Business Tax Reform: Simplification and Increased Uniformity of  
Taxation Would Yield Benefits (20-SEP-06, GAO-06-1113T).	 
                                                                 
Business income taxes, both corporate and noncorporate, are a	 
significant portion of federal tax revenue. Businesses also play 
a crucial role in collecting taxes from individuals, through	 
withholding and information reporting. However, the design of the
current system of business taxation is widely seen as flawed. It 
distorts investment decisions, hurting the performance of the	 
economy. Its complexity imposes planning and record keeping	 
costs, facilitates tax shelters, and provides potential cover for
those who want to cheat. Not surprisingly, business tax reform is
part of the debate about overall tax reform. The debate is	 
occurring at a time when long-range projections show that,	 
without a policy change, the gap between spending and revenues	 
will widen. This testimony reviews the nation's long term fiscal 
imbalance and what is wrong with the current system of business  
taxation and provides some principles that ought to guide the	 
debate about business tax reform. This statement is based on	 
previously published GAO work and reviews of relevant literature.
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-1113T					        
    ACCNO:   A61184						        
  TITLE:     Business Tax Reform: Simplification and Increased	      
Uniformity of Taxation Would Yield Benefits			 
     DATE:   09/20/2006 
  SUBJECT:   Cost analysis					 
	     Federal taxes					 
	     Financial analysis 				 
	     Flat tax						 
	     Income taxes					 
	     National sales tax 				 
	     Tax administration 				 
	     Tax administration systems 			 
	     Tax evasion					 
	     Tax law						 
	     Tax shelters					 
	     Taxpayers						 
	     Tax gap						 

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GAO-06-1113T

     

     * Background
          * Current Federal Taxation of Businesses
          * Criteria for Evaluating Business Tax Systems
     * Taxes on Business Income Are a Significant Source of Federal
     * Efficiency, Complexity, Compliance, and Equity Concerns Cont
          * Varying Effective Rates of Taxation Across Different Types o
          * Businesses Bear Significant Compliance Burdens Arising Both
          * Business Tax Complexity Also Makes IRS's Job of Enforcing Ta
     * Business Tax Reform Entails Broad Design Choices about the O
          * Income vs. Consumption as the Tax Base
          * Collecting the Tax at the Business or Individual Level
          * Territorial vs. Worldwide Taxation under an Income Tax
          * Destination-Principle vs. Origin-Principle Consumption Tax
          * The Extent of Transition Provisions
          * Criteria for a Good Tax System Provide Principles to Guide D
     * Concluding Observations
     * Contact and Acknowledgments
     * Government Accountability Office
     * Congressional Budget Office
     * Congressional Research Service
     * Joint Committee on Taxation
     * U.S. Department of the Treasury
     * President's Advisory Panel on Federal Tax Reform
     * National Retail Sales Tax
     * Consumption Value-Added Tax
     * Income Value-Added Tax
     * Flat Tax
     * Personal Consumption Tax
          * Order by Mail or Phone

Testimony

Before the Committee on Finance, U.S. Senate

United States Government Accountability Office

GAO

For Release on Delivery Expected at 10:00 a.m. EDT

Wednesday, September 20, 2006

BUSINESS TAX REFORM

Simplification and Increased Uniformity of Taxation Would Yield Benefits

Statement of David M. Walker

Comptroller General of the United States

GAO-06-1113T

Mr. Chairman and Members of the Committee:

I appreciate this opportunity to contribute to your consideration of
business tax reform.

Businesses, both corporate and noncorporate, are a crucial pillar of our
tax system. Corporate businesses paid $278 billion in federal corporate
income taxes in fiscal year 2005. In addition, between roughly 14 and 19
percent of the income of individuals who pay federal income tax comes from
business sources.1 Beyond paying income taxes, businesses are also
responsible for remitting both the employer and employee shares of social
insurance taxes, which amounted to $794 billion in fiscal year 2005.
Businesses are vital to our tax system in other ways too. They collect and
remit a large fraction of individual income taxes through withholding.
They report information about individuals' income and deductible expenses
to the Internal Revenue Service (IRS). Such withholding and third-party
information reporting greatly increases individual taxpayers' compliance
while reducing the size and intrusiveness of IRS.

Taxes are necessary because they fund a broad array of essential services
provided by the government. However, business taxes are part of our
overall fiscal system that, as the committee is aware, is currently
running large deficits and, as GAO's long-term budget simulations
illustrate, is projected to run ever larger deficits in the future.

Beyond raising revenue, taxes affect business decision making, thereby
affecting the performance of the economy. Taxes are only one factor
affecting business decisions-others include input costs and market
conditions-but they are a key factor controlled by policymakers. Making
business decisions based on tax considerations, rather than on the
underlying economic benefits results in the channeling of some investments
into less productive activities. This, in turn, reduces the standard of
living of all Americans.

Complexity in business tax laws imposes costs of its own, facilitates tax
shelters, and provides cover for those who want to cheat. Although the
precise amount of business tax avoidance is unknown, IRS's latest
estimates show a business tax gap of at least $141 billion for 2001. This
in turn undermines confidence in the fairness of our tax system-citizens'
confidence that their friends, neighbors, and business competitors are
paying their fair share of taxes.

1See the explanation below for how these percentages were estimated and
why we could not estimate them in terms of percent of taxed paid.

Not surprisingly, there is a growing debate about reforming the tax
system, including business taxes. The debate is partly about whether to
reform the current income tax so that it has a broader base and lower
rates or switch in whole or part to some form of a consumption tax. But it
is also about other fundamental design issues such as whether to maintain
different tax treatment for corporate and noncorporate business and the
extent to which business's foreign-source income should be taxed. The
President's Advisory Panel on Federal Tax Reform has taken a major step in
beginning this debate. The panel suggested two alternative proposals for
coordinated reform of the individual and corporate income taxes.

My statement reviews the nation's long-term fiscal imbalance, describes
what is wrong with our current system of business taxation, lists some of
the major strategic choices we must make about how to tax businesses in
the future, and then provides some principles that ought to guide the
debate about business tax reform. These principles are based on three
long-standing criteria typically used to evaluate tax policy-equity;
economic efficiency; and a combination of simplicity, transparency, and
administrability-which are discussed later.2 The principles include the
following:

           o  The proposed system should raise sufficient revenue over time
           to fund our current and future expected expenditures.
           o  The tax base should be as broad as possible, which generally
           helps to minimize tax rates, reduce complexity, lower compliance
           costs, lower economic efficiency costs per dollar of revenue
           raised, and which may improve equity.
           o  The proposed system should have attributes associated with high
           compliance rates-namely, taxable transactions that are transparent
           and few tax preferences or complex provisions.

           o  To the extent that other objectives, such as equity and
           simplicity, allow, the tax system should aim for increased
           economic efficiency by remaining as neutral as possible in its
           other structural features; for example, avoiding differences in
           taxation based on legal form of organization, source of financing,
           or type of asset. More neutral tax policy has the potential to
           enhance economic growth, increase productivity and improve the
           competitiveness of the U.S. economy in terms of standard of living
           o  Finally, the consideration of transition rules needs to be an
           integral part of the design of a new system.

2These criteria are also discussed at greater length in GAO, Understanding
the Tax Reform Debate: Background, Criteria, & Questions, GAO-05-1009SP
(Washington, D.C.: September 2005).

My statement today is drawn from previous GAO reports and testimonies
covering tax reform, alternative tax systems, and the costs of the current
system, which were done in accordance with generally accepted government
auditing standards, as well as reviews of relevant literature. The
discussions in this statement that are not based on our own work reflect
the consensus (and in some cases competing) views of economists as
summarized in studies by the Joint Committee on Taxation, the
Congressional Budget Office, the Congressional Research Service, the
Department of Treasury, and the President's Advisory Panel on Federal Tax
Reform. (See app. I for a list of relevant studies by GAO and these other
sources.)

                                   Background

Current Federal Taxation of Businesses

Most income derived from private sector business activity in the United
States is subject to federal corporate income tax, the individual income
tax, or both. The tax treatment that applies to a business depends on its
legal form of organization. Firms that are organized under the tax code as
"C" corporations (which include most large, publicly held corporations)
have their profits taxed once at the entity level under the corporate
income tax (on a form 1120) and then a second time under the individual
income tax when profits are transferred to individual shareholders in the
form of dividends or realized capital gains. Firms that are organized as
"pass-through" entities, such as partnerships, limited liability
companies, and "S" corporations are generally not taxed at the entity
level; however, their net incomes are passed through each year and taxed
in the hands of their partners or shareholders under the individual income
tax (as part of those taxpayers' form 1040 filing).3 Similarly, income
from businesses that are owned by single individuals enters into the
taxable incomes of those owners under the individual income tax and is not
subject to a separate entity-level tax.

The base of the federal corporate income tax includes net income from
business operations (receipts, minus the costs of purchased goods, labor,
interest, and other expenses). It also includes net income that
corporations earn in the form of interest, dividends, rent, royalties, and
realized capital gains. The statutory rate of tax on net corporate income
ranges from 15 to 35 percent, depending on the amount of income earned.4
The United States taxes the worldwide income of domestic corporations,
regardless of where the income is earned, with a foreign tax credit for
certain taxes paid to other countries. However, the timing of the tax
liability depends on several factors, including whether the income is from
a U.S. or foreign source and, if it is from a foreign source, whether it
is earned through direct operations or through a subsidiary.

The base of the individual income tax covers business-source income paid
to individuals, such as dividends, realized net capital gains on corporate
equity, and income from self-employment. The statutory rates of tax on net
taxable income range from 10 percent to 35 percent. Lower rates (generally
5 percent and 15 percent, depending on taxable income) apply to long-term
capital gains and dividend income.5 Sole proprietors also pay both the
employer and employee shares of social insurance taxes on their net
business income. Generally, a U.S. citizen or resident pays tax on his or
her worldwide income, including income derived from foreign-source
dividends and capital gains subject to a credit for foreign taxes paid on
such income.

3Limited liability companies can elect to be taxed as C corporations,
partnerships, or as "disregarded entities." Under the last option the
company's income and expenses are simply attributed to its parent
corporation.

4Also, marginal rates are higher over limited income ranges to recapture
the benefits of the rates below 35 percent. In addition, present law
imposes an alternative minimum tax (AMT) on corporations to the extent
that their minimum tax liability exceeds their regular tax liability. In
general, the AMT applies a lower tax rate to a broader tax base.
Specifically, the regular tax base is increased for AMT purposes by adding
back certain items treated as tax preferences and disallowing certain
deductions and credits.

5Individuals may also pay tax under the alternative minimum tax (AMT). The
base of this tax equals regular taxable income, plus the value of various
tax items, including personal exemptions and certain itemized deductions
that are added back into the base. This AMT income base is then reduced by
a substantial exemption and then taxed at a rate of 26 percent or 28
percent, depending on the taxpayer's income level. Taxpayers compare their
AMT tax liabilities to their regular tax liabilities and pay the greater
of the two.

Criteria for Evaluating Business Tax Systems

Three long-standing criteria-economic efficiency, equity, 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 and
people are likely to disagree about the relative importance of the
criteria.

Specific aspects of business taxes can be evaluated in terms of how they
support or detract from the efficiency, equity, simplicity, transparency,
and administrability of the overall tax system. To the extent that a tax
system is not simple and efficient, it imposes costs on taxpayers beyond
the payments they make to the U.S. Treasury. As shown in figure 1, the
total cost of any tax from a taxpayer's point of view is the sum of the
tax liability, the cost of complying with the tax system, and the economic
efficiency costs that the tax imposes. In deciding on the size of
government, we balance the total cost of taxes with the benefits provided
by government programs.

Figure 1: Components of the Total Cost of a Tax to Taxpayers

A complete evaluation of the tax treatment of businesses, which is a
critical element of our overall federal tax system, cannot be made without
considering how business taxation interacts with and complements the other
elements of the overall system, such as the tax treatment of individuals
and excise taxes on selected goods and services. This integrated approach
is also appropriate for evaluating reform alternatives, regardless of
whether those alternatives take the form of a simplified income tax
system, a consumption tax system, or some combination of the two.

Taxes on Business Income Are a Significant Source of Federal Revenue and Must Be
              Part of the Overall Considerations for Fiscal Reform

Businesses contribute significant revenues to the federal government, both
directly and indirectly. As figure 2 shows, corporate businesses paid $278
billion in corporate income tax directly to the federal government in
2005. Individuals earn income from business investment in the form of
dividends and realized capital gains from C corporations; income
allocations from partnerships and S corporations; entrepreneurial income
from their own sole proprietorships; and rents and royalties. In recent
years this business-source income, which is all taxed under the individual
income tax, has amounted to between roughly 14 percent and 19 percent of
the income of individuals who have paid individual income tax.6 In
addition to the taxes that are paid on business-source income, most of the
remainder of federal taxes is collected and passed on to the government by
businesses.

6Given the time frame available for preparing this statement we could not
obtain the detailed data we would need to estimate the average rates of
tax applied to business-source and non-business-source income.
Consequently, we have not tried to estimate the percent of individual
income tax attributable to business-source income.

Figure 2: Distribution of Federal Tax Revenue by Type of Tax, 2005
(Billions of Dollars)

Note: The business source income referred to in the figure includes the
income of sole proprietors, income from partnerships and S corporations,
dividends, capital gains, rents, and royalties. The percentage equals the
ratio of (net business-source income minus losses) over adjusted gross
income. When computing these percentages we did not include any income or
losses of individuals who did not have a tax liability in a given year.

Business tax revenues of the magnitude discussed make them very relevant
to considerations about how to address the nation's long-term fiscal
imbalance. Over the long term, the United States faces a large and growing
structural budget deficit primarily caused by demographic trends and
rising health care costs as shown in figure 3, and exacerbated over time
by growing interest on the ever-larger federal debt. 7 Continuing on this
imprudent and unsustainable fiscal path will gradually erode, if not
suddenly damage, our economy, our standard of living, and ultimately our
national security.

7Additional information about GAO's long-term fiscal simulations,
assumptions, data, and charts can be found at
http://www.gao.gov/special.pubs/longterm/.

Figure 3: Composition of Federal Spending as a Share of Gross Domestic
Product (GDP), Assuming Discretionary Spending Grows with GDP after 2006
and All Expiring Tax Provisions Are Extended

Note: The revenue projection in this figure includes certain tax
provisions that expired at the end of 2005.

We cannot grow our way out of this long-term fiscal challenge because the
imbalance between spending and revenue is so large. We will need to make
tough choices using a multipronged approach: (1) revise budget processes
and financial reporting requirements; (2) restructure entitlement
programs; (3) reexamine the base of discretionary spending and other
spending; and (4) review and revise tax policy, including tax
expenditures, and tax enforcement programs. Business tax policy, business
tax expenditures, and business tax enforcement need to be part of the
overall tax review because of the amount of revenue at stake.

Business tax expenditures reduce the revenue that would otherwise be
raised from businesses. As already noted, to reduce their tax liabilities,
businesses can take advantage of preferential provisions in the tax code,
such as exclusions, exemptions, deductions, credits, preferential rates,
and deferral of tax liability. Tax preferences-which are legally known as
tax expenditures-are often aimed at policy goals similar to those of
federal spending programs. For example, there are different tax
expenditures intended to encourage economic development in disadvantaged
areas and stimulate research and development, while there are also federal
spending programs that have similar purposes. Also, by narrowing the tax
base, business tax expenditures have the effect of raising either business
tax rates or the rates on other taxpayers in order to generate a given
amount of revenue.

Efficiency, Complexity, Compliance, and Equity Concerns Contribute to Calls for
                              Business Tax Reform

The design of the current system of business taxation causes economic
inefficiency and is complex. The complexity provides fertile ground for
noncompliance and raises equity concerns.

Varying Effective Rates of Taxation Across Different Types of Business
Investments Reduce Economic Efficiency

Our current system for taxing business income causes economic inefficiency
because it imposes significantly different effective rates of tax on
different types of investments.8 Tax treatment that is not neutral across
different types of capital investment causes significant economic
inefficiency by guiding investments to lightly taxed activities rather
than those with high pretax productivity.

However, the goal of tax policy is not to eliminate efficiency costs. The
goal is to design a tax system that produces a desired amount of revenue
and balances economic efficiency with other objectives, such as equity,
simplicity, transparency, and administrability. Every practical tax system
imposes efficiency costs.

There are some features of current business taxation that have attracted
criticism by economists and other tax experts because of efficiency costs.
My point in raising them here is not that these features need to be
changed-that is a policy judgment for Congress to make as it balances
various goals. Rather, my point is that these economic consequences of tax
policy need to be considered as we think about reform. The following are
among the most noted cases of nonneutral taxation in the federal business
tax system:

8Statutory and effective tax rates are not necessarily the same. An
effective tax rate, which is often lower-even substantially lower-than the
statutory rate, measures the amount of tax that a corporation actually
pays on a dollar of its economic income, when all aspects of the tax
(deductions, credits, deferrals, etc.) are taken into account.

           o  Income earned on equity-financed investments made by C
           corporations is taxed twice-under both the corporate and
           individual income taxes, whereas no other business income is taxed
           more than once. Moreover, even noncorporate business investment is
           taxed more heavily than owner-occupied housing-a form of capital
           investment that receives very preferential treatment. As a result,
           resources have been shifted away from higher-return business
           investment into owner-occupied housing, and, within the business
           sector, resources have been shifted from higher-return
           corporations to noncorporate businesses. Such shifting of
           investment makes workers less productive than they would be under
           a more neutral tax system. This results in employees receiving
           lower wages because increases in employee wages are generally tied
           to increases in productivity. 9 As noted above, such efficiency
           costs may be worth paying in order to meet other policy goals. For
           example, many policymakers advocate increased homeownership as a
           social policy goal.

           o  Depreciation allowances under the tax code vary considerably in
           generosity across different assets causing effective tax rates to
           vary and, thereby, favoring investment in certain assets over
           others. For example, researchers have found that the returns on
           most types of investments in equipment are taxed more favorably
           than are most investments in nonresidential buildings.10 These
           biases shift resources away from some investments in buildings
           that would have been more productive than some of the equipment
           investments that are being made instead.

           o  Tax rules for corporations favor the use of debt over
           shareholder equity as a source of finance for investment. The
           return on debt-financed investment consists of interest payments
           to the corporation's creditors, which are deductible by the
           corporations. Consequently, that return is taxed only once-in the
           hands of the creditors. In contrast, the return on equity-financed
           investment consists of dividends and capital gains, which are not
           deductible by the corporation. These forms of income that are
           taxed under the individual tax are paid out of income that has
           already been subject to the corporate income tax. The bias against
           equity finance induces corporations to have less of an "equity
           cushion" against business downturns.11

           o  Capital gains on corporate equity are taxed more favorably than
           dividends because that tax can be deferred until the gains are
           realized (typically when shareholders sell their stock). This bias
           against dividend payments likely means that more profits are
           retained within corporations than otherwise would be the case and,
           therefore, the flow of capital to its most productive uses is
           being constrained.12

           o  The complex set of rules governing U.S. taxation of the
           worldwide income of domestic corporations (those incorporated in
           the United States) leads to wide variations in the effective rate
           of tax paid on that income, based on the nature and location of
           each corporation's foreign operations and the effort put into tax
           planning. In effect, the active foreign income of some U.S.
           corporations is taxed more heavily than if the United States
           followed the practice of many other countries and exempted such
           income from tax. However, other U.S. corporations are able to take
           advantage of flexibilities in the U.S. tax rules in order to
           achieve treatment that is equivalent to or, in some cases, more
           favorable than the so-called "territorial" tax systems that exempt
           foreign-source active business income. As a consequence, some U.S.
           corporations face a tax disadvantage, while others have an
           advantage, relative to foreign corporations when competing in
           foreign countries. Those U.S. corporations that have a
           disadvantage are likely to locate a smaller share of their
           investment overseas than would be the case in a tax-free world;
           the opposite is true for those U.S. corporations with the tax
           advantage. Moreover, the tax system encourages U.S. corporations
           to alter their cash-management and financing decisions (such as by
           delaying the repatriation of profits) in order to reduce their
           taxes.

9Although it is difficult to estimate effective tax rates for broad
categories of assets with precision, the estimates from one recent study
showing the marginal effective tax rates on corporate investment,
noncorporate investments, and owner-occupied housing to be 32 percent, 18
percent, and 2 percent, respectively, suggest the potential magnitude of
the distortions. See Jane Gravelle, "The Corporate Tax: Where Has It Been
and Where Is It Going?" National Tax Journal, vol. 57, no. 4 (2004):
903-23.

10See Jane G. Gravelle, Capital Income Tax Revisions and Effective Tax
Rates, Congressional Research Service Report RL32099 (Washington, D.C.:
Jan. 5, 2005); and U.S. Department of the Treasury, Report to The Congress
on Depreciation Recovery Periods and Methods (Washington, D.C.: July
2000).

11For a more detailed discussion of these issues see U.S. Department of
the Treasury, Integration of the Individual and Corporate Tax Systems:
Taxing Business Income Once (Washington, D.C.: January 1992).

12Recent legislation has, at least temporarily, reduced and equalized the
tax rates on dividends and realized capital gains. These changes have both
reduced the extent of double taxation and the extent to which capital
gains are favored over dividends. Capital gains still receive some
preferred treatment because of the tax deferral.

The taxation of business income is part of the broader taxation of income
from capital. The taxation of capital income in general (even when that
taxation is uniformly applied) causes another form of inefficiency beyond
the inefficiencies caused by the aforementioned cases of differential
taxation across types of investments. This additional inefficiency occurs
because taxes on capital reduce the after-tax return on savings and,
thereby, distort the choice that individuals make between current
consumption and saving for future consumption. However, although research
shows that the demand for some types of savings, such as the demand for
tax exempt bonds, is responsive to tax changes, there is greater
uncertainty about the effects of tax changes on other choices, such as
aggregate savings.

Sometimes the concerns about the negative effects of taxation on the U.S.
economy are couched in terms of "competitiveness," where the vaguely
defined term competitiveness is often defined as the ability of U.S.
businesses to export their products to foreign markets and to compete
against foreign imports into the U.S. market. The goal of those who push
for this type of competitiveness is to improve the U.S. balance of trade.
However, economists generally agree that trying to increase the U.S.
balance of trade through targeted tax breaks for exports does not work.
Such a policy, aimed at lowering the prices of exports, would be offset by
an increase in the value of the dollar which would make U.S. exports more
expensive and imports into the Unites States less expensive, ultimately
leaving both the balance of trade and the standard of living of Americans
unchanged.13

13See relevant discussions in Joint Committee on Taxation, The Impact of
International Tax Reform: Background and Selected Issues Relating to U.S.
International Tax Rules and the Competitiveness of U.S. Businesses,
JCX-22-06 (Washington, D.C.: June 21, 2006); CBO, Effects of Adopting a
Value-Added Tax, (Washington, D.C.: February 1992); Brumbaugh, David L.,
Federal Business Taxation: The Current System, Its Effects, and Options
for Reform, Congressionsl Research Service report RL33171 (Washington,
D.C.: December 20, 2005); and Eric Toder, Assistant Deputy Secretary (Tax
Analysis), U.S. Department of Treasury, Testimony before the Senate Budget
Committee, February 22, 1995.

An alternative definition of competitiveness that is also sometimes used
in tax policy debates refers to the ability of U.S.-owned firms operating
abroad to compete in foreign markets. The current U.S. policy of taxing
the worldwide income of U.S. businesses places some of their foreign
operations at a disadvantage. The tradeoffs between a worldwide system and
a territorial tax system are discussed below.

Businesses Bear Significant Compliance Burdens Arising Both from the Complexity
of the Tax System and from Their Multiple Roles within the System

Tax compliance requirements for businesses are extensive and complex.
Rules governing the computation of taxable income, expense deductions, and
tax credits of U.S. corporations that do business in multiple foreign
countries are particularly complex. But even small businesses face
multiple levels of tax requirements of varying difficulty. In addition to
computing and documenting their income, expenses, and qualifications for
various tax credits, businesses with employees are responsible for
collecting and remitting (at varying intervals) several federal taxes on
the incomes of those employees. Moreover, if the businesses choose to
offer their employees retirement plans and other fringe benefits, they can
substantially increase the number of filings they must make. Businesses
also have information-reporting responsibilities-employers send wage
statements to their employees and to IRS; banks and other financial
intermediaries send investment income statements to clients and to IRS.14
Finally, a relatively small percentage of all businesses (which
nevertheless number in the hundreds of thousands) are required to
participate in the collection of various federal excise taxes levied on
fuels, heavy trucks and trailers, communications, guns, tobacco, and
alcohol, among other products.

It is difficult for researchers to accurately estimate compliance costs
for the tax system as a whole or for particular types of taxpayers because
taxpayers generally do not keep records of the time and money spent
complying with tax requirements. Studies we found that focus on the
compliance costs of businesses estimate them to be between about $40
billion and $85 billion per year.15 None of these estimates include the
costs to businesses of collecting and remitting income and payroll taxes
for their employees. The accuracy of these business compliance cost
estimates is uncertain due to the low rates of response to their
data-collection surveys. In addition, the range in estimates across the
studies is due, among other things, to differences in monetary values used
(ranging between $25 per hour and $37.26 per hour), differences in the
business populations covered, and differences in the tax years covered.

14Although this information reporting increases the compliance burden on
businesses, it does enable IRS to enforce tax compliance by wage earners
and investors at lower cost. This reduction in administrative costs, which
are paid out of the federal budget, means that taxes are slightly lower
than they otherwise would have to be.

15See GAO, Tax Policy: Summary of Estimates of the Costs of the Federal
Tax System, GAO-05-878 (Washington, D.C.: Aug. 26, 2005).

Business Tax Complexity Also Makes IRS's Job of Enforcing Tax Rules Very
Challenging and Can Reduce Public Confidence in the Fairness of the System

Although the precise amount of business tax avoidance is unknown, IRS's
latest estimates of tax compliance show a tax gap of at least $141 billion
for tax year 2001 between the business taxes that individual and corporate
taxpayers paid and what they should have paid under the law.16
Corporations contributed about $32 billion to the tax gap by
underreporting about $30 billion in taxes on tax returns and failing to
pay about $2 billion in taxes that were reported on returns. Individual
taxpayers that underreported their business income accounted for the
remaining $109 billion of the business income tax gap.17

A complex tax code, complicated business transactions, and often
multinational corporate structures make determining business tax
liabilities and the extent of corporate tax avoidance a challenge. Tax
avoidance has become such a concern that some tax experts say corporate
tax departments have become "profit centers" as corporations seek to take
advantage of the tax laws in order to maximize shareholder value. Some
corporate tax avoidance is clearly legal, some falls in gray areas of the
tax code, and some is clearly noncompliance or illegal, as shown by IRS's
tax gap estimate.

16Overall, IRS estimated a gross tax gap of $345 billion for tax year
2001. It further estimated that eventually $55 billion of the tax gap
would be recovered through late payments and enforcement actions,
resulting in a net tax gap of $290 billion. The tax gap includes
underreporting of taxes on tax returns, underpayment of taxes reported on
returns, or nonfiling, which is when taxpayers fail to file returns on
time or altogether.

17The amount of the business income tax gap attributed to individual
taxpayers could be greater than $109 billion. Although IRS estimated the
tax gap for individual income tax underpayment and nonfiling ($23 billion
and $25 billion, respectively, for tax year 2001), it did not estimate to
what extent such noncompliance was attributed to business income, as
opposed to nonbusiness income such as salaries and wages. Also, IRS
estimated the tax gap that arises from individuals misreporting tax
deductions and credits, but does not estimate what portion of the
misreporting was from business-related deductions and credits.

Often business tax avoidance is legal. For example, multinational
corporations can locate active trade or business operations in
jurisdictions that have lower effective tax rates than does the United
States and, unless and until they repatriate the income, defer taxation in
the United States on that income, thus reducing their effective tax rate.
In addition, investors can avoid paying the corporate income tax by
putting their money into unincorporated businesses or into real estate.

Complicating corporate tax compliance is the fact that in many cases the
law is unclear or subject to differing interpretations. In fact, some have
postulated that major corporations' tax returns are actually just the
opening bid in an extended negotiation with IRS to determine a
corporation's tax liability. An illustration-once again from the complex
area of international tax rules-is transfer pricing. Transfer pricing
involves setting the appropriate price for such things as goods, services,
or intangible property (such as patents, trademarks, copyrights,
technology, or "know-how") that is transferred between the U.S.-based
operations of a multinational company and a foreign affiliate. If the
price paid by the affiliate to the U.S. operation is understated, the
profits of the U.S. operation are reduced and U.S. taxable income is
inappropriately reduced or eliminated. The standard for judging the
correct price is the price that would have been paid between independent
enterprises acting at "arm's length." However, it can be extremely
difficult to establish what an arm's length price would be. Given the
global economy and the number of multinational firms with some U.S.-based
operations, opportunities for transfer pricing disputes are likely to
grow.

Tax shelters are one example of how tax avoidance, including corporate tax
avoidance, can shade into the illegal. Some tax shelters are legal though
perhaps aggressive interpretations of the law, but others cross the
line.18 Abusive shelters often are complex transactions that manipulate
many parts of the tax code or regulations and are typically buried among
legitimate transactions reported on tax returns. Because these
transactions are often composed of many pieces located in several parts of
a complex tax return, they are essentially hidden from plain sight, which
contributes to the difficulty of determining the scope of the abusive
shelter problem. Often lacking economic substance or a business purpose
other than generating tax benefits, abusive shelters have been promoted by
some tax professionals, often in confidence, for significant fees,
sometimes with the participation of tax-indifferent parties, such as
foreign or tax-exempt entities. These shelters may involve unnecessary
steps and flow-through entities, such as partnerships, which make
detection of these transactions more difficult.

18In a 2003 testimony, we reported that IRS had identified 27 kinds of
abusive shelter transactions-called listed transactions-promoted to
corporations and others. As of September 2006, IRS's Web site lists 31
such listed transactions. IRS also had a number of other transactions that
had to be reported to IRS and may have had some characteristics of abusive
shelters but were not, and possibly never would be, listed.

Regarding compliance with our tax laws, the success of our tax system
hinges greatly on individual and business taxpayers' perception of its
fairness and understandability. Compliance is influenced not only by the
effectiveness of IRS's enforcement efforts but also by Americans'
attitudes about the tax system and their government. A recent survey
indicated that about 10 percent of respondents say it is acceptable to
cheat on their taxes. Furthermore, the complexity of, and frequent
revisions to, the tax system make it more difficult and costly for
taxpayers who want to comply to do so and for IRS to explain and enforce
tax laws. The lack of transparency also fuels disrespect for the tax
system and the government. Thus, a crucial challenge in evaluating our
business tax system will be to determine how we can best strengthen
enforcement of existing laws to give businesses owners confidence that
their competitors are paying their fair share and to give wage earners
confidence that businesses in general bear their share of taxes. One
option that has been suggested as a means of improving public confidence
in the tax system's fairness is to make the reconciliation between book
and tax income that businesses present on schedule M-3 of their tax
returns available for public review.

 Business Tax Reform Entails Broad Design Choices about the Overall Tax System

Reform of our business tax system will necessarily mean making broad
design choices about the overall tax system and how business taxes are
coordinated with other taxes. The tax reform debate of the last several
years has focused attention on several important choices, including the
extent to which our system should be closer to the extreme of a pure
income tax or the other extreme of a pure consumption tax, the extent to
which sales by U.S. businesses outside of this country should be taxed,
the extent to which taxes should be collected from businesses or
individuals, and the extent to which taxpayers are compensated for losses
or costs they incur during the transition to any new tax system. Generally
there is no single "right" decision about these choices and the options
are not limited to selecting a system that is at one extreme or the other
along the continuum of potential systems. The choices will involve making
tradeoffs between the various goals for our tax system.

Income vs. Consumption as the Tax Base

The fundamental difference between income and consumption taxes lies in
their treatment of savings and investment. Income can be used for either
consumption or saving and investment. The tax base of a pure income tax
includes all income, regardless of what it is ultimately used for; in
contrast, the tax base of a consumption tax excludes income devoted to
saving and investment (until it is ultimately used for consumption). The
current tax system is a hybrid between a pure income tax and a pure
consumption tax because it effectively exempts some types of savings and
investment but taxes other types.

As noted earlier, evidence is inconclusive regarding whether a shift
closer to a consumption tax base would significantly affect the level of
savings by U.S. taxpayers. There is, however, a consensus among economists
that uneven tax treatment across different types of investment should be
avoided unless the efficiency costs resulting from preferential tax
treatment are outweighed by the social benefits generated by the tax
preference. That objective could be achieved under either a consumption
tax that exempts all new savings and investment from taxation (which means
that all business profits are exempt) or a revised income tax that taxed
all investments at the same effective rate. In comparison to the current
system, a consumption tax's exemption of business-source income would
likely encourage U.S. businesses to increase their investment in the
United States relative to their foreign investment.


Collecting the Tax at the Business or Individual Level

Both income and consumption taxes can be structured in a variety of ways,
as discussed in the following subsections, and the choice of a specific
design for either type of tax can have as significant implications for
efficiency, administrability, and equity as the choice between a
consumption or income base. 19 The exemption of saving and investment can
be accomplished in different ways, so consumption taxes can be structured
differently and yet still have the same overall tax base.

19For additional information on how differences in the structures of both
income and consumption taxes can affect tax administration and taxpayer
compliance burdens, see Tax Administration: Potential Impact of
Alternative Taxes on Taxpayers and Administrators, GAO/GGD-98-37
(Washington, D.C.: Jan. 14, 1998).


Both income and consumption taxes can be levied on individuals or
businesses, or on a combination of the two. Whether collected from
individuals or businesses, ultimately, individuals will bear the economic
burden of any tax (as wage earners, shareholders, or consumers). The
choice of whether to collect a tax at the business level or the individual
level depends on whether it is thought to be desirable to levy different
taxes on different individuals. A business-level tax, whether levied on
income or consumption, can be collected "at source"-that is, where it is
generated-so there can be many fewer tax filers and returns to administer.
Business-level taxes cannot, however, directly tax different individuals
at different rates. Individual-level taxes can allow for distinctions
between different individuals; for example, standard deductions or
graduated rates can be used to tax individuals with low income (or
consumption) at a lower rate than individuals with greater income (or
consumption). However, individual-level taxes require more tax returns,
impose higher compliance costs, and would generally require a larger tax
administration system.20

A national retail sales tax, a consumption value-added tax, and an income
value-added tax are examples of taxes that would be collected only at the
business level. A personal consumption tax and an integrated individual
income tax are examples of taxes that would be collected only at the
individual level. The "flat tax" proposed by economists Robert Hall and
Alvin Rabushka that has received attention in recent years is an example
of a tax collected at both the business and individual level.21 Our
current system for taxing corporate-source income involves taxation at
both the corporate and individual level in a manner that results in the
double taxation of the same income.

Territorial vs. Worldwide Taxation under an Income Tax

Under a pure worldwide tax system the United States would tax the income
of U.S. corporations, as it is earned, regardless of where it is earned,
and at the same time provide a foreign tax credit that ensures that the
combined rate of tax that a corporation pays to all governments on each
dollar of income is exactly equal to the U.S. corporate tax rate. Some
basic differences between the current U.S. tax system and a pure worldwide
system are that (1) in many cases the U.S. system permits corporations to
defer U.S. tax on their foreign-source income until it is repatriated and
(2) the U.S. foreign tax credit is limited to the amount of U.S. tax that
would be due on a corporation's foreign-source income. In cases where the
rate of foreign tax on a corporation's income exceeds the U.S. tax rate,
the corporation is left paying the higher rate of tax.

20For a further discussion of these issues, see GAO/GGD-98-37 .

21See app. II for brief descriptions of each of these types of taxes.

Under a pure territorial tax system the United States would simply exempt
all foreign-source income. (No major country has a pure territorial
system; they all tax mobile forms of foreign-source income, such as
royalties and income from securities.) The current U.S. tax system has
some features that result in some cases in treatment similar to what would
exist under a territorial system. First, corporations can defer U.S. tax
indefinitely on certain foreign-source income, as long as they keep it
reinvested abroad. Second, in certain cases U.S. corporations are able to
use the excess credits that they earned for taxes they paid to high-tax
countries to completely offset any U.S. tax that they would normally have
to pay on income they earned in low-tax countries.22 As a result, that
income from low-tax countries remains untaxed by the United States-just as
it would be under a territorial system. In fact, there are some cases
where U.S. corporations enjoy tax treatment that is more favorable than
under a territorial system. This occurs when they pay no U.S. tax on
foreign-source income yet are still able to deduct expenses allocable to
that income. For example, a U.S. parent corporation can borrow money and
invest it in a foreign subsidiary. The parent corporation generally can
deduct its interest payments from its U.S. taxes even if it defers U.S.
tax on the subsidiary's income by leaving it overseas.

Proponents of a worldwide tax system and proponents of a territorial
system both argue that their preferred systems would provide important
forms of tax neutrality. Under a pure worldwide system all of the income
that a U.S. corporation earns abroad would be taxed at the same effective
rate that a corporation earning the same amount of income domestically
would pay. Such a tax system is neutral in the sense that it does not
influence the decision of U.S. corporations to invest abroad or at home.
If the U.S. had a pure territorial tax system all of the income that U.S.
corporations earn in a particular country would be taxed at the same rate
as corporations that are residents of that country. The pure territorial
system is neutral in the specific sense that U.S. corporations investing
in a foreign country would not be at a disadvantage relative to
corporations residing in that country or relative to other foreign
corporations investing there.23 In a world where each country sets its own
tax rules it is impossible to achieve both types of neutrality at the same
time, so tradeoffs are unavoidable.

22In cases where a U.S. corporation earns income in a country with a
higher income tax than in the United States that corporation earns a
larger tax credit than is needed to offset the U.S. tax owed on that
foreign-source income. The difference between the foreign tax credit
earned on a specific amount of foreign-source income and the amount of
U.S. tax owed on that income is known as an excess foreign tax credit.

A change from the current tax system to a pure territorial one is likely
to have mixed effects on tax compliance and administration. On the one
hand, a pure worldwide tax system, or even the current system, may
preserve the U.S. tax base better than a territorial system would because
U.S. taxpayers would have greater incentive under a territorial system to
shift income and investment into low-tax jurisdictions via transfer
pricing. On the other hand, a pure territorial system may be less complex
for IRS to administer and for taxpayers to comply with than the current
tax system because there would be no need for the antideferral rules or
the foreign tax credit, which are among the most complex features of the
current system.

Destination-Principle vs. Origin-Principle Consumption Tax

Broad-based consumption taxes can differ depending on whether they are
imposed under a destination principle, which holds that goods and services
should be taxed in the countries where they are consumed, or an origin
principle, which holds that goods and services should be taxed in the
countries where they are produced. In the long run, after markets have
adjusted, neither type of tax would have a significant effect on the U.S.
trade balance. This is true for a destination-based tax because products
consumed in the United States would be taxed at the same rate, regardless
of where they were produced. Therefore, such a tax would not influence a
consumer's choice between buying a car produced in the United States or
one imported from Japan. And at the same time, U.S. exports of cars would
not be affected by the tax because they would be exempted. An origin-based
consumption tax would not affect the trade balance because the tax effects
that taxes have on prices would ultimately be countered by the same price
adjustment mechanism that we discussed earlier with respect to targeted
tax subsidies for exports.24

23The disadvantage that U.S. corporations have under the current system is
one reason why some U.S. multinational businesses have undergone
"corporate inversions," whereby their parent corporations have changed
their place of incorporation from the United States to a foreign country.

A national retail sales tax limited to final consumption goods would be a
destination-principle tax; it would tax imports when sold at retail in
this country and would not tax exports. Value-added taxes can be designed
as either destination or origin-principle taxes.

A personal consumption tax, collected at the individual level, would apply
to U.S. residents or citizens and could be formulated to tax their
consumption regardless of whether it is done domestically or overseas.
Under such a system, income earned abroad would be taxable but funds saved
or invested abroad would be deductible. In that case, foreign-produced
goods imported into the United States or consumed by U.S. citizens abroad
would be taxed. U.S. exports would only be taxed to the extent that they
are consumed by U.S. citizens abroad.

The Extent of Transition Provisions

A wide range of options exist for moving from the current business tax
system to an alternative one, and the way that any transition is
formulated could have significant effects for economic efficiency, equity,
taxpayer compliance burden, and tax administration. For example, one
transition issue involves whether tax credits and other tax benefits
already earned under the current tax would be made available under a new
system. Businesses that are deducting depreciation under the current
system would not have the opportunity to continue depreciating their
capital goods under a VAT unless special rules were included to permit it.
Similar problems could arise with businesses' carrying forward net
operating losses and recovering unclaimed tax credits. Depending on how
these and other issues are addressed, taxpayer compliance burden and tax
administration responsibilities could be greater during the transition
period than they currently are or than they would be once the transition
ends. Transition rules could also substantially reduce the new system's
tax base, thereby requiring higher tax rates during the transition if
revenue neutrality were to be achieved.25

24This time the mechanism would operate in the reverse direction-the tax
on U.S. exports would decrease the foreign demand for those products,
leading to a drop in the value of the dollar. That decline in the dollar's
value would reverse the tax-induced increase in the price of U.S. exports
and would raise the price of imports into the United States, offsetting
any price advantage they had gained from being exempt from the consumption
tax.

Criteria for a Good Tax System Provide Principles to Guide Decisions and Issues
for Consideration

Our publication, Understanding the Tax Reform Debate: Background,
Criteria, and Questions,26 may be useful in guiding policymakers as they
consider tax reform proposals. It was designed to aid policymakers in
thinking about how to develop tax policy for the 21st century. The
criteria for a good tax system, which our report discusses, provide the
basis for a set of principles that should guide Congress as it considers
the choices and tradeoffs involved in tax system reform. And, as I also
noted earlier, proposals for reforming business taxation cannot be
evaluated without considering how that business taxation will interact
with and complement the other elements of our overall future tax system.

The proposed system should raise sufficient revenue over time to fund our
expected expenditures. As I mentioned earlier, we will fall woefully short
of achieving this end if current spending or revenue trends are not
altered. Although we clearly must restructure major entitlement programs
and the basis of other federal spending, it is unlikely that our long-term
fiscal challenge will be resolved solely by cutting spending.

The proposal should look to future needs. Like many spending programs, the
current tax system was developed in a profoundly different time. We live
now in a much more global economy, with highly mobile capital, and with
investment options available to ordinary citizens that were not even
imagined decades ago. We have growing concentrations of income and wealth.
More firms operate multinationally and willingly move operations and
capital around the world as they see best for their firms.

As an adjunct to looking forward when making reforms, better information
on existing commitments and promises must be coupled with estimates of the
long-term discounted net present value costs from spending and tax
commitments comprising longer-term exposures for the federal budget beyond
the existing 10-year budget projection window.

The tax base should be as broad as possible. Broad-based tax systems with
minimal exceptions have many advantages. Fewer exceptions generally means
less complexity, less compliance cost, less economic efficiency loss, and
by increasing transparency may improve equity or perceptions of equity.
This suggests that eliminating or consolidating numerous tax expenditures
must be considered. In many cases tax preferences are simply a form of
"back-door spending." We need to be sure that the benefits achieved from
having these special provisions are worth the associated revenue losses
just as we must ensure that outlay programs-which may be attempting to
achieve the same purposes as tax expenditures-achieve outcomes
commensurate with their costs. And it is important to supplement these
cost-benefit evaluations with analyses of distributional effects-i.e., who
bears the costs of the preferences and who receives the benefits. To the
extent tax expenditures are retained, consideration should be given to
whether they could be better targeted to meet an identified need.

25For further discussion of transition issues see GAO-05-1009SP .

26 GAO-05-1009SP .

If we must raise revenues, doing so from a broad base and a lower rate
will help minimize economic efficiency costs. Broad-based tax systems can
yield the same revenue as more narrowly based systems at lower tax rates.
The combination of less direct intervention in the marketplace from
special tax preferences, and the lower rates possible from broad-based
systems, can have substantial benefits for economic efficiency. For
instance, one commonly cited rule of thumb regarding economic efficiency
costs of tax increases is that they rise proportionately faster than the
tax rates. In other words, a 10 percent tax increase could raise the
economic efficiency costs of a tax system by much more than 10 percent.

Aside from the base-broadening that minimizes targeted tax preferences
favoring specific types of investment or other business behavior, it is
also desirable on the grounds of economic efficiency to extend the
principle of tax neutrality to the broader structural features of a
business tax system. For example, improvements in economic efficiency can
also be gained by avoiding differences in tax treatment, such as the
differences in the current system based on legal form of organization,
source of financing, and the nature and location of foreign operations.
Removing such differences can shift resources to more productive uses,
increasing economic performance and the standard of living of Americans.
Shifting resources to more productive uses can result in a step up in the
level of economic activity which would be measured as a one-time increase
in the rate of growth. Tax changes that increase efficiency can also
increase the long-term rate of economic growth if they increase the rate
of technological change; however, not all efficiency-increasing tax
changes will do so.27

Impact on the standard of living of Americans is also a useful criterion
for evaluating policies to improve U.S. competitiveness. As was discussed
earlier, narrower goals and policies, such as increasing the U.S. balance
of trade through targeted tax breaks aimed at encouraging exports, are
generally viewed as ineffective by economists. What determines the
standard of living of Americans and how it compares to the standard of
living in other countries is the productivity of American workers and
capital. That productivity is determined by factors such as education,
technological innovation, and the amount of investment in the U.S.
economy. Tax policy can contribute to American productivity in several
ways. One, discussed in this statement, is through neutral taxation of
investment alternatives. Another, which I have discussed on many
occasions, is through fiscal policy. Borrowing to finance persistent
federal deficits absorbs savings from the private sector reducing funds
available for investment. Higher saving and investment from a more
balanced fiscal policy would contribute to increased productivity and a
higher standard of living for Americans over the long term.

A reformed business tax system should have attributes associated with high
compliance rates. Because any tax system can be subject to tax gaps, the
administrability of reformed systems should be considered as part of the
debate for change. In general, a reformed system is most likely to have a
small tax gap if the system has few tax preferences or complex provisions
and taxable transactions are transparent. Transparency in the context of
tax administration is best achieved when third parties report information
both to the taxpayer and the tax administrator.

Minimizing tax code complexity has the potential to reduce noncompliance
for at least three broad reasons. First, it could help taxpayers to comply
voluntarily with more certainty, reducing inadvertent errors by those who
want to comply but are confused because of complexity. Second, it may
limit opportunities for tax evasion, reducing intentional noncompliance by
taxpayers who can misuse the complex code provisions to hide their
noncompliance or to achieve ends through tax shelters. Third, reducing
tax-code complexity could improve taxpayers' willingness to comply
voluntarily.

27See GAO-05-1009SP for further discussion on the relationship between
efficiency and economic growth.

Finally, the consideration of transition rules needs to be an integral
part of the design of a new system. The effects of these rules can be too
significant to leave them simply as an afterthought in the reform process.

                            Concluding Observations

The problems that I have reviewed today relating to the compliance costs,
efficiency costs, equity, and tax gap associated with the current business
tax system would seem to make a strong case for a comprehensive review and
reform of our tax policy. Further, businesses operate in a world that is
profoundly different-more competitive and more global-than when many of
the existing provisions of the tax code were adopted. Despite numerous and
repeated calls for reform, progress has been slow. I discussed reasons for
the slow progress in a previous hearing on individual tax reform before
this committee. One reason why reform is difficult to accomplish is that
the provisions of the tax code that generate compliance costs, efficiency
costs, the tax gap and inequities also benefit many taxpayers. Reform is
also difficult because, even when there is agreement on the amount of
revenue to raise, there are differing opinions on the appropriate balance
among the often conflicting objectives of equity, efficiency, and
administrability. This, in turn, leads to widely divergent views on even
the basic direction of reform.

However, I have described some basic principles that ought to guide
business tax reform. One of them is revenue sufficiency. Fiscal necessity,
prompted by the nation's unsustainable fiscal path, will eventually force
changes to our spending and tax policies. We must fundamentally rethink
policies and everything must be on the table. Tough choices will have to
be made about the appropriate degree of emphasis on cutting back federal
programs versus increasing tax revenue.

Other principles, such as broadening the tax base and otherwise promoting
tax neutrality, could help improve economic performance. While economic
growth alone will not solve our long-term fiscal problems, an improvement
in our overall economic performance makes dealing with those problems
easier.

The recent report of the President's Advisory Panel on Federal Tax Reform
recommended two different tax reform plans. Although each plan is intended
to improve economic efficiency and simplify the tax system, neither of
them addresses the growing imbalance between federal spending and revenues
that I have highlighted. One approach for getting the process of
comprehensive fiscal reform started would be through the establishment of
a credible, capable, and bipartisan commission, to examine options for a
combination of selected entitlement and tax reform issues.

Mr. Chairman and Members of the Committee, this concludes my statement. I
would be pleased to answer any questions you may have at this time.

                          Contact and Acknowledgments

For further information on this testimony, please contact James White on
(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 testimony. Individuals making key contributions to this testimony
include Jim Wozny, Assistant Director; Donald Marples; Jeff Arkin; and
Cheryl Peterson.

Appendix I: List of Studies Reviewed

                        Government Accountability Office

Individual Income Tax Policy: Streamlining, Simplification, and Additional
Reforms Are Desirable. GAO-06-1028T . Washington, D.C.: August 3, 2006.

Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a Variety
of Approaches. GAO-06-1000T . Washington, D.C.: July 26, 2006.

Tax Compliance: Challenges to Corporate Tax Enforcement and Options to
Improve Securities Basis Reporting. GAO-06-851T . Washington, D.C.: June
13, 2006.

Understanding the Tax Reform Debate: Background, Criteria, & Questions.
GAO-05-1009SP . Washington, D.C.: September 2005.

Government Performance and Accountability: Tax Expenditures Represent a
Substantial Federal Commitment and Need to Be Reexamined. GAO-05-690 .
Washington, D.C.: Sept. 23, 2005.

Tax Policy: Summary of Estimates of the Costs of the Federal Tax System.
GAO-05-878 . Washington, D.C.: August 26, 2005.

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.
GAO-05-325SP . Washington, D.C.: February 1, 2005.

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

                          Congressional Budget Office

Corporate Income Tax Rates: International Comparisons. Washington, D.C.:
November 2005.

Taxing Capital Income: Effective Rates and Approaches to Reform.
Washington, D.C.: October 2005.

Effects of Adopting a Value-Added Tax. Washington, D.C.: February 1992.

                         Congressional Research Service

Brumbaugh, David L. Taxes and International Competitiveness. RS22445.
Washington, D.C.: May 19, 2006.

Brumbaugh, David L. Federal Business Taxation: The Current System, Its
Effects, and Options for Reform. RL33171. Washington, D.C.: December 20,
2005.

Gravelle, Jane G.. Capital Income Tax Revisions and Effective Tax Rates.
RL32099. Washington, D.C.: January 5, 2005.

                          Joint Committee on Taxation

The Impact of International Tax Reform: Background and Selected Issues
Relating to U.S. International Tax Rules and the Competitiveness of U.S.
Businesses. JCX-22-06. Washington, D.C.: June 21, 2006.

Options to Improve Tax Compliance and Reform Tax Expenditures. JCS-02-05.
Washington, D.C.: January 27, 2005.

The U.S. International Tax Rules: Background, Data, and Selected Issues
Relating to the Competitiveness of U.S.-Based Business Operations.
JCX-67-03. Washington, D.C.: July 3, 2003.

Background Materials on Business Tax Issues Prepared for the House
Committee on Ways and Means Tax Policy Discussion Series. JCX-23-02.
Washington, D.C.: April 4, 2002.

                        U.S. Department of the Treasury

Report to The Congress on Depreciation Recovery Periods and Methods.
Washington, D.C.: July 2000.

Integration of The Individual and Corporate Tax Systems: Taxing Business
Income Once. Washington, D.C.: January 1992.

                President's Advisory Panel on Federal Tax Reform

Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System.
Washington, D.C.: November 2005.

Appendix II: Descriptions of Alternative Tax Systems

Over the past decade, several proposals for fundamental tax reform have
been put forward. These proposals would significantly change tax rates,
the tax base, and the level of tax (whether taxes are collected from
individuals, businesses, or both). Some of the proposals would replace the
federal income tax with some type of consumption tax levied only on
businesses. Consumption taxes levied only on businesses include retail
sales taxes (RST) and value-added taxes (VAT). The flat tax would also
change the tax base to consumption but include both a relatively simple
individual tax along with a business tax. A personal consumption tax, a
consumption tax levied primarily on individuals, has also been proposed.
Similar changes in the level at which taxes are collected could be made
while retaining an income tax base. This appendix provides a brief
description of several of these proposals.

                           National Retail Sales Tax

The consumption tax that Americans are most familiar with is the retail
sales tax, which in many states, is levied when goods or services are
purchased at the retail level. The RST is a consumption tax because only
goods purchased by consumers are taxed, and sales to businesses, including
sales of investment goods, are generally exempt from tax. In contrast to
an income tax, then, income that is saved is not taxed until it is used
for consumption. Under a national RST, different tax rates could be
applied to different goods, and the sale of some goods could carry a zero
tax rate (exemption). However, directly taxing different individuals at
different rates for the same good would be very difficult.

                          Consumption Value-Added Tax

A consumption VAT, which like the RST, is a business-level consumption tax
levied directly on the purchase of goods and services. The two taxes
differ in the manner in which the tax is collected and paid. In contrast
to a retail sales tax, sales of goods and services to consumers and to
businesses are taxable under a VAT. However, businesses can either deduct
the amount of their purchases of goods and services from other businesses
(under a subtraction VAT) or can claim a credit for tax paid on purchases
from other businesses (under a credit VAT). Under either method, sales
between businesses do not generate net tax liability under a VAT because
the amount included in the tax base by businesses selling goods is equal
to the amount deducted by the business purchasing goods. The only sales
that generate net revenue for the government are sales between businesses
and consumers, which is the same case as the RST.

                             Income Value-Added Tax

An income VAT would move the taxation of wage income to the business level
as well. No individual returns would be necessary, so the burden of
complying with the tax law would be eliminated for individuals. An income
VAT would not allow businesses to deduct dividends, interest, or wages, so
the income VAT remitted by businesses would include tax on these types of
income. Calculations would not have to be made for different individuals,
which would simplify tax administration and compliance burdens but not
allow for treating different individuals differently.

                                    Flat Tax

The flat tax was developed in the early 1980s by economists Robert Hall
and Alvin Rabushka.1 The Hall-Rabushka flat tax proposal includes both an
individual tax and a business tax. As described by Hall and Rabushka, the
flat tax is a modification of a VAT; the modifications make the tax more
progressive (less regressive) than a VAT. In particular, the business tax
base is designed to be the same as that of a VAT, except that businesses
are allowed to deduct wages and retirement income paid out as well as
purchases from other businesses. Wage and retirement income is then taxed
when received by individuals at the same rate as the business tax rate. By
including this individual-level tax as well as the business tax, standard
deductions can be made available to individuals. Individuals with less
wage and retirement income than the standard deduction amounts would not
owe any tax.

                            Personal Consumption Tax

A personal consumption tax would look much like a personal income tax. The
major difference between the two is that under the consumption tax,
taxpayers would include all income received, amounts borrowed, and cash
flows received from the sale of assets, and then deduct the amount they
saved. The remaining amount would be a measure of the taxpayer's
consumption over the year. When funds are withdrawn from bank accounts, or
stocks or bonds are sold, both the original amount saved and interest
earned are taxable because they are available for consumption. If
withdrawn funds are reinvested in another qualified account or in stock or
bonds, the taxable amount of the withdrawal would be offset by the
deduction for the same amount that is reinvested. While the personal
consumption tax would look like a personal income tax, the tax base would
be the same as an RST. Instead of collecting tax on each sale of consumer
products at the business level, a personal consumption tax would tax
individuals annually on the sum of all their purchases of consumption
goods. Because it is an individual-level tax, different tax rates could be
applied to different individuals so that the tax could be made more
progressive, and other taxpayer characteristics, such as family size,
could be taken into account if desired.2

1See Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford,
Calif.: Hoover Press, 1995).

2To tax certain types of consumption that can occur within a business,
such as fringe benefits or the personal use of goods such as cars, many
personal consumption tax proposals also include a business-level "cash
flow" tax. Investment would be expensed under such a tax to ensure that
the overall tax base would be consumption.

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Highlights of GAO-06-1113T , a Testimony to the Committee on Finance, U.S.
Senate

September 20, 2006

BUSINESS TAX REFORM

Simplification and Increased Uniformity of Taxation Would Yield Benefits

Business income taxes, both corporate and noncorporate, are a significant
portion of federal tax revenue. Businesses also play a crucial role in
collecting taxes from individuals, through withholding and information
reporting. However, the design of the current system of business taxation
is widely seen as flawed. It distorts investment decisions, hurting the
performance of the economy. Its complexity imposes planning and record
keeping costs, facilitates tax shelters, and provides potential cover for
those who want to cheat.

Not surprisingly, business tax reform is part of the debate about overall
tax reform. The debate is occurring at a time when long-range projections
show that, without a policy change, the gap between spending and revenues
will widen.

This testimony reviews the nation's long term fiscal imbalance and what is
wrong with the current system of business taxation and provides some
principles that ought to guide the debate about business tax reform.

This statement is based on previously published GAO work and reviews of
relevant literature.

The size of business tax revenues makes them very relevant to any plan for
addressing the nation's long-term fiscal imbalance. Reexamining both
federal spending and revenues, including business tax policy and
compliance must be part of a multipronged approach to address the
imbalance.

Distribution of Federal Tax Revenue by Type of Tax, Fiscal Year 2005 ($
billions)

Some features of current business taxes channel investments into
tax-favored activities and away from more productive activities and,
thereby, reduce the economic well-being of all Americans. Complexity in
business tax laws imposes costs of its own, facilitates tax shelters, and
provides potential cover for those who want to cheat. IRS's latest
estimates show a business tax gap of at least $141 billion for 2001. This
in turn undermines confidence in the fairness of our tax system-citizens'
confidence that their friends, neighbors, and business competitors pay
their fair share of taxes.

Principles that should guide the business tax reform debate include:

           o  The proposed system should raise sufficient revenue over time
           to fund our current and future expected expenditures.
           o  The tax base should be as broad as possible, which helps to
           minimize overall tax rates.
           o  The proposed system should improve compliance rates by reducing
           tax preferences and complexity and increasing transparency.
           o  To the extent other goals, such as equity and simplicity,
           allow, the tax system should aim for neutrality by not favoring
           some business activities over others. More neutral tax policy has
           the potential to enhance economic growth, increase productivity
           and improve the competitiveness of the U.S. economy in terms of
           standard of living.
           o  The consideration of transition rules must be an integral part
           of any reform proposal.
*** End of document. ***