States is the only country that uses a retail sales tax rather than the value added tax (VAT). To make matters more complicated, sales tax isn’t a federal tax, which means that each state can levy its own consumption tax rates.

One thing to note is that there is no progressive consumption tax. The rate will be the same for all consumers, no matter their level of individual wealth. A pack of cigarettes carries the same tax rate whether it’s purchased by a farm worker or a shipping magnate. Yet while there isn’t a progressive consumption tax, wealthy individuals do tend to consume more high-value items which leads them to pay more over time.

Consumption taxes provide a major source of income for local, state, and federal governments. When well-designed, they shouldn’t curb consumer spending, providing a win-win for the economy.

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