    Understanding the Tax Reform Debate: Background, Criteria, and
    Questions (01-SEP-05, GAO-05-1009SP).

    Taxes are necessary because they fund the services provided by
    government. In 2005, Americans will pay about $2.1 trillion in
    combined federal taxes, including income, payroll, and excise
    taxes, or about 16.8 percent of gross domestic product. Beyond
    funding government, the federal tax system has profound effects
    on the economy as a whole and on individual taxpayers, both for
    today and tomorrow. Taxes change people's behavior and influence
    the economy by altering incentives to work, consume, save, and
    invest. This, in turn, affects economic growth and future
    income--and thus future government revenues. At the same time,
    the current tax system generates fierce controversy over
    fairness--who should pay and how much they should pay. In
    addition, the current tax system is widely viewed as overly
    complex, thereby reducing the ability of individuals to
    understand and comply with the tax laws. Furthermore, the tax
    system is costly to administer with most of the costs of
    administration, such as record keeping, understanding the laws,
    and preparing returns, borne by taxpayers. Concerns about the
    economic effectiveness, fairness, and growing complexity of the
    current tax system raise questions about its credibility. These
    concerns have led to a growing debate about the fundamental
    design of the federal tax system. The debate includes the type of
    base--income or consumption--and the rate structure--flatter or
    more progressive. Additionally, some question to what extent and
    how the tax system should be used to influence economic behavior
    and social policy.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-05-1009SP
        ACCNO:   A36118
      TITLE:     Understanding the Tax Reform Debate: Background,
    Criteria, and Questions
         DATE:   09/01/2005
      SUBJECT:   Comparative analysis
    	     Excise taxes
    	     Federal taxes
    	     Income taxes
    	     Personal income taxes
    	     Social security taxes
    	     Tax administration
    	     Tax administration systems
    	     Tax expenditures
    	     Taxpayers
    	     Voluntary compliance

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    ** figure captions are reproduced.  Tables are included, but    **
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    GAO-05-1009SP

                                        Contents

                                       Preface 1

    Introduction

    Section 1 Revenue- Taxes Exist to Fund Government

    7 The Current Tax System 7 Historical Trends in Tax Revenue 13 Historical
    Trends in Federal Spending 14 Borrowing versus Taxing as a Source of

    Resources 15 Long-term Fiscal Challenge 17 Revenue Effects of Federal Tax

    Policy Changes 19 General Options Suggested for Fundamental Tax Reform 21
    Key Questions 22

    Section 2 Criteria for a Good Tax System

    Equity

    Equity Principles Measuring Who Pays: Distributional Analysis Key
    Questions

    Economic Efficiency

    Taxes and Economic Decision Making
    Measuring Economic Efficiency
    Taxing Work and Savings Decisions
    Realizing Efficiency Gains
    Key Questions

    Simplicity, Transparency, and Administrability

    Simplicity Transparency Administrability

    24 26 26

    30 33 35 37 40 41 43 43

    45 45 47 49

                                        Contents

    Trade-offs between Equity, Economic Efficiency,

    and Simplicity, Transparency, and

    Administrability 52 Key Questions 52

        Section 3 Transitioning    Deciding if Transition Relief Is    54 54 55
                                Necessary Identifying Affected Parties
            to a Different       Revenue Effects of Transition Relief        56
                                    Policy Tools for Implementing
              Tax System                   Transition Rules                  56
                                            Key Questions                    57

                                       Appendixes

    Appendix I: Key Questions
    Section I: Revenue Needs-Taxes Exist to Fund

    Government Section II: Criteria for a Good Tax System Equity Efficiency
    Simplicity, Transparency, and

    Administrability Section III: Transitioning to a Different Tax System

    Appendix II: Selected Bibliography and

    Related Reports Government Accountability Office Congressional Budget
    Office Other Selected Sources

    Appendix III: Glossary

    58

    58 59 59 60

    61

    62

    63 63 63 64

    66

          Tables       Table 1:    Features of the Current Tax System         8
                       Table 2:    The 10 Largest Tax Expenditures in
                                    2004, Outlay Equivalent Estimates        12
                       Table 3:   Measures of Tax Burden, Distribution
                                  of Total Federal Taxes and Individual
                                          Income Taxes in 2004               32

                                    ii GAO-05-1009SP

                                        Contents

    Table 4:	The Corporate Tax Rate Schedule: Simple but Not Transparent 49

    Figures Figure 1:

    Figure 2: Figure 3:

    Figure 4: Figure 5:

    Figure 6: Figure 7:

    Figure 8:

    Figure 9:

    Figure 10: Figure 11:

    Figure 12: Figure 13:

    Figure 14:

    Issues to Consider When Assessing
    Alternative Tax Proposals 4
    Revenue Overview 7
    Sum of Tax Expenditure
    Outlay-Equivalent Estimates
    Compared to Discretionary
    Spending, 1981-2004 11
    Federal Revenue as a Percentage of
    GDP and by Source, 1962-2004 14
    Federal Spending as a Percentage of
    GDP and by Spending Category,
    1962-2004 15
    Federal Tax Revenue versus Federal
    Spending, 1962-2004 16
    Composition of Federal Spending as
    a Share of GDP, Assuming
    Discretionary Spending Grows with
    GDP after 2004 and That Expiring
    Tax Provisions Are Extended 18
    Formula for Determining Tax
    Revenue 19
    Trade-offs in the Criteria for
    Assessing Tax Reform 24
    Equity Overview 26
    Efficiency Costs Are One Cost
    Taxpayers Face in Complying with
    the Tax System 36
    Efficiency Overview 37
    Simplicity, Transparency, and
    Administrability Overview 45
    Compliance Burden Is One Cost
    Taxpayers Face in Complying with
    the Tax System 46

    Contents

    Figure 15: Taxpayer Noncompliance

    Categorized by Amount of

    Withholding and Information

    Reporting, 1992 51 Figure 16: Transition Issues Overview 54

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

                                    iv GAO-05-1009SP

    Preface

    Taxes are necessary because they fund the services provided by government.
    In 2005, Americans will pay about $2.1 trillion in combined federal taxes,
    including income, payroll, and excise taxes, or about 16.8 percent of
    gross domestic product.

    Beyond funding government, the federal tax system has profound effects on
    the economy as a whole and on individual taxpayers, both for today and
    tomorrow. Taxes change people's behavior and influence the economy by
    altering incentives to work, consume, save, and invest. This, in turn,
    affects economic growth and future income-and thus future government
    revenues. At the same time, the current tax system generates fierce
    controversy over fairness-who should pay and how much they should pay. In
    addition, the current tax system is widely viewed as overly complex,
    thereby reducing the ability of individuals to understand and comply with
    the tax laws. Furthermore, the tax system is costly to administer with
    most of the costs of administration, such as record keeping, understanding
    the laws, and preparing returns, borne by taxpayers.

    Concerns about the economic effectiveness, fairness, and growing
    complexity of the current tax system raise questions about its
    credibility. These concerns have led to a growing debate about the
    fundamental design of the federal tax system. The debate includes the type
    of base-income or consumption-and the rate structure-flatter or more
    progressive. Additionally, some question to what extent and how the tax
    system should be used to influence economic behavior and social policy.

    Some see tax rates as too high-discouraging work, savings, and investment
    and consequently slowing economic growth. At the same time, the myriad of
    tax deductions, credits, special rates, and so forth cause taxpayers to
    doubt the fairness of the tax system because they do not know whether
    those with the same ability to pay actually pay the same amount of tax. In
    addition, tax expenditures, also called tax preferences, just like
    spending programs, can lead to higher tax rates over time. Complexity and
    the lack of transparency that it can create exacerbate doubts about the
    current tax system's fairness. Public confidence in the nation's tax laws
    and tax administration is critical because we rely heavily on a system of
    voluntary compliance. If taxpayers do not believe that the tax system is
    credible, is easy to understand, and treats everyone fairly, then
    voluntary compliance is likely to decline.

    The debate about the fundamental design of the tax system is occurring at
    a time when the nation also faces large current deficits and a significant
    and structural longterm fiscal imbalance. Long-term budget simulations by
    GAO, the Congressional Budget Office, the Office of Management and Budget,
    and nongovernment analysts show that absent policy changes, the federal
    budget is on an unsustainable path. Known demographic trends and rising
    health care costs will cause ultimately

    unsustainable deficits and debt that will threaten our national security
    as well as the standard of living for the American people in the future.

    While additional economic growth is critical and can help to ease the
    burden, the projected fiscal gap is so great that it is unrealistic to
    expect that growth alone will solve the problem. Ultimately, the nation
    will have to decide what it wants from the federal government, that is,
    what level of spending do we want on programs, tax preferences, and other
    government services and how we will pay for that spending. Clearly, tough
    choices will be required. Addressing the projected fiscal gap will prompt
    policymakers to examine the advisability, which includes both the
    effectiveness and affordability, of a broad range of existing programs and
    policies throughout the entire federal budget-spanning discretionary
    spending, mandatory spending, entitlement programs, tax expenditures tax
    rates, and tax system design. This examination will likely result in
    actions affecting both tax revenues and tax expenditures.

    The background, criteria, and questions presented in this report are
    designed to aid policymakers and the public in thinking about how to
    develop tax policy for the 21st century. This report, while not intended
    to break new conceptual ground, brings together a number of topics that
    tax experts have identified as those that should be considered when
    evaluating tax policy. This report attempts to provide information about
    these topics in a clear, concise, and easily understandable manner for a
    nontechnical audience. In developing this report, we relied on government
    studies, academic articles, and the advice of tax experts to provide us
    with information on the issues surrounding the tax reform debate. For a
    short bibliography of related publications, see appendix II. For easy
    reference, key terms are defined in the glossary located in appendix
    III-these glossary terms appear in bold type the first time they are used
    in the text.

    This publication was prepared under the direction of James R. White,
    Director, Strategic Issues (Tax Policy and Administration Issues), who may
    be reached at (202) 512-9110 or WhiteJ@gao.gov. Contact points for our
    Offices of Congressional Relations and Public Affairs may be found on the
    last page of this report. Kevin Daly,

    Tom Gilbert, Don Marples, Donna Miller, Ed Nannenhorn, and Amy Rosewarne
    made key contributions. This report will be available at no charge on the
    GAO Web site at http://www.gao.gov.

    David M. Walker Comptroller General of the United States

    Introduction

    This report provides background information, criteria, and key questions
    for assessing the pros and cons of tax reform proposals, both proposals
    for a major overhaul of the current federal tax system and incremental
    changes to the system. Figure 1 outlines the key issues that we address.
    First, we discuss how the size and role of the federal government drive
    the government's revenue needs. Second, we describe a set of widely
    accepted criteria for assessing alternative tax proposals. These criteria
    include the equity, or fairness, of the tax system; the economic
    efficiency, or neutrality, of the system; and the simplicity,
    transparency, and administrability of the system. The weight one places on
    each of these criteria is a value judgment and will vary among
    individuals. As we note, there are trade-offs to consider among these
    criteria, and we discuss how these criteria can sometimes be in conflict
    with each other. Finally, we turn to a consideration of the issues
    involved in transitioning from the current tax system to an alternative
    tax system.

    Figure 1: Issues to Consider When Assessing Alternative Tax Proposals

               Issues to consider when thinking about tax system changes:

    Revenue

    Criteria for a good tax system:

    o  Equity

    o  Economic efficiency

    o  Simplicity, transparency, and administrability

    Transition effects

    Sources: GAO (text); PhotoDisc, IRS (images).

    The primary purpose of the tax system is to collect the revenue needed to
    fund the operations of the federal government, including its promises and
    commitments. Tax revenues may not fully match government spending each
    year, but over time, the federal government needs to be able to raise
    sufficient revenue to cover its current and expected financial
    obligations. Decisions about spending and the role of government have a
    direct impact on the government's ultimate revenue needs.

    Whether the resources to fund government spending are provided through
    taxes or borrowing has consequences for the economy and the federal
    budget. Borrowing (which has often led to budget deficits) may be
    appropriate for federal investiment such as building roads and scientic
    research, and during times of recession, war, and other temporary
    challenges. However, federal borrowing also absorbs scarce savings that
    would otherwise be available for growth-enhancing private investment. In
    addition, large amounts of borrowing may increase the share of interest
    payments in the federal budget overtime, placing additional pressure on
    future budgets.

    One's view about the equity of a tax system is based on subjective
    judgments about the fairness of the distribution of tax burdens. The
    actual burden of a tax-the reduction in economic well-being caused by the
    tax-is not always borne by the people who pay the tax to the government
    because tax burdens can be shifted to other parties. For example, the
    burden of a tax on business can sometimes be shifted to consumers by
    increasing prices or to workers by decreasing wages. Public debates
    regarding the equity of the tax system reflect a range of opinions about
    who should pay taxes and how much of the tax burden should be shouldered
    by different types of taxpayers.

    Taxes impose efficiency costs by altering taxpayers' behavior, inducing
    them to shift resources from higher valued uses to lower valued uses in an
    effort to reduce tax liability. This change in behavior can cause a
    reduction in taxpayers' well-being that, for example, may include lost
    production (or income) and consumption opportunities. Efficiency costs,
    along with the tax liability paid to the government and the costs of
    complying with tax laws, are part of the total cost of taxes to taxpayers.
    One of the goals of tax policy, but not the only goal, is to minimize
    compliance and efficiency costs. The extent to which efficiency costs can
    be reduced by reforming the tax system depends on the design features of
    the new tax system, such as the nature and number of any tax preferences.

    Simplicity, transparency, and administrability are related but different
    characteristics of a tax system. Simplicity is a gauge of the time and
    other resources taxpayers spend to comply with the tax laws. This includes
    the time and resources spent on record keeping, learning about tax
    obligations, and preparing tax returns. The transparency of a tax system
    refers to taxpayers' ability to understand how their liabilities are
    calculated, the logic behind the tax laws, what their own tax burden and
    that of others is, and the likelihood of facing penalties for
    noncompliance. Administrability refers to the costs, ultimately borne by
    taxpayers, of collecting and processing tax

    payments as well as to the costs of enforcing the tax laws. While
    simplicity, transparency, and administrability are related concepts, they
    are not the same thing. A very simple tax rule may not be transparent if
    the rationale for the rule is not clear. Similarly, not all simple taxes
    are easy to administer.

    Designing tax policy requires making trade-offs among these criteria. For
    example, a proposal to improve the efficiency and simplicity of the tax
    code may involve eliminating exemptions or deductions originally
    introduced to improve the equity of the system. Moreover, some criteria
    include subjective elements. One individual's perception of the equity of
    a tax proposal can differ from another's. However, being subjective or
    objective does not make a criterion superior.

    In addition to determining the type of tax system, policymakers also
    determine the amount of revenue to be raised, which involves balancing the
    costs of taxes against the benefits of government services. Despite the
    fact that no tax system is perfectly fair, efficient, simple, transparent,
    and without administrative costs, in general people are willing to pay
    taxes and bear the other costs of the tax system because they desire the
    benefits of government and understand that sufficient tax resources are
    necessary for a sound fiscal policy in the long term.

    Finally, because moving to an alternative tax system creates winners and
    losers, transition rules may be included in tax reform proposals to
    mitigate some of the windfall gains and windfall losses that are likely to
    occur. However, debate exists as to whether transition rules, which are
    usually proposed on equity grounds, are appropriate because they may also
    reduce the efficiency of the tax system and temporarily make the tax
    system more complex.

    Tax reform proposals can range from small changes to the tax code to more
    comprehensive changes. The issues and questions we discuss in this report
    are designed to apply to both incremental changes to the tax system, such
    as changing tax expenditures to encourage savings, and to more
    comprehensive tax reform proposals, such as switching from a predominantly
    income-based tax to a consumption tax base.

    In addition to discussing the criteria used to evaluate changes to the tax
    system, this report provides information about economic and budgetary
    trends, the current tax system, and definitions of important tax concepts.
    For each section of the report, we provide a set of key questions designed
    to help identify the important features of the proposals This is
    information that we believe would be useful for evaluating the proposals
    and identifying limitations of the data and analysis.

    Revenue-Taxes Exist to Fund Government

    Taxes exist to fund the services provided and the promises made by the
    government. Since tax revenue may not match spending in each year, the
    resources needed to fund government can be also be raised by borrowing
    (deficit financing). Both taxes and borrowing affect economic performance.
    Taxes can affect the economy because they alter decision making by people
    and businesses. Federal borrowing absorbs savings otherwise available for
    private investment and postpones the need to tax or reduce spending. (See
    fig. 2.)

    Figure 2: Revenue Overview

    Sources: GAO (text); PhotoDisc (images).

    The Current Tax System

    The federal tax system in the United States primarily consists of five
    types of taxes: (1) personal income taxes; (2) social insurance taxes
    (employee and employer contributions for Social Security, Medicare, and
    unemployment compensation); (3) corporate income taxes; (4) estate and
    gift taxes; and (5) excise taxes based on the value of goods and services
    sold and other taxes. The tax bases, rates, and collection points of the
    major federal taxes are summarized in table 1.

    Table 1: Features of the Current Tax System

                    Type of tax Tax base Tax rates Collection points

          Personal      Regular PIT          Regular PIT        Regular PIT
           income
         taxes (PIT)  Personal income,  Graduated rate           Employers
                                        structure:                withhold
                     including income   Statutory marginal     payments, but
                     from               rates
                      wages, interest   of 10%, 15%, 25%,     individuals file
                            and         28%,                        tax
                     dividends, capital     33%, and 35%.     returns wherein
                                 gains,                             they
                     and small business Deductions and other      are also
                                        tax                     required to
                          income.       expenditures, such as disclose nonwage
                                           refundable tax     income and remit
                                               credits
                        Numerous tax       like the Earned      appropriate
                                               Income              taxes.
                     expenditures exist Tax Credit, create a    Small business
                     that                                               owners
                     reduce the size of  group of taxpayers        self-report
                            the                  who                income and
                         tax base.      have no tax liability  remit taxes to
                                                or a                the
                                            negative tax        government.
                                             liability.
                          Personal
                        alternative         Personal AMT        Personal AMT
                                                                Individuals
                     minimum tax (AMT)  26% or 28% depending      compare
                       Taxable income     on taxable income    their regular
                                                                    PIT
                     exceeding certain   subject to the AMT.    liability to
                                                                 their AMT
                     threshold amounts     Individuals are     liability and
                                              eligible            pay the
                     based on filing     for a credit for a     greater of the
                     status.                   portion               two (less
                                        of the AMT paid in a  taxes previously
                                        prior
                                                              withheld or paid
                                                year.                   during
                                                                 the year).

    Corporate income taxes (CIT)

                                     Regular CIT    Regular CIT       Regular CIT
                               Corporate profits Statutory      Corporations file
                                          (total marginal rates tax
                                   revenues less range from 15% returns and remit
                                           total to 35%.
                                      expenses).                   payment to the
                                        Numerous
                                tax expenditures
                                           exist                      government.
                                 that reduce the
                                         size of
                                   the tax base.
                                   Corporate AMT  Corporate AMT     Corporate AMT
                              Broader definition    20% for all      Corporations
                                          of the      corporate           compare
                                        tax base income subject    regular CIT to
                                      (corporate to the tax
                                    income) than   less the AMT     corporate AMT
                                         regular     credit for         liability
                              CIT; less generous that tax year.       and pay the
                                                                       greater of
                               accounting rules.                         the two.

    Social insurance Social security

    taxes	First $90,000 of employee wages.

    Medicare

    All wages.

    Social security

    6.2% employee
    contribution.
    6.2% employer
    contribution.
    12.4% for self-employed.

    Medicare

    1.45% employee
    contribution.
    1.45% employer
    contribution.
    2.90% for self-employed.

    Social security

    Employers withhold taxes from employee paychecks. The self-employed remit
    taxes themselves.

    Medicare

    Employers withhold taxes from employee paychecks. The selfemployed remit
    taxes themselves.

    (Continued From Previous Page)

                    Type of tax Tax base Tax rates Collection points

    Unified transfer tax- estate, gift, and generation skipping tax (GST)
    Estate tax

    Fair market value of the decedent's cash and securities, real estate,
    trusts, annuities, business interests, and other assets included in the
    decedent's estate at death less allowable deductions in excess of $1.5
    million in 2005. There is an unlimited deduction for transfers to a
    surviving spouse.

    Gift tax

    Tax is imposed on the value of lifetime taxable transfers of gifts of
    property. Applicable exclusion amount of $1 million for 2005. In addition,
    there is an annual exclusion of $11,000 per donee and an unlimited
    exclusion for tuition and medical payments.

    GST

    Total generation skipping transfers (such as from a grandparent to a
    grandchild) in excess of $1.5 million in 2005.

    Estate tax

    Rates range from 45% to 47% in 2005. As a result of recent tax
    legislation, estate tax rates will fluctuate before the estate tax is
    eliminated in 2010. However, the estate tax will be reinstated in 2011.

    Gift tax

    Rates range from 41% to 47% in 2005. Rates fluctuate in the same manner as
    for the estate tax in coming years. Gift tax will be retained following
    repeal of estate and GST.

    GST

    47% (or highest statutory marginal tax rate for the estate tax) in 2005.
    GST rates decrease until the tax is repealed in 2010. GST is reinstated in
    2011.

    Estate tax

    Decedent's estate is responsible for filing returns and remitting payment
    to the government.

    Gift tax

    Gift donor is responsible for filing returns and remitting payment to the
    government.

    GST

    Depending on the form of the generation skipping transfer, gift donor,
    donee trustee, or decedent's estate is responsible for filing returns and
    remitting payment to the government.

         Excise and Selected goods,  Various rates apply to          Generally
           other                                                  collected by
           taxes     services, and   different goods,       businesses, which
                         other       services,
                      items (i.e.,      and other items.     remit payments to
                       gasoline,                                           the
                       alcoholic
                       beverages,                            government on a
                    tobacco, airline                         quarterly basis.
                    tickets,
                         etc.).

    Source: GAO analysis of Internal Revenue Service information.

    The revenue raised by the major federal taxes is determined by the size of
    their bases, their rates, and their levels of compliance. In addition,
    each tax base is affected by the size and growth rate of the economy.

    Although called income taxes, the current federal individual and corporate
    income taxes have some features characteristic of a consumption tax. The
    current income tax system taxes the income of individuals and
    corporations, such as wages, interest, dividend income, capital gains, and
    other types of business income, including that of sole proprietorships and
    partnerships. (Some income is double taxed-corporate

    earnings are subject to the corporate income tax and are taxed again under
    the individual income tax when they are distributed as dividends or as
    realized capital gains when shareholders sell their stock.) However, some
    income is treated as it would be under a consumption tax where income that
    is saved or invested is exempted from tax until it is consumed. For
    example, up to certain limits, income that is contributed to individual
    retirement accounts and defined contribution pension plans is tax-deferred
    during accumulation. The result is a hybrid incomeconsumption tax base
    wherein some types of savings and investment are exempt from taxation, but
    other types are not.

    The current tax system includes tax expenditures, also called tax
    preferences, which reduce the size of the tax base. Tax expenditures are
    usually justified on the grounds that they promote certain social or
    economic goals. They grant special tax relief (through deductions,
    credits, exemptions, etc.) that encourages certain types of behavior by
    taxpayers or aids taxpayers in certain circumstances. Tax expenditures can
    promote a wide range of goals. For example, individual retirement
    accounts, discussed above, promote the goal of increased personal savings
    and investment, and the tax expenditures for owner-occupied homes
    encourage homeownership.

    Summing one measure of tax expenditures, called outlay-equivalents,
    indicates that the aggregate value of tax expenditures was about $850
    billion in fiscal year 2004. Outlay-equivalents are budget outlays that
    would be required to provide the taxpayers who receive the tax
    expenditures with the same after-tax income as would be received through
    the tax expenditures.1 As an indication of the size and impact of tax
    expenditures, figure 3 compares them to discretionary spending. In some
    years the outlay-equivalents for income tax expenditures exceeded federal
    discretionary spending.

    1Summing outlay equivalent estimates is controversial because doing so
    does not take into account possible interactions among tax expenditures.
    In addition, there are several ways to define and measure tax
    expenditures. The size of a tax preference can change over time. For
    example, accelerated depreciation of machinery and equipment drops out of
    the list of the top 10 tax expenditures in 2006. Moreover, what is
    considered a tax expenditure depends on the tax base. Some provisions of
    the tax code that are considered tax expenditures under an income tax base
    would not be considered tax expenditures under a consumption tax base. For
    further information on how tax expenditures are defined and measured, see
    GAO, Government Performance and Accountability: Tax Expenditures Represent
    a Substantial Federal Commitment and Need to Be Reexamined, GAO-05-690
    (forthcoming).

    Figure 3: Sum of Tax Expenditure Outlay-Equivalent Estimates Compared to
    Discretionary Spending, 1981-2004

                  1,000 Dollars in billions (in constant 2004 dollars)

    900

    800

    700

    600

    500 // 0

    198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004

    Fiscal year

    Tax expenditure outlay-equivalent estimates

    Discretionary spending

    Source: GAO analysis of OMB budget reports on tax expenditures, fiscal
    years 1983-2006.

    A few large income tax expenditures account for most of the aggregate
    value. The 10 tax expenditures listed in table 2 accounted for over 60
    percent of the outlayequivalents in fiscal year 2004. The estimates in the
    table are for income tax expenditures. They do not include provisions that
    exclude income from other taxes, such as payroll taxes. For example, the
    income tax exclusion for health care permits the value of health insurance
    premiums to be excluded from employees' taxable earnings and also excludes
    this value from the calculation of Social Security and Medicare payroll
    taxes for both employees and employers.

    Table 2: The 10 Largest Tax Expenditures in 2004, Outlay Equivalent
    Estimates

                                  Dollars in billions
                           Tax preference                    Outlay equivalents
           Exclusion of employer contributions to medical          $126.7
                insurance premiums and medical care
        Deductibility of mortgage interest on owner-occupied        61.5
                               homes
        Net exclusion of pension contributions and earnings:        58.2
                               401(k)
        Net exclusion of pension contributions and earnings:        57.3
                           employer plans
         Deductibility of nonbusiness state and local taxes
                (other than on owner-occupied homes)                45.3
        Accelerated depreciation of machinery and equipment         44.7
         Exclusion of interest on public purpose state and          37.5
                             local debt
        Capital gains (other than agriculture, timber, iron         35.9
                           ore, and coal)
               Capital gains exclusion on home sales                35.0
             Exclusion of net imputed rental income on              32.8
                        owner-occupied homes

    Source: GAO analysis of Office of Management and Budget (OMB), Budget of
    the United States Government, Fiscal Year 2006, Analytical Perspectives.

    In the current tax system, tax rates vary across types of tax. Individual
    income and corporate income above certain levels are generally taxed at
    graduated rates. Taxes on individual income have six statutory marginal
    tax rates (the rate of tax paid on the next dollar of income that a
    taxpayer earns), ranging from 10 percent to 35 percent. Income earned by
    corporations has a statutory marginal rate structure that ranges from 15
    percent to 35 percent. A separate rate structure exists for the individual
    Alternative Minimum Tax (AMT)-a tax on individual income that was
    originally designed to keep taxpayers with higher incomes from taking
    advantage of various tax provisions in order to pay little or no income
    tax. The current tax system also includes social insurance taxes, which
    are applied to wages at flat rates and remitted in equal shares by
    employees and employers. However, currently the first $90,000 of an
    individual's wages is subject to payroll taxes for Social Security, while
    all wages are subject to payroll taxes for Medicare.

    The government's administrative burden and taxpayers' compliance burden
    vary depending on the type of taxpayer, the type of tax, and the
    collection point of the tax. For the individual income tax and social
    insurance taxes, the primary collection point occurs at the business
    level: employers bear the burden of withholding employees' taxes from
    their wages and remitting the tax payments to the government. However, all
    individuals with income above certain thresholds based on personal
    allowances and a standard deduction still must file tax returns. The
    Internal Revenue Service (IRS) bears the administrative burden of
    monitoring taxpayer compliance and applying penalties to noncompliant
    taxpayers when necessary.

    Historical Trends in Tax Revenue

    Total federal tax revenues have fluctuated from roughly 16 to 21 percent
    of gross domestic product (GDP) over the last 43 years. In figure 4, total
    federal revenue is highest in 2000 at 20.9 percent of GDP and lowest in
    2004 at 16.3 percent of GDP.

    As figure 4 also illustrates, there have been important changes to the
    composition of federal revenues over the last 43 years. Corporate and
    excise tax receipts as a percentage of GDP have declined since 1960, while
    social insurance tax receipts have grown. The individual income tax and
    social insurance taxes have accounted for the majority of federal revenues
    during this period.

    Figure 4: Federal Revenue as a Percentage of GDP and by Source, 1962-2004

    Source: GAO represenation of OMB data.

    Historical Trends in Federal Spending

    As figure 5 illustrates, over the last 43 years, federal spending as a
    portion of GDP has ranged from a low of 17.2 percent of GDP in 1965 to a
    high of 23.5 percent of GDP in 1983. In addition, figure 5 illustrates
    that as is the case with revenues, important changes to the composition of
    federal spending have occurred. For example, since 1962, the total share
    of federal spending devoted to national defense has decreased relative to
    the share devoted to Social Security and health care. Government

    provision of Social Security and health care accounted for over 40 percent
    of government spending in 2004, a dramatic increase from the share before
    1965 when the Medicare and Medicaid programs were enacted.

    Figure 5: Federal Spending as a Percentage of GDP and by Spending
    Category, 1962-2004 25 Percentage of GDP

    20

    15

    10

    5

    0

    Fiscal year

    Source: GAO representation of OMB data.

    Borrowing versus Taxing as a Source of Resources

    The resources to fund government are raised primarily through taxes.
    However, borrowing is another source. Figure 6 combines figures 4 and 5 to
    show that the federal government has generally run a deficit in recent
    decades.

    1962

                                1970 1980 1990 2000 2004

            Figure 6: Federal Tax Revenue versus Federal Spending, 1962-2004

    25.0 Percentage of GDP

    22.5

    20.0

    17.5

    15.0 //

               1962196419661968 1970197219741976197819801982198419861988
                            19901992199419961998200020022004

    Year

    Revenue Spending

    Source: GAO representation of OMB data.

    Public sector resources, whether from taxes or borrowing, make the
    benefits of government possible. However, taxes and borrowing also have
    costs. Obviously, they transfer money from the pockets of the public to
    the government. But they also affect the performance of the economy. As
    will be discussed under the criteria for a good tax system, taxes affect
    the performance of the economy by altering decisions, such as how much to
    work and save, what to consume, and where to invest.

    Federal borrowing has advantages and disadvantages that vary depending on
    economic circumstances. Borrowing, in lieu of higher taxes or lower
    government spending, may be viewed as appropriate during times of economic
    recession, war, or other temporary challenges. Federal borrowing might
    also be viewed as appropriate for federal investment, such as building
    roads, training workers, and conducting scientific research, that
    contributes to the nation's capital stock and productivity. If well
    chosen, such activities could ultimately help produce a larger economy.
    However, if not well chosen, such spending could displace more productive
    private sector investments.

    Federal borrowing also can impose significant costs and risks. Borrowing
    for additional spending or lower taxes for current consumption improves
    short-term well-being for today's workers and taxpayers, but does not
    enhance our ability to

    repay the borrowing in the future. In the near term, federal borrowing
    also absorbs scarce savings available for private investment and can exert
    upward pressure on interest rates. Over the long term, federal borrowing
    that restrains economic growth will also restrain the standard of living
    of future workers and taxpayers.

    Long-term Fiscal Challenge

    As discussed in our report on challenges facing the government, the fiscal
    policies in place today-absent substantive entitlement reform and changes
    in tax and spending policies-will result in large, escalating, and
    persistent deficits that are economically unsustainable over the long
    term.2 In other words, given current forcasts for growth, government
    spending and resources, today's policies cannot continue and must change.

    Over the next few decades, as the baby boom generation retires, federal
    spending on retirement and health programs, such as Social Security,
    Medicare, and Medicaid, will grow dramatically and bind the nation's
    fiscal future. Absent policy changes on the spending and/or revenue sides
    of the budget, a growing imbalance between federal spending and tax
    revenues will mean escalating and ultimately unsustainable federal
    deficits and debt. For example, as figure 7 indicates, if discretionary
    spending grows at the same rate as the economy and all expiring tax
    provisions are extended, federal revenues could be adequate to cover
    little more than interest on the federal debt by 2040.

    2GAO, 21st Century Challenges: Reexamining the Base of the Federal
    Government, GAO-05-325SP (Washington, D.C.: February 2005).

    Figure 7: Composition of Federal Spending as a Share of GDP, Assuming
    Discretionary Spending
    Grows with GDP after 2004 and That Expiring Tax Provisions Are Extended
    50 Percentage of GDP

    40

    30

    20

    10

    0 2004 2015 2030 2040 Fiscal year

    Net interest

    Social Security

    Medicare and Medicaid

    All other spending

    Source: GAO representation of OMB data.

    Notes: This figure is based on the assumption that discretionary spending
    grows at the same rate as GDP after 2004 and that expiring tax provisions
    are extended. Despite our assumption that expiring tax provisions are
    extended, revenue as a share of GDP increases through 2015 due to (1) real
    bracket creep, (2) more taxpayers being subject to the AMT, and (3)
    increased revenue from tax-deferred retirement accounts. After 2015,
    revenue as a share of GDP is held constant.

    Regardless of the assumptions used, reasonable long-term simulations
    indicate that the problem is too big to be solved by economic growth alone
    or by making modest changes to existing spending and tax policies. While
    entitlement reform as well as mandatory and discretionary spending cuts
    will likely be needed to close the longterm financial gap, the structure
    of the tax system should also be part of the debate as policymakers
    grapple with the nation's long-term fiscal challenge. As part of this
    process, consideration could be given to improving taxpayer compliance and
    enforcement efforts, expanding the tax base, increasing current tax rates
    and tax rates on future generations, or a combination of these.

    Revenue Effects of Federal Tax Policy Changes

    The amount of revenue raised from a tax is determined by the tax base, the
    tax rate, and the compliance rate, as shown in figure 8. Changes to the
    tax code can be revenue neutral, meaning that they are designed to raise
    the same amount of revenue as the current tax laws, or tax code changes
    can be designed to raise more or less revenue than the current tax laws.
    Additionally, changes to the federal tax system can have significant
    implications for state and local government tax revenues.

                     Figure 8: Formula for Determining Tax Revenue

    Tax base Tax rates Compliance = Tax revenuerate

                                           +

                                           +

    In general, the size of the tax base and the rates applied to that base
    will determine the amount of revenue that the government collects. Tax
    revenue is also affected by the level of taxpayer compliance; the greater
    the level of compliance, the more revenue is collected for a given tax
    rate and tax base. Thus, tax revenue is the product of the tax base, the
    tax rate, and compliance rates.

    Source: GAO.

    Tax revenue can be affected by changing the current tax base, which could
    include replacing it with a pure consumption tax base or broadening the
    current tax base by eliminating certain tax expenditures. As we noted
    earlier, tax expenditures, which the government uses to encourage specific
    social and economic goals, reduce the size of the tax base. Tax
    expenditures may be justified because, in some cases, it may be less
    costly to achieve these goals through reductions to the tax base than
    through spending programs. The choice of whether to use tax expenditures
    or spending depends on which approach better targets and meets the
    program's objectives at the lowest cost. Even though spending programs
    show up in the federal budget and tax expenditures are not included as
    federal spending, taxpayers are paying for the program in either case.
    Both should be transparent and subject to periodic oversight concerning
    such factors as whether they meet the program's objectives or conflict
    with other government programs, grants, and regulations that have similar
    objectives.

    The tax expenditure for employer-provided health care, discussed in text
    box 1, illustrates the importance of such oversight.

    Tax revenue can also be affected by changes in tax rates, where the amount
    collected depends on the definition of the tax base and taxpayer responses
    to changes in the rate. If the tax base is broad with few exclusions,
    deductions, and credits, then the tax rates required to generate a
    particular amount of revenue will be lower than if the base is narrow. The
    Tax Reform Act of 1986 broadened the current tax base, which is based
    largely on income, by eliminating some tax expenditures, which made more
    income taxable. Without any changes in rates, tax revenue would have
    increased, but instead, rates were lowered to keep revenue about the same.
    Within some range, rate increases bring in more revenue, but rates can
    become so high that a further increase discourages enough of the taxed
    activity to reduce revenue. A tax system is more adaptable to increased
    revenue needs to the extent that tax rates can be increased without other
    fundamental changes to the system and without excessively discouraging the
    taxed activity or increasing noncompliance.

    Tax revenue is also affected by policies that change compliance rates.
    Noncompliance means that only part of the tax liability actually gets
    paid. Increasing compliance would bring in more revenue from the existing
    tax base without having to raise rates. IRS estimates that the net tax gap
    (the difference between taxes legally

    owed to the government and what taxpayers actually paid to the government)
    was at least $257 billion in 2001, the most recent year available. This is
    about 13 percent of federal revenue. Some experts believe that simplicity
    and transparency can contribute to compliance, as voluntary compliance is
    likely to increase if taxpayers are less likely to make errors on their
    tax returns and have fewer opportunities to evade taxes.

    While federal tax policy changes may alter the amount of revenue collected
    by the federal government these changes can also alter the amount of
    revenue that state and local governments collect. State and local
    governments collect nearly one-third of all the tax revenue generated in
    the United States each year.

    In many cases, state governments link their tax bases to the federal tax
    base. For example, some states use a taxpayer's adjusted gross income from
    the federal tax return to calculate state income taxes. If the federal
    government enacted provisions that reduce the size of the tax base used to
    calculate a taxpayer's adjusted gross income, then absent policy changes
    in the affected states, these state governments would likely see a
    decrease in state tax revenues. Conversely, if the federal government
    reduced the number of tax expenditures, increasing the size of the tax
    base, state governments would likely see an increase in state tax
    revenues. Thus, major changes to the federal tax base could lead to a
    variety of challenging tax system changes at the state level. For example,
    if the federal government adopted a consumption tax base, many states may
    have to consider whether they wish to maintain state income taxes.

    General Options Suggested for Fundamental Tax Reform

    Recent years have seen a variety of proposals for fundamental tax reform.
    These proposals would significantly change the tax base, tax rates, and
    collection points of the tax.

    Some of the proposals would replace the federal income tax with some type
    of consumption tax. The retail sales tax, value-added taxes, the personal
    consumption tax, and the flat tax are all types of consumption taxes. They
    vary in their collection points and structure. Similarly, collection
    points and rate structure will vary under an income tax base.

    Text box 2 briefly summarizes the general categories of proposals.

    Key Questions

    1. What current taxes would the proposal change?

    o 	Does the proposal change personal income taxes, social insurance taxes,
    corporate income taxes, and/or estate and gift taxes?

    2. What is the nature of the proposed change to the tax system?

    o  Does the proposal change the tax base from income to consumption?

    o  Does the proposal include tax expenditures?

    o  Does the proposal change the tax rates?

    o  Does the proposal change the collection points for the tax?

    3. How will the proposed change affect total revenues?

    o  Are proposed changes to the tax code likely to be revenue neutral?

    o  If not, will they generate more or less revenue than the current tax
    laws?

    4.	What effect would the proposal have on the nation's projected budgets
    and longterm fiscal outlook?

    o 	Does the proposal take into consideration the sizable long-term fiscal
    gap that the country faces?

    5.	What tax expenditures are included in the proposal, and what tax
    expenditures, if any, have been removed from the current tax system?

    o 	Are the social and economic goals of the tax expenditures likely to be
    achieved and worth the cost in lost revenue?

    o 	When the total costs of a program are considered, would it be less
    costly to implement the program as a tax expenditure or as a spending
    program?

    6.	If the proposal changes the tax base, the tax rates, or the collection
    points, how would these changes alter the amount of revenue that the
    government is able to collect?

    7. What implications, if any, would the proposal have on the ability of
    state and local governments to collect tax revenues?

    o  Would the proposal tax the same base that many states rely on?

    o 	Would the proposal allow many states to continue to rely on the federal
    tax base as a starting point for determining state taxes?

    Criteria for a Good Tax System

    How should a tax system be designed to raise a given amount of revenue?
    More specifically, what criteria should be used to evaluate the advantages
    and disadvantages of a particular tax system, or a particular tax policy
    proposal? The answers matter because various combinations of tax bases and
    rates can raise the same amount of revenue.

    Three long-standing criteria-equity; economic efficiency; and a
    combination of simplicity, transparency, and administrability-are
    typically used to evaluate tax policy. These criteria are often in
    conflict with each other, and as a result, there are usually trade-offs to
    consider between the criteria when evaluating a particular tax proposal.
    Some of the criteria, such as equity and transparency, are more subjective
    while other aspects of some of the criteria, such as economic efficiency,
    can be defined more objectively. Additionally, people may disagree about
    the relative importance of the criteria. Consequently, citizens and
    elected officials are likely to hold a wide range of opinions about what
    the ideal tax system should look like. (See fig. 9.)

             Figure 9: Trade-offs in the Criteria for Assessing Tax Reform

    Sources: GAO (text); PhotoDisc (images).

    In the following sections, we explain these criteria. The fact that a
    particular tax is viewed favorably from the perspective of one of the
    criteria is not an overall endorsement of the tax.

    Equity

    There are a wide range of opinions regarding what constitutes an
    equitable, or fair, tax system. There are principles-a taxpayer's ability
    to pay taxes and who receives the benefits from the tax revenue that is
    collected-that are useful for thinking about the equity of the tax system.
    However, these principles do not change the fact that conclusions about
    whether one tax is more or less equitable than another are value
    judgments. Similarly, analytical tools, such as distributional analysis,
    while providing useful factual information about who pays a tax and how
    much they pay, do not replace individuals' value judgments about what
    constitutes a fair tax system. (See fig. 10.)

    Sources: GAO (text); PhotoDisc, (c)Corbis (images).

    Equity Principles

    Two principles of equity underlie debates about the fairness of different
    tax policies. The ability to pay principle and the benefits received
    principle do not identify one tax policy as more equitable than another,
    but they can be used to clarify and support judgments about equity. When
    making judgments about the overall equity of government policy, it is
    important to consider both how individuals are taxed and how the benefits
    of government spending are distributed. Even if some judge tax

    policy to be inequitable, government policy as a whole may be considered
    more equitable once the distribution of both taxes and government benefits
    is accounted for. For the purposes of this report, we have confined our
    discussion of equity to the distribution of tax burdens.

    Ability to Pay Principle

    The ability to pay principle states that those who are more capable of
    bearing the burden of taxes should pay more taxes than those with less
    ability to pay. The ability to pay principle relates taxes paid to some
    measure of ability to pay, such as overall wealth, income, or consumption.
    However, ability to pay may vary depending on the measure chosen. For
    example, a taxpayer's ability to pay, measured by overall wealth, may
    differ significantly from his or her ability to pay measured by income. A
    taxpayer who worked for many years and then retired may have accumulated a
    significant amount of wealth and may, as a result, have a higher ability
    to pay taxes but may have low current income.

    Some features of the current income tax can be viewed as reflecting
    attempts to account for differences in ability to pay. For example, two
    taxpayers with the same income may not have the same level of economic
    well-being-the same ability to pay-if one has high medical expenses and
    the other does not. For this reason, the current income tax allows
    deductions for large medical expenses. Other provisions of the tax code,
    such as the deduction for the number of dependents, may also adjust income
    to better reflect ability to pay. Some items that clearly affect ability
    to pay, such as the contribution provided by a nonworking spouse to a
    family's well-being, are not included in taxable income, in part because
    of difficulties in valuing these aspects of economic well-being. People
    have different views about the factors that affect ability to pay.

    Additionally, some do not agree that income is the best measure of ability
    to pay. As noted above, some argue that consumption provides a better
    measure of a taxpayer's ability to pay taxes than income.

    Horizontal and Vertical Equity

    The concepts of horizontal equity and vertical equity are refinements of
    the ability to pay principle.

    Horizontal equity requires that taxpayers who have similar ability to pay
    taxes receive similar tax treatment. Targeted tax expenditures, such as
    deductions and credits, could affect horizontal equity throughout the tax
    system because they may favor certain types of economic behavior over
    others by taxpayers with similar financial conditions. For example, two
    taxpayers with the same income and identical houses may be taxed
    differently if one owns his or her house and the other rents because
    mortgage interest on owner-occupied housing is tax deductible.

    Vertical equity deals with differences in ability to pay. Subjective
    judgments about vertical equity are reflected in debates about the overall
    fairness of the following three types of rate structures, where for this
    example, income is used as the measure of ability pay:

    o 	Progressive tax rates: The tax liability as a percentage of income
    increases as income increases.

    o 	Proportional tax rates: Taxpayers pay the same percentage of income,
    regardless of the size of their income.

    o 	Regressive tax rates: The tax liability is a smaller percentage of a
    taxpayer's income as income increases.

    Just because the statutory rate structure for a tax is progressive does
    not necessarily mean that the tax system is progressive overall. For
    example, when considering an individual income tax, if statutory marginal
    tax rates increase as taxable income increases the tax rate structure is
    progressive. However, as shown in text box 3, statutory tax rates are not
    the same as effective tax rates-progressive statutory tax rates could be
    offset by other features of the tax system. Average effective tax rates,
    or the amount of tax that a taxpayer actually pays as a percentage of his
    or her total income (after deductions, credits, and exclusions are removed
    from the equation) may make the tax less progressive if there are a
    variety of provisions in the tax code that reduce the taxable income of
    wealthier taxpayers.

    People hold different opinions as to whether the current rate structure is
    vertically equitable. Some believe that the rate structure should be more
    progressive, and that effective tax rates should rise with income more
    rapidly than they do under the current system. Others support a
    proportional rate structure. They believe that a tax system that imposes a
    single flat tax rate on income is more equitable because each additional
    dollar earned is taxed at the same rate.

    Benefits Received Principle

    In contrast to the ability to pay principle, the benefits received
    principle states that the amount of tax paid should be directly related to
    the benefits that a taxpayer receives from the government. In practice,
    the benefits received principle requires the government to identify who
    benefits from specific government services. As a result, the benefits
    received principle is usually not applicable when considering government
    programs intended to provide societywide benefits or redistribute wealth.

    The federal tax on gasoline is an example of a tax that is sometimes
    justified on the benefits received principle. Gas taxes are paid by road
    users. This means that the people who pay the tax (drivers) are the same
    taxpayers who receive the benefits from the revenue collected in the form
    of both new and improved highways. User

    fees, such as postage stamps or fees to enter national parks, are another
    example of taxes based on the benefits received principle.

    Measuring Who Pays: Distributional Analysis

    Distributional analysis, which shows tax burden by differing income
    groups, is used to measure how different tax proposals would affect
    taxpayers with varying ability to pay, or the way in which the tax burden
    is to be shared among various income groups. Some tax reform proposals may
    alter the distribution of taxes paid among various groups of taxpayers,
    while other tax reform proposals may be distributionally neutral, or
    maintain the same distribution of tax burdens as the tax system that is
    already in place. The Tax Reform Act of 1986 is an example of a tax reform
    proposal that was intended to be distributionally neutral.

    The distributional analyses of a specific tax proposal may differ for a
    variety of reasons. Among the most important are (1) the time period
    included in the analysis, (2) the manner in which ability to pay is
    measured, (3) the unit of analysis, (4) assumptions regarding tax
    incidence, (5) the taxes included in the analysis, and (6) the measures of
    tax burden used in the table.

    Time period of the analysis: Most distributional analysis tables use
    annual measures of income and taxes, although some use longer periods.
    However, a 1-year time horizon provides a limited perspective on the
    distributional effects of federal taxes. For example, consider the same
    individual at different points in his or her life. When he or she enters
    the workforce, income and wealth usually are relatively low but increase
    over time when prime earnings years are reached and assets and savings
    begin to be accumulated. With retirement, annual wages fall and savings
    are the primary support for the retirees lifestyle. As a result of
    fluctuations in income over time, annual tables measuring the distribution
    of tax burdens may group together people who have different lifetime
    economic circumstances.

    Ability to pay measure: Most studies that measure distributional effects
    of alternative tax proposals include a broad measure of income that
    includes more than just taxable income to measure a taxpayer's ability to
    pay. Some types of nonwage income, such as investment income, are
    relatively easy to identify and include in distributional tables, while
    others are more difficult. For example, distributional analyses may
    attempt to adjust for such factors as the value of employer-provided
    fringe benefits in order to broaden the definition of income to better
    reflect ability to pay.

    However, while income is the most commonly used measure of ability to pay
    in distributional analysis, other measures of ability to pay, such as
    consumption, may also be used to create distributional tables. As we
    mentioned earlier, some believe that consumption is a better measure of
    ability to pay taxes than income.

    Unit of analysis: The unit of analysis used to group taxpayers together
    may also affect the outcome of distributional tables. Some analysts create
    distributional tables using individual taxpayers as the unit of analysis,
    while others group taxpaying units (people included on a tax return,
    families, or households) together. Distributional tables may differ if one
    table uses individual taxpayers and another table uses a taxpaying unit
    because a taxpaying unit may include more than one individual who pays
    taxes.

    Tax incidence: The actual burden of a tax does not always fall on the
    people or businesses that actually pay the tax to the government, and
    assumptions about tax incidence may affect the results of distributional
    tables. The statutory incidence of a tax-the parties who are legally
    required to pay the tax-may not be the same as its economic incidence-the
    parties who actually bear the burden of the tax-because taxpayers who
    legally must pay the tax can sometimes shift the burden to others through
    changes in prices, wages, and returns on investments. For example, from a
    statutory perspective, the employee and employer contribution to the
    payroll tax are equal. However, most analysts agree that employees bear
    the entire burden of the payroll tax in the form of reduced wages.

    Determining who bears the burden of the corporate income tax is an example
    of how difficult it can be to determine the incidence of a tax. Text box 4
    illustrates some of the issues associated with identifying the incidence
    of the corporate income tax.

    Taxes included in the analysis: Some distributional tables include
    different taxes in the analysis, so when comparing two distribution
    tables, identifying which taxes are included in the analysis is necessary
    to ensure that a valid comparison can be made between the two estimates.
    For example, in table 3, one side of the table includes all federal taxes,
    while the other side only includes the federal income tax. Because it is
    often difficult to isolate the incidence of some taxes, analysts sometimes
    exclude those taxes from the analysis.

    Measures of tax burden: Distributional tables may also produce different
    results based on the measures of tax burden that are used. Effective tax
    rates and share of tax liability (portion of total taxes that households
    in each quintile collectively remitted to the government), the measures
    used in table 3, are two common measures of tax burden. Some
    distributional tables show how effective tax rates would change if the tax
    code were changed.

    Different Assumptions Lead to Different Distributional Analyses

    The Office of Tax Analysis in the Treasury Department, the Congressional
    Budget Office (CBO), and the Joint Committee on Taxation are the three
    government sources of tax distributional analysis, and their
    distributional tables may differ based on the assumptions that they make
    about the issues we have outlined above.

    The example in table 3, which shows two measures of tax burden,
    illustrates the fact that making different assumptions when conducting
    distributional analysis can lead to different results.

    Table 3: Measures of Tax Burden: Distribution of Total Federal Taxes and
    Individual Income Taxes in 2004

                         Total federal taxes          Individual income taxes
                  Average effective tax                 Average
         Income           rates         Share of tax effective tax Share of tax
        quintiles                        liability       rates      liability
         Lowest           5.2%              1.1%         -5.7%        -2.7%
        quintile
         Second           11.1%             5.2%         -0.1%        -0.1%
        quintile
         Middle           14.6%            10.5%         3.5%          5.4%
        quintile
         Fourth           18.5%            19.5%         6.6%         15.2%
        quintile
         Highest          23.8%            63.5%         14.2%        82.1%
        quintile
           All            19.6%            100.0%        9.0%         100.0%

    Source: Congressional Budget Office, Effective Federal Tax Rates Under
    Current Law, 2001 to 2014 (Washington, D.C.: August 2004).

    Note: In table 3, numbers do not always add due to rounding.

    Both of the distribution tables were prepared by CBO using the same
    methodology to measure the distributional effects of the tax system in
    2004 using 2001 income (adjusted for inflation and nominal income growth
    to reflect income in 2004) as the base for the analysis. The only
    difference between the left side of the table and the right side of the
    table is the taxes that are included in the analysis. The left side
    includes total federal taxes, excluding estate and gift taxes and several
    other miscellaneous sources of revenue, while the right side of the table
    only includes individual income taxes. The table that presents total
    federal taxes uses the assumption that individuals bear the burden of the
    employee and employer share of

    payroll taxes, and owners of capital income bear the burden of the
    corporate income tax. The effective tax rates for individual income taxes
    are negative for the two lowest income quintiles because the table
    includes some offsets to tax liability, such as the earned income tax
    credit.

    Key Questions

    1. How is a taxpayer's ability to pay broadly defined:

    o  Income?

    o  Consumption?

    o  A broader definition of overall wealth?

    2.	What factors other than income, such as medical expenses, number of
    dependents, and so forth, does the proposal account for when considering a
    taxpayer's ability to pay taxes?

    3. Will taxpayers with equal ability to pay taxes pay the same amount?

    o 	If not, what provisions of the proposal do not adhere to the principle
    of horizontal equity?

    4. How will the tax system tax people with differing ability to pay?

    o  Are the statutory tax rates progressive, proportional, or regressive?

    o 	Are the average effective tax rates progressive, proportional, or
    regressive (accounting for credits, deductions, and other tax
    expenditures)?

    5.	Are there any components of the tax proposal that are justified on the
    benefits received principle?

    o 	If so, what mechanisms are in place to determine that taxpayers who pay
    taxes for a particular government program are the same taxpayers who
    benefit from the provisions of that program?

    6.	Does the proposal maintain the distribution of taxes (i.e., is the
    proposal distributionally neutral)?

    o  If not, who will be paying more in taxes and who will be paying less?

    o 	If so, what features of the proposal are in place to ensure that it
    will remain distributionally neutral?

    7. What type of distributional analysis was done?

    o 	What time period is covered? For example, does the distributional
    analysis measure the lifetime or annual effects of the tax system?

    o  How is ability to pay (income, consumption, or wealth) measured?

    o  What is the unit of analysis (individuals, households, or taxpaying
    units)?

    o 	What assumptions are made about tax incidence (e.g., who is assumed to
    pay the corporate income tax)?

    o  What taxes are covered in the distributional analyses?

    o 	What measures (e.g., tax rates, share of tax liability) are being used
    to calculate the distribution of tax burden?

    Economic Efficiency

    One reason people bear taxes is they desire the benefits of government
    programs and services. As taxpayers, they balance the costs of taxes with
    the benefits of government. From a taxpayer's perspective, the cost of
    taxes includes more than the tax liability paid to the government. These
    costs include efficiency costs, which result from taxes changing the
    economic decisions that people make-decisions such as how much to work,
    how much to save, what to consume, and where to invest. These changes,
    referred to by economists as distortions, reduce people's well-being in a
    variety of ways that can include a loss of output or consumption
    opportunities. These reductions in well-being are efficiency costs, also
    called deadweight losses, excess burdens (excess because they are a cost
    in addition to the tax liability), or welfare losses.

    Because taxes generally create inefficiencies, minimizing efficiency costs
    is one criterion for a good tax. However, the goal of tax policy is not to
    eliminate efficiency costs. The fact that taxes impose efficiency and
    other costs beyond the tax liability does not mean that taxes are not
    worth paying. The goal of tax policy is to design a tax system that
    produces the desired amount of revenue and balances economic efficiency
    with other objectives, such as equity, simplicity, transparency, and
    administrability. Moreover, as noted in the revenue section, the failure
    to provide sufficient tax revenues to finance the level of spending we
    choose as a nation gives rise to deficits and debt. Large sustained
    deficits could ultimately have a negative impact on economic growth and
    productivity.

    Because taxes impose efficiency costs, the total cost of taxes to
    taxpayers is larger than their tax liability (the check they send to the
    U.S. Treasury). The total cost of taxes from a taxpayer's point of view is
    the sum of the tax liability, the efficiency costs, and the costs of
    complying with the system (which we discuss later), as shown in figure 11.

    Figure 11: Efficiency Costs Are One Cost Taxpayers Face in Complying with
    the Tax System

    Total cost of

    Tax liability + + Compliance = a tax to burden a taxpayer

    In addition to the tax revenue collected and the compliance burden of
    taxation, taxes generate efficiency costs that reduce people's well-being.
    For example, these efficiency costs can come in the form of lost output or
    consumption opportunities.

    Source: GAO.

    From a national perspective tax revenue is not a cost. Tax revenue is not
    lost to the nation-it is moved from taxpayers' pockets to the Treasury in
    order to pay for the programs and services that the government provides.
    On the other hand, efficiency costs and compliance burden are costs from a
    national perspective because, for example, they can result in forgone
    production and consumption opportunities, as well as the loss of
    taxpayers' time spent on complying.

    Tax systems can differ in the magnitude and nature of their efficiency
    costs. Differences in the base, rates, preferences, or tax-induced
    responses can all affect the extent one tax distorts when compared to
    another. Tax systems can cause distortions that affect both individual
    taxpayers and businesses. Figure 12 outlines some of the key issues to
    consider when thinking about the efficiency of the tax system.

    Sources: GAO (text); PhotoDisc (image).

    Equity concerns may force a trade-off between fairness and efficiency.
    Progressive tax rate schedules are believed to have higher efficiency
    costs than a proportional schedule that raises the same amount of revenue.
    However, proponents of progressive rates are willing to trade off some
    efficiency in order to gain, in their view, more vertical equity. As will
    be shown below, efficiency costs, although they are hard to measure, often
    can be defined objectively. Nevertheless, they still must be balanced with
    the more subjective criteria like equity when reaching general conclusions
    about a tax proposal.

    Taxes and Economic Decision Making

    Economic efficiency can be thought of as the effectiveness with which an
    economy utilizes its resources to satisfy people's preferences. Economists
    generally agree that (from the perspective of efficiency and ignoring
    other considerations, such as equity) markets are often the best method
    for determining what goods and services should be produced and how
    resources should be allocated. Self-interest is assumed to motivate
    resource owners to try to use their resources in a manner that realizes
    the highest return. When resources are directed to their highest valued
    uses the economy is said to be efficient.

    Inefficiencies reduce the economic well-being of people in the aggregate,
    since resources are not directed to their highest valued uses. By
    reallocating resources from lower valued uses to higher valued uses, the
    economic well-being of people can be increased. However, gains from
    reallocating resources from lower valued uses to higher valued uses may
    not be distributed in manner considered fair, that is, some people may
    lose because of the reallocation.

    Generally, taxes alter or distort decisions about how to use resources,
    creating economic inefficiencies. By changing the relative attractiveness
    of highly taxed and lightly taxed activities, taxes distort decisions such
    as what to consume, how much to work, and how to invest. Households and
    firms generally respond to taxes by choosing more of lower taxed items and
    less of higher taxed items than they would have otherwise. The change in
    behavior can ultimately leave individuals with a combination of
    consumption and leisure that they value less than the combination that
    they would have chosen under a tax system that does not distort their
    behavior.

    As a simple example of the effects of a tax distortion, suppose an
    investor is choosing between two investments, one that has an expected
    annual return of 10 cents on every dollar invested and a second that has
    an expected annual return of 15 cents. If the income from neither
    investment is taxed, or if the income is taxed equally, the investor will
    choose the second investment with its higher economic rate of return.
    However, if the first investment continues to be untaxed, while the second
    is subject to a 40 percent tax, the decision will be based on the
    investment's after-tax rate of return. In this case the after-tax return
    on the first investment continues to be 10 cents for every dollar
    invested, while the after-tax return on the second investment is now 9
    cents. An investor would choose the first investment because it has a
    higher after-tax return. However, this results in a loss to the economy,
    or inefficiency. Society gains a 10 cent return from the first investment,
    all of which goes to the investor. Society would have gotten the 15 cent
    return from the second investment, 9 cents for the investor, and 6 cents
    for the government.

    Note that a tax does not actually have to raise revenue to cause
    inefficiencies. In the previous example, the investor who chose the first
    investment would pay no tax. However, the tax system design has distorted
    the investor's decision-making and reduced output.

    The example of the tax-preferred treatment of owner-occupied housing
    illustrates a trade-off between efficiency costs and using the tax system
    to achieve other social goals. Text box 5 presents some estimates of the
    efficiency costs of the tax treatment of owner-occupied housing due to
    large differences in effective tax rates across three major investment
    categories. However, even in situations such as the one outlined in the
    text box, where the tax preference imposes some efficiency costs, there
    may still be valid reasons for using tax preferences as a tool of
    government for achieving certain social and economic goals. As we note in
    the example, most economists agree that the tax-preferred treatment of
    owner-occupied housing distorts investment

    patterns in the economy. The tax preference promotes the social goal of
    increased home ownership-a goal that many policymakers advocate.

    Although taxes generally result in efficiency losses, there are
    exceptions. In special cases, tax distortions may offset other
    inefficiencies, which can be caused by what economists call market
    failures. An example is an externality or spillover, where the benefits or
    costs of an activity are not fully captured by the individuals or firms
    undertaking the activity. Research and development is commonly cited as
    generating positive externalities-in some cases, the entity doing the
    research and development may produce knowledge that enters the public
    realm and is freely available to users. For example, some medical
    innovations, such as surgical techniques, cannot be patented. To the
    extent that benefits cannot be sold in a market, private firms that
    innovate will not reap the full financial benefits of the innovation and,
    therefore, will invest too little in research. Tax incentives for research
    might be one way to address the problem, but other governmental tools such
    as grants, loans, or regulations could also be considered. Efficient taxes
    are special cases-tax systems large enough to fund the federal government
    impose efficiency costs.

    Measuring Economic Efficiency

    While economists generally agree that the tax system imposes significant
    efficiency costs, estimating the magnitude of tax-related efficiency costs
    in an economy as complex as ours is extremely difficult. However, several
    attempts have been made to estimate the efficiency costs of parts of the
    tax system. For example, one study estimated the total efficiency cost of
    the personal income tax on labor income, which distorts labor supply
    decisions, to be from $137 billion to $363 billion in 1994.3 A second
    study estimated the effects of the unequal taxation of savings and
    consumption to be about $45 billion in 1995.4 Text box 5 summarized
    estimates of the efficiency losses associated with the tax treatment of
    owner-occupied housing as ranging from 0.1 to 1 percent of GDP. For
    further information on efficiency cost estimates, see GAO, Tax Policy:
    Summary of Estimates of the Costs of the Federal Tax System, GAO-05-878
    (forthcoming).

    These partial estimates indicate the significant uncertainty surrounding
    the magnitude of tax-induced efficiency costs. Nevertheless, they suggest
    that the overall efficiency costs imposed by the tax system are large-on
    the order of several percentage points of GDP.

    As a result of these difficulties, simple rules of thumb are commonly used
    to provide rough estimates of the efficiency costs of taxes. Text box 6
    describes two such rules of thumb.

    3Martin Feldstein, "Tax Avoidance and the Deadweight Loss of the Income
    Tax," The Review of Economics and Statistics, vol. 81, no. 4 (1999).

    4Jinyong Cai and Jagadeesh Gokhale, "The Welfare Loss From a Capital
    Income Tax," Federal Reserve

    Bank of Cleveland Economic Review, vol. 33, no. 1 (1997).

    The extent to which tax reform can reduce such tax-induced inefficiencies
    and thus increase our economic well-being depends on the design of a
    reformed system. All practical tax systems distort some decisions so it is
    not possible to eliminate all the efficiency costs associated with taxes.
    The magnitude of the efficiency costs in a reformed tax system would
    depend on such design features as the treatment of savings versus
    consumption, the number of tax expenditures, and the level and
    progressivity of tax rates. While some economists believe that a pure
    consumption tax with no preferences and a flat rate would reduce
    efficiency costs relative to the current tax system, such a pure tax may
    not be a feasible alternative because of equity and other concerns.

    In addition, as has been discussed, the revenue consequences of tax reform
    have economic effects. The efficiency gains from a reformed tax system
    could be offset if the new system increases long-term deficits.

    Taxing Work and Savings Decisions

    In part because of the difficulty of measuring the efficiency cost of
    taxes, discussions of the impact of taxes on the economy sometimes focus
    on the effect that taxes have on changes in the output of the economy,
    labor supply, or other such economic variables. However, such changes do
    not necessarily measure efficiency costs. Efficiency loss is the
    difference between individuals' well-being with a tax and individuals'
    well-being under a revenue neutral, hypothetical tax that does not
    distort, called a lump sum tax.

    Three choices commonly discussed are the choice between work and leisure,
    the choice between consumption and saving, and the choice between domestic
    and foreign investment. Intertwined with effects that taxes have on these
    choices is the effect of taxes on economic growth.

    Work versus leisure: Taxes-both income and consumption taxes-can affect
    the decisions that people make about how much time to devote to work or
    leisure in two ways. First, taxes may increase the incentive to work
    because workers must work more to maintain their after tax income. Second,
    taxes may reduce the incentive to work because workers earn less from an
    additional hour of work. The net effect may be no change to the overall
    supply of labor. However, even in this case, there is still an efficiency
    cost, which is determined by the second effect. By reducing hourly after
    tax earnings, income and consumption taxes distort decisions about how
    many hours to devote to work or leisure.

    Empirical research generally shows that at least for primary wage earners,
    decisions about labor force participation are not very responsive to
    taxes. However, decisions about labor force participation by secondary
    wage earners have been shown to be more responsive to changes in the tax
    system.

    Consumption versus savings: Taxes on capital reduce the after-tax return
    to savings. In effect, this makes future consumption (savings) more
    expensive relative to current consumption and thus has the potential to
    distort savings decisions. While research has shown that the demand for
    some types of savings, such as the demand for taxexempt bonds, is
    responsive to changes in the tax system, there is greater uncertainty
    about the effects of changes in the tax system on other choices, such as
    aggregate savings.

    Domestic versus foreign investment: Taxes on income from capital can
    affect the location of investment by changing the relative after-tax
    return on domestic and foreign investment. This matters because the
    location of investment can affect the income of U.S. citizens. The income
    of people working in the United States is closely tied to their
    productivity, which generally increases with the amount of domestic
    investment. At the same time, U.S. citizens who own capital can earn
    higher incomes by investing their capital-in the United States or
    abroad-wherever it earns the highest rate of return. In a world of
    increasing capital mobility due to increasing trade and decreasing
    communication and transportation costs, the effect of taxes on the
    location of investment is even more important than in the past

    Efficiency and economic growth: Removing or reducing distortions caused by
    the tax system can affect the size of the economy. Increasing the
    efficiency of the tax system can expand the economy through a temporary
    increase in the rate of growth. An increase in efficiency is an increase
    in well-being that comes from using existing resources in a better way.
    Efficiency raises capacity to a higher level but does not necessarily
    continue to increase it without additional resources. Such an increase
    could show up as a temporary increase in the growth of the economy.
    However, the long-term growth rate depends on the rates of change in
    population, the capital stock, and technology. Changes to the tax system
    that would increase economic efficiency could increase the long-term
    growth rate if they increase the rate of technological change. Thus, tax
    changes that increase economic efficiency may or may not result in an
    increased long-term rate of economic growth.

    Efficiency versus fiscal effects: As has been discussed, taxes may have
    both efficiency effects and fiscal policy effects. Government spending in
    excess of government revenues creates deficits, which if large enough and
    continued over a period of time will ultimately have a negative impact on
    economic growth and productivity to the extent that they absorb savings
    that would otherwise finance investment in the private economy. Thus, the
    gain from changing the tax system to increase economic efficiency could be
    offset if the tax changes increase the deficit.

    Tax policies designed to enhance economic efficiency can be designed
    independently of fiscal policy. For example, the Tax Reform Act of 1986
    was designed, in part, to achieve increased efficiency by broadening the
    tax base and lowering rates in a way that was revenue neutral. Such a
    revenue neutral change would have no effect on deficits and debt.

    Realizing Efficiency Gains

    The extent to which efficiency gains are realized by switching to an
    alternative tax system depends on at least two factors. First, the
    efficiency gains of switching to a new tax system depend on the extent to
    which that tax system reduces distortions caused by tax preferences, rate
    differences, sectoral differences, and switching the base from income to
    consumption. Second, the change to a new tax system may not improve the
    overall efficiency of the economy if the distorting tax incentives
    eliminated by switching to a new tax system are replaced with government
    spending or regulation that provides the same incentives.

    Key Questions

    1. Does the proposal tax income, spending, assets, and investments
    differentially?

    o  Which types of income, spending, assets, and investments are tax
    preferred?

    o  Which decisions are likely to be distorted?

    2. What social goals, if any, is the tax proposal trying to promote?

    o 	Is there an efficiency justification for the goal, or is the goal
    justified on other grounds, such as equity?

    3. Do estimates of the cost of achieving the goal include efficiency
    costs?

    4. What are the trade-offs between equity, efficiency, and the other
    criteria?

    5.	Is the tax proposal accompanied by estimates of the efficiency gains or
    losses to be realized by the new tax system?

    o 	Is the tax proposal accompanied by estimates of economic activity
    (e.g., change in labor supply or change in GDP) that will be encouraged or
    discouraged by the new tax system?

    o 	Is the proposal accompanied by estimates of the efficiency loss or gain
    associated with these changes in economic activity?

    6. How does the tax change affect leisure versus work decisions?

    7. How does the tax change affect savings versus consumption decisions?

    8.	How does the tax change affect decisions about foreign versus domestic
    investment?

    9.	How does the tax change affect choices between different types of
    investments and different types of consumption?

    10. Is the tax proposal likely to increase economic growth?

    o  Is the growth achieved through a onetime rearranging of resources?

    o  Is the growth achieved through a permanent increase in the rate of
    growth?

    o 	Does the tax proposal contain estimates of its effect on growth (often
    measured by changes in GDP) and estimates of the costs of achieving the
    growth (such as reduced leisure time)?

    11.	In addition to efficiency effects, will the proposal have other
    economic effects by increasing or reducing the deficit?

    Simplicity, Transparency, and Administrability

    Simplicity, transparency, and administrability are interrelated and
    desirable features of a tax system. Simple tax systems are, in many cases,
    the most administrable, and tax systems that are both simple and
    administrable are often considered to be the most transparent. However,
    even though there is considerable overlap between simplicity,
    transparency, and administrability, they are not identical. (See fig. 13.)

    Because there is considerable overlap between these concepts, even though
    they are not the same thing, we combine simplicity, transparency, and
    administrability into one section and discuss them as a group. While
    others may not use the same terminology, the debates implicitly use the
    same or very similar criteria.

    Sources: GAO (text); PhotoDisc (images).

    Simplicity

    Simple tax systems impose less of a compliance burden on the taxpayer than
    more complex systems. Taxpayer compliance burden is the value of the
    taxpayer's own time and resources, along with any out-of-pocket costs to
    paid tax preparers and other tax advisors, invested to ensure compliance
    with tax laws. As figure 14 demonstrates, in addition to the actual tax
    payments remitted to the government and

    the efficiency costs of taxation that we discussed earlier, compliance
    burden is the third cost that the tax system imposes on taxpayers.
    Compliance costs include the value of time and resources devoted to (1)
    record keeping, (2) learning about requirements and planning, (3)
    preparing and filing tax returns, and (4) responding to IRS notices and
    audits. Taxpayers can either choose to fulfill these responsibilities on
    their own or they can hire paid preparers to aid them in complying with
    the tax code. According to IRS, over 61 percent of returns filed in 2003
    included a paid preparer's signature, contributing to considerable
    out-of-pocket costs to taxpayers.

    Source: GAO.

    The current tax system has grown increasingly complex over time, and many
    believe that taxpayer compliance burden has grown accordingly. The amount
    of time that taxpayers actually spend filling out tax forms may only
    constitute a small amount of the overall compliance burden. For many
    taxpayers, the bulk of the compliance burden comes in the form of tax
    planning and record keeping. For example, taxpayers spend time determining
    how the growing number of tax expenditures will affect their respective
    tax liabilities. The Treasury Department listed 146 tax expenditures in
    2004, up about 26 percent since the last major tax reform legislation in
    1986. Frequent changes in the tax code reduce its stability, contributing
    to compliance burden by making tax planning more difficult and increasing
    uncertainty about future tax liabilities. Moreover, an increasing number
    of taxpayers are becoming subject to the individual AMT. Determining how
    the provisions of the AMT affect a taxpayer's tax liability adds to the
    compliance burden.

    Compliance burden is difficult to measure in part because it is difficult
    to measure the amount of time taxpayers spend planning and preparing their
    returns and the value

    of that time.5 Nevertheless, researchers have made several attempts to
    quantify the costs that taxpayers incur while complying with the tax
    system. Most estimates suggest that taxpayer compliance burden falls
    between $100 billion and $200 billion each year.

    Because compliance burden is difficult to measure, other, less direct
    measures of burden are frequently used. These include the number of pages
    in the tax code, the number of IRS forms to fill out, the length of tax
    instructions, and the number of lines on the tax form. These measures are
    believed to be correlated with compliance burden, but the correlation is
    recognized to be far from perfect. In some situations, longer instructions
    and more details on a form may reduce compliance burden by clarifying what
    a taxpayer must do to comply with the tax laws. These alternative measures
    of simplicity may provide some insight into the simplicity of the tax
    code, but they do not directly measure the impact that the tax code has on
    the costs to taxpayers of complying with the nation's tax laws.

    The intergovernmental effects of tax policy changes can also affect
    compliance burden. Due to the close links between the federal tax system
    and the tax systems in many states, changes to the federal tax system
    could have implications for the compliance burden that taxpayers face when
    completing their state tax returns. For example, if the federal government
    switched from the current income tax system to a national retail sales
    tax, or a different type of consumption tax, but states-most of which have
    developed income tax forms that are based in large part on an individual's
    federal tax return-maintain their income tax requirements, then overall
    taxpayer burden would not likely be greatly reduced. Taxpayers might not
    have to file federal tax returns, but many, if not all, of the record
    keeping and administrative tasks would still exist when complying with the
    state-level income tax requirements.

    Transparency

    A transparent tax system is one that taxpayers are able to understand.
    Transparent tax systems impose less uncertainty on taxpayers, allowing
    them to better plan their decisions about employment, investment, and
    consumption. This leads to more confidence that they can accurately
    predict their future tax liabilities and contributes to the credibility of
    the tax system. Tax systems that are difficult to comply with and
    administer may lack transparency. A nontransparent tax system could be
    difficult to administer because tax administrators may have difficulty
    consistently applying the law to taxpayers in similar situations. In this
    sense, transparency is closely linked to

    5It is difficult to measure the amount of time that taxpayers spend
    planning and preparing their returns because, among other reasons, when
    surveyed, taxpayers may overstate or understate the amount of time that
    they spent depending on how straightforward or complicated their returns
    were (i.e., how frustrating the experience was). Additionally, there is no
    consensus among researchers regarding the appropriate monetary value to be
    assigned to each hour of time spent on tax compliance activities.

    the simplicity and administrability of the tax system. Transparent tax
    systems include the following elements:

    o 	Taxpayers can easily calculate their liabilities: Taxpayers can easily
    follow instructions and tax rate tables in order to determine their tax
    base, their marginal tax rate, and their tax liability to the government.

    o 	Taxpayers grasp the logic behind tax laws and tax rates: Taxpayers can
    look at a tax form or a tax rate schedule and understand lawmakers'
    reasoning. For example, whether or not they agree with it, taxpayers are
    likely to be able to comprehend the logic behind a progressive rate
    schedule.

    o 	Taxpayers know their own tax burden and the tax burden of others:
    Irrespective of who actually writes a check to the government, taxpayers
    can identify who actually bears the burden of a tax. For example, the
    payroll tax is not transparent to the extent that taxpayers in general are
    unaware of the incidence of the tax. Even though payroll taxes are divided
    equally between employees and employers, economists generally agree that
    employees bear the entire burden of payroll taxes in the form of reduced
    wages.

    o 	Taxpayers are aware of the extent of compliance by others: Taxpayers
    understand the extent to which the tax laws are enforced, meaning that
    they know how likely their friends, neighbors, and business competitors
    are to actually pay what they owe.

    While the concept of transparency is closely linked to simplicity and
    administrability, they are not always the same. For example, some tax
    provisions may be simple but not transparent. The corporate tax rate
    schedule example in table 4 illustrates this. While determining taxable
    income under the corporate income tax is often a complex procedure, it is
    relatively simple for corporations to calculate their tax liabilities by
    referring to tax tables published by the IRS once this income has been
    determined. However, the logic underlying the marginal tax rates in the
    corporate tax schedule is not transparent. The marginal rate structure is
    progressive up to taxable income of $335,000, but marginal rates then
    decrease before increasing again and then decreasing once more.

    Table 4: The Corporate Tax Rate Schedule: Simple but Not Transparent

                                                 Marginal tax rate in the tax
        Tax bracket (taxable corporate income)             bracket
                    $0 to $50,000                            15%
                  $50,001 to $75,000                         25%
                 $75,001 to $100,000                         34%
                 $100,001 to $335,000                        39%
               $335,001 to $10,000,000                       34%
              $10,000,001 to $15,000,000                     35%
              $15,000,001 to $18,333,333                     38%
                   Over $18,333,333                          35%

    Source: IRS instructions for Form 1120.

    Some experts who have written on transparency believe that the tax code's
    transparency has declined in recent years. Numerous tax provisions have
    made it more difficult for taxpayers to understand how their tax liability
    is calculated, the logic behind the tax laws, and what other taxpayers are
    required to pay.

    Administrability

    Administrable tax systems allow the government to collect taxes as cost
    effectively as possible. Even though tax administration is usually
    considered to be IRS's responsibility, taxpayers, employers, and financial
    intermediaries such as banks and tax professionals play important roles in
    administering the tax code. For example, under the current system, banks
    file information returns about the amount of interest earned by deposit
    holders that assist IRS in determining tax liabilities. There is overlap
    between the simplicity and the administrability of a tax system, but
    simple tax systems are not always easier to administer.

    Comparing the Administrability of Tax Systems

    All tax systems have administrative costs. A more administrable tax system
    collects more of the statutorily required tax at a lower cost per dollar
    collected. However, there are trade-offs between the level of compliance
    and administrative costs to IRS. The costs of enforcing the tax code
    sufficiently to achieve complete compliance from all taxpayers are likely
    to be prohibitive. In addition, the costs of administrating the tax code
    are not limited to the budgetary costs of IRS. As noted above, some of
    these costs are shared by other parties in the form of increased
    compliance burden. Finally, the costs can be affected by the use of
    different enforcement policies.

    The following summarizes the key tasks required for administering tax
    systems:

    o 	Processing tax returns and payments: Currently, IRS processes over 130
    million individual income tax returns each year, which taxpayers file
    electronically or through the mail. Under today's technology and any
    proposed alternatives to the current system, a return-free tax system may
    be difficult to implement.

    o 	Enforcing the tax code: Perhaps the government's most challenging role
    in administering the tax system is detecting and penalizing taxpayer
    noncompliance. Under the current system, withholding and information
    reporting are important enforcement tools that generally increase
    compliance rates. However, they are not sufficient by themselves, and IRS
    devotes considerable resources to collecting taxes owed but not remitted.

    o 	Providing taxpayer assistance: In order to reduce compliance burden and
    increase compliance rates, tax administrators generally provide assistance
    to taxpayers by such means as publishing forms and answering questions.

    A tax change proposal may reduce the cost of some administrative tasks but
    raise others. Compared to the current personal income tax, consumption
    taxes like an NRST or a VAT reduce the number of filers because only
    businesses file. As a result, they reduce processing costs and eliminate
    the compliance burden on individual taxpayers. However, other aspects of
    enforcement costs may increase because administrators would no longer be
    able to rely on withholding and information returns as enforcement tools.

    The way the tax system is structured by Congress can affect how it is
    administered, and this can affect compliance. For example, taxes withheld
    from employees and taxes that have information reporting requirements have
    lower income misreporting rates than other taxes. As figure 15 shows,
    taxes on wage and salary income, which is subject to both withholding and
    information reporting, have the lowest rate of misreported income; whereas
    taxes on income from such sources as self-employment (nonfarm proprietor
    income) have the highest rate of misreported income.

    35 Percentage of misreported income

    31.8

    30

    25

    20

    15

    10

    5

    0 Substantial
    information reporting Substantial Some information Little or no
    and withholding information reporting reporting reporting

    o  Wages and salaries  o  Pensions and annuities  o  Credits  o  Nonfarm
    proprietor

    o  Dividend income  o  Deductions income

    o  Interest income  o  Partnership/S-Corp  o  Informal supplier

    o  Unemployment income income compensation  o  Exemptions  o  Other income

    o  Social Security benefits  o  Capital gains  o  Rents and royalties

    o  Alimony income  o  Farm income

    o  Form 4947 income adjustments

    Source: IRS.

    Regardless of the amount of withholding and third-party information
    reporting required, other government enforcement activities are likely to
    be needed under any proposed tax system in order to ensure that taxpayers
    comply with the tax code. Proposals that simplify the tax code and
    administrative efforts to aid honest taxpayers in complying with the tax
    laws could increase compliance; however, under any system, costly
    enforcement efforts, perhaps including face-to-face audits of taxpayers,
    will likely always be needed to help detect and penalize dishonest
    taxpayers.

    Measuring administrative costs is difficult. Budgetary costs are easily
    measured: IRS's budget in fiscal year 2004 was $10.2 billion. However, as
    discussed earlier, the costs of other parties in tax administration are
    harder to determine. Compliance burden estimates range from $100 billion
    to $200 billion. Despite the uncertainty, the range of estimates indicates
    that compliance burden is likely to considerably outweigh IRS's budgetary
    costs.

    Changes in the technology of tax administration and in the tax code may
    have had offsetting and, as yet, unmeasured effects on the costs of tax
    administration. On the one hand, recent innovations in computer software
    and electronic financial transactions have made it easier to administer
    the tax code. On the other hand, since the last major tax reform
    initiative in 1986, the number of special rates, credits, deductions, and
    other provisions in the tax code have increased. This added complexity has
    made the tax code more difficult to administer.

    Trade-offs between Equity, Economic Efficiency, and Simplicity,
    Transparency, and Administrability

    While the concept of administrability is closely linked to the concepts of
    simplicity and transparency, they are not always the same. For example, a
    national retail sales tax would be a relatively simple form of taxation
    for taxpayers to understand. At the same time, a national retail sales tax
    could present administrative difficulties because it would be difficult to
    distinguish between similar commodities that are tax exempt and those that
    are not, and to distinguish retail sales, which are taxed, from sales to
    other companies, which are not taxed.

    Similarly, just because a tax is administrable does not necessarily mean
    it would be transparent. For example, although payroll taxes are fairly
    easy to administer, who pays them in an economic sense is not necessarily
    transparent. As we discussed earlier, many economists agree that employees
    bear the entire burden (both the employer and employee share) of payroll
    taxes, making the incidence of payroll taxes nontransparent.

    Improving the simplicity, transparency, and administrability of the tax
    system may affect the equity and efficiency of the tax system. Simplified,
    transparent, and administrable tax codes are generally thought to enhance
    efficiency because (1) taxpayers can redirect resources that would have
    been used to comply with the tax code to other, more productive purposes
    and (2) these tax systems have fewer incentives that distort decision
    making about work, savings, and investment. However, proposals to simplify
    the tax system may reduce equity because many tax provisions that are
    complex and difficult to comply with are also designed to promote
    fairness.

    Key Questions

    1.	What impact is the tax proposal likely to have on the compliance burden
    that taxpayers face?

    o 	Will more or fewer taxpayers be required to fill out tax forms and file
    them with IRS?

    o  What information will taxpayers be required to provide on the tax
    forms?

    o  Does the proposal contain any estimates of its effect on compliance
    burden?

    2.	Will taxpayers' planning responsibilities (record keeping, research,
    etc.) likely increase or decrease in comparison to those under the current
    tax system?

    3. Is the proposed tax system transparent?

    o  Can taxpayers identify their tax liability easily?

    o  Can taxpayers understand the logic behind the tax that they are paying?

    o 	Do taxpayers know what their true tax burden is (i.e., do they
    understand the incidence of the tax system)?

    o 	Do taxpayers understand the incidence of the tax system in terms of the
    tax burdens of other taxpayers?

    o  Are taxpayers aware of the extent of compliance by others?

    4. How would the tax system be administered?

    o 	What would be the role of taxpayers, employers, information return
    providers, and the IRS under the proposal?

    o  Does the proposal contain estimates of its effect on budgetary costs?

    o 	Does the proposal contain any information about how administrative
    costs would be shared?

    5. What would be the proposal's impact on IRS?

    o 	How would IRS functions of processing, compliance, collections, and
    taxpayer assistance be affected?

    o 	What enforcement tools (e.g., withholding and information reporting)
    would be added or taken away from tax administrators?

    o  Does the proposal contain information about its likely effect on
    compliance?

    6.	Are there trade-offs between the simplicity, transparency, and
    administrability of the proposed tax system?

    7.	Under the tax proposal, have efforts to enhance the simplicity,
    transparency, and administrability of the tax system resulted in
    trade-offs with respect to the equity and efficiency of the proposal?

    Transitioning to a Different Tax System

    Transition rules are sometimes proposed when switching to an alternative
    tax system. The rules are often intended to compensate certain people or
    entities whose losses are determined to be inequitable. However, not all
    tax experts agree that transition rules are appropriate when implementing
    changes to the tax code. Since transition rules are short-term tax
    policies, they should be judged by the same criteria for a good tax system
    that we discussed earlier. Many of the same trade-offs between the
    criteria that exist when considering tax reform proposals are also
    relevant when considering how to move from the current tax system to an
    alternative tax system. (See fig. 16.)

                         Figure 16: Transition Issues Overview

    Issues to consider when thinking about tax system changes: likely to
    create winners and losers, and the government may attempt to mitigate
    large gains and losses by implementing transition Revenue rules. The
    following are issues to consider when thinking about transitioning to an
    alternate tax system: Criteria for a good tax system: Determining if
    transition

    o  Equity relief is necessary  o  Economic efficiency Identifying affected
    parties  o  Simplicity, transparency,

    and administrability Revenue effects of transition rules

    Policy tools for transition period

    Sources: GAO (text); Dynamic Graphics (images).

    Deciding if Transition Relief Is Necessary

    Changes to the tax code can create winners and losers. Taxpayers' losses,
    which are more often discussed in debates than gains resulting from tax
    policy changes, may be more obvious when tax changes increase government
    revenues or if the changes are

    designed to be revenue neutral. However, even tax decreases can create
    losers depending on whether the tax burden is redistributed, spending cuts
    are made, or the tax burden on future generations is increased. Deciding
    if transition relief is necessary involves how to trade off between
    equity, efficiency, simplicity, transparency, and administrability.

    Decisions about whether to tax previously accumulated savings when
    switching to a consumption tax provide an example of the trade-offs that
    need to be considered when determining if transition relief is merited.
    Some argue that switching from the current tax system to a consumption tax
    would merit some transition relief for equity reasons because accumulated
    savings, which may have already been taxed once under the income tax
    system, would be subject to a second tax when used for consumption
    purposes. In other words, those who had saved previously would be taxed
    higher than those just beginning to save. Proponents for transition relief
    argue that taxpayers who accumulated savings have an implicit contract
    with the government that savings would not be taxed when withdrawn. The
    notion that taxpayers rely on the continued existence of government policy
    when they make economic decisions is one of the key equity justifications
    for offering transition relief.

    However, not everyone agrees that transition relief is justifiable based
    on equity grounds. Opponents of transition relief argue that taxpayers
    knowingly accept the risk that government policy may change when they make
    decisions, such as how much to save, and therefore do not need to be
    compensated for any losses that result from switching to an alternative
    tax system.

    There are also trade-offs between equity and efficiency that should be
    considered when thinking about transition relief. The efficiency gains
    that could be realized by switching to a consumption tax could be negated
    if the government offered transition relief to taxpayers. Taxing
    accumulated savings is economically efficient because doing so does not
    distort work or savings behavior-taxpayers cannot avoid paying the tax by
    changing their behavior to work or save less. Offering transition relief
    would reduce the revenue gain from taxing accumulated savings, thereby
    requiring higher consumption tax rates.

    Finally, developing and implementing transition rules could add a
    significant amount of complexity to the tax system-a characteristic of the
    tax system that the switch to an alternative tax system was likely
    intended to reduce. The new complexity would be temporary, phasing out
    with the transition rules.

    Identifying Affected Parties

    Identifying winners and losers, the amount of gains and losses, and
    effective mitigation policies is complicated by the different ways tax
    changes can affect taxpayers. Tax law changes, by definition, affect
    taxpayers' future liabilities. In some cases, those future tax changes are
    capitalized into the prices of marketable assets.

    For example, changes in the tax treatment of owner-occupied housing have
    the potential to affect current housing prices. In other cases, such as
    wealth accumulated in a savings account, tax law changes might affect the
    value of the wealth but do not change the price of a marketable asset. In
    still other cases, the after-tax return to future behavior, such as hours
    worked, is altered. Regardless of how taxpayers feel the impact of a tax
    change, the impact on their ability to consume over time is the same
    (assuming everything else is constant).

    Revenue Effects of Transition Relief

    If transition relief is provided to compensate taxpayers for financial
    losses due to changes in the tax code, then revenues equivalent to these
    losses will need to be found from other sources, assuming the proposal is
    revenue neutral. One alternative source of revenue would be to tax those
    who have received windfall gains from the policy changes. However, debates
    about transition relief typically center around how to handle taxpayers
    who are likely to suffer windfall losses and not on how to impose special
    taxes on those who experience windfall gains.

    Policy Tools for Implementing Transition Rules

    The two most commonly discussed policy tools for transitioning to an
    alternative tax system are grandfather clauses and phase-in rules.

    o 	Grandfather clauses: Grandfather clauses are typically used to exempt
    people who would be subject to a new rule from the provisions of that
    rule. Grandfather clauses are generally used to exempt current assets or
    investments from new tax rules in order to protect taxpayers who purchased
    those assets from being penalized by unexpected changes to the tax system.
    One problem with grandfather clauses is that over time they can lead to
    unequal tax treatment of similar assets.

    o 	Phase-in periods for new laws: Another form of transition relief would
    be to phase in new legislation over a period of time in order to reduce
    the effects that new tax laws would have on taxpayers.

    o 	Combination of grandfather clauses and phase-in periods: It would also
    be possible to develop transition rules that allow for certain
    assets/investments to be grandfathered and others subject to phased-in tax
    laws. One possible variant previously outlined by the Treasury Department
    would be to apply new tax laws immediately to all new assets but phase in
    the tax laws on existing assets.

    Key Questions

    1. Does the proposal include transition rules?

    o  If so, what are they?

    o  What gains and losses are the rules intended to mitigate?

    o  Who bears these gains or losses?

    2. What are the expected revenue effects of the transition rules?

    o 	If the proposal is intended to be revenue neutral, what additional
    revenue sources will be used during the transition period?

    3. How will the transition rules affect the equity of the tax system as a
    whole?

    o  Why were some taxpayers selected for transition relief but not others?

    o  Who will pay for the transition relief?

    4. How will the transition rules affect the overall efficiency of the tax
    system?

    o 	Do the transition rules have efficiency costs that offset some of the
    gains from changing the tax system?

    o  Do estimates of these efficiency costs exist?

    5.	How will the transition rules affect the overall simplicity,
    transparency, and administrability of the tax system?

                               Appendix I: Key Questions

    Section I: Revenue Needs-Taxes Exist to Fund Government

    1. What current taxes would the proposal change?

    o 	Does the proposal change personal income taxes, social insurance taxes,
    corporate income taxes, and/or estate and gift taxes?

    2. What is the nature of the proposed change to the tax system?

    o  Does the proposal change the tax base from income to consumption?

    o  Does the proposal include tax expenditures?

    o  Does the proposal change the tax rates?

    o  Does the proposal change the collection points for the tax?

    3. How will the proposed change affect total revenues?

    o  Are proposed changes to the tax code likely to be revenue neutral?

    o  If not, will they generate more or less revenue than the current tax
    laws?

    4.	What effect would the proposal have on the nation's projected budgets
    and longterm fiscal outlook?

    o 	Does the proposal take into consideration the sizable long-term fiscal
    gap that the country faces?

    5.	What tax expenditures are included in the proposal, and what tax
    expenditures, if any, have been removed from the current tax system?

    o 	Are the social and economic goals of the tax expenditures likely to be
    achieved and worth the cost in lost revenue?

    o 	When the total costs of a program are considered, would it be less
    costly to implement the program as a tax expenditure or as a spending
    program?

    6.	If the proposal changes the tax base, the tax rates, or the collection
    points, how would these changes alter the amount of revenue that the
    government is able to collect?

    7. What implications, if any, would the proposal have on the ability of
    state and local governments to collect tax revenues?

    o  Would the proposal tax the same base that many states rely on?

    o 	Would the proposal allow many states to continue to rely on the federal
    tax base as a starting point for determining state taxes?

    Section II: Criteria for a Good Tax System

    Equity

    1. How is a taxpayer's ability to pay broadly defined:

    o  Income?

    o  Consumption?

    o  A broader definition of overall wealth?

    2.	What factors other than income, such as medical expenses, number of
    dependents, and so forth, does the proposal account for when considering a
    taxpayer's ability to pay taxes?

    3. Will taxpayers with equal ability to pay taxes pay the same amount?

    o 	If not, what provisions of the proposal do not adhere to the principle
    of horizontal equity?

    4. How will the tax system tax people with differing ability to pay?

    o  Are the statutory tax rates progressive, proportional, or regressive?

    o 	Are the average effective tax rates progressive, proportional, or
    regressive (accounting for credits, deductions, and other tax
    expenditures)?

    5.	Are there any components of the tax proposal that are justified on the
    benefits received principle?

    o 	If so, what mechanisms are in place to determine that taxpayers who pay
    taxes for a particular government program are the same taxpayers who
    benefit from the provisions of that program?

    6.	Does the proposal change the distribution of taxes (i.e., is the
    proposal distributionally neutral)?

    o  If not, who will be paying more in taxes and who will be paying less?

    o 	If so, what features of the proposal are in place to ensure that it
    will remain distributionally neutral?

    7. What type of distributional analysis was done?

    o 	What time period is covered? For example does the distributional
    analysis measure the lifetime or annual effects of the tax system?

    o  How is ability to pay (income, consumption, or wealth) measured?

    o  What is the unit of analysis (individuals, households, or taxpaying
    units, etc.)?

    o 	What assumptions are made about tax incidence (e.g., who is assumed to
    pay the corporate income tax)?

    o  What taxes are covered in the distributional analyses?

    o 	What measures (e.g., tax rates, share of tax liability) are being used
    to calculate the distribution of tax burden?

    Efficiency

    1. Does the proposal tax income, spending, assets, and investments
    differentially?

    o  Which types of income, spending, assets, and investments are tax
    preferred?

    o  Which decisions are likely to be distorted?

    2. What social goals, if any, is the tax proposal trying to promote?

    o 	Is there an efficiency justification for the goal, or is the goal
    justified on other grounds, such as equity?

    3. Do estimates of the cost of achieving the goal include efficiency
    costs?

    4. What are the trade-offs between equity, efficiency, and the other
    criteria?

    5.	Is the tax proposal accompanied by estimates of the efficiency gains or
    losses to be realized by the new tax system?

    o 	Is the tax proposal accompanied by estimates of economic activity
    (e.g., change in labor supply or change in gross domestic product (GDP))
    that will be encouraged or discouraged by the new tax system?

    o 	Is the proposal accompanied by estimates of the efficiency loss or gain
    associated with these changes in economic activity?

    6. How does the tax change affect leisure versus work decisions?

    7. How does the tax change affect savings versus consumption decisions?

    8.	How does the tax system affect decisions about foreign versus domestic
    investment?

    9.	How does the tax change affect choices between different types of
    investments and different types of consumption?

    10. Is the tax proposal likely to increase economic growth?

    o  Is the growth achieved through a onetime rearranging of resources?

    o  Is the growth achieved through a permanent increase in the rate of
    growth?

    o 	Does the tax proposal contain estimates of its effect on growth (often
    measured by changes in GDP) and estimates of the costs of achieving the
    growth (such as reduced leisure time)?

    11.	In addition to efficiency effects, will the proposal have other
    economic effects by increasing or reducing the deficit?

    Simplicity, Transparency, and Administrability

    1.	What impact is the tax proposal likely to have on the compliance burden
    that taxpayers face?

    o 	Will more or fewer taxpayers be required to fill out tax forms and file
    them with the Internal Revenue Service (IRS)?

    o  What information will taxpayers be required to provide on the tax
    forms?

    o  Does the proposal contain any estimates of its effect on compliance
    burden?

    2.	Will taxpayers' planning responsibilities (record keeping, research,
    etc.) likely increase or decrease in comparison to those under the current
    tax system?

    3. Is the proposed tax system transparent?

    o  Can taxpayers identify their tax liability easily?

    o  Can taxpayers understand the logic behind the tax that they are paying?

    o 	Do taxpayers know what their true tax burden is (i.e., do they
    understand the incidence of the tax system)?

    o 	Do taxpayers understand the incidence of the tax system in terms of the
    tax burdens of other taxpayers?

    o  Are taxpayers aware of the extent of compliance by others?

    4. How would the tax system be administered?

    o 	What would be the role of taxpayers, employers, information return
    providers, and the IRS under the proposal?

    o  Does the proposal contain estimates of its effect on budgetary costs?

    o 	Does the proposal contain any information about how administrative
    costs would be shared?

    5. What would be the proposal's impact on IRS?

    o 	How would IRS functions of processing, compliance, collections, and
    taxpayer assistance be affected?

    o 	What enforcement tools (e.g., withholding and information reporting)
    would be added or taken away from tax administrators?

    o  Does the proposal contain information about its likely effect on
    compliance?

    6.	Are there trade-offs between the simplicity, transparency, and
    administrability of the proposed tax system?

    7.	Under the tax proposal, have efforts to enhance the simplicity,
    transparency, and administrability of the tax system resulted in
    trade-offs with respect to the equity and efficiency of the proposal?

    Section III: Transitioning to a Different Tax System

    1. Does the proposal include transition rules?

    o  If so, what are they?

    o  What gains and losses are the rules intended to mitigate?

    o  Who bears these gains or losses?

    2. What are the expected revenue effects of the transition rules?

    o 	If the proposal is intended to be revenue neutral, what additional
    revenue sources will be used during the transition period?

    3. How will the transition rules affect the equity of the tax system as a
    whole?

    o  Why were some taxpayers selected for transition relief but not others?

    o  Who will pay for the transition relief?

    4. How will the transition rules affect the overall efficiency of the tax
    system?

    o 	Do the transition rules have efficiency costs that offset some of the
    gains from changing the tax system?

    o  Do estimates of these efficiency costs exist?

    5.	How will the transition rules affect the overall simplicity,
    transparency, and administrability of the tax system?

    Appendix II: Selected Bibliography and Related Reports

    Government Accountability Office

    Government Performance and Accountability: Tax Expenditures Represent a
    Substantial Federal Commitment and Need to Be Reexamined. GAO-05-690
    (Forthcoming).

    Tax Policy: Summary of Estimates of the Costs of the Federal Tax System.
    GAO-05878 (Forthcoming).

    Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal
    Sustainability but Will Require a Variety of Strategies. GAO-05-527T.
    Washington, D.C.: April 14, 2005.

    21st Century Challenges: Reexamining the Base of the Federal Government.
    GAO05-325SP. Washington, D.C.: February 1, 2005.

    Federal Debt: Answers to Frequently Asked Questions-An Update.
    GAO-04-485SP. Washington, D.C.: August 12, 2004.

    The Honorable David M. Walker, Comptroller General of the United States.
    Truth and Transparency: The Federal Government's Financial Condition and
    Fiscal Outlook. Address to the National Press Club. September 17, 2003.

    Alternative Minimum Tax: An Overview of Its Rationale and Impact on
    Individual Taxpayers. GAO/GGD-00-180. Washington, D.C.: August 15, 2000.

    Tax Administration: Potential Impact of Alternative Taxes on Taxpayers and
    Administrators. GAO/GGD-98-37. Washington, D.C.: January 14, 1998.

    Congressional Budget Office

    Statement of Douglas Holtz-Eakin, Director. The Economic Costs of
    Long-Term Federal Obligations. Washington, D.C.: February 16, 2005.

    Effective Tax Rates: Comparing Annual and Multiyear Measures. Washington,
    D.C.: January 2005.

    Effective Federal Tax Rates Under Current Law, 2001 to 2014. Washington,
    D.C.: August 2004.

    Revenue and Tax Policy Brief: The Alternative Minimum Tax, No. 4.
    Washington, D.C.: April 15, 2004.

    Effective Federal Tax Rates, 1997 to 2000. Washington, D.C.: August 2003.

    Options to Cut Taxes. Washington, D.C.: June 2000.

    The Incidence of the Corporate Income Tax. Washington, D.C.: March 1996.

    Library of Congress, Congressional Research Service

    Esenwein, Gregg A. and Jane G. Gravelle. The Flat Tax, Value-Added Tax,
    and National Retail Sales Tax: Overview of the Issues. CRS Report RL32603.
    Washington, D.C.: December 14, 2004.

    Esenwein, Gregg A. The Alternative Minimum Tax for Individuals. CRS Report
    RL30149. Washington, D.C.: November 15, 2004.

    Labonte, Marc. The Size and Role of Government: Economic Issues. CRS
    Report RL32162. Washington, D.C.: March 22, 2005.

    Luckey, John R. Federal Estate, Gift, and Generation-Skipping Taxes: A
    Description of Current Law. CRS Report 95-416. Washington, D.C.: January
    5, 2005.

    Other Selected Sources

    Aaron, Henry J. and William G. Gale. Economic Effects of Fundamental Tax
    Reform. Washington, D.C.: Brookings Institution Press, 1996.

    Cai, Jinyong and Jagadeesh Gokhale. "The Welfare Loss From a Capital
    Income Tax." Federal Reserve Bank of Cleveland Economic Review, vol. 33,
    no. 1 (1997).

    Cronin, Julie-Anne. U.S. Treasury Distributional Analysis Methodology,
    Office of Tax Analysis Paper 85. Washington, D.C.: U.S. Department of the
    Treasury, September 1999.

    Feldstein, Martin, "Tax Avoidance and the Deadweight Loss of the Income
    Tax." The Review of Economics and Statistics, vol. 81, no. 4 (1999):
    674-680.

    Gravelle, Jane G., "The Corporate Tax: Where Has It Been and Where Is It
    Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23.

    Joint Committee on Taxation, Methodology and Issues in Measuring Changes
    in the Distribution of Tax Burdens. JCT Report JCS-7-93. Washington, D.C.:
    June 1993.

    Mikesell, John L. Fiscal Administration: Analysis and Application for the
    Public Sector, 5th Edition. Fort Worth, Tex.: Harcourt Brace Publishers,
    1999.

                                 Appendix III: Glossary

    Ability to Pay Principle	A concept of tax fairness that states that people
    with different amounts of wealth, income, or other levels of well-being
    should pay tax at different rates. Wealth includes assets such as houses,
    cars, stocks, bonds, and savings accounts. Income includes wages,
    interest, dividends, and other payments.

    Adjusted Gross Income (AGI)	All income subject to taxation under the
    individual income tax after subtracting certain deductions, such as
    certain contributions for individual retirement accounts, and alimony
    payments. Personal exemptions and the standard or itemized deductions are
    also subtracted from AGI to determine taxable income.

    Alternative Minimum Tax (AMT)	A separate tax system that applies to both
    individual and corporate taxpayers. It parallels the income tax system but
    with different rules for determining taxable income, different tax rates
    for computing tax liability, and different rules for allowing the use of
    tax credits.

    Average Tax Rates	The total amount of tax a taxpayer pays divided by some
    measure of his or her income. In the current tax system, average tax rates
    are sometimes presented as the amount of tax a taxpayer pays divided by
    his or her taxable income. Average effective tax rates differ in that they
    are developed using a broader measure of total income than taxable income.

    Benefits Received Principle	A concept of tax fairness that states that
    people should pay taxes in proportion to the benefits they receive from
    government goods and services.

    Capital Gains	A capital asset's selling price less its initial purchase
    price. Investments that have been sold at a profit are called realized
    capital gains. Investments that have not yet been sold, but would yield a
    profit if they were sold have unrealized capital gains.

    Collection Point	The individual or business that actually remits payment
    of taxes to the government.

    Compliance Burden	The time and resources, including out-of-pocket costs,
    that taxpayers spend each year in order to comply with the tax laws.
    Compliance burden is often cited as a measure of the overall simplicity of
    the tax code.

    Consumption Tax Base	A tax base where people pay taxes on goods and
    services that they purchase, or consume, effectively excluding savings and
    investment from the tax base. Capital assets are usually fully expensed
    when purchased under a consumption tax rather than depreciated over time,
    as is the case under an income tax.

    Corporate Income Taxes	Taxes paid by corporations on net income, or the
    difference between corporate revenues and corporate business expenses.

    Credit	An amount that offsets or reduces tax liability. When the allowable
    credit amount exceeds the tax liability, and the difference is paid to the
    taxpayer, the credit is considered refundable.

    Deduction	An amount that is subtracted from the tax base before tax
    liability is calculated. Deductions claimed before and after the adjusted
    gross income line on the Form 1040 are sometimes called "above the line"
    and "below the line" deductions, respectively.

    Deficit	The amount by which the government's spending exceeds its revenues
    for a given period, usually a fiscal year.

    Defined Contribution Pension Plans

    A type of retirement plan that establishes individual accounts for
    employees to which the employer, participants, or both make periodic
    contributions. Employees bear the investment risk and often control, at
    least in part, how their individual account assets are invested.

    Discretionary Spending	Outlays controlled by appropriation acts, other
    than those that fund mandatory programs.

    Distortion	Changes in behavior, such as how much to work, what to consume,
    and where to invest, due to taxes, government benefits, or monopolies.

    Distributional Analysis	An analytical tool used by government agencies and
    other analysts to identify how different tax proposals or tax systems
    would affect different groups of taxpayers with differing ability to pay
    taxes, usually measured by income.

    Dividend Income	A taxable payment made by a company to its shareholders,
    often quarterly, out of the company's retained earnings. Dividends are
    usually given out in the form of cash, but can also be given out as stock
    or other property.

    Economic Incidence	The person or group of people that actually bear the
    burden of a tax regardless of who remits payment to the government. For
    example, even though businesses remit tax sales tax payments to the
    government, individuals who purchase items may bear the actual burden of
    the tax.

    Effective Tax Rates	The amount of tax that a taxpayer pays to the
    government expressed as a percentage of some overall measure of total
    income.

    Efficiency Costs	A reduction in economic well-being caused by distortions,
    or changes in behavior due to taxes, government benefits, monopolies, and
    other forces that interfere in the market. Efficiency costs can take the
    form of lost output or consumption opportunities.

    Employer-Provided Health Care	Insurance plans offered by employers to
    employees where the employer pays all or a portion of an employee's health
    insurance costs. Employer-provided health care payments are not counted as
    nonwage income, and therefore these payments are not subject to taxation.

    Entitlement 	Programs that require the payment of benefits to persons,
    state or local governments, or other entities if specific criteria
    established in the authorizing law are met.

    Estate and Gift Taxes	Assets an individual owns at the time of his or her
    death or gifts made during the course of his or her life may be subject to
    transfer taxes, sometimes referred to as estate and gift taxes. Estate and
    gift taxes are more likely to affect wealthier individuals, and most
    citizens are unaffected by estate and gift taxes.

    Excise Taxes A tax on the sale or use of specific products or
    transactions.

    Exemption	A part of a person's income on which no tax is imposed. It is
    the amount that taxpayers can claim for themselves, their spouses, and
    eligible dependents. There are two types of exemptions-personal and
    dependency. Each exemption reduces the income subject to tax. The
    exemption amount is a set amount that changes from year to year.

    Externality	A benefit or cost that is not captured or paid by the
    individuals or firms creating them.

    Flat Tax	A type of tax reform proposal that, in most cases would change
    the tax base to a consumption tax base and impose a single, or flat, tax
    rate on individuals and businesses. Most flat tax proposals would not
    really be "flat" because they grant exemptions for at least some earnings.

    Grandfather Clause	Provisions that are typically used to exempt people who
    would be subject to a new rule from the provisions of that rule. Thus, in
    the case of tax law changes, only people who engage in certain activities
    after a tax law change will be affected by changes to the tax treatment of
    that activity.

    Gross Domestic Product (GDP)	The value of all final goods and services
    produced within the borders of a country such as the United States during
    a given period. The components of GDP are consumption expenditures (both
    personal and government), gross investment (both private and government)
    and net exports.

    Horizontal Equity	The concept that people with the same ability to pay
    should be taxed at the same rate.

    Income Tax Base	A tax base where individuals are taxed on the basis of
    income, or both the goods and services they consume as well as their
    savings and investments. Under an income tax, capital assets are usually
    depreciated over time rather than being fully expensed at the time they
    are purchased, as would be the case under a consumption tax.

    Individual Retirement Accounts	Investment accounts that allow people to
    save a certain amount of income each year and, in most cases, deduct the
    savings from taxable income, with the savings and interest tax deferred
    until the person retires.

    Mandatory Spending	Also known as "direct spending." Mandatory spending
    includes outlays for entitlements (for example, food stamps, Medicare, and
    veterans' pension programs), interest payments on the public debt and
    nonentitlements such as payments to the states from Forest Service
    receipts. By defining eligibility and setting the benefit or payment
    rules, the Congress controls spending for these programs indirectly rather
    than through appropriations acts.

    Marginal Tax Rates	Tax rate that taxpayers pay on the next dollar of
    income that is earned. Marginal tax rates can be presented as both
    marginal statutory rates and marginal effective rates.

    Medicaid	A federal program that states administer to help pay medical
    costs for low income citizens. Each state in which applicants for the
    program reside establishes criteria for financial need. Medicaid
    supplements Medicare to pay for some of the costs that Medicare does not
    cover.

    Medicare	A federal entitlement program that delivers medical care to
    eligible workers, spouses of workers, and retired workers when they reach
    age 65.

    Net Tax Gap	The difference between taxes legally owed to the government
    and taxes actually paid to the government, less collected enforcement
    revenue.

    Payroll Taxes	Often synonymous with social insurance taxes. However, in
    some cases the term "payroll taxes" may be used more generally to include
    all tax withholding. For the purposes of this report, payroll taxes are
    synonymous with social insurance taxes.

    Personal Income Taxes	Taxes on income earned by individuals, including
    income from wages, interest, and nonwage income.

    Phase-in Rule A rule that allows for a new tax provision to be implemented
    gradually rather than immediately upon enactment of a new tax law.
    Phase-in rules help mitigate windfall losses during the transition to a
    new set of tax laws.

    Progressive Tax Rates	A tax rate structure where tax liability as a
    percentage of income increases as income increases.

    Proportional Tax Rates	A tax rate structure where taxpayers pay the same
    percentage of income, regardless of their income.

    Regressive Tax Rates	A tax rate structure where tax liability is a smaller
    percentage of a taxpayer's income as income increases.

    Retail Sales Tax	A tax levied on the sale price of a good and collected by
    the seller of the good.

    Revenue Neutral	A term applied to tax bills or proposals are designed to
    raise the same amount of revenue as the system that is being replaced.

    Social Insurance Taxes	Tax payments to the federal government for Social
    Security, Medicare, and unemployment compensation. While employees and
    employers pay equal amounts in social insurance taxes, economists
    generally agree that employees bear the entire burden of social insurance
    taxes in the form of reduced wages.

                              Spillovers See externality.

    Standard Deduction	A deduction that reduces income subject to tax and
    varies depending on filing status, age, blindness, and dependency. The
    standard deduction is taken instead of itemizing deductions.

    Statutory Incidence	The party, usually an individual or a business, that
    is legally required to pay a tax to the government.

    Statutory Tax Rate Tax rates as written into law.

    Tax Burden See economic incidence.

    Tax-Exempt Bonds	Bonds issued by state and local governments for public
    projects on which interest that is earned is exempt from federal income
    tax.

    Tax Expenditures	A revenue loss attributable to a provision of the federal
    tax laws that grants special tax relief that encourages certain kinds of
    behavior by taxpayers or to aid taxpayers in special circumstances. The
    Congressional Budget and Impoundment Act of 1974 lists six types of tax
    expenditures: exclusions, exemptions, deductions, credits, preferential
    tax rates, and deferrals.

                         Tax Incidence See economic incidence.

    Tax Liability	The amount of tax that a taxpayer is legally required to pay
    to the government at a given time.

                         Tax Preferences See tax expenditures.

    Taxable Income	Income subject to tax that is used to determine tax
    liability. In the case of the federal income tax, taxable income is equal
    to a taxpayer's adjusted gross income less personal deductions and
    exemptions.

    Third-Party Information Information reported to IRS by third parties, such
    as banks or

    Reporting	employers, that allows IRS to verify that information reported
    by taxpayers on their tax returns is accurate.

    Value-Added Tax	A tax levied at each stage of production or distribution
    on the value added to the product during that stage of production.
    Value-added taxes are now commonly used in many Western European countries
    as a source of revenue.

    Vertical Equity The concept that people with differing ability to pay
    taxes should pay different rates of taxes or different percentages of
    their incomes in taxes.

    Voluntary Compliance	A system of compliance that relies on individual
    citizens to report their income freely and voluntarily, calculate their
    tax liability correctly, and file a tax return on time.

    Windfall Gain	A sudden and usually unexpected gain for a taxpayer or group
    of taxpayers owing to changes to the tax system.

    Windfall Loss	A sudden and usually unexpected loss for a taxpayer or group
    of taxpayers owing to a change in the tax system. Transition rules are
    often proposed to mitigate the effects of windfall losses.

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