[Economic Report of the President (2003)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 5

Tax Policy for a Growing Economy

The income tax has been the single largest revenue source for the
Federal Government ever since World War II. Today it touches nearly
every aspect of our lives. The income tax also fosters economic
inefficiency, and its complexity leads to staggering compliance
costs. Past efforts at partial reform of the income tax have not
succeeded in reducing its complexity, removing its distortions of
economic incentives, or making it more fair. Some might think that
significant obstacles block the way to making great progress toward
achieving these goals, but in fact such reform can be accomplished
within the basic framework of the existing tax system.

In 2001 the Internal Revenue Service spent $8.9 billion on processing,
enforcement, and information systems, but this direct cost of
administering the income tax is just a small fraction of its total
cost. It has been estimated that individual taxpayers in the
aggregate spend up to 3 billion hours each year to comply with the
tax system--about 27 hours per taxpayer. The present tax code, with its
myriad exclusions, exemptions, adjustments, deductions, and credits
has grown into a labyrinth of complexity. In tax year 2000 nearly 72
million taxpayers (56 percent of all taxpayers) used paid tax
preparers to complete their tax forms. Many taxpayers purchase
tax-help books and computer software. Compliance costs are also
onerous for business taxpayers, especially small businesses, and the
typical Fortune 500 company spends almost $4 million a year on tax
matters.

The current tax system also causes households and businesses to
rearrange their affairs in a number of ways that make poor use of
economic resources, leading to substantial economic waste and,
ultimately, reducing real incomes. The system affects a number of
important economic decisions, such as how much to save and invest,
how much risk to take, how much home mortgage debt to carry, how much
in tax-exempt bonds to hold, when to realize capital gains, whether
to hold assets that produce dividends or capital gains or interest,
how much labor to supply and how much to hire, whether to organize
business operations in corporate or noncorporate form, and to what
extent to comply with the tax system. Perhaps one of the more salient
distortions in the income tax today is that caused by the ``double
tax'' on corporate income. As discussed extensively later in this
chapter, this double taxation occurs when income distributed to
shareholders as dividends or realized as capital gains is subject to
individual tax after already being taxed at the corporate level.
Double taxation causes too little capital to be allocated to the
corporate sector and a disproportionate share of capital to be
allocated to other sectors of the economy. For a discussion of the
President's recent proposal to eliminate the double tax on corporate
income see Chapter 1.

These distortions and others lower saving rates and inhibit
investment, capital accumulation, risk taking, and innovation,
thereby lowering the growth potential of the economy, real incomes,
and consumption. It has been estimated, for example, that elimination
of the double tax on corporate income alone could increase economic
well-being by as much as $52 billion each year forever. Tax
preferences provided through the array of exclusions, exemptions,
adjustments, deductions, and credits represent policy decisions to
exclude some income from the tax base, but this poses a tradeoff: a
higher overall tax rate is then required to raise a given amount of
revenue, and this  distorts household and business decisions and
imposes a corresponding burden on the economy. Reduction or removal of
many of these distortions, through broadening the tax base and
lowering tax rates, would, by one estimate, increase accumulated
capital by 10 to 15 percent and real GDP by 2 to 6 percent. The
economic gains from fundamental reform of the tax system could lead
to substantial increases in economic well-being for all Americans.

The major objectives of tax reform are to reduce complexity, improve
economic incentives, and address fairness. The central theme that
brings these objectives together is that household and business
decisions should depend on the tax code as little as possible. Taxing
all income, but taxing it only once, is a key ingredient of many
reform plans. This would involve broadening the tax base while
lowering tax rates. Some efforts have also focused on a shift from
taxing income to taxing consumption or consumed income.

A possible argument against reform is the suggestion that the current
tax system instead needs to be ``ripped out by its roots'' and
completely replaced. Arguments for such wholesale reform certainly
have merit. This chapter, however, illustrates  ways in which the
current system could be modified to improve incentives and boost
real incomes.

An important goal of any tax reform proposal is to reduce complexity.
In the current tax system, much of the complexity and thus much of
the compliance burden result from the numerous tax preferences,
differential taxation, and the taxation of capital income. Aspects of
the current system often involve complicated phase-ins and phaseouts
designed to target tax benefits to certain groups of individuals or
businesses. Replacing these targeted tax preferences with broad
exclusions or lower tax rates would reduce this complexity.
Differential taxation, or the taxation of different types of income
at different rates--such as the double tax on corporate income and the
exclusion for many employer-provided fringe benefits--creates
incentives for taxpayers to rearrange their affairs to realize income
in ways that are taxed more lightly. The use of tax shelters and
arrangements that allow taxpayers to defer their tax liability is, to
a large extent, the result of these kinds of differentials. Reducing
differential taxation would reduce complexity, reduce the incentives
for tax shelters, and improve other economic incentives. Finally,
research suggests that compliance costs are substantially higher
for taxpayers with significant amounts of financial and business
income. Defining such income and allocating it to individual
taxpayers involves substantial recordkeeping. Many reform proposals
would both reduce the tax on certain types of capital income, to
promote saving and investment, and simplify the taxation of such
income.

Some opponents of reform argue that taxing consumption rather than
income would necessarily place a relatively heavier tax burden on
lower income taxpayers. Conventional distributional analysis
typically considers a snapshot of taxpayers' economic well-being at
a particular point in time. Research has shown that, when a longer
view is taken, differences in well-being, whether measured by income
or by consumption, tend to be not as great, because of the fluidity
of household incomes over time. Also, analyses of the distributional
effects of moving to a tax based on consumption rather than income
often do not recognize that a substantial portion of capital income,
which is earned primarily by higher income taxpayers, is taxed under
both income and consumption tax principles. The distributional
effect of moving to a consumption tax looks considerably more
progressive when the taxation of a substantial portion of capital
income under a consumption tax is taken into account. Indeed, both an
income tax and a consumption tax levy tax on the extraordinary (or
what economists call supernormal or inframarginal) returns to capital.

This chapter revisits these issues, focusing particularly on ways in
which the influence of taxes on key economic decisions could be
diminished within the framework of the current tax system. First,
the key objectives of reducing complexity, improving economic
incentives, and achieving fairness are laid out in greater detail.
The broad principles that underlie the two main approaches to
taxation, that based on income and that based on consumption, are
then described. These principles focus on how to raise enough revenue
to fund a given level of government services in a way that has the
least effect on economic decisions. Next, a framework is outlined
against which the current, hybrid tax system can be compared and
contrasted. Then two issues important to evaluating the distributional
effects of moving to a consumption tax--the fluidity of taxpayer
incomes and the taxation of capital income under a consumption
tax--are discussed. This is followed by a discussion of how the
current tax system taxes neither wholly income nor wholly
consumption, highlighting the ways in which the current system
departs from these broad principles. Finally, the chapter considers
some of the major decisions and tradeoffs involved in proposed
changes to the tax system. Modest structural changes are outlined
that would move the current tax system toward either an income- or
a consumption-based system, improve economic incentives, and reduce
complexity.

Objectives of Tax Reform

At the outset, some overriding and fundamental objectives for tax
reform can be identified: simplicity, fairness, and the promotion of
long-term economic growth through improvements in incentives. These
objectives are very much interrelated. Complexity, for example, can
undermine one view of fairness if, despite the progressive tax rate
schedule and targeted tax preferences, taxpayers perceive that higher
income taxpayers pay less tax than they should, through tax avoidance
and tax sheltering. Similarly, complexity from the phase-in and
phaseout of targeted tax preferences can distort economic decisions,
and thus impede long-term growth, by imposing a high effective tax
rate on certain taxpayer decisions. But sometimes these objectives
come in conflict. For example, addressing fairness through targeted
tax preferences may distort economic decisions and undermine
long-term growth through differential taxation and a higher overall
tax rate.

Simplicity: Freeing up Resources for Productive Use

The current tax system is often viewed as difficult to understand,
and the resulting billions of hours and billions of dollars devoted
to tax administration and compliance are a drag on the economy. As
mentioned above, taxpayers spend as much as 3 billion hours a year on
Federal tax matters, and compliance costs associated with the Federal
income tax equal about 10 percent of revenue, or about $135 billion
in 2001. The numerous tax preferences and the interactions among
them, together with differential taxation, give rise to much of the
complexity in the current tax system. The taxation of capital income
and the complex rules governing depreciation also result in
considerable complexity for both households and businesses. The rules
used to define business receipts and deductions require recordkeeping
and complex calculations, sometimes over many years. Self-employed
taxpayers spend an average of 60 hours a year on such tax matters.
Studies consistently find that compliance costs are most onerous for
smaller businesses. Taxpayers with capital income, such as capital
gains, dividends, interest, and rental income, also tend to have
high compliance costs.

Compliance costs can be high even for individuals who receive most
of their income as wages. The number of tax preferences has risen,
often involving multiple definitions, and preferences often give rise
to complicated interactions between provisions. For example, the tax
code currently defines a ``child'' in at least five different ways:
one way for purposes of qualifying for the child tax credit, another
to qualify for the child and dependent care tax credit, another to
determine head of household filing status, another for the Earned
Income Tax Credit (EITC), and another for the exemption for
dependents. Taxpayers with children may need to understand which
definition applies to some or all of these provisions when filling
out their tax returns. Multiple definitions also encumber the
provisions of the tax code relating to education expenses (such as
the Lifetime Learning credit, the Hope credit, the education
deduction, Coverdell Savings Accounts, and college savings and
prepaid tuition plans), household maintenance tests, and earnings
tests. An increasing number of taxpayers are also required to comply
with two parallel tax systems: the regular tax and the alternative
minimum tax (Box 5-1).

A major source of complexity in the current income tax is its attempt
to target tax benefits to meet a variety of social goals. Integration
of social goals into the tax system takes the form of altering the
definition of ability to pay across a wide set of taxpayer
characteristics. In this respect, defining a child five or more
different ways is important if it is desirable to vary tax preferences
along these dimensions. However, it comes with considerable compliance
and economic costs. What is often not appreciated is the extent to
which the targeting of these tax preferences subjects taxpayers with
the same income to different effective tax rates (Box 5-2).
Elimination and consolidation of tax preferences would help simplify
the tax system and improve economic incentives.

Fairness: Relating Taxes to Ability to Pay and to Economic Well-Being

The income tax system should relate a taxpayer's tax liability to his
or her ability to pay and to his or her economic well-being. This is
the rationale behind the current progressive rate structure, whereby
tax rates rise with annual income, as well as behind many of the
existing tax preferences. However, the link to ability to pay begins
to weaken when taxpayers with the same level of income pay different
amounts of tax, because of differences in eligibility for some tax
preferences, or have different opportunities to avoid paying taxes.
Taxpayers fortunate enough to receive good tax advice might, for
example, learn of opportunities to shelter income from tax legally;
this can erode confidence in the tax system. Faith in the fairness of
the tax system can also be undermined when compliant taxpayers see
others evading substantial amounts of tax.

How ability to pay is measured is also crucial to perceptions of
fairness. The current income tax system uses annual income as a
yardstick for ability to pay. Some have argued, however, that what a
taxpayer actually consumes better reflects his or her economic
well-being than how much income that taxpayer earns. Consumption
patterns are determined by incomes over a time horizon that extends
well beyond 1 year. A household's past income and, in particular,
its expectations about future income are critical in determining how
much the household spends in any given year. Researchers have

----------------------------------------------------------------------
Box 5-1. The Toll of Two Taxes: Compliance with the Regular and the Alternative Minimum Tax

An increasing number of taxpayers are required to comply with two
parallel income tax systems: the regular tax and the alternative
minimum tax (AMT). Although the AMT itself is not very complicated,
taxpayers may be surprised to learn that some of the deductions and
credits they claim under the regular tax, and even the benefit of the
lower rate brackets, are substantially reduced if they become subject
to the AMT. Indeed, these factors are exactly what push many
taxpayers onto the AMT.

The AMT is, in many respects, an example of a government policy that
has had unintended consequences. The minimum tax, the precursor to
today's AMT, was enacted in 1969 following a report that 155 very
high income individuals had paid no tax. Although its original intent
was to ensure that a relatively few high-income individuals pay tax,
it is projected that some 40 million taxpayers will pay the AMT by
2012, assuming that the tax reductions enacted in 2001 are
permanently extended (Chart 5-1). Moreover, more than two-thirds of
married taxpayers with two or more children and 97 percent of
taxpayers with incomes between $75,000 and $100,000 will face the AMT
by 2010. Some estimates indicate that by 2008 the AMT will raise more
revenue than the regular tax.
______________________________________________________________________

[

generally concluded that incomes over longer time horizons are a
better indicator of differences in economic well-being than income in
any one year.

Annual incomes can vary from lifetime incomes for many reasons. One
is that income tends to vary in a predictable way over a person's
working life. Most individuals' earnings are relatively low when
they enter the work force and then rise as they gain job experience.
Earnings typically peak after midlife and fall after one enters
retirement. Early in their lives, taxpayers might dissave (that is,
dip into their savings or, more likely, borrow) to finance college
and job training expenses, and then save during their middle years
so as to accumulate wealth on which to support themselves in
retirement. How much a taxpayer consumes in a given year depends both
on that taxpayer's earnings and on how much he or she decides to
save. Aggressive savers can support a higher level of consumption
in retirement. Incomes can also vary in response to a variety of
other events, such as transitions between jobs, unemployment,
marriage and divorce, illness, and volatility in business income
and income from the sale of assets.

Two conclusions can be drawn from this distinction between lifetime
and annual incomes. First, annual consumption rather than annual
income might be a better proxy for economic well-being, because
consumption is more closely related to income over a longer time
horizon than to income in a given year. Second, the use of annual
income in analyzing the distributional effects of the current tax
system and proposed changes overstates the extent of inequality among
taxpayers. Some of the measured inequality will actually reflect
comparisons between taxpayers of different ages--for example,
comparing a working professional with a retiree who left the work
force long ago. Other measured inequality will reflect temporary
shocks to income due to changes in employment status, living
arrangements, and the uneven manner in which some people earn their
income. Distributional analyses that take these factors into
account may provide a better measure of ability to pay and of
economic well-being.

Long-Term Growth: Boosting Economic Performance by Improving Incentives

A central aspect of tax reform is whether it can improve the
economy's overall performance, leading to a rise in real incomes.
Reducing the tax system's deleterious impact on incentives to work,
save, invest, and innovate would help increase growth and boost real
incomes in the long term. The tax system affects these incentives in
a number of ways. Differentials in the rate of tax imposed on
economic decisions cause households and businesses to shift attention
and effort to less taxed activities. These distortions in household
and business decisions can result in a misallocation of resources in
the economy and reduce real incomes below what could be achieved
otherwise.

----------------------------------------------------------------------
Box 5-2. What Tax Rate Do Taxpayers Really Face?

Many taxpayers look to their statutory tax rates--their ``tax
bracket''--to gauge how large a bite the Federal Government takes
from their paycheck. Some might be surprised to learn that their
effective marginal tax rate--what they actually pay on their last
dollar of income--can differ substantially from their statutory tax
rate. Moreover, even though statutory tax rates are relatively low at
low levels of income, reflecting the progressivity of the current
tax rate schedule, the effective marginal tax rates that low-income
taxpayers face can in some situations be unexpectedly high.

Chart 5-2 shows the effective marginal tax rate for a hypothetical
family of four at various income levels. What is striking about this
chart is that effective rates do not consistently rise with income.
Rather, there are numerous spikes and steps that reflect the phase-ins
and phaseouts of various deductions, credits, and other provisions.
Taxpayers may receive a tax benefit from the child tax credit, for
example, but find that the tax on their last dollar of income is
pushed up as this credit phases out.

The distribution of effective marginal tax rates for taxpayers at
given income levels is shown in Chart 5-3, which documents the extent
to which effective marginal tax rates vary at given levels of income.
The chart shows marginal tax rates for the 10th, 50th, and 90th
percentiles, where taxpayers are ranked at each level of income by
their marginal tax rate. At any given income level, 50 percent of
taxpayers will have marginal tax rates above the line indicated for
the median taxpayer, and 10 percent of taxpayers will have marginal
tax rates exceeding the line for the 90th percentile. For example,
10 percent of taxpayers with $50,000 in income have marginal tax
rates that are below 15 percent (the tax rate at the 10th percentile);
50 percent have marginal tax rates below, and half above, 15.3
percent; and 10 percent have marginal tax rates above 27.8 percent.

As the chart shows, marginal tax rates diverge considerably even
among taxpayers at the same income level, especially at lower
incomes. The divergence arises because of the various deductions
and credits that phase in and then out at various rates, depending
on a host of taxpayer characteristics and choices. Indeed, these
phase-ins and phaseouts would cause considerable variation in
effective marginal rates even under a flat statutory tax rate
schedule.
______________________________________________________________________



[


As described above, reduction of these distortions can have a
substantial effect on capital accumulation (and thus wealth),
increase long-term growth, and boost real incomes.

Analysis of Alternative Reforms

The two main approaches typically advocated by economists to
revamping the current income tax involve moving the current tax base
to one that is closer to comprehensive income, or replacing the
current income tax with a tax that falls only on consumption.
Comprehensive income, which some advocate as the best measure of an
individual's overall well-being and ability to pay, is defined as
current consumption plus increases to wealth. Taxation based on
comprehensive income would include in the tax base all labor income,
income from the ownership of capital (such as dividends, interest,
rents, and accrued capital gains), and gifts and bequests received.
Deductions reflecting the cost of earning income, such as job-related
training expenses, would be allowed because they reflect neither
purchases for consumption nor any accretion to wealth. One feature of
a comprehensive income tax is that it treats individuals with the same
accrued purchasing power equally, regardless of the source, thus
adhering to the principle of horizontal equity. An individual
receiving income primarily from labor, for example, would be treated
no differently than a person with the same level of income from
capital or a bequest.

This framework, however, has some practical problems related to the
taxation of capital gains, inflation, income volatility, and imputed
income. Although capital gains reflect additions to wealth,
measuring these gains as they accrue is at best problematic: it
requires frequent valuation of assets, and accurate market values
for some assets cannot easily be established. Another problem is
that inflation causes asset appreciation unrelated to changes in
purchasing power; a proper accounting would require that the
inflationary component of capital gains be removed from the tax
base. Dividends and net interest income should likewise be included
in taxable income only to the extent they exceed inflationary
returns. Yet another problem is that the volatility of taxable income
combined with a progressive tax rate schedule could cause two
taxpayers who have the same taxable income when cumulated over
several years to pay different amounts of tax, thereby violating
the principle that taxpayers with equal ability to pay be treated
equally.

One of the most vexing problems associated with a comprehensive
income tax is the need to include imputed income in the tax base.
Imputed income arises from consumption or accretions in wealth that
occur outside of normal market mechanisms and therefore are difficult
to value. The value of the services that a homemaker provides is a
standard example of imputed income. Another is imputed rent, which
accrues to a taxpayer who owns his or her own home, because that
taxpayer is just as well off as another who owns a house of equal
value but receives rental income from a tenant. Under a comprehensive
income tax, imputed rent--the flow of housing services received by
owner-occupants who, in effect, rent their house to themselves--would
be included in income. Expenses related to producing that income,
including depreciation, mortgage interest, and property taxes, would
be excluded from income, however. Clearly, taxing such imputed values
raises enormous practical difficulties.

A key aspect of analyzing a tax base is taking into account all of
the points of collection in the tax system. Income, for example, can
be taxed and collected either at the business or at the individual
level. If tax on a comprehensive income tax base were collected
entirely at the business level, businesses would pay tax on their
business receipts, less expenses, but would deduct neither
compensation to employees, nor interest payments, nor dividends
paid to shareholders. If businesses are not allowed to deduct
compensation, they in effect withhold and remit to the government the
tax on compensation when paying the business-level tax.

Tax on interest and dividends could also be paid at either the
business or the individual level. If paid only at the business
level, dividends and interest would not be deductible, and the
corresponding income would be excluded from tax at the individual
level. If, instead, dividends and interest were taxed only at the
individual level, businesses would receive a full deduction for
dividends and interest paid.

The current income tax demonstrates the importance of considering
all points of collection. Under the current tax system, interest
income is not subject to the business-level tax because interest
payments are treated as a deductible business expense. Instead,
interest payments are included in individuals' taxable income. In
contrast, corporate dividends are subject to tax at the business
level because dividend payments are not deductible. What is striking,
however, is that dividends are also included in individuals'
taxable income. Dividends are thus taxed twice.

Consumption, rather than income, has been suggested as another
potential tax base. As discussed above, one rationale is the claim
that consumption is more closely related to a taxpayer's well-being
than annual income. Also, by taxing consumption rather than income,
the tax system would not distort taxpayers' decisions about how much
income to save. In contrast, because the income tax includes the
return to saving in the tax base, it taxes future consumption
(that is, current saving) more heavily than current consumption.
Under an income tax, current consumption is tax-favored relative to
future consumption, thereby discouraging saving.

A hypothetical consumption tax could be implemented in any of several
ways. It could, for example, take the form of a national retail sales
tax imposed broadly on all consumption goods at the final stage of
production. An alternative form of consumption tax, common in Europe,
is the credit-invoice method value-added tax (VAT), where a business
pays taxes on its total receipts but receives a credit for taxes
previously paid by suppliers on goods that the business has purchased
from them. This  tax builds in a degree of self-enforcement, because
businesses can claim a credit against their tax bill only if another
business has previously paid tax on the sale. Nevertheless, the
experience with State sales taxes and with the European VAT suggests
that compliance can be undermined and considerable complexity added
when certain final products are fully or partly exempted. Some have
suggested that transactions-based national retail sales taxes, where
revenue is collected at every point of final sale, raise difficult
administrative and compliance issues and may become infeasible at a
rate above 10 percent.

Alternatively, a tax on final goods consumed by households could be
imposed on businesses' total receipts less payments to other
businesses, including purchases of equipment and structures. This
type of entity-based consumption tax, called a subtraction-method
VAT, imposes tax on final purchases by consumers, which is remitted
on the value added by businesses at each stage of production.
Because a subtraction-method VAT does not provide a deduction for
compensation, nearly 60 percent of the tax base reflects compensation
to workers. Under this approach, the tax on housing consumption would
essentially appear as a tax on the construction and sale of new
homes. This payment of tax on the value added at each stage of the
production of new homes is equivalent to ``prepaying'' the tax on the
future stream of annual housing consumption that the home provides;
that is, it is equivalent to a tax on annual imputed rental income.

The deduction for purchases from other businesses under a subtraction-
method VAT ensures that the tax does not fall on previously taxed
business sales. Unlike with an income tax, the deduction for
investment expenditure (in other words, expensing rather than
depreciation) exempts from tax a portion of the return to a
capital investment. In economic terms, the deduction for
investment expenditure exactly equals the tax on the cash flow
from the expected ``normal'' return on the investment. Therefore
the deduction eliminates the tax on this part of the investment
return; that is, the return to capital at the margin is fully exempt
from tax. However, to the extent the investment returns an amount in
excess of the expected normal return, perhaps because of chance,
innovation, or successful risk taking, the tax on these above-normal
returns (what economists call supernormal or inframarginal returns)
will exceed the tax value of the initial deduction. That is, these
supernormal returns will generally be taxed. Treatment of investment
earnings under a consumption tax would thus be similar to that under
Individual Retirement Accounts, as Box 5-3 explains.

The subtraction-method VAT has received a lot of attention in
discussions of tax reform because, with slight modification, its
structure becomes very similar to that of the current income tax.
Instead of taxing compensation at the business level as under the
subtraction-method VAT, compensation could be taxed at the household
level by allowing businesses to deduct employee

----------------------------------------------------------------------
Box 5-3. How Are Consumption Taxes and Individual Retirement Accounts
Similar?

Individual Retirement Accounts (IRAs) treat investment earnings in
the same way that a consumption tax would. They thus provide a
framework for describing how a consumption tax would exempt a
portion of investment earnings from tax. If taxpayers deduct
contributions to an IRA from their taxable income, they are also
required to include all distributions from the IRA in their taxable
income. For the purpose of discussing the tax treatment of the return
to saving under a consumption tax, the IRA contribution limits can
be ignored. An investor with unlimited access to capital would invest
up to the point where the payoff from an additional dollar invested
(the marginal investment) just covers the costs of the investment,
including taxes. The value of the upfront deduction for the initial
investment, however, will exactly offset (in present value) the tax
on the expected normal return when the IRA is distributed.
Consequently, with an IRA the decision to invest an additional dollar
is unaffected by the tax. Returns above the expected normal return
(extraordinary returns), however, will generally be subject to tax.

Consumption taxes treat investment earnings in essentially the same
way. Under a national retail sales tax--the most straightforward
type of consumption tax--no tax is paid on income that is saved or
on investment earnings that are reinvested. Tax is paid only on sales
of final goods and services, that is, when the taxpayer consumes.
The taxpayer, in effect, receives an upfront deduction on savings.
Imposing a tax on final sales is thus effectively the same as taxing
a distribution from an IRA. Other types of consumption taxes, such
as the subtraction-method value-added tax and the two-tiered value-
added tax, where compensation is taxed at the household level, work
in essentially the same way.

Roth IRAs provide tax benefits that are similar to those of
deductible IRAs but differ in the timing of taxes paid. In contrast
to a deductible IRA, contributions to Roth IRAs are not deductible
from taxable income. Contributions are made with after-tax dollars,
but distributions from Roth IRAs are tax free. An important insight
about deductible IRAs and

[


Roth IRAs is that an equivalent investment in each type of account
will result in the same after-tax account balance and finance the
same amount of consumption during retirement.

The table above illustrates the equivalence between deductible and
Roth IRAs for an investment without extraordinary returns. In this
example, $1,000 is invested in a deductible IRA and $1,000 in a Roth
IRA before paying tax. In the case of the deductible IRA, the upfront
deduction offsets any tax due. In the case of the Roth IRA, the
taxpayer contributes the after-tax amount to the IRA. After 1 year
the initial investment plus investment earnings are distributed. Tax
is paid on the distribution from the deductible IRA, but not on that
from the Roth IRA. The key point is that the after-tax distributions
from the two IRAs are identical; that is, both investments finance
the same level of consumption. This result will always hold provided
the duration and rates of return of the investments are the same and
the tax rates at the time of contribution and the time of
distribution are equal. Aside from these factors, savers should
generally be indifferent between deductible and Roth IRAs.

What is the significance of this difference in the timing of tax
payments between deductible and Roth IRAs? Under a Roth IRA the
taxpayer effectively is prepaying tax. Conversely, under a deductible
IRA, the government in effect becomes a co-investor in an amount
equal to the upfront deduction. The government receives its share
of the earnings on the investment in the form of the tax payment
due upon distribution. For an investment with expected normal
returns, the tax payment due upon distribution under a deductible
IRA is equivalent to the prepayment of tax under a Roth IRA. If the
government could ``reinvest'' the tax received from prepayment under
a Roth IRA in an equivalent investment, the value of its investment
would be exactly equal to the tax payment due upon distribution under
the deductible IRA.

However, this equivalency may not hold if the investment yields
certain types of extraordinary returns: what economists sometimes
call inframarginal returns, such as might result from innovation,
discovery, or an idea with an extraordinarily large payoff. If these
returns are, at some level, fixed, they preclude reinvestment of the
tax prepayment at the same extraordinarily high return. In contrast,
risky investments do not necessarily produce inframarginal returns,
because additional investments could be made at the same rate of
return.

The table compares the after-tax value of investments in deductible
and Roth IRAs with such extraordinary returns. With a deductible IRA
the extraordinary returns are taxed through the government's role as
a co-investor. However, under the Roth IRA, this type of
extraordinary return goes untaxed, and the Roth IRA has a
correspondingly higher after-tax value than the deductible IRA.

This result has important implications for consumption taxes. A
consumption tax that works like a deductible IRA will tax all
extraordinary investment returns, including inframarginal returns
from innovation and ingenuity. The example of the deductible IRA also
illustrates how expensing of investment taxes such extraordinary
returns. The different tax treatment of extraordinary returns under a
deductible IRA than under a Roth IRA also illuminates the key
difference between a destination-based tax, which taxes imports but
not exports, and an origin-based tax, which taxes exports but not
imports (discussed later in the chapter). The taxation of exports
under the origin principle works like a prepayment mechanism that has
the effect of exempting extraordinary returns from tax.
______________________________________________________________________

compensation and imposing a tax on compensation at the household
level. In contrast to a subtraction-method VAT, this structure
(sometimes called a two-tiered consumption tax) has several
possible advantages. First, its similarity in structure to the
current income tax could ease the transition and facilitate
acceptance. Second, unlike transactions-based and entity-based
consumption taxes, a two-tiered consumption tax would permit
progressivity to be introduced directly through the household-level
tax by allowing generous exemptions to individuals or by retaining
tax preferences available under current law. Of course, targeting
of tax preferences for social policy objectives introduces complexity
and may have the unintended consequence of distorting taxpayer
behavior by implicitly imposing high effective marginal tax rates.

Switching to a consumption tax without the necessary transition
provisions might impose a one-time levy on existing capital. In the
context of a cash flow tax, such as a subtraction-method VAT, that
allows expensing of investment, this one-time levy occurs because
full expensing makes new investment cheaper. The one-time levy would
not distort economic decisions, however, because it is imposed on
existing capital, for which the decision to invest has already been
made, not on new capital. Taxing existing but not new capital may
transfer income from the old, who have accumulated assets over
their lifetimes, to the young, who have just begun to do so. This
raises important issues of fairness. The one-time tax on existing
capital would mean a reduction in the tax burden of the young,
reflected through lower tax rates, which itself would offset the
decline in value of existing assets and improve incentives to work
and save and allow a higher rate of capital accumulation.

Consumption tax reform could offer some type of transition relief to
reduce the one-time tax on existing capital. Partial transition
relief could take the form of allowing businesses to retain their
basis in existing capital. The extent of transition relief would
determine the size of the tax on existing capital. The more
generous the transition relief, the smaller the benefits of a shift
to a consumption tax base.

What Does the Current System Tax?

The current tax system deviates from both a comprehensive income tax
base and a comprehensive consumption tax base in important ways.
First, a substantial share of income is removed from the tax base
through the exclusions, exemptions, deductions, and credits available
under current law. As Chart 5-4 shows, tax preferences under current
law reduce the income tax base from what it would be under a
comprehensive income tax by over 40 percent. A few major preferences,
such as the personal exemption, the standard deduction, and itemized
deductions, including the home mortgage interest deduction, account
for 40 percent of income excluded from the comprehensive income tax
base. Exclusions, primarily for tax-preferred savings and employer-
provided health insurance, remove another 30 percent, with other
tax preferences accounting for the rest of the gap.

Tax preferences can distort economic decisions by creating tax
differentials between different types of income and consumption.
These preferences are similar to government transfers, or to
subsidies that have the same effect as direct government
expenditures. As already noted, these preferences pose a tradeoff
against the higher marginal and average tax rates needed to raise a
given amount of revenue, which then distort household and business
decisions. Preferences that apply unequally to taxpayers with
similar resources also violate the principle of horizontal equity.

Many of these preferences, however, serve useful social purposes.
Some of the preferences listed in Chart 5-5, for example, such as
that for employer-provided health insurance, subsidize health care
expenditure. The personal exemption, the child tax credit, and the
EITC adjust taxable income to reflect ability to pay.

An important difference between a comprehensive income tax and the
current income tax is the high degree of differential taxation
present in the latter. The double tax on newly equity-financed
corporate investment, as described later in the chapter, is one of
the most important examples, but others abound. There is considerable
variation across asset types in the acceleration of

[


depreciation allowances, implying different tax rates for different
investments. The current tax system also taxes capital gains and
dividends differently, excludes from tax the implicit returns from
consumer durables, and exempts from tax the interest paid on State
and local government bonds.

Like a comprehensive consumption tax, the current income tax also
exempts a substantial amount of income generated from returns to
savings through a variety of tax-preferred retirement plans and
accounts. (Together these amount to the largest item listed in
Chart 5-5.) In 1998 roughly 99 million individuals participated,
as either active workers, separated but vested workers, survivors, or
retirees, in the current system of employer-managed pensions. About
29 million workers were active participants in defined-contribution
plans (plans in which benefits vary with the return on the invested
funds). Contributions to these plans are tax deductible, with
employers often providing matching contributions. Another 23 million
workers participated in defined-benefit plans, to which employers
make tax-deductible contributions on behalf of employees, with
benefits typically based on past pay and years of service. The
investment income earned within these accounts accrues tax-free, but
distributions are included in taxable income.

Individual Retirement Accounts (IRAs) and similar arrangements such
as Medical Savings Accounts, Coverdell Savings Accounts, and college
savings and prepaid tuition (Section 529) plans provide similar
tax advantages. The

[


combined effect of the upfront deduction for contributions and the
tax deferral on earnings is a zero tax (in present value terms) on
the returns to assets held within these accounts, although, as
discussed below (and in Box 5-3), so-called extraordinary returns
are still taxed in all but the Roth IRA and other types of accounts
where tax is ``prepaid.'' In 2001 about $10.9 trillion in assets
was held within these tax-preferred retirement accounts. An
additional $22 billion was held within State-sponsored prepaid
tuition and college savings plans.

Because saving is the difference between income and consumption, the
exclusion of significant amounts of investment income from the tax
base has the effect of transforming the current tax system into a
system that is partly based on consumption. Table 5-1 puts this
point in perspective by comparing various categories of saving in
the United States for 1999 (the latest date for which consistent
data are available). Gross household saving was about $853 billion
in that year. Saving net of borrowing was about $274 billion,
implying a household saving rate of about 4.0 percent of income.
Saving in tax-preferred accounts--defined-benefit plans, defined-
contribution plans, IRAs, and life insurance accounts--accounted for
nearly 30 percent of gross household saving in 1999.

Saving in owner-occupied housing accounted for another 30 percent of
gross household saving. As previously noted, imputed rental income is
not taxed under the current system. Most of the appreciation in the
value of owner-occupied housing is likewise not taxed through the
current exclusion from capital gains taxation ($500,000 for taxpayers
filing jointly, $250,000 for single taxpayers). This treatment
exempts from tax most investment income from owner-occupied housing.
Interest and dividends are taxed when received, but tax on the
appreciation of financial assets is paid only upon disposition of
the asset (that is, tax is deferred), and then at preferential
capital gains rates, although the amount subject to tax includes
inflationary as well as real gains.

Although tax-preferred retirement saving and housing thus face
effective tax rates on the expected normal return that are close
to zero (in present value), taxpayers do not, in many cases, face a
zero tax rate on their last dollar of investment income. There are
two explanations for this. First, an individual's saving may exceed
his or her eligible contributions to these accounts. Second,
taxpayers may be investing outside of these accounts because their
purposes are other than the prescribed goals of these accounts.
Moreover, only about 50 percent of employees had access to or were
covered by an employer-managed pension plan in 1999. However,
virtually all individuals with earnings have access to some type of
tax-preferred savings program, including IRAs, because taxpayers
without access to an employer-managed pension plan are generally
eligible to deduct contributions to an IRA from taxable income. Thus
the set of taxpayers who do not receive consumption tax treatment on
their last dollar of retirement savings consists of those without
access to a pension plan and who make the maximum IRA contribution,
plus those (very few) with access to a pension plan who make the
maximum contribution. Data for the mid-1990s indicate that only
about two-thirds of taxpayers reporting deductible IRA contributions
(2.5 million in 1996) contributed the maximum amount allowed, and
some of these taxpayers also contributed to 401(k)-type plans. Most
other taxpayers received consumption tax treatment on their last
dollar of saving for retirement, and even more will do so as the
higher contribution limits for both 401(k)-type plans and IRAs,
enacted under the Economic Growth and Tax Relief Reconciliation
Act of 2001, are phased in over the next several years.

A number of special considerations arise when one contrasts the
current tax system with either the comprehensive income or the
consumption tax model. These considerations affect important
productive resources or sectors of the economy, such as human
capital, housing, and the nonprofit sector, and are discussed below.

Taxation of Human Capital

Because human capital is the most important component of national
wealth, it is also important to consider the tax treatment of this
capital under a comprehensive income or consumption tax. Investment
in human capital through education can be thought of as creating an
intermediate input to be used in the production of a final good and
that pays a return: the educated worker's future stream of wages.
Under the consumption tax model, only final goods, not intermediate
goods, should be subject to tax. Under the current tax system, the
tax treatment of human capital investment is mixed. Costs of human
capital accumulation include forgone earnings as well as direct costs
such as books, tuition, and supplies. Presently, of course, the
implicit cost of education represented by earnings forgone while
receiving education is not subject to tax but, consistent with a
consumption tax, is immediately expensed. Direct costs, including
books, tuition, and supplies, however, are currently subject to
varying degrees of taxation.

Under current law a variety of tax provisions affect the tax
treatment of education expenditure. The Hope and Lifetime Learning
tax credits and the temporary deduction for higher education expenses
(scheduled to expire after 2004) all provide varying degrees of
relief, but they may not provide relief at the margin or for the
last dollar of postsecondary education expenditure for many
taxpayers. There are also several types of education savings
vehicles, such as Coverdell Savings Accounts and State college
savings and prepaid tuition plans, which exclude investment earnings
on education-related savings from tax. The college savings plans in
particular, because of their very high contribution limits, tend to
provide consumption tax treatment at the margin on the return to
saving for higher education. The potential costs of the residual bias
against human capital formation can be significant. Research has
indicated that a 1-percentage-point increase in the income tax rate
may cause the long-run stock of human capital to decline by almost 1
percent--an effect with significant implications for national wealth.
Nevertheless, in addition to the various types of household saving
listed in Table 5-1, the expensing of forgone earnings and the
various tax preferences for education move the current system
toward consumption tax treatment of human capital.

Taxation of Housing

As discussed above, investment in owner-occupied housing is tax-
favored relative to other investment under the current tax system.
The primary source of this tax preference is the exclusion of the
annual value of housing services--imputed rental income--from income
taxation. Although the owner of a rental property is taxed on his or
her rental income, no tax is paid on the annual flow of housing
services received by owner-occupants. Owner-occupied housing enjoys
other tax advantages. Certain expenses related to homeownership,
such as mortgage interest and State and local property tax payments,
are allowed as itemized deductions. The deductibility of local
property taxes lowers the price of local public services. As noted
above, the first $500,000 of capital gains is excluded from income
upon sale of a primary residence. These advantages result in greater
consumption of housing services, and services provided by local
governments are tax-favored relative to similar, privately provided
services.

Taxation of Nonprofits

The nonprofit sector--religious groups, private educational
institutions, government-sponsored enterprises, hospitals, and
various associations and foundations--is excluded from the current
income tax to the extent that the organizations themselves are
generally not subject to tax. The wages of nonprofits' employees
are, of course, subject to tax. There are also substantial tax
incentives in the tax system for individuals and businesses to
contribute to nonprofit organizations. Whether this relative tax
advantage would be retained if the current income tax were replaced
by a consumption tax depends on how the tax is structured. Under a
two-tiered consumption tax similar in structure to the current income
tax, the current relative tax advantage of nonprofits could be
retained. The wages of their employees would remain subject to tax
under this type of consumption tax. However, under a transactions-
based consumption tax, such as a national retail sales tax, there
would be greater difficulty in exempting nonprofit organizations
from tax. In the case of a national retail sales tax, a system of
exemptions for purchases made by nonprofits would be needed, and
this could add complexity. The cost of charitable giving to
nonprofits, however, might change substantially under a consumption
tax, for two reasons. First, there is the issue of whether the
individual and business deductions for charitable giving would be
retained. Second, incentives to give would be affected by any change
in the tax rate schedule. To the extent tax rates fall as a
consequence of fundamental tax reform, the tax incentive for
individuals and businesses to give to nonprofits would decline as
well.

Distributional Consequences of Tax Reform

It is sometimes argued that a consumption tax base is less fair than
an income tax base because the benefit of not taxing capital income
accrues largely to those with higher incomes. However, this claim
depends critically on the time frame used to analyze the
distributional effects of the two tax bases. Consumption taxes are
generally less regressive when viewed from a lifetime perspective
than when viewed from an annual perspective. It might be expected
that, for many individuals, lifetime consumption should be roughly
equal to lifetime income. If this is the case, the lifetime
incidence of a consumption tax and of an income tax should be
close to proportional.

Also, as discussed above, a one-year snapshot of the distributional
effects of many tax changes can be misleading, because this type
of distributional analysis fails to take into account the fluidity
of taxpayer incomes and other characteristics (Box 5-4). Younger
taxpayers entering the work force are likely to have relatively low
incomes as they continue to acquire human capital through education
and job experience. As their human capital develops, their incomes
tend to rise, peaking shortly before retirement. Saving and
consumption patterns follow this cycle, with a period of
accumulation accelerating in midlife and peaking before retirement,
when dissaving begins. These patterns have been well documented, and
distributional analyses that do not take them into account may be
misleading.

Consumption taxes may also be less regressive than often thought
because the bases of both a consumption tax and an income tax include
key elements of what is commonly called capital income. Capital
income can be broken down into four components: the return to waiting
(that is, the opportunity cost of capital), the return to risk taking
(the risk premium), economic profit (that is, the inframarginal
return to investing), and the difference between expected and
actual returns. The key to analyzing the difference in distributional
effects between a consumption tax and an income tax is that a
consumption tax exempts the first component of capital income from
tax, whereas an income tax includes it. The remaining three
components are generally taxed under both systems.

To understand how some forms of a consumption tax subject some
capital income to tax, it is useful to consider how the tax treats
investment expenditure. Under a cash flow consumption tax, a firm
expenses its capital purchases. A successful investment will generate
a series of future cash flows to the firm. These future cash flows
will be subject to tax, but the present value of the expected future
series of tax liabilities, as valued by the market, will be exactly
equal to the tax value of expensing the capital expenditure.
Because deductions have the same impact as other Federal Government
capital market transactions, they are valued the same as a risk-
free investment, often assumed to be represented by the interest
rate on Treasury bills.

The key point is that, to the extent that future cash flows from
the investment exceed (in present value) the initial investment, the
excess will generally be taxed. Future cash flows resulting from
extraordinary profits, due to innovation or the return to risk
taking, are all generally subject to tax. That is, to the extent the
actual return exceeds the yield on a risk-free investment, as
reflected by the Treasury bill rate, the difference will generally be
subject to tax under both a consumption tax and an income tax. The
general public is thus, in a sense, a proportional shareholder in
all enterprises--a co-investor--under an income or a consumption tax.
Thus the general public shares in the rewards to the extent the
returns are unexpectedly high, and shares in the losses in the case
of a shortfall. Only the return to waiting is generally exempt from
tax under a consumption tax. As noted above (Box 5-3), certain types
of extraordinary returns, such as inframarginal returns, may also be
free from tax if tax is ``prepaid,'' because the government no longer
acts as a co-investor and does not share in these inframarginal
returns. However, under a consumption tax, prepayment may be limited
to difficult-to-tax activities, such as housing services and
investment in intangibles.

How important is it that only the opportunity cost of capital--the
expected normal return--generally goes untaxed under a consumption
tax? The answer depends critically on how large this opportunity
cost is relative to total capital income, and on who tends to
receive this component of capital income. If this component is large
and received primarily by higher income taxpayers, shifting to a
consumption tax would have the immediate effect of benefiting these
taxpayers. It is important to note that the real risk-free rate of
return available to a tax-exempt investor has historically been
below 1 percent a year.

----------------------------------------------------------------------
Box 5-4.  Taxpayers Exhibit Substantial Fluidity Across Tax Rate
Brackets

Do taxpayers tend to face the same marginal tax rate over time, or
do they change tax rate brackets as predictable and unpredictable
life events occur and their circumstances change? The table on the
next page considers the dynamics of statutory tax rate brackets over
a 10-year period: the statutory tax rate brackets of taxpayers in
1987 are compared with their statutory tax rate brackets in 1996
(these were the years for which these data are available). In each
year the statutory tax rates the taxpayer would have faced had the
Economic Growth and Tax Relief Reconciliation Act of 2001 been in
place in 1987 and 1996 (with appropriate inflation adjustments) are
compared. If most taxpayers face the same tax rate at the beginning
and the end of this 10-year period, it might be concluded that a
static, one-year snapshot is a good indicator of a taxpayer's
lifetime average tax rate.

The tabulations, however, show a substantial amount of dynamics.
Taxpayers who remained subject to the same statutory tax rate in
both year 1 and year 10 are on the diagonal of the table (shown
in bold). About 53 percent of taxpayers (the proportion of
taxpayers not on the diagonal) were in a different tax rate
bracket at the end of the period than at the beginning. There was
significant movement toward higher tax brackets, reflecting upward
mobility. In all, about 28 percent of taxpayers had moved to a
higher tax rate bracket at the end of the

[

10 years. About 66 percent of the taxpayers in the bottom (zero tax
rate) bracket in year 1 had moved to a higher bracket after 10
years, the vast majority moving to either the 10 percent or the 15
percent bracket. About 47 percent of taxpayers in the bottom two
brackets combined (the zero and 10 percent brackets) had moved to a
higher bracket by the end of the period, although relatively few
moved beyond the 15 percent bracket. There is also substantial
movement down the tax rate schedule. In all, about 26 percent of
taxpayers moved to a lower tax bracket. About 51 percent of the
taxpayers in the top bracket in the first year were in a lower tax
bracket after 10 years. Forty-seven percent of taxpayers in the top
two brackets in year 1 had moved down to at least the 28 percent tax
bracket by year 10.

Although relatively few taxpayers moved from the lowest tax rate
brackets to the highest, a considerable fraction moved from the
highest brackets to the lowest. Of those starting in the 15 percent
tax bracket or below, only 1 percent reached the top two brackets.
In contrast, of those starting in the 33 percent bracket or above,
15 percent had moved to the 15 percent bracket or below after 10
years. Of course, taxpayers in the lower brackets may also be more
likely to become nonfilers, a possibility not accounted for here.

A considerably larger percentage of taxpayers were subject to any
particular tax rate at some time over the 10-year period than in
just the initial period. For example, more than twice as many
taxpayers were subject to one of the top two rates in either year
1 or year 10 (3.3 percent of returns) than in just the first year
(1.5 percent of returns). Moreover, this calculation excludes those
taxpayers who may have faced the top two rates during the intervening
years but not in year 1 or year 10, and the possibility that some
taxpayers may not have filed a tax return in some years. An analysis
of all taxpayers who filed a return in year 1 and were still alive in
year 10 shows that nearly four times (5.8 percent) as many taxpayers
were subject to one of the top two rates in at least 1 of the 10
years.

A number of factors explain the fluidity of taxpayers across tax rate
brackets over time. One piece of the puzzle is that most taxpayers'
incomes grow as they gain job experience and education, but then
decline in retirement as they leave the work force and rely on
their Social Security benefits, pensions, and savings, which may
be nontaxable. Chart 5-6 shows the change in a hypothetical couple's
marginal tax rate as that couple's income follows this life cycle
pattern of growth followed by decline. In this example, a two-earner
couple with two children earn about $65,000 at age 30 and pay income
and Social Security taxes. They buy a home and save for life's
uncertainties, their children's education, and their own retirement,
using taxable accounts plus a 401(k). When they retire, they collect
Social Security and live to the age of 85. For simplicity, it is
assumed that they neither receive an inheritance nor leave a
bequest. The couple's marginal tax rate, the rate paid on the last
dollar of earnings, varies greatly over the life cycle, reflecting
the couple's passage through the various tax rate brackets and the
phase-in and phaseout of various tax deductions and credits as their
earnings and other characteristics change. The couple at first faces
a 15 percent marginal tax rate, then briefly faces a marginal tax
rate of 20 percent because of the phaseout of the child tax credit,
and then faces a 25 percent marginal tax rate in midlife during the
peak earnings years. Toward the end of life the couple is in the 15
percent statutory rate bracket, reflecting the decline in income
in retirement, but pays 27.75 cents on the last dollar of income
because the couple is in the phase-in range of the tax on Social
Security benefits.

Many taxpayers also have short-term fluctuations in their income as
they move in and out of the labor force or between jobs, or as their
business and investment income is hit by the ebbs and flows of the
business cycle. Finally, factors other than income, such as having
children, going through marriage and divorce, or facing unusually
high medical expenses, as well as charity or home mortgage interest,
can all affect which tax bracket a taxpayer falls into.

The substantial movement of taxpayers across rate brackets suggests
that tax burdens in a given year may tell a very different story of
the distribution of the tax burden than do measures of tax burdens
over longer horizons. These differences are important for evaluating
the distributional effects of changes in tax rates. Analyses that
rely on annual snapshots of taxpayer incomes are likely to suggest
that a small fraction of taxpayers benefit from rate cuts, when in
fact a larger fraction of taxpayers are likely to benefit because
of the substantial movement of taxpayers up and down the tax rate
schedule over time.
----------------------------------------------------------------------

[

Decisions on the Path to Reform

A number of choices would be involved in any effort to reform the tax
system. Some of these choices represent substantial shifts in tax
policy but could be made without major structural changes to the
current tax. Also, some of these changes do not involve a choice
between the income and the consumption tax frameworks but must be
addressed within either framework.

Integration and the Double Tax on Corporate Income

The current tax system imposes a heavy tax burden on equity-financed
corporate investment through the double tax on corporate income.
Eliminating the high degree of differential taxation is the rationale
behind the President's proposal to abolish this double taxation.
Corporate income from a newly equity-financed project is subject to
two layers of tax. First, the corporate tax is paid on earnings at
the firm level at a maximum rate of 35 percent. For income
distributed as a dividend, the second layer of tax is paid by
individual shareholders at a maximum rate of 38.6 percent (plus
any State or local income tax). Alternatively, for assets held for
more than 5 years, shareholders pay tax at a statutory rate of 18
percent on the appreciation in stock value that arises from
corporate earnings retained and reinvested in the firm. The total
effective tax on corporate income is calculated by combining the
two layers of tax. As Table 5-2 shows, the effective tax rate (for
Federal tax alone) on corporate income distributed to shareholders
as dividends can be as high as 60.1 percent. For corporate income
that is retained by the firm and realized by a shareholder as a
capital gain, the effective tax rate can be as high as 40.9 percent
after accounting for substantial deferral. The effective tax rate on
capital gains is lower than the effective rate on dividends because
of the preferential tax rate on long-term capital gains realizations
and the ability to defer taxes until gains are realized.

The double taxation of corporate income affects economic decisions
in a number of important ways that may reduce corporate investment,
encourage artificially high debt-to-equity ratios, discourage the
payment of dividends, and favor noncorporate organizational forms.
The high tax on capital may also discourage risk taking and
innovation through its effect on entrepreneurship. New firms
innovate by developing new products and technologies and are a
testing ground for new forms of internal organization. Other firms
can imitate successful new approaches, leading to economy-wide
improvements in productivity and faster economic growth.

[

Debt Versus Equity Financing

Equity financing is tax disadvantaged relative to debt financing
because interest income, unlike dividends, is generally subject to
only one layer of tax, at the individual tax rate. As already
mentioned, interest payments are deductible as a business expense
and thereby excluded from the corporate tax base. Table 5-2 shows
that the maximum effective tax rate on interest earnings is 38.6
percent, the maximum tax rate on ordinary income. The encouragement
of debt financing through the tax system results in an increased
risk of bankruptcy and financial distress. A heavier debt burden
leaves firms particularly vulnerable to capital market risk during
a downturn or weakness in the economy. Business failures and
financial distress can result in losses to shareholders,
debtholders, and employees alike.

Dividend Payout Policy

The double taxation of dividends may also distort corporate dividend
payout policy and the investment decisions of firms. The economics
literature has generally found that, for new equity-financed
investments, corporate income paid out as dividends is tax-
disadvantaged relative to corporate income that is retained. This
has important economic consequences. The heavier tax burden on
dividends can encourage investment in established businesses with
internally generated earnings, because these businesses will tend to
have more retained earnings because of the tax distortion. The
distortion also favors stock repurchases over dividends.

Dividends may also provide a number of important benefits to
investors that have a direct bearing on corporate governance.
Payment of dividends may provide a signal to investors of a
company's underlying financial health. Indeed, it may be a
particularly potent signal given the current backdrop of shaken
confidence in corporate financial reporting. A firm cannot continue
to pay dividends for very long unless it has the earnings to
support such payments. Corporate managers and directors may have
better information about the firm's future cash flows than do persons
outside the company, and dividend payments may reflect this
information. Dividend payments may also be one way for shareholders
to impose discipline on corporate managers: reducing the amount of
cash at the discretion of management may focus management's attention
on the most productive investments rather than on purchases that may
not increase shareholder value.

Choice of Organizational Form

The high tax on corporate income affects the allocation of capital,
shifting it from the corporate sector to owner-occupied housing and
the noncorporate business sector (which includes sole
proprietorships, partnerships, S corporations, and nonprofit
organizations). This entails an inefficient use of resources and
reduces real output and incomes. The higher tax on corporate
income discourages the use of the corporate form of organization
despite the nontax benefits of incorporation such as limited
liability and more centralized management. The corporate and the
noncorporate forms may also offer different advantages with respect
to scale economies and the development of entrepreneurial skill,
which may not be fully exploited because of the tax distortion.

Table 5-3 shows the extent to which the current system taxes capital
in the corporate sector at a higher rate than capital in other
sectors, particularly the noncorporate business and housing
sectors. The economy-wide effective tax rate is roughly 20 percent.
However, the overall effective tax rate of between 32.2 percent and
34.5 percent in the corporate sector (depending on the treatment
of intangibles) is well over half again as high as the 20.0 to 21.2
percent effective tax rate (again depending on intangibles) in
the noncorporate business sector. The effective tax rate on owner-
occupied housing, in contrast, is 3.9 percent. The tax penalty on
income from capital in the corporate sector relative to other sectors
is thus substantial.

The President's proposal to eliminate the double tax on corporate
income would encourage a more productive allocation of capital. A
study by the Treasury Department estimates that, even in the absence
of increased investment, the long-run economic benefit of eliminating
the double tax ranges from about 0.11 to 0.74 percent of consumption,
or between $8 billion and $52 billion in 2001. Moreover, the repeal
of the double tax would be expected to lead to increased investment
and thus further economic gains from stronger growth and job
creation.


[

Uniform Taxation of Investment

Another key aspect of the current tax system is that the provisions
for depreciation do not provide deductions that mirror the economic
lives of assets, nor do they adequately account for inflation. This
divergence between depreciation as provided in the current tax code
and economic depreciation is a departure from the framework of a
comprehensive income tax. Table 5-3 shows how a move to economic
depreciation would change effective tax rates in the corporate sector.

Revamping the current system of depreciation to more closely reflect
economic depreciation would be a fundamental reform that would level
the playing field across different types of business investment.
However, as shown in Table 5-3, such a change would actually raise
the effective tax rate on overall business investment, because it
does not include the accelerated depreciation and expensing available
for some investments under current law. Although greater neutrality
between types of business investments would be achieved, particularly
within the corporate sector, the distortion between business
investments and owner-occupied housing would be increased. Also, a
system based on economic depreciation is complicated by the
difficulty of frequently updating asset classes and lives to keep
pace with innovation and changes in technology. Moreover, true
economic depreciation would require indexing of depreciation
allowances for inflation, which may contribute to complexity.

As described above, under the consumption tax model, businesses would
deduct from their receipts all business expenses, including purchases
of equipment and structures. Consequently, a shift to a consumption
tax would involve replacing the system of depreciating investment
under current law and the income tax model with complete expensing.
Expensing of investment in the year it is placed in service is more
generous than either current or economic depreciation for most
investment, and it exempts from tax the expected cash flow from a
marginal investment. With expensing, there is no tax on investment
at the margin, because expensing exactly offsets (in present value)
the tax on the expected future cash flow from the investment. Cash
flow that arises from risk taking, inframarginal returns, and
unexpected losses or gains would continue to be taxed, because it
exceeds the present value of expensing. (See Box 5-3 above for a
discussion of the tax treatment of these types of extraordinary
returns in the case of deductible and Roth IRAs.) Expensing is
needed under the consumption tax model to exclude purchases of
intermediate goods from the tax base, so that only final sales to
consumers, and hence consumption, are taxed.

Expensing of investment would dramatically lower the taxation of
capital income. As Table 5-3 shows, it would lower the economy-wide
effective tax rate on investment to near zero and virtually eliminate
the tax-based disincentive to save and invest. Expensing also
improves neutrality by removing tax differences between investments
in the corporate and investments in the noncorporate sector.

The relative tax advantage of housing would be greatly altered under
either the income or the consumption tax model. A comprehensive
income tax would subject housing services to taxation, eliminating
the relative tax advantage of housing and improving economic
incentives, but introducing considerable complexity. Under a
consumption tax, housing consumption would be taxed either by taxing
the sale of newly constructed housing (that is, prepayment) or by
taxing the annual flow of housing services. Housing would lose its
tax advantage relative to other capital. The effect of these changes
on housing prices and the housing stock is the subject of extensive
debate.

Broadening the Tax Base and Lowering Tax Rates

Broadening the tax base usually means eliminating the various tax
preferences under the current tax system. These preferences represent
a policy decision to reduce the effective tax rate for some, but they
pose a tradeoff in that a higher overall tax rate is needed under
both the income and the consumption tax models to raise an
equivalent amount of revenue. Eliminating preferences would improve
incentives in two ways. First, as illustrated above, many of the
preferences carry with them high implicit tax rates as the benefits
are phased out. Eliminating these preferences repeals these high
implicit rates and the associated kinks in the effective tax rate
schedule. Second, once the preferences are eliminated, the same
amount of revenue can be raised with lower overall tax rates.
Chart 5-4 earlier in the chapter showed that the current tax base
is considerably smaller than either the income or the consumption
tax base.

Chart 5-4 also indicated that the existing tax preferences are
just as important, if not more important, in determining the size of
the tax base when saving is included as when it is excluded (that is,
the difference between the comprehensive income and comprehensive
consumption tax bases). The broader tax base under either reform
would allow tax rates to be lowered. Lower rates improve economic
incentives, spurring private activity by making more productive use
of resources.

There are many avenues by which marginal tax rates can affect
individual and business decisions. Individuals can shift compensation
toward less taxed sources; they can adjust labor supply, saving,
investment, and portfolio allocation decisions; and they can alter
their compliance behavior. The economic benefits of lower tax rates
were precisely the rationale behind the reduction in tax rates
enacted in the Economic Growth and Tax Relief Reconciliation Act of
2001. Some estimates suggest that the reduction in the top statutory
tax rate from 39.6 percent to 35 percent will raise the affected
taxpayers' taxable incomes by as much as 3 percent when fully
effective in 2006. This rise in taxable incomes reflects
individuals' decisions to work, save, and invest more, to increase
tax compliance, to reduce evasion, and otherwise to shift efforts
to activities that become more lightly taxed as a result of the
lower tax rates. The extent to which taxes distort these decisions
is, to some extent, diminished by lower tax rates. Moreover, the
rise in taxable incomes means that individuals' behavioral response
to the lower tax rates works to offset the direct cost of rate
reduction to the government.

Some estimates indicate that repeal of the double tax on corporate
income, combined with the uniform treatment of investment and
general base broadening, would increase capital accumulation by
over 10 percent and output by perhaps as much as 4 percent in the
long run. A shift to a consumption tax would go even further by
excluding income from saving from the tax base. Most estimates
suggest that a shift to a consumption tax base would generally
increase the size of the capital stock in the long run, with some
estimates suggesting an increase of as much as 20 percent. Although
estimates of the impact on output vary, some models indicate that
real output might rise in the long run by as much as 6 percent.

Income Versus Consumption as the Base

The major difference between the consumption and income models is
that a consumption tax does not distort the choice between current
and future consumption (that is, saving); in other words, it is
intertemporally efficient. In contrast, an income tax distorts the
relative prices of current and future consumption by reducing the
after-tax return to saving. Under an income tax, current consumption
is tax-favored, and saving disfavored, relative to future
consumption.  Taxing consumption rather than income would eliminate
this distortion. Because the tax base under the comprehensive
consumption tax model is smaller than under the comprehensive income
tax model, however (Chart 5-4), a higher tax rate would be required
to raise a given amount of revenue, which may involve some degree
of additional distortion. Nevertheless, as discussed above, studies
indicate that elimination of the tax on income from saving can have
important salutary effects on economic growth and real incomes by
encouraging saving.

International Tax Considerations

The U.S. economy is increasingly linked to the world economy through
trade and investment. Domestically based multinational businesses
and their foreign investment help bring the benefits of global
markets back to the United States by providing jobs and income. Like
all firms, multinationals face a number of business decisions,
including how much to invest and where. Because multinationals by
definition operate in a number of countries, they also have to decide
in which country to locate their headquarters, and their decisions in
turn affect which countries reap the majority of benefits from the
multinationals' operations.

In the context of tax reform, it is important to consider how changes
in the international taxation of income would change the incentives
for companies to locate production, intangible assets, and research
and development in one country rather than another. Reform can have
important effects on these business decisions and on the efficient
use of the Nation's economic resources, affecting employment and
the competitiveness of workers in the United States.

Two alternative approaches to taxing international flows of income
are the territorial system and the worldwide system. Under the
territorial system, individuals and businesses pay tax on income only
where it is earned, regardless of where they themselves reside.
(Certain passive or financial income from abroad, such as royalties,
also is subject to tax in the country of residence.) Under the
worldwide system, all income is subject to tax in the taxpayer's
country of residence, regardless of where it is earned. Income
earned abroad may also be subject to tax by the country where it is
earned. On the principle that the same income should not be taxed by
more than one country, foreign taxes are generally creditable against
domestic tax on foreign income up to the domestic tax rate.

The United States uses a hybrid of these two systems. Resident
individuals and businesses are subject to tax based on their
worldwide income. For foreign subsidiaries of U.S. multinational
companies, tax is usually paid only when income is distributed to
the domestic parent company as a dividend; that is, tax is deferred
until repatriation, at which time a credit can be claimed for
foreign taxes paid. It is primarily the opportunity of tax deferral
of certain active income that distinguishes the tax treatment of
international income by the United States from a pure worldwide
system. Deferral has the effect of relieving a substantial portion
of the U.S. tax, in present value terms, on the income of foreign
subsidiaries of U.S. companies. However, because tax is imposed
upon repatriation, there is a disincentive to repatriate foreign
income; this disincentive is absent under a territorial system.

The rules surrounding deferral are the source of considerable
complexity, involving a bewildering assortment of definitions
and rules. Deferral is extended to income from active business
operations abroad in order to provide an equal footing with other
operating businesses in the same foreign country. Deferral of U.S.
tax is not extended to income from portfolio investments and other
income viewed as highly mobile. Consequently, certain income from
portfolio-type foreign investments (for example, interest,
dividends, and royalties) is ``deemed distributed'' and is subject
to current U.S. tax. However, such income also includes various
categories that are more active than passive, such as foreign base
company sales and services income, income from shipping, and
certain income from oil activities.

The foreign tax credit requires companies to make complex
calculations in order to claim the credit against the U.S. tax on
repatriated dividends. The foreign tax credit is calculated by
``basket'' or type of income (for example, passive, financial
services, and general active income) so that excess credits
generated on highly taxed active foreign business income cannot be
used to reduce the U.S. tax on lower taxed foreign income such as
passive interest. Over the past 30 years, U.S. companies have
repatriated roughly half of the after-tax income earned by their
foreign subsidiaries.

The U.S. system of taxing international income dates back to the
1960s, when the United States was the source of half of all
multinational investment worldwide, produced 40 percent of the
world's output, and was the world's largest capital exporter.
From this perspective it was appealing to construct a tax system
that was viewed as neutral with respect to the location of foreign
investment by taxing all income and taxing it all at the same rate.
However, this system is based on the idea that investment abroad is
a substitute for domestic investment and on the assumption of
perfectly competitive markets in a world with aggressive pricing and
ease of entry, and with no brand-name loyalty, economies of scale,
or other sources of extraordinary profits.

The underpinnings of the worldwide system have shifted, however. It
is now recognized that most multinational corporations produce
differentiated products and compete in industries characterized by
economies of scale, thereby undermining the perfect competition
model of the past. There is some evidence that returns on foreign
investment surpass those on domestic investment and exhibit above-
normal returns because of factors such as intangibles (brands,
patents, and the like). Moreover, the United States is now the
world's largest importer of capital and no longer dominates foreign
markets. For example, in 1960, 18 of the world's 20 largest
companies (ranked by sales) were located in the United States, but
by the mid-1990s that number had fallen to 8. Companies can choose
where to locate, and, under the worldwide system of taxation,
unless the domestic tax rate is the same in all countries in which
a company operates, the decision where to locate the company's
headquarters will be affected by the countries' tax systems.

There is some concern that the United States has become a less
attractive location for the headquarters of multinational
corporations. Although multinationals operate in a number of
countries, the Department of Commerce reports that the bulk of
the revenue, investment, and employment of domestic multinational
companies is located in the United States. In 1999 U.S. parent
companies accounted for about three-fourths of U.S.-based
multinationals' sales, capital expenditure, and employment.
Therefore, where a firm chooses to place its headquarters will
have a large influence on how much that country benefits from its
domestic and international operations.

The United States is also one of only a few industrialized countries
(Switzerland and the Netherlands are other prominent examples) that
do not provide some form of integration of the corporate and
individual income tax systems. The resulting double taxation of
corporate income makes it more difficult for U.S. companies to
compete against foreign imports at home, or in foreign markets
through exports from the United States, or through foreign direct
investment.

Another major choice in international taxation, and one that is
particularly important under the consumption tax model, is that
between the so-called destination and origin principles. Under the
destination principle, imports are taxed by making them nondeductible
or by levying an import tax, and exports are tax-exempt. The tax
base then includes all domestic consumption, whether goods and
services are produced at home or abroad. Under the origin principle,
the opposite rule applies: exports are taxed, but imports are not,
and the tax base becomes consumption plus net exports. Either the
origin or the destination principle can be applied under a
consumption tax, but the destination principle has the intuitive
appeal of promoting economic growth domestically by exempting, and
thereby promoting, exports.

Nevertheless, under a flat-rate consumption tax, the origin and
the destination principle are equivalent at the margin. Under the
destination principle, again, foreign investment is essentially
expensed, and the cash flow from the investment is taxed as imports.
The tax benefit of expensing will exactly equal in present value the
tax on the expected normal return of the investment as it returns
through imports. Under the origin principle, taxes are essentially
prepaid by taxing exports, and no tax is due on the returning cash
flow. Returning profits would thus be taxed under the destination
principle, but not under the origin principle. The timing of the tax
payment will be different, but in present value terms the taxes paid
under the destination principle and under the origin principle will
be the same for an equivalent level of exports. This is similar to
the equivalency between deductible IRAs and Roth IRAs discussed in
Box 5-3. The equivalency does not necessarily hold, however, in the
presence of extraordinary returns (returns to innovation,
inventions, ideas, and risk taking). The returning extraordinary
profits would be taxed under the destination principle, but not
necessarily under the origin principle. It is also important to note,
however, that the tax on the returning cash flow under the
destination principle could be avoided if a taxpayer is able to
relocate abroad. Such a taxpayer would receive the benefit of the
export exemption (expensing) and might avoid the tax on the returning
cash flow (imports) through relocation. Under the origin principle,
in contrast, the tax cannot be avoided because it is, in effect,
prepaid.

Conclusion

Changes in tax policy involve many different objectives and can take
many different forms. This chapter has focused on the primary
choices involved in tax reform and the major differences among
taxing consumption, taxing income, and maintaining the current
hybrid tax. Proposals for tax reform pose the difficult question of
how best to balance the sometimes competing objectives of simplicity,
fairness, and faster long-term growth. Policy changes can improve
efficiency and boost real incomes, but it also matters enormously
that all Americans have the opportunity to achieve economic success.