Consumption tax: What it is, how it works and why it matters

Taxes can be levied in a few different ways. While some taxes apply on money that you earn, a consumption tax is levied when you spend money. There are several different types of consumption taxes, and many of them don’t exist in the United States.

A consumption tax is levied on the sale 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 made up more than 32 percent of tax revenue in OECD (Organization for Economic Cooperation and Development) countries in 2021, according to a report by the Tax Foundation.

In many countries, consumption taxes make up one of the largest sources of national tax revenue. The U.S. 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. 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 people in the U.S. are probably most familiar with. Sales tax, usually levied at the state and local level, is applied to purchases. Sales taxes are usually charged as a percentage of the purchase price.
• Value-added tax (VAT): A VAT tax is applied at each step in the supply chain of a good or service. The value-add 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’s sold. There’s no VAT in the U.S., but more than 170 countries levy a value-added tax.
• 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, alcohol and gasoline. Some excise taxes are known as sin taxes, because they apply to products or services the government wants to discourage.

Examples of consumption tax

The most common example of a consumption tax in the U.S. is the sales tax, which applies at the state and local level to various purchases.

Suppose you purchase 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 $72.50 in sales tax, which goes to the state government. Keep in mind, though, that most cities and counties in California also levy their own sales taxes, 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 revenue, including state income taxes and property taxes.

Consumption tax vs. income tax

Both income and consumption taxes are levies on your money, but they apply at different times. An income tax applies when you earn money such as wages, interest and dividends. Consumption taxes apply when you buy goods or services.

In the case of income taxes, your employer likely withholds income taxes out of your paychecks before you receive the money. (Either that, or you’re self-employed and have to make estimated tax payments.)

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 their effect on taxpayers. In the U.S., federal income taxes are progressive, rather than being based on a flat tax system. That means not everyone pays the same rate — it varies depending on your income. And the percentage of your income you pay in taxes increases as your income increases.

But consumption taxes are usually regressive taxes, meaning the percentage of your income that you pay decreases as your income increases.

For example, a person making $100,000 and a person making $25,000 both pay the same dollar amount of sales tax on a $100 item, but that tax eats up a greater percentage of income for the person earning $25,000.