Most economists agree that the choice of the appropriate tax base is between taxing some measure of income or taxing some measure of consumption. Broadly defined, income is the increase in an individual's ability to consume during a period of time. Income can include labor earnings (both cash and benefits), interest payments, rents, royalties, dividends, increases in asset values, alimony, and pension payments. An important dimension of income taxation is that saving and investment are included in the tax base. Using income as the tax base is equivalent to taxing potential consumption. In effect, this taxes all resources that people put into the economy. A tax system with an income base is distortionary because taxes affect decisions on when, how, and how much to save and invest. For example, in taxing household saving, future consumption (financed by saving) becomes relatively more expensive compared to current consumption. As a result, households tend to consume more and save less than they otherwise would if saving were not taxed.

   By contrast, consumption is defined as the actual amount that people and businesses spend buying goods and services today. When a tax system has a consumption base, it only taxes what people take out of the economy. While there are several possible measures of a consumption tax base-retail sales, value-added, and consumed income, among others-all of these measures share the attribute of excluding saving and investment from the tax base. Such a tax system is considered "neutral" and efficient because it neither encourages nor discourages savings and investment decisions; it allows people to decide whether to consume now or to invest in the future based on market prices instead of on how to avoid paying taxes. Relative to an income tax, the consumption tax base results in a larger, more efficient stock of capital, which in turn makes workers more productive. Output and wages rise, resulting in higher standards of living. As a result, many economists feel that consumption is a better base for pro-growth tax policy.

   Our current tax system has a hybrid tax base, with elements of both income and consumption tax bases. Some, but not all, of the return to saving and investment is excluded from the tax base through various provisions. For example, individual retirement accounts (IRAs), employer-sponsored retirement savings plans, lower tax rates on capital gains and dividends, and accelerated depreciation for certain types of investment are some of the provisions in the current tax code that provide at least a partial consumption tax base. Recent estimates suggest that about 65 percent of the return to household financial assets is taxed under an income tax base, with the remainder receiving consumption tax treatment.