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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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
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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 [email protected]. 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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