Skip to content
× FreshBooks App Logo
FreshBooks
Official App
Free - Google Play
Get it
You're currently on our US site. Select your regional site here:

Consumption Tax Definition & How It Works?

Updated: January 17, 2023

There are a number of different taxes in the United States of America. 

These taxes are imposed upon a wide range of things, and the cost of these will most often fall upon the consumer at the end of the sales cycle. 

Perhaps the most common type of tax is the consumption tax. But what exactly is the consumption tax and how does it differ from income tax?

Read on as we take a closer look.

List IconTable of Contents


    KEY TAKEAWAYS

    • Consumption taxes are the popular name for taxes on goods and services.
    • Value-added tax and retail sales taxes are two types of consumption taxes. 
    • Consumers are subject to a consumption tax when they make purchases, whereas income earners are subject to an income tax.

    What Is a Consumption Tax?

    A consumption tax is a charge for buying a good or service. It is a taxing system in which people are charged according to how much they spend rather than how much they contribute to the economy.

    Retail sales taxes, excise taxes, value-added taxes, use taxes, taxes on gross business earnings, and import tariffs are a few types of consumption taxes. Consumers who pay a higher retail price for the good or service must pay these taxes. The final consumer carries the burden of the tax.

    Save 40 Hours During Tax Season

    How Does Consumption Tax Work?

    Consumption tax is included in the increased price. Which the vendor collects and sends to the relevant local, state, or federal government. Consumption taxes are frequently assessed at various rates on various commodities. This is depending on whether such items are viewed as necessities (like food) or as luxury goods (such as jewelry).

    The concept of a consumption tax is not new. For a significant portion of its history, the U.S. government levied a consumption tax before switching to income tax. A variation of this had the support of the Bush administration, but it was rejected. The concept advocated for the United States to change the tax system to a national consumption tax. Currently, even though the U.S. imposes sales taxes and excise taxes, it does have a national income tax system.

    A consumption tax system would encourage saving while punishing spending in a perfect world. The United States does not have a national consumption tax. However, many other nations throughout the world have implemented one in some capacity.

    Types of Consumption Taxes

    Excise Tax

    A tax known as an excise tax is one that only applies to a certain category of commodities or activities, generally alcohol, tobacco, gasoline, or travel. Some excise taxes are levied to prevent people from engaging in particular behaviors, or purchasing specific commodities that are deemed to be harmful to the economy.

    Sin taxes are the more popular name for these excise levies. People who gain from a program or infrastructure are subject to additional excise taxes. For instance, gasoline taxes are levied on motorists in order to maintain roads, highways, and bridges.

    Excise taxes can be assessed on the federal, state, or local level.

    Value-Added Tax

    Value-added taxes, or VATs, are the main kind of consumption tax used by the majority of European nations as well as Canada. In Canada, the value-added tax (VAT) is known as a harmonized sales tax (HST) in some provinces and a goods and services tax (GST) in others.

    A VAT is a tax that is applied to the difference between a producer’s costs for labor and raw materials and the price of completed items. The “value-added” to products and services from the point of production to the point of consumption is therefore subject to this consumption tax.

    Retail Sales Tax

    Ad valorem sales tax is typically determined by applying a percentage rate to the sale’s taxable price. Despite the fact that sales tax is imposed in the United States, it is a state and local sales tax rate rather than a federal income tax. Additionally, all purchases, including those for food, healthcare, and shelter, are exempt from sales taxes. Nearly all consumption is taxed in nations that have enacted the sales tax as a national consumption tax.

    Import Duties

    Taxes imposed on an importer for products entering the nation are known as import tariffs. The importer passes the taxes on to the ultimate customers through increased prices. Depending on the imported commodity, the nation of origin, and a number of other circumstances, the amount of this consumption tax that must be paid varies significantly. In addition to being based on the quantity, weight, or volume of the imported products, import tariffs can also be determined as a percentage of their value.

    It's Time For Owners To Own Tax Season

    Advantages of Consumption Tax

    Many of the arguments put up by those who favor a consumption tax in place of income taxes strike the typical taxpayer as reasonable. People would only be required to pay taxes on the things and services they consume, rather than on their wages.

    One advantage is that it would supposedly level the playing field for tax evaders, which is one advantage. People who receive payments under the table or through illicit ways would no longer benefit from lower taxes. The largest benefit of enacting this kind of tax may likely be that everyone would have to pay sales taxes whenever they bought products or services.

    Disadvantages of Consumption Tax

    It could be argued that, unlike income taxes, these taxes are not required to be paid. This is true, but in order for consumers to continue living the lifestyle they have grown accustomed to, the same or possibly even a higher rate of taxation will be necessary. Once more, the government will receive its money.

    A potential drawback of such a tax structure is that certain consumer items or services might be subject to a greater rate of taxation than others, based on arbitrary criteria such as whether an item is considered a luxury or through the use of a “sin tax.”

    Examples of Consumption Tax

    Examples of consumption taxes include excise taxes (such as business and occupation tax, liquor or cigarette tax), sales and use taxes on retail purchases and certain services, VAT, and import taxes.

    Consumption Tax vs. Income Tax

    People are subject to a consumption tax when they make purchases. When someone earns money or receives interest, dividends, or capital gains from their investments, they are subject to income tax.

    A consumption tax, in contrast to income taxes, which penalize savers and reward spenders, is said to promote consumer spending  and increase economic efficiency. As a result, its proponents contend that taxing people on what they take from the finite resource pool through consumption rather than what they add to it through income is only fair.

    However, opponents claim that a consumption tax is unfair to the poor, who must spend a greater percentage of their income. This is because consumption tax is regressive in nature, and wealthier individuals and households spend less of their money on consumption than disadvantaged households.

    Summary

    A tax imposed on consumer spending on products and services is known as a consumption tax. The money that is spent on consumption serves as the tax basis for this type of tax.

    Indirect taxes on consumption, like a sales tax or a value-added tax, are the norm. But a consumption tax can also be designed as a direct, individual taxation method.

    Less Taxin'. More Relaxin'

    FAQS on Consumption Tax

    What Is the State and Local Consumption Tax?

    It is a tax levied by both the state and municipal governments, usually in the form of retail sales tax. The tax at a state level will depend on which state you are in. As a business, you collect sales tax from your customers at the point of sale. You can electronically file and remit sales tax to the state. You can select whether to pay with a credit card or directly from your bank account.

    Why Do Economists Like Consumption Taxes?

    A consumption tax accomplishes what tax economists refer to as “temporal neutrality”. They claim that it is superior to an income tax. A tax is “neutral” when it does not affect spending habits and resource allocation.

    What Is the Difference Between Sales and Consumption Tax?

    State and local governments apply sales taxes on retail purchases of products and services that aren’t exempt from taxes. A value-added tax (VAT) is a sort of consumption tax that is imposed on the value added to products as they go through the production process and are eventually sold to consumers.

    Is Consumption Tax Progressive or Regressive?

    Simple personal consumption taxes have an income regressive effect, meaning the taxes are paid regardless of income.

    WHY BUSINESS OWNERS LOVE FRESHBOOKS

    553 HRS

    SAVE UP TO 553 HOURS EACH YEAR BY USING FRESHBOOKS

    $ 7000

    SAVE UP TO $7000 IN BILLABLE HOURS EVERY YEAR

    30M+

    OVER 30 MILLION PEOPLE HAVE USED FRESHBOOKS WORLDWIDE

    Try It Free for 30 Days. No credit card required. Cancel anytime.