Consumption tax: What it is and how it works

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Taxes come in many different forms. While some taxes apply at the time that money is earned, a consumption tax applies at the time money is spent. There are several different types of consumption taxes, some of which exist in parts of the world or apply to different goods.

Consumption tax definition

A consumption tax is one that applies to the sale or purchase of a good or service. While consumption taxes come in several different forms, they generally apply at the time of purchase.

How consumption taxes work

Consumption taxes are a tax on how people or businesses spend their money. These taxes on the purchase of goods and services are usually percentage-based, meaning they apply as a percentage of the total purchase price.

Consumption taxes are an important source of tax revenue for local, state and federal governments around the world. In fact, these taxes on goods and services make up more than 32 percent of tax revenue in OECD — or Organization for Economic Cooperation and Development — countries.

In many countries, consumption taxes make up one of the largest sources of national tax revenue. The United States stands out as being one of the few major countries that doesn’t have a federal consumption tax.

Types of consumption taxes

A consumption tax isn’t a single type of tax that’s levied against Americans. Instead, it’s a broad term that can describe a variety of taxes on goods and services.

  • Sales tax: This is the type of consumption tax that those in the United States are probably most familiar with. Sales taxes, usually applied at the state and local level, are taxes applied on purchases. Sales taxes are usually charged as a percentage of the purchase price.
  • Value-added tax (VAT): A VAT is a type of tax that’s applied at each step in the supply chain of a good or service. The value-added that’s taxed is the difference between the value of the item at the time it starts production and the value at the time it is sold. There is no VAT in the United States, but more than 160 countries have one.
  • Excise tax: Taxes imposed on certain goods, services and activities are known as excise taxes. Products that are often subject to excise taxes include cigarettes, gambling, alcoholic beverages and gasoline. Some excise taxes are known as sin taxes, because they apply to products the government wants to discourage.

Examples of consumption tax

The most known example of a consumption tax in the United States is the sales tax, which applies at the state and local level to various purchases.

Suppose you purchased a computer in California for $1,000. California’s sales tax is 7.25 percent, so in addition to the $1,000 you pay for the computer, you also pay an additional $72.50 in sales tax, which goes to the state government. Many local governments in California (including cities and counties, which may vary widely on sales tax rates) also have their own sales tax, so it’s likely you would pay even more than just the state’s 7.25 percent tax.

It’s worth noting that California has the highest sales tax in the nation, so this example would look quite different in other states. Only a handful of states have a sales tax of 7 percent or higher, and a few states have no sales at all. Those states without a sales tax rely more heavily on other types of taxes for their state tax revenue. These typically include income taxes and property taxes.

Consumption tax vs. income tax

Both income and consumption taxes are taxes on your money, but they apply at entirely different times. An income tax applies when you earn money such as wages, interest and dividends. Consumption taxes apply at the time goods and services are purchased and sold.

People often don’t realize they’re paying these taxes. In the case of income taxes on your wages, your employer likely takes income taxes out of your paychecks before you even receive the money. While income taxes apply when you earn money, consumption taxes apply when you spend it.

In addition to being applied to your money at different times, income and consumption taxes also differ in how they affect taxpayers. In the United States, income taxes are progressive. In other words, the percentage of your income you pay increases as your income increases.

But consumption taxes are usually regressive taxes, meaning the percent of your income that you pay decreases as your income decreases. For example, someone making $100,000 and someone making $25,000 both pay the same dollar amount of sales taxes on a $100 item, but that tax eats up a greater percentage of the person’s income earning $25,000.

A final difference between income and consumption taxes comes down to what they primarily fund. Income taxes are the largest source of revenue for the federal government — they make up more than 50 percent of federal tax revenue. State governments, on the other hand, rely more heavily on consumption taxes. After intergovernmental transfers — meaning funding from the federal government to the state governments — sales taxes account for the largest source of state tax revenue.

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Written by
Erin Gobler
Personal finance writer
Erin Gobler is a personal finance expert and journalist who seeks to make the financial services industry more accessible by breaking down complicated financial topics in simple terms.
Edited by
Senior editorial director
Reviewed by
Senior wealth manager, LourdMurray