Bruce's Tax System [Eric]

I do think it would be worthwhile to shift to a pure consumption-based tax system. I would do it by exempting all saving from taxation. This could be done by consolidating all existing tax deferred savings accounts--IRA's, Keoghs, 401k's, etc.--into one savings vehicle. All contributions would be tax-deductible, all withdrawals would be fully taxed at ordinary income tax rates. Money inside the account compounds tax-free until withdrawn. There would be no limit on contributions, no limit on withdrawals; no age restrictions and so on. Since there are only two things that can be done with income--either save or spend it--all taxation would necessarily fall on consumption if such accounts existed.

This sounds great on paper, and some of the principles behind it might be worth incorporating into our current system.

But off the top of my head, the problem seems to be that this creates an initial incentive for people to save a lot, perhaps too much savings with frequent withdrawals. And that means that if they then anticipate a cut in the tax rates meaning the value of their savings would go up they would be overly averse to withdrawing money in the short term, causing a brief slowdown in withdrawals and thus in consumer spending.

The opposite would be worse. If the income-tax rate goes up, then that means the amount of money they effectively have in savings just went down. But that furthermore means that if people anticipate an increase in the tax rates, there could be a great mass of withdrawals as people cash out of the savings accounts and put their money into other investments. And that could then turn into runs on the savings accounts. And as we know, runs are definitely not fun.

What mechanisms would you put in place to stop these sorts of hazards from occurring?