Debt-Financed Consumption and a Hybrid Income-Consumption Tax

The debate between proponents of income taxation and proponents of consumption taxation has focused almost exclusively on the differing treatment of savings under the two tax bases. This is odd, given that income and consumption tax bases also differ in their treatment of debt-financed consumption. This Essay addresses the largely-ignored question of the taxation of debt-financed consumption. It contends that a strong case can be made in favor of a hybrid income-consumption tax base under which taxation is triggered by the earlier of consumption or income, so that both debt-financed consumption and saved income are included in the tax base. The Essay explains how one might reasonably favor consumption tax treatment of consumer debt even if one favors strict accretion-style income taxation on the savings side. It also considers how the case for the proposed tax treatment of debt-financed consumption is strengthened if most life cycle savings are already taxed under a consumption tax model (as is the case under the current federal income tax). Adoption of the proposal would have significant consequences–largely favorable–for many taxpayers. If taxpayers use loans to smooth consumption by shifting spending power from higher-income later years to lower-income earlier years (as in the case of student loans to cover living expenses, and credit card debt incurred during periods of unemployment), then treating those loans as determinative of the timing of taxation will benefit taxpayers by shifting tax base inclusions from higher-bracket years to lower-bracket years. It might also be appropriate to allow the earned income tax credit (EITC) with respect to debt-financed consumption