Consumption Tax

Updated on January 4, 2024
Article byVikram Shakti
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What is Consumption Tax?

Consumption tax is the tax levied on spending by the consumer for purchasing products or services. It is a type of indirect tax that is paid by the consumer along with the cost of the product at the time of purchase. These taxes takes form in sales tax, excise duties, and other taxes on goods and services.

Consumption Tax

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A consumption tax bill is generally collected by a vendor from their customers and in turn forwarded to the state or federal authorities after a fixed period, usually monthly or yearly, depending on the jurisdiction and the law of the particular state. The United States used consumption tax before it shifted to a progressive tax regime and adopted the income tax.

Consumption Tax Explained

Consumption tax is a charge levied indirectly to consumers for goods and services which takes the form of a sales tax, excise duties and other forms of taxes. They are charges by the vendor in the bill to their customers and in turn forward the taxes to their state or federal government on a monthly or yearly basis based on their jurisdiction.

Upon careful observation of the MRP (maximum retail price) of any product, the break up for the taxes can be seen. Whenever a consumer purchases a product or service in an economy, he/she pays a certain price for the same. This price is inclusive of taxes levied by the government. Value-added taxValue-added TaxValue-added tax (VAT) refers to the charges imposed whenever there is an accretion to a product's usefulness or value throughout its supply chain, i.e., from its manufacturing to its final selling point. It is an indirect tax levied on the product consumption.read more, sales taxSales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company's welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%).read more, customs tax, and GSTGSTThe full form of GST is Goods and Service Tax and is levied on the consumption of goods and services. It is a destination-based tax, which means that the tax is paid where the goods or services are consumed.read more is included in the bill; these are considered as consumption tax. It is also known as cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more tax or expenditure tax.

National consumption taxis a tax levied on spending in an economy. The idea is to neutralize the effect of tax on basic products by taxing luxury products more. In this way, the poor can benefit from an economy. It taxes individuals who can afford more and gives the benefit to the poor by taxing basic necessity products less.

It is a concept of the West slowly making its way into the East. Having said that, in this tax, every product has to be taxed separately and appropriately so that it doesn’t burden the poor and also doesn’t damage the demand for the products. The ideology is to keep the government revenue intact without disturbing the economies of products. It has to be executed carefully in a particular economy to reap the advantages.

While income tax is the tax paid on the earned incomeEarned IncomeEarned income is any amount earned by an individual, such as a salary, wages, or employee compensation. It can also be an individual's income through their own business.read more, this is the tax on the expense. This tax is regressiveTax Is RegressiveA regressive tax is the system of taxation where all citizens in the country are taxed at the same rate without considering their income levels. As a result, a more significant percentage of the income of the low-income group is charged as tax compared to the high-income group.read more, and accumulation along with deduction will only increase the purchasing power of the consumer.

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Features

A number of features comprise to account for the overall tax of an economy. Let us understand the features of a national consumption tax through the discussion below.

  • Each individual who is paying a consumption tax will get a certain amount of exemption and deductions. It is to benefit the poor who have lower consumption power, and they don’t have to pay taxes.
  • Individuals eligible to pay taxes will not get any sort of deductions as they can save, and these savings would have been already subjected to deductions.
  • The tax payee will be getting exemption from tax on all the incomes placed via investments as the consumption tax only taxes the amount spent or consumption made.
  • Under this, people are taxed based on their consumption patterns and how much they consume instead of how much they contribute to the economy.

How To Calculate?

Let us understand the metric that accounts for every consumption tax bill in most economies. This will help us understand the intricate details of the concept and its related factors in detail.

  • Each individual who is paying a consumption tax will get a certain amount of exemption and deductions. It is to benefit the poor who have lower consumption power, and they don’t have to pay the taxes.
  • Individuals eligible to pay taxes will not get any sort of deductions as they can save, and these savings would have been already subjected to deductions.
  • The tax payee will be getting exemption from tax on all the incomes placed via investments as the consumption tax only taxes the amount spent or consumption made.
  • Under this, people are taxed based on their consumption patterns and how much they consume instead of how much they contribute to the economy.

Examples

Let us understand the concept of a consumption tax bill with the help of a couple of examples. These examples will help us understand the intricate details of the concept.

  • It has to be seen from the economy’s point of view. The government will have to collect the appropriate tax from its consumers. While designing the tax rates for each product type, it has to make sure it doesn’t burden or hamper the purchasing power of the consumers.
  • Likewise, basic necessity products are taxed less, and this is compensated by taxing luxury products at a higher rate. Suppose a consumer wants to buy a sports car, the car is levied a hefty luxury taxLuxury TaxThe luxury tax is a tax obtained from people purchasing expensive goods or services that offer luxury and are typically not perceived as essential goods.read more and higher registration amount. In the same economy, if a below poverty line consumer wants to buy his daily needs, the tax is relatively lower.
  • No doubt, if the consumer buying the car will also get his daily needs at the same price but would have paid higher taxes for luxury items.

Advantages

Let us understand the advantages of the national consumption tax through the discussion below.

Disadvantages

Despite the advantages mentioned above, there are a few factors that prove to be a hassle for both vendors and consumers. Let us understand the disadvantages of the consumption tax bill through the points below.

  • It can discourage consumer spending as it taxes more on spending more in an economy.
  • To report and track, it is difficult from the government’s perspective compared to the income tax.
  • Consumption tax on luxury products is very high; this will increase the price of the products in the market. It can lead to a reduction in demand.
  • To make this work, everything and anything being sold in the economy has to be taxed. It will just increase the price and decrease the demand, ultimately reducing the spending in the economy.
  • Retired individuals could be taxed twice because of this tax, which is a burden on the individual.
  • In some scenarios, even the poor will end up paying more taxes than they can afford. It can be because of its lousy execution.

Consumption Tax vs. Income Tax

Governments choose either a national consumption tax or an income tax regime. Despite similar implications, there are a few differences in their fundamentals. Let us understand the differences through the comparison below.

  • Consumption tax is also called a cash-flow tax or expenditure tax; Income tax is simply based on total income.
  • Consumption tax is different for a different type of products and services, whereas the income tax bracket is the same for all individuals.

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