[Economic Report of the President (2005)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 3

Options for Tax Reform

The current Federal tax system is unnecessarily complex and distorts
incentives for work, saving, and investment. As a result, it imposes
large burdens on taxpayers and on the U.S economy as a whole in the
form of high compliance costs and distortions in economic decisions.
Tax reform could make the tax system simpler and fairer and
promote growth of the economy. Various tax reform proposals have
been made to replace the current tax system. Most of these proposals
are variations on a few basic types of taxes. This chapter discusses
these basic prototypes for reform.   The President has not endorsed
any specific proposal, and this chapter does not advocate the
adoption of any particular prototype for reform.
The key points in this chapter are:
  The current tax system imposes high costs on society in
addition to the taxes actually collected.
  Income taxes and consumption taxes are the primary
alternatives for raising government revenues.
  The main types of consumption taxes are the retail sales
tax, the value added tax, the flat tax, and the consumed
income tax.
  While the tax system could be completely redesigned,
important benefits could also be obtained through
simplification and reform of the current tax system.

Why Do We Need Tax Reform?
People often think of the tax burden in terms of the dollar amounts
of taxes paid, but this is only part of the total burden. The tax
system also imposes two indirect burdens: the costs (in time and
money) of complying with tax rules and the costs (including slower
economic growth) of tax-induced distortions of economic activity.
Although all tax systems impose direct and indirect costs, such
costs are unduly high under the current system.
The Direct Burden of the Tax System: Taxes Paid
As measured by the revenues collected, the direct burden of Federal
taxes is estimated to be $2.1 trillion, or 16.8 percent of GDP in
fiscal year 2005 (Table 3-1). This percentage is less than the
average of about 18 percent for the last 50 years because of the
effects of the recession and of temporary





economic stimulus provisions that expired at the end of December
2004, but is projected to return to the historical average under
proposed policies. The largest share of revenues (over 92 percent)
comes from taxes on income and its components: the individual income
tax (43.5 percent), payroll taxes for Social Security and other
social insurance programs (nearly 38 percent), and the corporate
income tax (11 percent).
Even when state and local taxes are included, the United States
relies more on taxes on income than most other developed countries
(Table 3-2). Over 70 percent of taxes imposed by all levels of
government in the United States are individual income, corporate
profit, and payroll taxes, compared to the 62 percent average for
all Organization for Economic Cooperation and Development (OECD)
countries. The United States relies much less on taxes on consumer
goods and services (under 18 percent) than other countries (32
percent average). Much of this difference reflects higher total tax
burdens in other OECD countries, which generally impose value added
taxes (VATs) on sales of goods and services in addition to income
and payroll taxes.




High Compliance Costs

The complexity of the U.S. income tax is legendary (Box 3-1), and
it leads to high compliance costs for taxpayers and the government.
The costs of the Internal Revenue Service (IRS) administering the
tax system and monitoring compliance are about 0.5 percent of
revenues. But these are just a small part of the compliance costs
associated with the tax system, which are estimated to be as much
as 10 percent of revenues. The complexity of the current system
imposes substantial burdens on taxpayers in time and money spent to
prepare and file tax returns, maintain tax-related records, read and
understand instructions, engage in tax planning, and, for more than
half of individual taxpayers, pay a tax preparer. The IRS estimated
that for tax year 2000, individual taxpayers spent 3.2 billion hours
on tax compliance, an average of 25.5 hours per return. Assuming a
value of $15 to $25 per hour for



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Box 3-1: Complexity of the Current System

The current tax system includes many provisions that duplicate or
conflict with each other and that are unnecessarily complicated. Some
examples of complexity affecting large numbers of taxpayers are:
 There are approximately 30 different kinds of special
retirement or special purpose savings accounts under
the tax system. Each has its own rules, and
participation in one of them can affect whether an
individual can participate in another.
 Numerous phaseout provisions intended to limit tax
benefits to lower-income taxpayers require
additional calculations and create high marginal
tax rates in the phaseout range. Two such provisions
apply to the taxation of Social Security benefits.
 Tax complexity is not just the bane of the wealthy. The
Earned Income Tax Credit, which provides a subsidy to
the working poor and is a basic element of our national
income support system, has 13 pages of instructions and
complex eligibility requirements.
 The Alternative Minimum Tax (AMT) requires taxpayers to
calculate their income taxes twice--once under regular tax
rules and a second time under AMT tax rates and rules.
By 2010, more than one in five taxpayers will have to
calculate the AMT and pay it if it is higher than their
regular tax.
 Over 10 million dependents have to file income tax returns
each year.  Many of them are teenagers with jobs or young
children who have modest amounts of investment income.
The so-called Kiddie Tax applies to a much smaller number
of dependent filers, but involves complex rules and can
result in very high marginal tax rates in certain
cases.

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taxpayers' time and adding the $19 billion spent on tax preparers,
computer software, and similar expenses results in a total estimated
individual compliance cost between $67 billion and $99 billion.
Burdens vary substantially among taxpayers. For example, taxpayers
with self-employment income spent almost 60 hours preparing returns.
Other taxpayers spent an average of 13.8 hours, but 10.9 more hours
if they filed the Alternative Minimum Tax (AMT) form.


Effects on Behavior and Excess Burden
The third type of burden imposed by the tax system, called excess
burden, arises when high tax rates reduce incentives for work,
saving, and investment, distort economic decisions, and divert
resources from productive activity into tax avoidance. Excess burden
means that it costs the economy more than one dollar to raise one
dollar in revenue. High excess burden ultimately reduces economic
growth and lowers living standards. This section examines the
evidence of the effects of high tax rates on economic behavior and
how these effects translate into measures of excess burden.
Tax Effects on Individual Behavior
An individual's after-tax return from increased work effort,
saving, or investment depends on the individual's marginal tax rate,
the tax rate that applies to the last dollar of the individual's
income. For example, the after-tax return from earning one
additional dollar is $0.75 for a taxpayer in the 25 percent tax
bracket. By reducing after-tax returns, high marginal tax rates
reduce incentives for additional work effort. The same principle
applies to saving and other economic activities.
A variety of statistical studies have found that high income tax
rates adversely affect labor supply, particularly for certain
segments of the population. The income tax rate reductions in the
1980s significantly increased the labor force participation and
hours of work of high-income married women, with a total increase
in labor supply of as much as 12-15 percent. The effects were much
smaller for men (up to 2-3 percent) and for female heads of
households (up to 4 percent). Some economists argue that these
studies understate the effects of taxes on labor supply because they
do not include tax effects on the intensity of work effort, career
choice, and investments in human capital (such as education), which
are more difficult to measure.
In addition to reducing the numbers of hours they work, taxpayers
respond in many other ways to avoid the effects of high tax rates.
For example, taxpayers take their compensation in nontaxable forms
such as health insurance and alter their portfolios to focus on
tax-favored investments. The total effect of such responses is
summarized by the responsiveness of taxable income to changes in
marginal tax rates. While the results vary among studies, a
reasonable estimate is that a 10 percent decrease in after-tax
returns leads to about a 4 percent decrease in taxable income.
Thus, for example, if the marginal tax rate was increased from 25
percent to 28 percent, this would reduce after-tax returns by
4 percent. Taxpayers' behavioral responses would reduce taxable
income by 1.6 percent (0.4 times 4 percent), and this would reduce
the addition to revenue by nearly 15 percent.
Tax Effects on Business Behavior
Businesses can respond to taxes in various ways, including
changing their level of investment and employment, their method of
finance, and their organizational form. Current law distorts many
business decisions, resulting in inefficient use of resources and
reduced economic output.
Some of the largest distortions are associated with the corporate
income tax. This tax results in corporate income being taxed once
under the corporate income tax and then a second time at the
individual level when received as dividends or when reinvested
earnings result in taxable capital gains. This double taxation of
corporate income favors financing investment with debt instead of
equity because interest paid by the corporation on its debt is
deductible while dividend payments to shareholders are not.
Double taxation of corporate income also creates a bias in favor
of using business forms not subject to the double tax, such as
partnerships, sole proprietorships, limited liability companies,
and subchapter S corporations. The double tax also discourages
paying dividends. As a result, prior to the 2003 reductions in
dividend tax rates, dividend payments by corporations had declined
since the 1980s (Box 3-2).
Current tax law also distorts decisions about investment in
equipment and buildings. Under an income tax, proper measurement
of income requires that the cost of investment in new equipment be
depreciated by deducting the decreases in economic value over the
useful life of the investment, sometimes called economic
depreciation. Current depreciation rules, however, differ
significantly from an ideal measure of economic depreciation,
leading to biases among investment choices. For example, if a
company chooses offices with plaster walls, it would have to
depreciate those walls over 39 years. But because cubicle
partitions are considered to be office furniture under IRS rules,
they can be depreciated over 7 years. Thus, the tax law favors the
purchase of cubicle partitions because the faster tax write-off
saves the company money.
Other research has shown the adverse effects of high tax rates on
entrepreneurial activity. Several studies examined the response of
small businesses to the tax reductions of the 1980s and found that
when income tax rates were reduced, entrepreneurial businesses grew
faster, were more likely to invest in new equipment and structures,
and were more likely to hire additional workers.


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Box 3-2: The Initial Effects of the 2003 Reductions in Tax Rates on
Dividends

Corporate income is taxed twice, first under the corporate income tax
and then a second time under the individual income tax as dividends or
capital gains. Consequently, the total Federal tax rate on corporate
income can be very high. For example, in 2000, the total Federal tax
rate on a dollar of corporate income paid out as a dividend could be as
high as 60.75 percent (calculated as the 35 percent corporate rate plus
an individual tax rate of up to 39.6 percent on the 65 cents of
after-tax corporate income available for dividends). State income
taxes add to this total.
Economists are in broad agreement that this system creates serious
economic distortions. Indeed, historically the United States was almost
alone among advanced countries in failing to provide some form of
relief from double taxation of corporate income. A key provision of
the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)
reduced the double tax by reducing the individual income tax rates for
both dividends and capital gains.
Proponents of JGTRRA argued that it would lead to more dividends
being paid by corporations. Was this prediction correct? One study
reported that in the first three months after the law was passed,
corporate boards of directors increased dividends by 9 percent at
their first opportunity following enactment. A subsequent study found
that the percentage of publicly traded firms paying dividends began to increase precisely when the new law became effective in 2003. This
percentage had been declining for more than 20 years. The study found
that nearly 150 firms started paying dividends after the tax cut,
adding more than $1.5 billion to total quarterly dividends. The most
notable example of a company initiating payments is Microsoft
Corporation, which previously had not paid dividends in spite of
accumulating large cash reserves. Many firms already paying dividends
raised their regular dividend payments, and a smaller number of firms
made special one-time dividend payments to shareholders.
Overall, the response has been unprecedented in the recent history of
tax changes. Based on statistical analysis of the historical
relationships between dividends and tax rates, another study estimated
that over time, dividends will increase by 31 percent, about $111
billion in additional annual dividends at 2002 levels.

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Excess Burden
Because taxes distort economic decisions and lead to inefficient
use of resources, they cause reductions in economic welfare that
exceed the amount of tax collected. These costs above and beyond the
revenues collected are called the "excess burden" of the tax system.
Higher marginal tax rates lead to more distortion in behavior, and
therefore to greater excess burden. In addition, the more responsive
taxpayers are to higher marginal tax rates, the greater the excess
burden will be. A recent study estimated that the excess burden
associated with increasing the individual income tax by one dollar
is 30 to 50 cents. In other words, the total burden of collecting
$1.00 in additional income taxes is between $1.30 and $1.50, not
counting compliance costs.

Income Taxation Versus Consumption Taxation
The main bases available for Federal taxation are income and
consumption. Economists define income as the increase in an
individual's ability to consume during a period of time. By this
definition, anything that allows a person to consume more is income,
including compensation for services, interest, rents, royalties,
dividends, alimony, and pensions. This broad measure of income also
includes noncash benefits, such as health insurance provided by an
employer, and increases in the value of stock and other assets.
While the base of an income tax is the increase in potential
consumption (i.e., income), a consumption tax applies only to the
portion of income that individuals actually consume.
Tax reform proposals generally follow either the principle of
taxing consumption or the principle of reforming the existing system
to conform more closely to a pure income tax. In thinking about this
distinction, it is important to note that the current system already
has many features of a consumption tax: investment income is exempt
from tax when it is saved in certain forms, such as IRAs; unrealized
capital gains are not taxed; and small businesses can immediately
deduct the cost of a certain amount of new investment, as would be
the case under a consumption tax. Thus, characterizing the current
system as an income tax is something of a misnomer; it is more of a
hybrid between an income tax and a consumption tax.
Before turning to the main prototypes in the following section,
this section examines the choice between income and consumption
taxation from the standpoint of key criteria for evaluating a tax
system: fairness, growth, and simplification.
Fairness
A traditional standard for fairness is that taxes should be levied
according to individuals' ability to pay. Thus, proponents of income
taxation argue that it is fair because income best reflects the
ability to pay taxes. In addition, a common view is that individuals
with higher incomes should pay a greater proportion of their income
in taxes--the tax system should be progressive. As shown in Box 3-3,
the current income tax system is highly progressive.

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Box 3-3: What Is the Current Distribution of the Tax Burden?

A major criterion for judging a tax system is whether it is fair.
One way to examine this question is to look at the shares of the tax
burden borne by taxpayers in various parts of the income distribution.
Nearly two-thirds of the total Federal tax burden is borne by the top
20 percent of taxpayers. This includes individual and corporate income
taxes, payroll taxes, and excise taxes, but not the effects of temporary economic stimulus provisions that expired at the end of 2004. As shown
in Chart 3-1, the share of taxes of the top 20 percent increased as a
result of the tax cuts enacted since 2001.



Another way to look at fairness is in terms of taxes as a percent of
income. As shown in Chart 3-2, Federal taxes take a larger share of
income for higher-income groups, both before and after the tax cuts.



The bottom 40 percent of the population received the largest
percentage reductions in total Federal taxes (Chart 3-3). After the
tax cuts, the bottom 40 percent of the population paid no income taxes,
and, on balance, received money back from the income tax system.
In summary, the tax relief passed during the President's first term increased the overall progressivity of the Federal tax system.



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Critics of consumption taxes often argue that they are regressive,
that is, they represent a higher proportion of the income of
lower-income families. Conventional analyses use an annual measure of
income as a measure of ability to pay and assume that the burden is
borne by consumers. They generally show that a proportional tax on
consumption would be highly regressive. Annual incomes, however,
often vary substantially from year to year, so one year's income may
not be a good indicator of ability to pay. When a lifetime measure
of income is used, the regressivity of consumption taxes appears
less pronounced.
Some studies question whether income is the most appropriate basis
for measuring fairness. One reason for taxing consumption is the
belief that it is a better measure of lifetime ability to pay than
annual income. If so, progressivity should be measured with respect
to consumption rather than income, and an inclusive flat rate
consumption tax would be proportional by definition.  In addition,
as discussed below, there are ways to tax consumption while
addressing concerns about distributional fairness. Furthermore,
increased economic activity from a more efficient tax system could
be sufficient to improve the economic welfare of all income groups.
Finally, when considering the fairness of taxes, it is important
to keep in mind that the ultimate burden of a tax is not necessarily
borne by the taxpayer who writes the check to the government. In
particular, the burden of taxes paid by corporations is ultimately
borne by individuals in their roles as stockholders, workers, and
consumers. A common view of economists is that in the short run,
before there is time for economic adjustments, the burden of
increases in corporate income taxes is borne entirely by
shareholders. Thus, under this view, most of the corporate income
tax burden is borne in the short run by high-income households,
because the ownership of corporate stock is highly concentrated in
high-income households. Over time, however, at least part of the
burden of corporate taxes is likely to be shifted to owners of
noncorporate businesses, workers, and consumers. Such shifting of
tax burdens can significantly affect perceptions of the fairness of
particular taxes. For example, the corporate income tax might be
viewed as less fair if the burden is seen as resulting in lower
long-run wages for workers rather than being incurred by well-to-do
corporate shareholders.
Effects on Growth of the Economy
Increasing economic efficiency and promoting growth of the economy
are important goals for tax reform. A tax system that inflicts fewer
distortions on economic decisions would improve the efficiency of
the use of resources in the economy and thus improve the general
welfare. One source of inefficiency is tax preferences, that is,
provisions that provide more generous tax treatment of certain
types of income and expenditures than would be accorded under a more
uniform or pure version of the tax. Such preferences cause investment
funds to flow to tax-favored lines of business at the expense of
potentially more productive investment and thus reduce the overall
output of the economy.
Consumption tax proponents argue that a consumption tax would be
more conducive to growth than an income tax even in the absence of
tax preferences.  A consumption tax would be more neutral with
respect to investment decisions since new investments would be
immediately deductible (expensed). As noted above, the current
income tax is not neutral among investments, and it is inherently
more difficult to achieve neutrality under an income tax. By
removing the tax on the returns to saving and investment, a
consumption tax would increase saving and investment. Over time, this
would increase the stock of capital. With a larger stock of capital,
workers would be more productive, and output and wages would rise.
Some recent research estimates that changing to a tax on consumption
could increase the net national saving rate by 16 to 43 percent after
a year and by 12 to 31 percent after 14 years, depending on the type
of tax adopted. National output per capita would decrease by 0.5
percent or increase by up to 4.4 percent after a year and increase by
0.5 to 6.3 percent after 14 years. The research suggests that wages
would increase by 0.8 to 1.4 percent after 14 years.
Reform of the income tax could also promote economic growth. Income
tax reform could lead to a more uniform, broad-based, low-rate income
tax that would reduce distortions in economic decisions. The above
research suggests that such an income tax reform would increase the
saving rate by 10 percent after one year and by 6 percent after 14
years and that national output per capita would increase by 3.8
percent after one year and by 4.4 percent after 14 years.
However, even if there are long-run economic gains from a tax
reform proposal, these must be weighed against the costs of
transition from the current tax system to the new one. Taxpayers
would incur costs adjusting to compliance under a new system and the
IRS would incur start-up costs developing rules, forms, and
administrative procedures. In addition, major tax reform could
result in significant gains or losses for some taxpayers when the
prices of assets change. If losers were to be fully compensated for
their losses, the potential gains from reform would be reduced. None
of the preceding analysis implies that tax reform should not be
undertaken. Rather, the key point is that transition issues need to
be taken into account when assessing the costs and benefits of the
various reform proposals.
Finally, tax reform could impose large transition costs on state
and local governments. Some tax reform proposals call for repeal of
Federal income taxes. Since most state income taxes rely on the
Federal tax as a starting point, states would either have to find
another source of revenue or administer their income taxes on their
own. Other proposals would impinge on the traditional state reliance
on sales taxes by adding a Federal tax on this base.
Simplification
Proponents of consumption taxes argue that they would be simpler
than income taxes. Some consumption tax prototypes, such as a
national retail sales tax or a value added tax, would be simpler for
individuals because the point of collection would be shifted from
individuals to businesses. This feature is not unique to consumption
taxes, however, because it would be possible to design a
comprehensive income tax that could be collected at the business
level. Consumption taxes would also be simpler because allowing
immediate deduction for all purchases would eliminate the need to
keep track of depreciation deductions over time and to make
distinctions among various types of property. In addition, the
complexities associated with taxing capital gains would be
eliminated, since capital gains are not part of a consumption tax
base.
Proponents of income taxes point out that the current income tax
system could be greatly simplified, and that starting from scratch,
one could design a much simpler system. They also note that it is
unfair to compare an idealized consumption tax with the current
system. Thus, either a consumption tax or a reformed income tax could
be much simpler than current law, but there may be some additional
simplification potential under a consumption tax.
Tax Reform Prototypes
The previous section examined some general issues of tax reform.
This section considers the most prominent consumption tax prototypes
and potential reforms of the current system. The President has not
endorsed any specific proposal, and this chapter does not advocate
the adoption of any particular prototype for reform.
Consumption Tax Prototypes
If tax reform takes the path of taxing consumption rather than
income, there are four basic types of consumption taxes to consider:
the retail sales tax, the value added tax (VAT), the flat tax, and
the consumed income tax. This section begins with a brief description
of the four taxes and then discusses each in more detail.
The simplest consumption tax to understand is the retail sales tax,
which imposes tax liability when an individual purchases goods or
services for consumption. Retail sales taxes are levied by most
states and many local governments.
The starting point for thinking about value added taxes is to note
that most goods are produced in stages. For example, a farmer grows
wheat and sells it to a miller, who grinds it into flour and sells
it to a baker, and so on until a loaf of bread is delivered to a
grocery store to be sold to consumers. Instead of being collected
all at once at the final sale to consumers, the value added tax is
levied on the value added to the good or service at each stage of
its production. At each stage, the tax base is receipts for the sale
of goods and services less purchases of goods and services from other
firms (Box 3-4).


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Box 3-4: The Equivalence of Sales Taxes and Value Added Taxes

The retail sales tax and value added tax provide different methods of
taxing the consumption of goods and services. Consider a simple example
of bread produced and sold to households. A farmer grows wheat and
sells it to a miller for $300. The miller grinds the wheat into flour
and sells it to a baker for $600. The baker transforms the flour into
bread and sells it to the grocer for $800. The grocer sells the bread
to consumers for $1,000.



Now consider a 20 percent tax on consumption. Under the retail sales
tax, the grocer would compute the tax as 20 percent of sales and owe
$200 to the government. The farmer, miller, and baker would not pay
sales tax because they sold only to other businesses for resale.
A 20 percent value added tax collects the same total revenue one step
at a time as value is added to the product at each stage. The miller
pays a VAT of $60, calculated by subtracting purchases of $300 from
$600 of sales and paying the 20 percent tax rate on the difference of
$300. The other businesses would compute their tax in the same way.
The total tax would add up to $200, the same amount as under the
retail sales tax.
A European VAT (called a credit-invoice VAT) is calculated by
imposing the tax on the full value and then giving a credit for VAT
paid at the previous stages. The grocer would compute the $40 VAT as
20 percent of sales of $1,000 (or $200) less tax credits of $160
shown on the receipts for purchases of $800 from the baker. The other businesses would compute their tax in the same way.
Consider what happens if the grocer fails to file and pay the amount
of tax that is owed. Under the sales tax, the full amount of tax is
lost to evasion. But under the VAT, only the tax on the last stage
would be lost. In addition, the invoices at each stage provide a paper
trail that helps improve compliance.

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Because the sum of value added at each stage equals the value of
the final product, taxing value added at each stage gives the same
overall result as taxing final products at the retail level.
Therefore, the VAT is just another way of taxing the same base as
the retail sales tax. From an economic standpoint, they are
equivalent.
The flat tax consists of a business tax and an individual level
tax, both of which use a single flat tax rate. Calculation of the
business tax base begins with a computation like that of the VAT,
receipts less purchases from other firms. Next, wages are deducted
from the business tax base. If wages are then taxed at the same flat
rate under the individual tax, the result is the same as the VAT and
retail sales tax. Therefore the key difference is that wages are
taxed at the individual level rather than being included in the
business tax base. This difference allows for building progressivity
into the system by providing an exemption of, say, $40,000 for a
family of four.
Under a consumed income tax, taxpayers would first calculate their
income as they do under the current income tax. Then they would be
allowed a deduction for any saving during the year. Since
consumption is equal to income minus saving, this too is a
consumption tax.
These seemingly quite different taxes are equivalent ways of
taxing the same base: consumption. As discussed in the following
sections, the choice among them is affected by various administrative
and compliance issues as well as the availability of mechanisms for
obtaining distributional fairness.
National Retail Sales Tax
Sales taxes are levied by all but five states, and provide nearly
38 percent of state tax revenues. Most state sales taxes are levied
at rates between 4 percent and 6 percent. Many states, however,
exempt or apply a lower rate to food purchases, prescription drugs,
and certain other ``necessities'' to improve the perceived fairness of
the tax and also exempt most services.
Under a retail sales tax, individuals would no longer have to file
tax returns because taxes are remitted to the government only by
retail businesses. This is an important feature of retail sales
taxes and other transactions-based taxes, which shift the burden of
complying with the tax system from individuals to businesses. Since
there would be many fewer tax filers, proponents argue that total
compliance costs would be much lower than under the current system.
Under a retail sales tax, only final sales to consumers should be
taxed since the intent is to tax consumption. Taxing business-to-
business sales can result in cascading, a situation in which the
tax is imposed multiple times before the consumer level.
Nevertheless, states currently obtain about 40 percent of their sales
tax revenues from business-to-business sales, although many
business-to-business sales are exempted. The economic distortions
associated with cascading can be severe at higher tax rates, and thus
a national retail sales tax would have to differ from state taxes by
not taxing such sales. A related problem is that it is sometimes
difficult to distinguish final sales for consumption from sales for
use in production. For example, how would a store selling a computer
know for certain whether it is being purchased for resale (exempt),
for use in another business (exempt), or for home entertainment
(taxable)? This issue would arise with many dual-use products and
services.
To replace a significant portion of Federal tax revenues, tax
rates for a national retail sales tax would have to be much higher
than current state and local rates. The exact rate would depend on
which Federal taxes were to be replaced and on whether education
expenses, prescription drugs, medical expenses, and other necessary
goods and services would be taxed. Some recent research suggests
that to replace revenues from the individual and corporate income
taxes, a national sales tax rate would have to be at least 30 percent
if the tax base were that of a "typical state" and business-to-
business sales were exempt. Such high rates could create strong
incentives for tax evasion and avoidance. Some tax economists
believe that sales tax rates over 10 percent could be problematic
because of the incentive for evasion and avoidance.
Concerns about the impact of sales taxes on lower-income
households could be addressed by exempting certain necessary goods
and services or by providing a refundable tax credit sufficient to
cover a certain amount of tax. Exemptions and preferential rates to
address equity concerns, however, increase the complexity of sales
taxes and lead to uneven taxation of consumption. Refundable credits
could require the filing of some type of tax return by lower income households. However, this would defeat one of the main goals of the
retail sales tax, which is reducing administrative burdens on
households. In any case, both solutions would require higher tax
rates to achieve a given amount of revenue. Uneven taxation and high
tax rates would undermine a principal potential benefit of this type
of reform: reducing economic distortions and promoting growth.
Value Added Tax (VAT)
Value added taxes are used in all European Union countries and in
more than 100 countries around the world. European countries, which
generally adopted VATs in the 1960s or early 1970s, typically impose
a standard rate of 16 to 20 percent and a lower 5 to 10 percent or
zero rate on products such as food and drugs. It is important to
note that countries adopting VATs have not used them to replace
income taxes; they are in addition to individual and corporate
income taxes.
VATs avoid the problem of cascading taxes by allowing credit for
the VAT paid on purchases. European VATs also create a paper trail
that is believed to improve compliance. In spite of these
advantages, VATs have not received serious consideration in the
United States. Similar to the sales tax, VATs are viewed as
regressive, at least when annual income is used as the measure of
ability to pay. Critics of the VAT are not mollified by the fact
that it is possible to impose lower VAT rates on commodities such as
food. Another concern is that VAT tax rates would tend to increase
over time as has occurred in Europe because the VAT is such an
efficient and largely hidden tax.
The Flat Tax
Reducing the tax burden for low-income households is cumbersome
under the sales tax and VAT because they are collected at the
business level. One of the advantages of the flat tax is that it
allows for progressivity by providing a personal exemption based on
family size.
The exemption leads to a fundamental trade-off in designing a flat
tax. A higher exemption level means more families at the bottom of
the income scale pay no tax and the distribution of the tax burden
is more progressive. But the higher the exemption, the higher the
tax rate required to raise any given amount of revenue. A higher
rate reduces the anticipated gains in economic efficiency. The
Treasury Department estimated in 1996 that a 22.9 percent tax rate
would be required to raise as much revenue as the individual and
corporate taxes, while keeping the Earned Income Tax Credit and
exempting $40,700 income (at 2003 levels) for a family of four.
The flat tax would be simpler than the current tax system. The
individual tax is simple because it applies only to compensation
for labor services and tax liability varies only with family size.
The business level tax is simpler than the current corporate income
tax. For example, since all purchases are deductible immediately,
there is no need to keep track of depreciation deductions over a
period of years or to distinguish between current expenses and
capital costs. The flat tax would also reduce the costs of tax
planning. Applying the same tax rate to all types of businesses and
to both individual and business income is important because it
eliminates many opportunities for avoiding taxes by changing the
organizational form of a business or by shifting income to entities
subject to lower tax rates and deductions to entities with higher
rates. The double tax on corporate income and the associated
distortions would also be eliminated.
A pure flat tax would eliminate many popular deductions, including
those for home mortgage interest and charitable contributions.
Retaining these deductions would require a higher tax rate and more
complicated tax forms, and thus lose some of the gains in economic
efficiency and simplification. In addition, some critics argue that
even with a large exemption, the flat tax is likely to shift tax
payments away from the highest income groups and toward lower- and
middle-income groups. Finally, there would still be many
complexities and opportunities for tax avoidance and evasion.
Suppose, for example, that a business owner bought a computer for
personal use. If the owner claimed it was for business, he or she
could deduct the entire cost of the computer.
There are many variants of the basic flat tax idea. For example,
some proposals would allow for greater progressivity by using
multiple tax rates in the individual tax. Other proposals would
retain some deductions, such as those for charitable contributions
or mortgage interest. Each variation sacrifices some of the
efficiency gains and basic simplicity of the flat tax to achieve
other goals.
Consumed Income Tax
Under a consumed income tax, taxpayers first compute income as
they do under the income tax. Then taxpayers are allowed an
unlimited deduction for net saving during the year. A consumed
income tax is comparable to a traditional IRA for which
contributions are deductible and withdrawals are subject to tax, but
would have no limits on contributions or penalties on withdrawals.
To prevent taxpayers from simply borrowing money and claiming a
deduction for putting the proceeds into a savings account, any
borrowing would be added to income and thus be taxable.
The consumed income tax offers more flexibility than the flat tax
in allocating the burden among income classes because the individual
tax base is broader and most proposals include a progressive rate
structure. The primary disadvantage is complexity. It retains the
complexity of the current system because taxpayers start by
computing income as they would under current law. Then a second
procedure to compute saving net of borrowing adds an additional
layer of complexity.
Reform Within the Current System
A change to any of the consumption tax proposals would scrap the
current tax system and replace much or all of it with a new one.
Businesses and individuals would have to learn how to comply with
and best arrange their affairs under the new system. A new
administrative apparatus would be required for some proposals. While
sales taxes have long been used in this country and VATs in many
other countries, these are imposed at lower rates than would be
required to replace all Federal revenues and are used along with,
rather than as replacements for, income taxes.
Given the costs of transition to an entirely new tax system, some
proposals focus on reform within the current structure. Starting
from the current system would reduce transition and adjustment costs
and considerable benefits could be obtained by simplifying and
rationalizing tax provisions that overlap or are otherwise overly
complex. Advantages of the prototypes and the tax principles
discussed above could guide the direction of reform.
The Administration's tax program has already achieved significant
reforms within the current system. Achievements include lowering
marginal tax rates, reducing the double tax on corporate income,
simplification, and improved fairness for families. This section
discusses possible additional reforms that would provide
simplification, improve fairness, or promote economic growth.
Lower Tax Rates and Broader Base
The principle behind the Reagan Administration's major tax reform
in 1986 was to reduce tax rates and broaden the tax base by
eliminating deductions and tax credits. The Tax Reform Act of 1986
was largely successful in this effort. Individual income tax rates
were collapsed into two rates, 15 percent and 28 percent, with the
top rate falling from 50 percent to 28 percent. The corporate tax
rate was reduced, from 46 percent to 34 percent. Lowering rates
reduced the distortions of the tax system and is often credited
with increasing work effort and entrepreneurial activity and
reducing tax avoidance activities. The overall reform was revenue
neutral and slightly progressive. Even though the top marginal tax
rates were reduced, progressivity was enhanced because high-income
taxpayers lost many tax preferences.
While the achievements of the 1986 reform have eroded over time,
the basic principles of lower rates and a broader base benefited the
economy and could be useful in guiding reform within the current
system.
Rationalizing Saving Incentives
Income taxes create a bias against saving because taxpayers who
choose to save for later consumption have a larger total lifetime tax
burden than those who do not save. To offset this bias, current law
includes a variety of provisions that promote saving. Some are
targeted at individual saving for retirement, some at employer plans
for employee retirement, and some at saving for specific purposes,
such as education and medical expenses.
The multitude of special purpose saving options encourages
taxpayers to establish small pools of savings that can only be used
for one purpose. Taxpayers have less flexibility since saving
intended for one purpose cannot be used for another (except by
paying a penalty). Taxpayers are likely to be unaware of all the
options available, frustrated trying to decide which options are
best for them, and confused by the detailed requirements. Since
many incentives are available only to certain taxpayers, the
multitude of options may add to perceptions that the tax system is
unfair because some taxpayers are eligible, but others are not.
Moreover, the large number of special accounts may be an impediment
for lower-income and less sophisticated taxpayers concerned about
making the wrong choices, which can have sizable penalties associated
with them.
The current set of saving incentives could be combined into a
simpler system with one type of account for individual retirement
saving, one for employer-sponsored retirement saving, and one for
lifetime saving for anticipated future education, health, home
purchases, or other expenses. The President's budgets have included
proposals for Retirement Savings Accounts (RSAs), Employer Retirement
Savings Accounts (ERSAs), and Lifetime Savings Accounts (LSAs).
Under these proposals and after a transition period, the savings
incentives of over 90 percent of households would no longer be
adversely affected by the tax system.
Double Taxation of Corporate Income
Corporate income is taxed first at the corporate level and then a
second time under the individual income tax as dividends or capital
gains. The tax relief enacted in 2003 reduced the double tax by
lowering individual income tax rates for both dividends and capital
gains. The current provisions expire after 2008, however. Thus, tax
reform could include a permanent extension of current provisions or
go further and completely eliminate double taxation of corporate
income.
Depreciation Rules
As discussed above, the logic of an income tax requires that firms
be able to deduct the amount by which their physical investments
depreciate in value each year. Current law allows deductions for
different types of equipment and buildings over nine recovery periods
from 3 to 39 years. A 2000 Treasury Department report on depreciation
concluded that the current system is based on outdated recovery
periods, does not account for new industries and technologies, and
favors some assets while penalizing others. As a result, the system
distorts investment decisions and results in an inefficient
allocation of capital in the economy.
There are several approaches that reform could take. One option is
to rationalize the current depreciation system to make it more
neutral in its effects on investment decisions. An effort to bring
depreciation rules closer to economic depreciation would raise a
number of difficult measurement issues, however. Another approach
would simplify the current system by reducing the number of recovery
periods and grouping investments into broader categories.
A third approach is to increase investment incentives and move
part way toward a consumption tax by increasing the generosity of
depreciation allowances. For example, a temporary bonus depreciation
provision in the 2002 tax bill allowed taxpayers to deduct 30 percent
of the cost of an investment in the first year with the remaining
70 percent of the cost to be deducted over the life of the
investment. That is, 30 percent of the cost was deducted immediately
as under a consumption tax, while 70 percent was depreciated as under
an income tax. First-year bonus depreciation was increased to 50
percent in 2003 and 2004.
These approaches have the potential to improve the allocation of
capital and increase incentives for investment. The cost of
increased incentives would have to be balanced against other
objectives, such as keeping income tax rates low.
The Alternative Minimum Tax (AMT)
The AMT is a separate tax system requiring taxpayers to compute
their income tax liability a second time under different rules and
then pay the AMT if it is higher than the regular tax. As a result,
the AMT adds considerable complexity, and dealing with it must be an
important element of any tax reform. The predecessor to the current
AMT was enacted in 1969 to ensure that high-income taxpayers with
substantial amounts of tax preferences would at least pay a moderate
sum in taxes. Unlike many income tax provisions, Congress did not
index the AMT for inflation. Later, Congress increased AMT tax rates
from 21 percent to 24 percent in 1991 and to 26 percent and 28
percent in 1993. With higher rates and no indexing for inflation, it
was only a matter of time before large numbers of taxpayers would be
affected. During the last several years, Congress has passed several
temporary measures to keep the number of AMT taxpayers from growing
too rapidly. However, under current law, the number of taxpayers
paying the AMT is expected to grow rapidly from 3 million in 2004 to
38 million by 2010. Most of the newly-affected taxpayers will not be
those with the highest incomes. One study projects that under
current law, over half of all taxpayers with incomes of $75,000 to
$100,000 (in $2003) and 94 percent of married taxpayers with two
children in that income range will be subject to the AMT by 2010.
Because taxpayers have to compute their taxes twice to see if they
have to pay the AMT, it is a major source of complexity. Further,
the lowest rate under the AMT is 26 percent, a higher rate than
would otherwise be faced by middle-income families. Finally, while
some tax preferences are added back into the tax base, many features
of the AMT are inconsistent with sensible tax principles. For
example, some costs of earning income are not deductible and
personal exemptions are treated as a tax preference under the AMT.
Alternatives for AMT reform include repeal or limiting its effect
to high-income taxpayers by increasing exemption levels and lowering
AMT tax rates. Significant changes to the AMT would be costly,
however, as various estimates suggest that the 10-year cost of full
repeal would be nearly $1 trillion.
Simplification
Many provisions in the current tax system overlap, conflict, or are
otherwise overly complex. The Congressional Joint Committee on
Taxation and others have produced lists of such provisions.
Elimination or simplification of such provisions could substantially
reduce compliance burdens and distortions of the current system. In
addition, some would broaden the tax base thus allowing for further
reductions in tax rates.
An example of the potential for simplification was provided when
Congress recently enacted legislation similar to an Administration
proposal for a single definition of a dependent child in determining
when taxpayers can claim several widely-used tax benefits.
Previously, five different standards for a dependent child applied
under different tax provisions, leading to confusion and inadvertent
errors. This reform will benefit many lower- and middle-income
households by providing a single set of rules and reducing burdensome
record-keeping requirements.
While there are many complex provisions, among the prime candidates
for simplification are the capital gains rates affecting certain
special types of gains, taxes on dependent children with small
amounts of investment income, and provisions that phase out certain
tax benefits at higher income levels.

Conclusion
This chapter has examined problems of the current tax system and
examined some of the major options for tax reform. The President has
not endorsed any specific proposal. Well-designed reforms, however,
should be able to simplify the system and enhance both fairness and
economic efficiency.
Although tax reform has been discussed for many years, it is a
particularly pressing need at the current time. Increasing numbers
of taxpayers will be affected by the alternative minimum tax, which
will be a major source of frustration and complexity. In addition,
the tax reductions enacted since 2001 will expire in a few years
unless they are extended or a new, reformed tax system is adopted.
If these provisions are allowed to expire, the result will be
substantial increases in taxes on taxpayers in all income groups,
with the largest percentage increases being imposed on lower- and
middle-income households. Taken together, these looming problems
provide a natural opportunity to rethink the entire system of
taxation.