Tax Administration: Potential Impact of Alternative Taxes on Taxpayers
and Administrators (Letter Report, 01/14/98, GAO/GGD-98-37).

GAO reviewed alternative tax systems, focusing on: (1) the major
differences in design among the tax alternatives; and (2) how the
alternatives, by incorporating different design features, may affect the
taxpayers' burden of complying with the tax laws and the government's
responsibilities for administering those laws.

GAO noted that: (1) the alternative tax systems that GAO studied differ
in their potential impacts on taxpayer compliance burden and tax
administration; (2) the different potential impacts of the tax systems
can largely be explained by four basic design features: (a) the basis
for taxation; (b) the type of taxpayer; (c) preferential tax treatment
for certain individuals, businesses, or goods and services; and (d) the
rate structure for individuals; (3) the differences in the four basic
design features of the tax systems GAO studied explain in large part the
differing potential impacts of the tax systems on taxpayer compliance
burden and tax administration; (4) simplifying the determination of tax
liability for taxpayers could simplify assessing compliance and
providing taxpayer assistance for tax administrators; (5) tax systems
that would tax only businesses, rather than individuals and businesses,
could reduce taxpayer compliance burden and the costs of tax
administration by greatly reducing the number of taxpayers required to
file returns; (6) tax systems that combine a business tax with a
relatively simple individual tax, such as flat tax or some version of a
reformed income tax, could add limited burden relative to a
business-only tax; (7) tax systems requiring individuals to report more
information about their personal finances could add more burden than a
business tax combined with a simple individual tax because more
individuals could have to file tax returns and the returns would be more
complicated; (8) an alternative tax system incorporating tax
preferences--exemptions, special deductions, credits, or multiple rates
on goods and services aimed at various economic and social goals--would
generally add complexity; (9) tax preferences generally increase
taxpayer compliance burden by complicating the determination of tax
liability, adding recordkeeping requirements, and creating incentives to
engage in tax planning; (10) tax preferences generally increase taxpayer
compliance burden by complicating the determination of tax liability,
adding recordkeeping requirements, and creating incentives to engage in
tax planning; (11) tax systems with multiple tax rates for individuals,
which could include income taxes and a personal consumption tax, do not
need to add burden to taxpayers' calculation of tax liability compared
to single-rate systems; and (12) in addition to impacts due to the four
basic design features, the transition to an alternative tax system could
affect taxpayer compliance burden and tax administration.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-98-37
     TITLE:  Tax Administration: Potential Impact of Alternative Taxes 
             on Taxpayers and Administrators
      DATE:  01/14/98
   SUBJECT:  Tax administration
             Consumption taxes
             Flat tax
             Value-added taxes
             Income taxes
             Taxpayers
             Tax returns
             Tax administration systems
             Tax law

             
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Cover
================================================================ COVER


Report to the Chairmen and Ranking Minority Members, Committee on
Finance, U.S.  Senate and Committee on Ways and Means, House of
Representatives

January 1998

TAX ADMINISTRATION - POTENTIAL
IMPACT OF ALTERNATIVE TAXES ON
TAXPAYERS AND ADMINISTRATORS

GAO/GGD-98-37

Alternative Taxes

(268702)


Abbreviations
=============================================================== ABBREV

  AMT - Alternative minimum tax
  CBIT - Comprehensive Business Income Tax
  CBO - Congressional Budget Office
  FICA - Federal Insurance Contributions Act
  IRA - Individual retirement arrangement
  IRS - Internal Revenue Service
  OECD - Organization for Economic Cooperation and Development
  RST - Retail sales tax
  TDA - Taxpayer delinquent account
  TDI - Taxpayer delinquency investigation
  VAT - Value-added tax

Letter
=============================================================== LETTER


B-265785

January 14, 1998

The Honorable William V.  Roth, Jr.
Chairman, Committee on Finance
United States Senate

The Honorable Daniel Patrick Moynihan
Ranking Minority Member, Committee on Finance
United States Senate

The Honorable Bill Archer
Chairman, Committee on Ways and Means
House of Representatives

The Honorable Charles B.  Rangel
Ranking Minority Member, Committee on Ways and Means
House of Representatives

In the past few years, many proposals have been put forward to
comprehensively reform the federal income tax system.  Proponents of
tax reform believe that replacing the current income tax system would
improve the performance of the economy and make the tax system
fairer.  Proponents of several proposals also believe that reform
would make administration of the tax law easier and less costly for
the government and make compliance with the law easier for taxpayers. 

To help Congress evaluate how tax reform would affect tax
administration and the burdens taxpayers face in complying with the
tax law, we studied, at our own initiative, the basic design features
of several kinds of tax systems.\1 The generic systems we studied are
a national retail sales tax (RST), two types of value-added taxes
(VAT), a flat tax, a personal consumption tax, and several versions
of broad-based income taxes.  Various forms of these alternative tax
systems have been included in specific legislative proposals in the
current and past sessions of Congress or have been prominent in tax
reform discussions generally. 

In this report, we describe (1) the major differences in design among
the alternatives we studied and (2) how the alternatives, by
incorporating different design features, may affect the taxpayers'
burden of complying with the tax laws and the government's
responsibilities for administering those laws.  The basic design
features we considered in contemplating alternative systems are the
tax base (what is taxed); the types of taxpayers (whether
individuals, businesses, or both are legally subject to tax); tax
preferences (tax system provisions, including exemptions, deductions,
credits, and multiple rates, directed at various economic and social
goals); and the tax rate(s).  We considered taxpayers' compliance
burden to include the time, effort, and cost of filing the required
returns and maintaining necessary records.  We defined tax
administration as including the government processing taxpayer
returns, assessing compliance with tax laws, collecting taxes owed,
and providing taxpayer assistance. 

This report is intended to be a reference document for readers with
different interests and needs.  The letter summarizes (1) how the
basic design features are included in the current income tax system
and could be incorporated into alternative tax systems and (2) what
the resulting impacts on compliance burden and administration could
be.  For readers who want more details on particular alternative tax
systems, the relevant appendixes contain more in-depth treatment. 


--------------------
\1 For information on how comprehensive tax reform could affect the
economy, see Congressional Budget Office, The Economic Effects of
Comprehensive Tax Reform, July 1997. 


   BACKGROUND
------------------------------------------------------------ Letter :1

Tax systems can have multiple goals.  For example, in addition to the
common goal of raising revenue for the government, goals can also
include redistributing income, stabilizing the economy, and achieving
various other social and economic objectives through the use of
preferences.  Generally speaking, the greater the number of goals,
the more complex is the tax system. 


      CRITERIA AND TRADE-OFFS
      RELATING TO THE DESIGN OF A
      TAX SYSTEM
---------------------------------------------------------- Letter :1.1

Tax systems are commonly judged and compared according to four
criteria:  equity, economic efficiency, simplicity, and
administrability.  A tax system is generally considered better than
alternatives that raise the same amount of revenue if it is more
equitable, more economically efficient, simpler for taxpayers to
comply with, and easier and less costly to administer.\2 In this
report, we focus on simplicity and administrability and do not
analyze equity and efficiency.  In deliberating on any changes to the
current tax system, Congress would need to consider each of the four
criteria. 

Designing a tax system that is superior on each of the four criteria
is difficult because the criteria frequently conflict with one
another and trade-offs must be made.  For example, a tax system that
provides credits to low-income individuals may be judged by some to
be more equitable than a system without this feature.  However, if
including credits makes it necessary for more individuals to
calculate their income and file tax returns, the tax system could
become more complex for both taxpayers and tax administrators. 


--------------------
\2 Equity refers to value judgments about how to tax taxpayers with
either similar or differing abilities to pay tax; thus, different
people have different views of what constitutes a fair tax system.  A
tax is economically efficient if, in the absence of market failures
or other distortions, it does not alter or distort incentives, such
as incentives to save, work, and consume.  See, also, Joint Committee
on Taxation, Description and Analysis of Proposals to Replace the
Federal Income Tax (JCS-18-95), June 5, 1995, pp.  58-59. 


      THE CURRENT SYSTEM
---------------------------------------------------------- Letter :1.2

The federal tax system raised about $1.4 trillion in fiscal year 1995
through individual and corporate income taxes, payroll taxes, various
excise taxes on certain goods and services, and estate and gift
taxes.  Income taxes accounted for 62 percent of total federal tax
revenue. 

The current income tax system includes an individual tax and a
business tax.  Wages, interest and dividend income, capital gains,
and some types of business income, including that of sole
proprietorships and partnerships, are taxed under the individual
income tax.  Individual income is taxed at graduated rates.  Income
earned by certain corporations is subject to a separate business
income tax, also at different rates. 

The current system provides exemptions and different tax rates on
savings and investment through a variety of special provisions, such
as the preferential treatment of pensions, individual retirement
accounts, life insurance, annuities, state and municipal bonds, and
capital gains.  The result is a hybrid income-consumption system of
taxation that exempts some types of saving and investment from tax
but taxes others.\3

The current system includes numerous other tax preferences.  Examples
include the earned income credit; specific deductions for home
mortgage interest, charitable contributions, and state and local
taxes; and exclusions of employer contributions for health insurance. 

Requirements for filing returns and performing other tax-related
functions vary.  All individuals with gross income above certain
thresholds based on personal allowances and a standard deduction must
file returns.  Businesses have certain responsibilities beyond filing
returns, including withholding and remitting employee income and
payroll taxes, such as Social Security, Medicare, and unemployment
taxes.  Further, many businesses must send information returns to the
Internal Revenue Service (IRS) and to individuals detailing income
paid as wages, interest, and dividends. 

For more detailed descriptions of the federal income tax system, as
well as its complexity and burdens for both taxpayers and tax
administration, see appendix II. 


--------------------
\3 A consumption tax is designed to tax only income that is used for
consumption, effectively exempting from tax income that is saved or
invested. 


      KINDS OF ALTERNATIVE TAX
      SYSTEMS WE STUDIED
---------------------------------------------------------- Letter :1.3

In the last several years, proposals for making fundamental changes
to the tax system have been discussed by policymakers and tax experts
in government, academia, and the private sector.  An overview of tax
reform design issues appears in appendix III.  The alternative tax
systems we studied are briefly described below and are further
detailed in appendixes IV through VIII. 

  -- A national RST would generally be collected by businesses making
     retail sales to final customers, with sales to other businesses
     generally not taxed. 

  -- VATs, now widely used internationally, are business-level taxes
     levied directly on the sales of goods and services.  All types
     of businesses, not just retail businesses, are subject to the
     tax, and sales to both consumers and other businesses are
     taxable.  With the credit method VAT, used by most
     industrialized countries, businesses claim a credit for tax paid
     on their purchases from other businesses, and with the
     subtraction method VAT, businesses deduct the amount of their
     purchases of goods and services from other businesses.  Thus,
     under a VAT, businesses pay tax on the value they add to the
     goods and services they purchase. 

  -- The flat tax discussed in this report would have both business
     and individual components.  The business tax would be similar to
     the subtraction VAT, except that wages, salaries, and pensions
     would be deducted by businesses.  Individuals would pay tax on
     wages, salaries, and pensions received above levels of
     allowances for themselves and their dependents.  The same,
     single (flat) tax rate would apply to both individuals and
     businesses. 

  -- A personal consumption tax would look much like the current
     individual income tax in that individuals would continue to pay
     tax on many kinds of income, such as wages, salaries, and
     interest and dividend payments received.  It would differ in
     that borrowed funds would be included in the tax base, and funds
     that are saved or invested would be deducted.  In most
     proposals, the personal consumption tax has been supplemented by
     a business tax designed to ensure that business purchases of
     goods and services for consumption, such as nonpension fringe
     benefits, would be taxed. 

  -- Income tax reform options that would replace the current income
     tax with a more broadly based income tax have been discussed by
     the Department of the Treasury and others over the years. 
     Instead of being replaced by a consumption tax system, the
     current tax system could be changed to a broad-based income tax
     system by, for example, eliminating preferences on certain types
     of income.  Some proposals for reforming the income tax would
     also change the collection point, or level, of tax.  Options we
     studied include levying taxes on businesses only, on businesses
     combined with a relatively simple individual tax, and primarily
     on individuals. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

The alternative tax systems we studied differ in their potential
impacts on taxpayer compliance burden and tax administration.  The
different potential impacts of the tax systems can largely be
explained by four basic design features:  (1) the basis for taxation
(income or consumption); (2) the type of taxpayer (individuals,
businesses, or both); (3) preferential tax treatment (e.g.,
exemptions, special deductions, and credits) for certain individuals,
businesses, or goods and services; and (4) the rate structure for
individuals (single or multiple rates).  Table 1 compares the design
features of the tax systems we studied and shows: 

  -- Many of the alternatives, namely, a national RST, VAT, flat tax,
     and personal consumption tax, would tax the same
     base--consumption. 

  -- Two consumption tax alternatives--the national RST and the
     VAT--would levy tax only on businesses, while the other two--the
     flat tax and the personal consumption tax--could tax both
     individuals and businesses.  Similarly, an income tax could be
     designed to tax individuals only, businesses only, or both
     individuals and businesses.\4

  -- Regardless of the base or the type of taxpayer, preferences
     could be included in any tax option, although the types of
     preferences provided would differ among systems. 

  -- Finally, under income or consumption tax systems that include a
     tax on individuals, individuals could be taxed at different tax
     rates, possibly including a zero rate. 



                                      Table 1
                      
                      Major Design Features of Alternative Tax
                           Systems and the Current System

                                                Tax       Number of tax rates for
        Tax base        Type of taxpayer    preferences        individuals\a
    ----------------  --------------------  ------------  ------------------------
Ta
x
sy
st
em
al
te
rn
at                                                                        Possibly
iv  Inco  Consumptio  Individual  Business        Possib        More      more
e   me    n           s           es        Yes   ly      One   than one  than one
--  ----  ----------  ----------  --------  ----  ------  ----  --------  --------
Cu  x     x           x           x         x                   x
rr
en
t
sy
st
em

Re  x                 x           x               x                       x
fo                    --------    -------
rm                    x           -
ed                    --------
in                                -------
co                                -
me                                x
ta
x
al
te
rn
at
iv
es

Na        x                       x               x       N/A   N/A       N/A
ti
on
al
RS
T

Va        x                       x               x       N/A   N/A       N/A
lu
e-
ad
de
d
ta
x

Fl        x           x           x               x       x
at
ta
x

Pe        x           x           \b              x                       x
rs
on
al
co
ns
um
pt
io
n
ta
x
----------------------------------------------------------------------------------
N/A = not applicable

\a Other than a tax rate of zero. 

\b Appendix VIII discusses options for taxing business purchases of
consumer goods and services, such as nonpension fringe benefits.  One
option would be to supplement the personal consumption tax with a
business-level cash flow tax. 

Source:  GAO analysis of the designs of alternative and current tax
systems. 

The differences in the four basic design features of the tax systems
we studied explain in large part the differing potential impacts of
the tax systems on taxpayer compliance burden and tax administration. 
For example, consumption-based taxes, such as the national RST, VAT,
flat tax, and personal consumption tax, would eliminate many of the
issues of defining and recognizing income that complicate income tax
systems and, in this respect, reduce taxpayer compliance burden and
tax administration activities.  This is because under an income tax,
taxpayers would be required to establish depreciation costs for
different types of assets, account for income earned but not
necessarily received, and keep records on the value of assets over
time.  Conversely, under a consumption tax, taxpayers could generally
rely on records of sales, of purchases, or of funds actually received
to calculate their tax liability.  Simplifying the determination of
tax liability for taxpayers could simplify assessing compliance and
providing taxpayer assistance for tax administrators. 

While different from income tax systems, the consumption-based
systems could also differ from each other in their potential impact
on taxpayer compliance burden and tax administration.  For example,
the personal consumption tax, requiring individuals to report their
borrowing and saving, could be more burdensome for both taxpayers and
administrators than other consumption-based systems.  Another example
involves a VAT and a national RST.  Because all sales, not just
retail sales, are included in a VAT, more recordkeeping and taxpayers
could be required under a VAT than under a national RST.  However,
some experts believe that the additional records could make
compliance assessment simpler for tax administrators. 

Tax systems that would tax only businesses, rather than individuals
and businesses, could reduce taxpayer compliance burden and the costs
of tax administration by greatly reducing the number of taxpayers
required to file returns.  With a VAT, a national RST, or a
business-level income tax, only businesses would be responsible for
determining tax liability, filing returns, and remitting taxes. 
Individuals' compliance burdens could be eliminated.  Tax
administrators could focus on many fewer taxpaying entities, thus
reducing the numbers of returns processed, actions taken to collect
taxes owed, and taxpayer questions needing answers.  In addition,
businesses would no longer be required to withhold individual tax and
file many types of information returns. 

Tax systems that combine a business tax with a relatively simple
individual tax, such as the flat tax or some versions of a reformed
income tax, could add limited burden relative to a business-only tax. 
A simple individual tax, if administered largely through withholding
and document matching, would have little need for the filing of
individual tax returns.  Tax systems requiring individuals to report
more information about their personal finances, such as a personal
consumption tax or a more complicated individual income tax, could
add more burden than a business tax combined with a simple individual
tax because more individuals could have to file tax returns and the
returns would be more complicated.  More tax returns and more
complicated returns would make returns processing, assessing taxpayer
compliance, and answering taxpayer questions more difficult for tax
administrators. 

The alternative tax systems in table 1 could all incorporate tax
preferences.  But, incorporating tax preferences--exemptions, special
deductions, credits, or multiple rates on goods and services aimed at
various economic and social goals--would generally add complexity. 
Tax preferences generally increase taxpayer compliance burden by
complicating the determination of tax liability, adding recordkeeping
requirements, and creating incentives to engage in tax planning. 
Similarly, tax administration would be made more complicated because
tax administrators would need more information and time to verify the
accuracy of tax returns and collect taxes owed.  Tax administrators
would also face more questions from taxpayers. 

Tax systems with multiple tax rates for individuals, which could
include income taxes and a personal consumption tax, do not need to
add burden to taxpayers' calculation of tax liability compared to
single-rate systems.  Multiple rates for individuals add little to
the burden of computing tax liability because the use of tax tables
minimizes this burden.  Rate schedules for multiple rate systems
could include a zero rate or provide one implicitly through a
standard deduction or personal exemptions.  A zero rate or its
equivalent would limit the number of taxpayers having to file returns
and reduce the processing volume for tax administrators.  However,
tax systems with multiple rates could encourage tax planning, which
would increase burden for taxpayers and make tax administration more
complex. 

In addition to impacts due to the four basic design features, the
transition to an alternative tax system could affect taxpayer
compliance burden and tax administration.  The extent of the impact
would depend on the type of transition allowed.  For example, if a
consumption tax system were adopted, a transition might allow for the
gradual phaseout of depreciation.  In the event of such a transition,
taxpayers and tax administrators could be required to keep and check
records for both the old and the new systems, complicating the
determination and verification of tax liability during the transition
period. 


--------------------
\4 Regardless of whether a tax is levied on individuals or
businesses, individuals will ultimately bear the economic burden of
any tax.  For example, while an RST is levied on, or collected by,
businesses, individuals are commonly thought to bear the economic
burden of the tax through higher prices.  Because this report focuses
on compliance burden rather than on economic burden, we use the term
taxpayer to refer to the individual or other entity on whom the tax
is levied rather than to whoever bears the economic burden of the
tax. 


   MAJOR DESIGN DIFFERENCES AMONG
   ALTERNATIVE TAX SYSTEMS
------------------------------------------------------------ Letter :3

Table 1 lists four basic design features of the tax systems we
studied:  (1) the basis for taxation (income or consumption); (2)
whether individuals, businesses, or both would be subject to tax; (3)
whether tax preferences could exist for certain individuals,
businesses, or goods and services; and (4) the rate structure for
individuals (single or multiple rates). 


      AN INCOME OR CONSUMPTION TAX
      BASE
---------------------------------------------------------- Letter :3.1

One major difference in the design of alternative tax systems is
whether the tax base is income or consumption.  An income tax system
generally does not allow deductions for savings and requires that
earnings on savings be measured and taxed as they are earned.  Also,
it generally requires that businesses depreciate their purchases of
assets, that is, deduct the cost of assets over time rather than at
the time they are purchased. 

Consumption-based tax systems differ from income-based tax systems in
that they generally exempt from tax income from savings and
investment.  The national RST, VAT, flat tax, and personal
consumption tax would achieve this exemption in different ways. 
Under a national RST, businesses would generally not pay tax on goods
and services they buy.  Under the VAT and the flat tax, businesses
could immediately deduct purchases of goods and services, including
purchases of plant and equipment, that they made from other
businesses.  Under a personal consumption tax, funds that are saved
or invested would be deducted by individuals. 


      TYPE OF TAXPAYER
---------------------------------------------------------- Letter :3.2

Another major design difference among alternative tax systems is who
would be subject to tax.  Consumption and income taxes could be
levied on individuals, businesses, or both.  By levying tax directly
on individuals, a tax system can make distinctions among individuals
or households to account for varying individual circumstances by, for
example, allowing deductions and multiple rates.  Alternatively, a
tax system could focus only on businesses and thus require fewer
taxpayers. 

The alternative consumption tax systems we considered differ from one
another according to who would be taxed. 

  -- The national RST and the VAT generally would only tax
     businesses.  All types of businesses, including corporations, as
     well as partnerships and sole proprietorships, could be subject
     to tax.  A national RST would differ from a VAT in that only
     businesses making retail sales would be subject to a national
     RST, while retail and wholesale businesses could be VAT
     taxpayers. 

  -- The flat tax would collect much of the tax base from businesses
     but also would include a relatively simple individual tax. 

  -- The personal consumption tax would continue to tax individuals. 
     In conjunction with this tax, businesses could be subject to a
     supplemental tax. 

Similar to the national RST, VAT, or flat tax, an income tax could be
designed to collect taxes from businesses rather than from
individuals.  Such an income tax could, for example, disallow
business deductions for wages and free individuals from filing
returns.  It would collect tax on all or part of individuals' incomes
where the incomes were generated and before they were paid.  Other
income tax options would, like the current income tax system and the
personal consumption tax system, tax most types of income at the
individual level.\5


--------------------
\5 The various income tax options are described in appendix IV. 


      PREFERENTIAL TREATMENT
---------------------------------------------------------- Letter :3.3

Each of the various alternatives could include tax preferences,
although the types of preferences provided would differ among
alternatives.  These preferences could include special deductions,
exemptions, and/or credits, as well as various tax rates on different
types of income or goods and services. 

The types of taxpayers in a tax system would influence the type of
preferences that could be allowed.  Alternatives that tax individuals
directly could include preferences designed to target specific groups
of individuals.  It would be more difficult for a tax system, such as
a national RST or a VAT, that applied only to businesses to provide
preferences for groups of individuals because businesses can apply
different tax rates to goods and services but cannot distinguish
among individuals.  Preferences under business-level taxes could also
include exemptions of specific types of businesses or activities. 


      TAX RATES
---------------------------------------------------------- Letter :3.4

The fourth design difference is the rate structure for
individual-level income or consumption tax systems.  The alternatives
that we considered that include an individual-level tax--the flat
tax, the personal consumption tax, and several income tax
options--could tax different individuals at different rates.  All
these options could include what is, in effect, a zero tax rate by
providing a standard deduction or personal allowances.  For example,
under the flat tax, individuals with wage income under the personal
allowance amount would not owe any individual tax; wage income above
the deduction or allowance amounts would be taxed at a single rate. 
Individual-level taxes in general could apply a single tax rate or
multiple rates. 


   IMPLICATIONS OF THE ALTERNATIVE
   TAX SYSTEMS FOR TAXPAYER
   COMPLIANCE BURDEN AND TAX
   ADMINISTRATION
------------------------------------------------------------ Letter :4

Because of differences in the four basic design features, the tax
systems we studied would have different impacts on taxpayers' and tax
administrators' responsibilities, and thus on taxpayers' compliance
burden and the costs of tax administration.  This section describes
basic types of taxpayer and administration responsibilities and the
potential effects of the alternative tax systems on each of them. 


      TAXPAYERS' AND TAX
      ADMINISTRATORS' BASIC
      RESPONSIBILITIES
---------------------------------------------------------- Letter :4.1

The taxpayer compliance burden created by any tax system will depend
on how many taxpayers have tax-related responsibilities, such as
filing tax returns, and on what difficulties these taxpayers face
carrying them out.  Similarly, tax administration is affected both by
the number of taxpayers and by the difficulty of carrying out
administrative responsibilities related to each taxpayer.  Table 2
shows the basic taxpayer and tax administration responsibilities we
identified.\6



                                Table 2
                
                Basic Responsibilities of Taxpayers and
                           Tax Administrators

                                          Tax administrators' related
Taxpayers' responsibilities               responsibilities
----------------------------------------  ----------------------------
File tax returns                          Process filed returns and
                                          maintain accurate taxpayer
                                          accounts

Determine correct tax amounts, maintain   Devise programs, such as
supporting documentation, and produce     examination and document
support for information on returns upon   matching programs, to assess
request of tax administrator              taxpayers' compliance with
                                          laws

Remit taxes owed                          Collect taxes owed but not
                                          remitted

Get assistance, if necessary, from tax    Assist taxpayers by
administrators or paid preparers to       answering specific
voluntarily comply                        questions, providing tax
                                          forms and publications, or
                                          helping with tax return
                                          preparation
----------------------------------------------------------------------
Source:  GAO analysis of taxpayer and tax administrator
responsibilities under tax systems in general. 

In many respects, tax systems that are relatively easy for taxpayers
to comply with will also be relatively easy to administer, and
alternatives that are relatively burdensome for taxpayers will also
be more difficult to administer.  For instance, the more taxpayers
that have to file returns, the more returns the administrators must
process and accounts they must maintain.  Likewise, a system's
complexity resulting from exemptions, deductions, and other
preferences could affect taxpayers and administrators similarly by
increasing their respective burdens. 

However, in some instances, burden could be shifted from government
administrators to taxpayers or from taxpayers to government
administrators.  For example, U.S.  businesses currently perform some
duties to help ensure compliance, such as withholding and providing
information returns, that tax administrators could do through other
means. 


--------------------
\6 In this report, we do not focus on tax administrators' activities,
such as monitoring private pension plans, that do not fall under one
of the four basic responsibilities we describe.  Similarly, we do not
address whether new government spending programs that could require
separate administration would replace certain activities now
encouraged through the tax system. 


      POTENTIAL EFFECTS OF
      ALTERNATIVE TAX SYSTEMS ON
      TAXPAYERS' AND
      ADMINISTRATORS' BASIC
      RESPONSIBILITIES
---------------------------------------------------------- Letter :4.2

The overall costs to taxpayers and tax administrators of carrying out
their basic responsibilities under the tax systems we studied are
difficult to quantify.  Even for the current income tax system, while
IRS' administration costs are known, only very rough estimates exist
for taxpayer compliance burden.  This is because of the difficulty in
separating accounting and recordkeeping costs for tax purposes from
those that are incurred for other purposes and because taxpayers may
not measure such costs.  Estimates of taxpayer compliance burden for
the current income tax vary widely, but all are many times larger
than IRS' fiscal year 1998 budget of $7.8 billion. 

In a qualitative sense, changing from the current income tax system
to an alternative system would potentially affect each of the basic
responsibilities that taxpayers and tax administrators have.  The
following discussion of possible impacts on each area of
responsibility precedes a table summarizing them and relating them to
different tax systems. 


         RETURN FILING AND
         PROCESSING
-------------------------------------------------------- Letter :4.2.1

The tax systems we studied could differ significantly from each other
in the number of returns filed by taxpayers and processed by
administrators.  Business-level tax systems generally have fewer
filers than individual-level tax systems or systems that combine a
business and individual tax.  Business-level tax systems also
generally require less information reporting. 

The current income tax system is relatively complex in the sense that
some income is taxed at the individual level, some at the business
level, and some at both levels.  In 1995, taxpayers filed and IRS
processed about 116 million individual tax returns, of which about 18
million reported income from a sole proprietorship.  Another 6
million returns were filed by partnerships and corporations. 
Employers, investment institutions, and others sent IRS about 1.1
billion information returns, including withholding documents for
wages and information on investment earnings. 

The alternative tax systems that would only tax businesses, such as
the national RST or the VAT, would eliminate individual tax filing
requirements.  In addition, businesses would not be required to file
information returns related to individuals.  The total number of
returns filed under these options would depend on how many businesses
were subject to tax and on how frequently returns were required.  For
instance, while only businesses would be required to file tax returns
under a national RST or a VAT, they could be required to file
quarterly or monthly.  Under a VAT, small businesses could be
exempted, and under a national RST, wholesalers would not have to
file tax returns. 

The alternatives that include a business tax and a relatively simple
individual tax would likely require return filing by businesses and
by some individuals.  However, the number of individual returns filed
and processed under these alternatives could be significantly less
than under the current income tax system.  Under a flat tax or one
reformed income tax option, a "return-free" filing system could be
feasible because wages and salaries would be the only type of income
subject to tax for many individuals.  These employees would not have
to file returns if employers withheld tax on wages during the year
and made any necessary adjustments in withholding at the end of the
year so that the amount of tax withheld equaled tax liability.  If
these alternatives also featured large standard deductions or
personal allowances, the need for individual returns would be further
reduced. 

Under the personal consumption tax or certain reformed income tax
options we studied, large numbers of individual tax returns and
information returns could still be required.  The individual tax
under these systems would be relatively complex in the sense that
many types of funds or income would be taxable for individuals. 
Withholding correct amounts of tax would be more difficult for
employers and other businesses because final tax liability would
depend on the total amount of income or funds individuals receive
from many sources.  Unless withholding was extended to other types of
taxable funds, individuals would likely be required to account for
all types of taxable funds on their tax returns, and employers and
businesses could be required to provide information returns to both
individuals and tax administrators.  Under a personal consumption
tax, additional information returns related to borrowing and saving
could be required, resulting in increased burden for the businesses
required to file the returns and for tax administrators. 


         DETERMINING CORRECT TAX
         AMOUNTS AND ASSESSING
         COMPLIANCE
-------------------------------------------------------- Letter :4.2.2

Because of differences in the four design features we discussed
earlier, the tax systems we studied would differ in the burden
experienced by taxpayers in determining their tax liability and in
the costs to tax administrators of assessing compliance. 

In terms of the first design feature, the basis for taxation,
consumption-based taxes, such as the national RST, VAT, flat tax, and
personal consumption tax, could make determining tax liabilities by
taxpayers and, correspondingly, tax administrators' assessment of
taxpayers' compliance simpler in some respects than income-based
taxes.  This is because many difficulties of defining and recognizing
income would be eliminated.  To measure income from saving and
investment as it is earned, taxpayers have to estimate costs for
depreciation, account for income earned but not necessarily received
as cash, and keep records on the value of assets over time.  Also,
taxpayers could have to decide if expenses are deductible or must be
capitalized.  Similarly, tax administrators must be able to verify
the income measurements required under an income tax.  In contrast,
consumption tax liability can generally be accurately calculated by
taxpayers and verified by tax administrators by using records of
sales, purchases, and funds actually received. 

Whether an income or consumption tax system includes an individual
tax and how complex that tax is would also affect the ease or
difficulty of determining taxes and assessing compliance.  Under the
flat tax and one income tax option we considered, many individuals
would face relatively few recordkeeping responsibilities and
determining tax liability would be relatively simple, especially if
taxes on wages were withheld by businesses.  Tax administrators could
largely administer these individual taxes by checking that proper
amounts were withheld or by matching individual tax returns with
information returns.  Based on experience with the current income tax
system, compliance would likely be high and few audits of individuals
might be necessary.  In contrast, under alternatives with more
complex individual-level taxes, recordkeeping and tax determination
burdens would likely be higher.  For example, under some individual
income tax options, individuals would have to keep records or receive
information reports for many types of income.  Under a personal
consumption tax, individuals could be responsible for keeping records
on borrowing and saving and including these amounts in their tax
calculations.  More extensive document matching and auditing would
probably be needed to ensure a high level of compliance. 

Even though a national RST and a VAT tax the same
base--consumption--and the same type of taxpayer--businesses--they
could still affect assessing tax compliance differently.  For a
national RST and a subtraction VAT, administrators would have to rely
on businesses' own records to verify that the proper tax had been
paid.  However, with a credit VAT, there would be a certain amount of
checking available through records of other businesses; this is
thought by some tax specialists to improve compliance.  Also, based
on state and international experience, many experts believe that
including sales of all types in the tax base and allowing businesses
to deduct or receive a tax credit for purchases from other
businesses, as under a VAT or flat tax, would have some compliance
advantages over a national RST.  While including sales of all types
in the tax base would require more recordkeeping and more taxpayers,
it could better ensure that business purchases would not be
overtaxed, taxes of sales to households would be reported, and a
paper trail would be created so that compliance could be better
assessed. 

Preferences--that is, exemptions, deductions, credits, and multiple
rates on goods and services--could be part of any of the alternative
tax systems we considered and could often complicate, but sometimes
simplify, how tax liability is determined and verified.  Preferences
could force taxpayers to determine and tax administrators to verify
whether an income or consumption item is taxable, nontaxable,
deductible, or taxable at a different rate.  The burdens associated
with extensive use of preferences could include (1) more
recordkeeping than otherwise, as was the case for the estimated 33
million individuals who reduced their tax liability by itemizing tax
deductions for tax year 1993; (2) more time for determining and
reporting tax liability; and (3) more tax planning by taxpayers. 
These burdens would require more audit time from tax administrators. 
On the other hand, in some instances, preferences given through
exemptions could simplify taxpayers' burden.  For example, if, as is
commonly done with a VAT, large numbers of small businesses were
exempted, they would not have to file returns or remit tax, thus
easing their compliance burden.  However, tax administrators would
have to verify compliance by determining that only eligible taxpayers
took the exemption. 

The fact that some tax systems--the current income tax, versions of a
reformed income tax, and the personal consumption tax--have or could
have multiple rates on individuals imposes little additional burden
on taxpayers or tax administrators except to the extent that multiple
rates encourage tax planning.  Graduated rates alone have little
effect on the actual tax calculation burden of taxpayers who can
determine their tax liability through a tax table.  Tax
administrators still must verify that proper rates have been applied. 
However, multiple tax rates could encourage taxpayers to devote
resources to tax planning in order to avoid high marginal rates. 


         TAX REMITTANCE AND
         COLLECTION
-------------------------------------------------------- Letter :4.2.3

The issues related to this third area of taxpayer and tax
administration responsibilities we discuss--tax remittances and
collections--may not differ greatly among the tax systems we
considered except that widely different numbers of taxpayers would be
responsible for remitting the taxes.  If individuals, including the
18 million individuals owning sole proprietorships, no longer had to
file tax returns as individuals but only in their capacity as
business owners, nonbusiness collection issues related to them would
disappear.  Similarly, if a simpler tax reduced the problems tax
administrators found during examinations, or if changes in
withholding or other information reporting reduced the number of
mismatches requiring follow-up, tax administrators would be less
likely to assess additional taxes they would then have to collect. 

In its responsibility for collecting unpaid taxes from taxpayers who
filed but did not pay the required tax or who did not file required
returns, in fiscal year 1995, IRS' collection function disposed of
millions of taxpayer delinquencies.  Business delinquencies most
commonly involved employment taxes. 

An issue of concern to administrators in the current tax system
involves businesses, particularly small ones, getting into financial
difficulty and using collected taxes as working capital rather than
remitting them to the administrators.  This problem could continue
under many of the alternatives we considered, including a national
RST or a VAT, and it could be more pervasive if the amounts of taxes
to be collected and remitted by businesses were higher than under the
current income tax system or state sales tax systems.  The amounts
could be higher because specific businesses would be processing
federal taxes on their sales in addition to their payrolls and could
face a greater temptation to retain some of the money for their own
use.  More frequent remitting and filing could reduce noncompliance
but increase the burden on businesses. 


         TAXPAYER QUESTIONS AND
         ASSISTANCE
-------------------------------------------------------- Letter :4.2.4

Although the universe of taxpayers who must file returns could change
under the various alternatives, those who would still need to file
would likely have questions that still needed to be answered.  Even
if a "return-free" tax system were adopted, questions about
individuals' involvement with the system would still arise.  However,
the probable reduction in the number of taxpayers, particularly
individuals, under some of the alternatives and the removal of
certain complex provisions, such as defining and recognizing income
and providing deductions, would likely reduce the overall level of
assistance needed. 

On the other hand, the more complications introduced under any
alternative tax system, such those introduced with many preferences,
the greater would be the need for tax administrator assistance in
those areas.  Greater assistance would also be needed for certain
alternatives' distinctive complicating features, such as the personal
consumption tax' reliance on borrowing and savings information.  The
more radical the departure from the current income tax system, the
more likely that assistance or education would be needed in the short
term. 

Table 3 provides primarily qualitative information about alternative
tax systems in the four areas of taxpayer and tax administrator
responsibilities we have just discussed.  More detailed tables for
each tax system are shown in appendixes IV through VIII. 



                                                                       Table 3
                                                       
                                                        Potential Implications of Alternative
                                                          Tax Systems for Taxpayers and Tax
                                                                    Administrators

                                                               Taxpayer and tax administrator responsibilities
                        -----------------------------------------------------------------------------------------------------------------------------
                                                            Determining correct tax
                                                            amounts and assessing          Tax remittance and            Taxpayer questions and
Tax system alternative  Return filing and processing        compliance                     collection                    assistance
----------------------  ----------------------------------  -----------------------------  ----------------------------  ----------------------------
Current system          In 1995, 116 million individual     Need to define and recognize   Collections needed from       Almost 111 million calls
                        tax returns, including              income; wide range of          millions of nonfilers and     answered by IRS in fiscal
                        18 million sole proprietorships; 6  exemptions, deductions, and    filers without full           year 1995
                        million corporate and partnership   credits; complex               remittance; small
                        tax returns filed; 1.1 billion      calculations; documents        businesses' employment taxes
                        information returns filed by        matched, enhancing             a particular problem
                        businesses and other payers         compliance; about 1.7 and 2.0
                                                            percent of individual and
                                                            corporate returns,
                                                            respectively, examined in
                                                            fiscal year 1995

Reformed income tax     For individual tax, number of       Complexity owing to measuring  For individual tax, most tax  Most current questions still
alternatives            filers contingent on amounts of     capital income; continuing     remitted by businesses        relevant, unless individual-
                        standard deduction and              need to match documents and/   through withholding, but      level tax simplified or
                        withholding; number of tax and      or examine returns; possibly   delinquent accounts possibly  eliminated
                        information returns reduced (or     complex changes needed to tax  increased by taxing more
                        possibly eliminated) by options     all income but tax planning    types of income; individual
                        taxing more income at business      possibly reduced               remittances and delinquent
                        level                                                              accounts possibly reduced
                                                                                           under other options

National RST            Businesses, including at least 10   No need to define and          Nonbusiness collection        Fewer questions than under
                        million retailers and service       recognize income;              issues eliminated;            the current system because
                        providers, responsible for filing   difficulties arising from      delinquent amounts a          of individuals not filing
                        periodically during the year if     exemptions for goods and       continuing concern given      and fewer likely areas of
                        they sell to final consumers;       services or sales to           large collections by          inquiry
                        information returns generally       businesses and from            businesses and possible
                        eliminated                          incompatible state and         temptation for small
                                                            federal tax systems;           businesses, especially, to
                                                            compliance chiefly verified    use collections as working
                                                            by checking records on sales,  capital
                                                            not income

VAT                     About 24 million businesses         No need to define and          Nonbusiness collection        Fewer questions than under
                        (corporations, partnerships, and    recognize income; fraud        issues eliminated; tax        the current system because
                        sole proprietorships) responsible   potential related to exports;  payment spread over all       of individuals not filing
                        for filing, unless small            credit VAT: tax system         businesses, not just those    and fewer likely areas of
                        businesses exempted; information    complicated by exemptions of   selling to final consumers;   inquiry
                        returns eliminated                  goods or services and          if small businesses not
                                                            multiple rates,                exempt, collection problems
                                                            administration simplified by   increased
                                                            invoice mechanism;
                                                            subtraction VAT: unlike
                                                            credit VAT situation,
                                                            multiple rates and exemptions
                                                            not suitable and auditing
                                                            dependent on business' own
                                                            records

Flat tax                Both individuals and businesses     Compliance aided by no need    Fewer delinquency problems    Taxpayer assistance on many
                        responsible for filing, though      to define and recognize        for individuals likely if     complex issues unneeded
                        nearly half of individuals          income, by fewer deductions,   withholding continues, but    owing to tax's simplicity,
                        possibly excused owing to large     and by continued withholding;  small business difficulties   although individual returns
                        personal allowances; no             unlike credit VAT situation,   similar to difficulties with  still possibly required
                        information returns for savings or  auditing dependent on          employment taxes
                        investment                          business' own records

Personal                Large number of individual filers   Many issues of defining and    Withholding possibly not      Questions on filing
consumption tax         likely; business filings or         recognizing income             closely matching tax          requirements, filing status,
                        allocations to individuals needed;  eliminated; information        liability, with more returns  account information
                        new information returns possible    returns, audits needed to      owing taxes after matching,   continued but not on
                                                            verify borrowing (e.g., on     possibly leading to more      calculations of capital
                                                            credit cards), proceeds from   delinquent accounts than      income; new questions on
                                                            sales of assets, and savings   otherwise                     borrowing, proceeds from
                                                                                                                         sales of assets, savings
-----------------------------------------------------------------------------------------------------------------------------------------------------
Source:  GAO analysis of tax system alternatives. 


   TRANSITION TO A NEW TAX SYSTEM
------------------------------------------------------------ Letter :5

A wide range of options exist for moving from the current income tax
system to an alternative tax system, and the way that any transition
is formulated could have significant effects for economic efficiency,
equity, taxpayer compliance burden, and tax administration.  Many
transition issues involve how income and deductions related to saving
done before the transition to the new system should be treated. 
Consumption taxes, while designed to encourage new saving, could tax
existing saving when it is used for consumption; in general, existing
saving would not be subject to tax again under the current income tax
system.  Special rules designed to exempt existing saving from tax
could burden individuals with additional recordkeeping, filing, and
tax determination requirements and create additional tax compliance
issues for tax administrators.  Another transition issue involves
whether tax credits and other tax benefits already earned under the
current tax should be made available under a new system.  For
example, what would happen to depreciation expenses for existing
investments that businesses would have been able to deduct if the
current tax were retained?  Depending on how these and other
compliance issues are addressed, taxpayer compliance burden and tax
administration responsibilities could be greater in the transition
period than when a new system is fully phased in.  We discuss
transition broadly in appendix III and on an
alternative-by-alternative basis in appendixes IV through VIII. 


   OTHER ISSUES
------------------------------------------------------------ Letter :6

Other issues, many of which are hard to handle even now, could also
have significant implications for both taxpayers and tax
administrators under most, if not all, of the alternative tax systems
we discuss.  Some of these issues are (1) the extent to which
employee benefits, such as employer-provided health insurance, should
be included in the tax base; (2) how to deal with the special
complexity and difficulty of taxing financial services; (3) how
housing would be taxed; (4) whether governments and nonprofit
organizations should be taxpayers and filers; and (5) how
international activities would be taxed. 

Another important issue would be the relationship between federal tax
filing and reporting requirements and those of states and localities,
especially in those jurisdictions that currently piggyback on the
federal income tax system.  Changing the federal system could
effectively force states to change or even abandon their own income
tax systems because they depend on the federal tax infrastructure. 
For example, states depend on IRS' information reporting program and
use income reported on federal tax returns as a starting point on
state returns. 

These issues are discussed broadly in appendix III or in separate
sections in the appendixes for the various tax system alternatives. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7

To accomplish our objectives related to the different alternatives,
we (1) studied relevant literature, (2) reviewed our previous reports
covering taxpayer compliance burden and tax administration issues
throughout the 1980s and 1990s, (3) held discussions with tax
specialists inside and outside IRS, and (4) examined data related to
current tax systems.  The bibliography at the end of this report
lists our major references on alternative tax systems.  We did our
work in Washington, D.C., between August 1995 and November 1997 in
accordance with generally accepted government auditing standards. 
Our objectives, scope, and methodology are further discussed in
appendix I. 

The alternatives included in this study were chosen because they
represented different approaches that have emerged in public
discussions about tax reform.  They do not include all possible ways
of changing the current income tax system.  The report focuses on the
implications for compliance burden and administration of replacing
the current income tax system, although some advocates for changing
the tax system have proposed replacing other taxes as well.  The
report does not analyze implications for the economy, such as effects
on saving, work incentives, and economic growth, or for the
distribution of the tax burden among different types of individuals. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

We provided a draft of this report to the Secretary of the Treasury
and the Acting Commissioner of Internal Revenue for comment.  IRS
deferred to Treasury, and responsible Treasury officials, including
the Director of the Office of Tax Analysis, provided comments in a
July 31, 1997, meeting.  The Treasury officials had no major problems
with the draft but suggested various points that we should emphasize,
make parallel, or clarify.  We have incorporated their comments as
appropriate. 


---------------------------------------------------------- Letter :8.1

We will send copies of this report to the Secretary of the Treasury,
the Commissioner of Internal Revenue, other interested committees,
and other interested parties on request. 

This work was done under the direction of Mark J.  Gillen, Assistant
Director for Tax Policy and Administration Issues; other major
contributors are listed in appendix IX.  If you have any questions,
please call either one of us on (202) 512-9110. 

Lynda D.  Willis
Director, Tax Policy and
 Administration Issues

James R.  White
Associate Director, Tax Policy
 and Administration Issues


OBJECTIVES, SCOPE, AND METHODOLOGY
=========================================================== Appendix I

Our work had two objectives.  The first was to describe major
differences in attributes among alternative tax systems.  Our second
objective was to describe how the alternatives, by incorporating
these differences, may affect taxpayers' burden of complying with the
tax laws and the government's responsibilities for tax
administration.  Taxpayers' compliance burden includes their filing
the required returns, maintaining the necessary records to support
the information reflected on those returns, and accurately
calculating their tax liabilities in the face of whatever complexity
the tax code presents.  Tax administration responsibilities include
processing taxpayer returns and maintaining accurate taxpayer
accounts, verifying the accuracy of return information, collecting
the proper amount of taxes owed and considered delinquent, and
providing taxpayers with needed information or assistance.  We
selected the major alternatives we studied based on the ideas that
have emerged in public discussions about tax reform. 

To accomplish our first objective--describing the major differences
in attributes among alternative tax systems--we studied the
literature related to the current income and sales tax systems and to
various alternative tax systems that have been developed over the
years.  This literature included our own reports on income and
consumption taxes and reports of other government organizations,
journal articles, academic and research papers, and other materials
related to the various alternatives.  A bibliography of sources we
used discussing alternative tax systems appears at the end of this
report.  We also attended tax conferences to enhance our
understanding of these tax system alternatives and how they related
to specific proposals that have emerged.  In the report, we limited
ourselves to discussing the basic features of each alternative
system, knowing that any implementing details would have to evolve
through the political process. 

In accomplishing the first part of our second objective--describing
how alternative systems might affect taxpayer compliance
responsibilities--we considered what categories of taxpayers might
still have to file returns under the various systems.  We also
researched the literature for information that would enable us to
analyze items, such as the amount of taxpayer recordkeeping and
calculations that would be required in preparing tax returns, the
type of information that would be included in the returns, and filing
frequency.  Finally, we pinpointed references in our previous reports
to taxpayer compliance burden issues and assessed how these issues
would be affected under new systems. 

We did similar work in accomplishing the last part of our second
objective--describing the alternative systems' potential impacts on
tax administration.  In reviewing the relevant literature, we
specifically examined our previous reports covering various aspects
of the tax systems and IRS.  We also discussed specific
administrative functions with tax specialists inside and outside IRS,
reviewed data on IRS' recent administrative experiences from
published sources and from within IRS, and studied summaries of state
sales tax experiences.  In analyzing the alternatives, we addressed
(1) the administrative functions of returns processing, document
matching and examination, collections, and taxpayer services; and (2)
issues pertaining to transition, state tax administration, and
international tax administration. 

In addition, to help accomplish the second objective, we interviewed
officials of, and reviewed documents from, three state tax
administrations and two state tax associations.  The three states
were New York, Florida, and New Mexico.  We selected these three
states based on suggestions from the Federation of Tax Administrators
of states that were knowledgeable about issues we were examining. 
Because of the existence of actual sales tax systems in the various
states and credit-invoice value-added taxes (VAT) in different
countries, the collective experience with these taxes was more
specific than the experience with other alternatives we were
studying. 

Our intention in doing this study was to stress compliance and
administration issues associated with the alternative systems using
knowledge that we had accumulated throughout the 1980s and the 1990s. 
Our intention was not to examine other implications of the
alternatives, such as their effect on the economy or on the
distribution of the tax burden.  Nor did we rank them against each
other, assess the relative severity of the various implications, or
weigh the administrative arguments and counterarguments regarding
particular ideas. 

In identifying issues in as broad an arena as the potential impact of
alternative tax systems on taxpayers and the potential implications
for tax administration, we touched on some topics only briefly or not
at all.  For example, we did not do an in-depth analysis of the
relationship of alternative systems to IRS' sweeping Tax Systems
Modernization plans.  This IRS effort, inextricably linked with
streamlining whatever IRS-administered tax system might exist,
regardless of whether it modified or replaced the current income tax,
involves years of work and billions of dollars.  However, basic tax
administration functions, such as returns processing, document
matching and examination, collections, and taxpayer services, would
still be in place under a new system.  We did not try to estimate the
resources or costs involved in administering any of the systems,
regardless of how the modernization effort proceeded. 

Similarly, our study did not focus on the relationship of individual
alternatives to the particular problems of taxpayer compliance and
tax system administration for specific types of entities.  For
example, this report does not concentrate on the special
considerations that would apply under different alternatives
regarding the financial services industry and nonprofit
organizations.  It does, however, describe how financial and
nonprofit services might present administrative difficulties under a
consumption tax. 

In focusing on the effects on the agency primarily responsible for
tax administration, we did not analyze the impacts on other agencies. 
For instance, we did not examine how the U.S.  Customs Service's
taxation of imports and tracking of exports would be affected.  Nor
did we evaluate the role of the Federal Reserve System in receiving
payments under a new tax system. 

We requested comments on a draft of this report from the Secretary of
the Treasury and the Acting Commissioner of Internal Revenue.  IRS
deferred to Treasury, and we met with Treasury officials on July 31,
1997, to discuss the report.  Treasury's comments are characterized
near the end of the letter of this report and incorporated into the
letter and appendixes as appropriate. 

We did our work in Washington, D.C., between August 1995 and November
1997 in accordance with generally accepted government auditing
standards. 


CURRENT INCOME TAX
========================================================== Appendix II


   BACKGROUND
-------------------------------------------------------- Appendix II:1

In fiscal year 1995, IRS' revenues totaled about $1.4 trillion from a
variety of sources.\1 As shown in figure II.1, about half came from
the individual income tax, more than three-quarters of which had been
withheld by employers.  About a third more arrived through employment
taxes, with the largest component by far being Social Security and
Medicare taxes under the Federal Insurance Contributions Act (FICA). 
Another 13 percent of IRS' total revenues resulted from the corporate
income tax.\2

   Figure II.1:  Sources of IRS
   Gross Revenue, Fiscal Year 1995

   (See figure in printed
   edition.)

Source:  IRS, 1995 Data Book. 


--------------------
\1 This amount is before considering refunds of $106 billion and
associated interest. 

\2 Based on IRS estimates projected from samples, about 2 percent of
the 2.1 million income year 1993 returns of active corporations (not
including S corporations, real estate investment trusts, and
regulated investment companies) accounted for about 96 percent of the
income tax after credits due from those corporations for that year. 


      INDIVIDUAL INCOME TAX
------------------------------------------------------ Appendix II:1.1

As shown in table II.1, depending on its amount, individuals' income
is taxed at five different rates, ranging from 15 to 39.6 percent,
with most taxpaying individuals falling into the 15-percent tax
bracket.  Individuals in certain circumstances are not liable for any
income tax at all and may even be eligible for the earned income
credit, which can pay them money.  The credit is available to
low-income working people with children and, beginning in tax year
1994, to certain people without children. 



                               Table II.1
                
                   Estimated Number of Tax Year 1993
                Individual Tax Returns Classified by the
                 Highest Marginal Rate at Which Tax Was
                                Computed

                                                 Number of returns (in
Tax rate category                                            millions)
----------------------------------------  ----------------------------
15 percent                                                        65.6
28 percent                                                        21.2
28 percent (capital gains)                                         0.3
31 percent                                                         2.2
36 percent                                                         0.8
39.6 percent                                                       0.5
Form 8615\a                                                        0.3
All categories\b                                                  90.7
----------------------------------------------------------------------
Note:  This table excludes individual tax returns with no tax
liability. 

\a This form contained certain investment income reported by children
under age 14. 

\b The number in this row does not equal the sum of the other rows
because of rounding. 

Source:  IRS, Individual Income Tax Returns 1993. 

Individuals figure their income tax by going through a series of
steps.  First, they compute their taxable income by determining their
filing status (e.g., single versus married); the exemptions to which
they are entitled; their total income; adjustments to income; and
deductions from income, either a standard deduction based on filing
status or deductions itemized to their specific circumstances.  They
then use their taxable income to compute their tax liability, which
may be adjusted by, among other items, tax credits and other taxes
such as the alternative minimum tax (AMT). 


      CORPORATE INCOME TAX
------------------------------------------------------ Appendix II:1.2

Corporations determine their income tax in the same basic way as
individuals do:  they subtract various deductions from their income
to reach taxable income, and they compute their final tax,
considering AMT if needed.  The corporate AMT is intended to ensure
that taxpayers with substantial economic income or with positive
financial statement income in a given year remit tax for that year. 
Deductions subtracted from income in computing regular taxable income
include the cost of goods sold, wages, interest, contributions to
employee benefit programs, and depreciation of assets, such as
equipment whose full value cannot be deducted immediately. 
Depreciation spreads the cost of such assets over time to reflect
their benefits in the periods the businesses use them.  Depending on
their taxable income, corporations remit regular tax (as opposed to
AMT) using four rates, ranging from 15 to 35 percent. 


      RELATIONSHIP TO STATE AND
      FOREIGN INCOME TAXES
------------------------------------------------------ Appendix II:1.3

For reasons of simplicity and compliance, state income tax systems
greatly depend on the federal system.  According to the Federation of
Tax Administrators, 37 states (including the District of Columbia)
with an individual income tax use either the individual's federal tax
liability, taxable income, or adjusted gross income as a starting
point for the individual's state income tax computation.  Forty-two
of the 47 jurisdictions with a corporate income tax start their
calculations with the corporations' federal taxable income.  In
addition, as the Multistate Tax Commission has pointed out, states
rely on federal information reporting and withholding rules for their
own administrative purposes and depend extensively on federal audits
of taxpayers.\3

Both U.S.  individuals and corporations are subject to U.S.  income
tax on their worldwide taxable income.  If they remit foreign income
taxes on foreign-source income, they may, in a complicated
calculation, generally take foreign tax credits against U.S.  income
tax imposed on that income.  The United States has a network of about
50 bilateral tax treaties that cover how nations interact on the
income tax. 


--------------------
\3 According to its executive director, the Multistate Tax Commission
is an interstate compact agency created to preserve federalism and
promote fairness in state and local taxation of businesses. 


   IMPACT ON TAXPAYERS' COMPLIANCE
   BURDEN
-------------------------------------------------------- Appendix II:2

As taxpayers strive to comply with federal, state, and local tax
requirements, they spend time, incur costs, and experience
frustration.  We refer to this time, cost, and frustration as
taxpayer compliance burden.  Table II.2 summarizes key aspects of the
burden, which can vary from little to great from taxpayer to
taxpayer, that taxpayers experience under the current income tax. 



                               Table II.2
                
                   Summary of Some Key Aspects of the
                Compliance Burden of the Current Income
                            Tax on Taxpayers

Burden              Characteristics of the burden
------------------  --------------------------------------------------
Burden on individual taxpayers
----------------------------------------------------------------------
Return filing       116 million returns filed in 1995

Records kept        Records supporting tax returns supposed to be
                    kept--e.g., receipts, proof of payment, and
                    documentation supporting deductions and credits;
                    burden alleviated by information reports given to
                    individuals

Calculations made   Complicated calculations for some taxpayers
                    included for provisions such as dependency tests
                    and capital gains

Complexity faced    Many pages of instructions involved and millions
                    of supplemental forms and schedules filed--e.g.,
                    33 million schedules of itemized deductions for
                    tax year 1994; difficulties existing in defining
                    and recognizing income; however, in actual
                    practice, minimal complexity faced by millions of
                    individuals


Burden on business taxpayers
----------------------------------------------------------------------
Return filing       24 million returns filed in 1995

Records kept        Records supporting income and expenses supposed to
                    be kept

Calculations made   Complicated calculations included for provisions
                    such as depreciation, the alternative minimum tax,
                    and the foreign tax credit

Complexity faced    Detailed rules involved; complexity reflected in
                    areas such as depreciation, the alternative
                    minimum tax, and the foreign tax credit;
                    difficulties existing in defining and recognizing
                    income

Requirement to      1.1 billion information and withholding documents
furnish             filed
information
returns
----------------------------------------------------------------------
Source:  GAO analysis of available information about the current
income tax. 


      DOCUMENTS FILED
------------------------------------------------------ Appendix II:2.1

One indicator of this burden is that every year taxpayers and others
file millions of documents with IRS, with some filing one and others
filing many.  For example, in 1995, individuals filed 116 million
personal income tax returns, with most of them including salaries,
wages, or pensions.\4 These individuals included 18 million schedules
for sole proprietorships.  Because corporations and partnerships
filed another 6 million income tax or income returns, the total
number of business returns filed was 24 million.  In addition,
employers submitted 29 million employment tax returns.  Finally, as
table II.3 shows, employers, financial institutions, and others filed
1.1 billion information and withholding documents, which ease the
burden recipients would bear if they had to generate the information
on their own.  Documents, such as wage and various other income
statements, are important for compliance purposes but not very
burdensome for recipients to retain, although employers must generate
them.  Although almost all information returns were filed with IRS in
nonpaper format through magnetic tape filing, electronic filing, or
diskette filing, most business income and employment tax returns and
most individual tax returns were not filed electronically. 



                               Table II.3
                
                 Information and Withholding Documents
                             Filed in 1995

                                                             Number of
                                                               filings
                                                                   (in
Type of filing                                               millions)
----------------------------------------------------------  ----------
W-2: Wage and Tax Statements                                       205
1099DIV: Dividends and Distributions                               101
1099INT: Interest Income                                           259
1099MISC: Miscellaneous Income                                      74
1099R: Distributions From Pensions, Annuities, Retirement           49
 or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.
1099B: Proceeds From Broker and Barter Exchange                     92
 Transactions
1099G: Certain Government Payments                                  59
5498: Individual Retirement Arrangement Information                 63
1098: Mortgage Interest Statement                                   64
K-1 (Form 1065): Partner's Share of Income, Credits,                21
 Deductions, Etc.
1099SSA/RRB: Social Security Benefit Statement and                  46
 Payments by the Railroad Retirement Board
Others                                                              30
======================================================================
Total                                                            1,062
----------------------------------------------------------------------
Note:  Total does not add due to rounding. 

Source:  IRS, Calendar Year Projections of Information and
Withholding Documents for the United States and Service Centers: 
1996-2003, 1996 Update. 

Although in recent years over 100 million individuals filed income
tax returns annually, as table II.4 shows, most of them did not
report many common income, adjustment, deduction, and credit items
every year.  For instance, for tax year 1993, most of the 114.6
million individuals who filed did not claim such items as capital
gains or losses, rental income, itemized deductions, the earned
income credit, or the foreign tax credit, minimizing their compliance
burden.  And, although almost 33 million individuals itemized their
deductions and included themselves in the millions of taxpayers
filing supplemental forms and schedules, relatively few of those
itemized, for instance, miscellaneous deductions that generally
involve much taxpayer time and recordkeeping whether claimed or not. 
Over a lifetime, of course, circumstances could allow taxpayers to
include many items on their returns that do not show up every year. 



                               Table II.4
                
                   Estimate of Individuals Reporting
                Different Items on Their Tax Returns for
                             Tax Year 1993

                                                  Number reporting (in
Item                                                         millions)
----------------------------------------  ----------------------------
Salary and wage income                                            98.0
Taxable interest income                                           65.2
Dividend income                                                   24.7
Business or professional net income or                            15.6
 loss
Net capital gain or loss                                          18.4
Pensions and annuities in adjusted gross                          17.4
 income
Rent and royalty net income or loss                               11.0
Partnership and S corporation net income                           5.5
 less loss
Primary taxpayer IRA adjustment                                    4.0
Standard deduction                                                80.8
Any itemized deduction                                            32.8
Medical and dental expenses                                        5.5
Taxes paid                                                        32.3
Interest paid                                                     27.5
Charitable contributions                                          29.8
Total miscellaneous deductions                                     8.3
Earned income credit                                              15.1
Foreign tax credit                                                 1.3
----------------------------------------------------------------------
Source:  IRS, Individual Income Tax Returns 1993. 

Another indicator of the tax system's impact on taxpayers is how
often they must file returns and remit taxes--the greater the
frequency, the more the burden.  Generally, individuals must file
annually, even though their wages and salaries may be withheld
throughout the year.  Individuals, including sole proprietors,
however, did file 36 million estimated tax returns in 1995, and they
paid estimated taxes as many as four times during the year. 
Businesses generally file income tax returns annually and often remit
estimated tax four times a year.  They also withhold income, Social
Security, and Medicare taxes from their employees periodically, file
quarterly employment tax returns, and transfer the funds withheld to
a financial institution monthly, semiweekly, or even more often
depending on the amount of tax. 


--------------------
\4 The potential universe of individual filers is larger than the 116
million filers in 1995.  For instance, for tax year 1992, IRS
identified almost 60 million potential individual nonfilers, mostly
by matching data on information returns, such as wage statements from
employers, with data on filed income tax returns.  However, IRS took
no enforcement action on most of them, primarily because it later
determined that the individuals had no legal filing requirement.  For
instance, the individual might not have had enough gross income to
have to file. 


      RECORDS KEPT
------------------------------------------------------ Appendix II:2.2

Another burden of complying is that individuals and businesses must
keep records supporting their tax returns.  For instance, individuals
should keep receipts, canceled checks or other proof of payment, and
documentation to support any deductions or credits claimed. 
Similarly, for small businesses, IRS requires that records be kept to
support the income, expenses, and credits reported.  IRS believes,
though, that generally these are the same records needed for
businesses to monitor themselves and prepare financial statements. 
Nevertheless, the corporate tax return does have a schedule on which
the taxpayer reconciles the income or loss shown on its books with
that shown on its tax return.  The schedule includes such items as
depreciation and contribution carryovers. 

Individuals and businesses can use various methods of accounting,
although many businesses are precluded from using the cash method for
tax purposes.  Instead, they use the accrual method, designed to
match income and expenses in the correct year.  The accrual method is
required when income-producing inventory is involved. 

Keeping the right documentation has been a problem for some
taxpayers.  We found this, for example, when we reviewed 185 Tax
Court petitions dealing with "ordinary and necessary" business
expenses related to a taxpayer's trade or business.  For sole
proprietors, small and medium-sized corporations, and individuals
claiming employee business expenses, the most frequent source of
disagreement with IRS in those petitions was the adequacy of
documentation for a given expense deduction.  These disputes were
especially frequent where the documentation requirements were the
most rigorous--for entertainment, travel, meals, and automobile
expenses.\5

In another example, we found that the test that taxpayers used to
claim other people as dependents on their tax returns was too complex
and burdensome for them to voluntarily comply with.  The test
required taxpayers to maintain detailed records and make complex
calculations.  According to our estimates, 43 percent of taxpayers
that IRS found had not met the dependent support test did not have
adequate records to show whether they provided the necessary
support.\6


--------------------
\5 See Tax Administration:  Recurring Issues in Tax Disputes Over
Business Expense Deductions (GAO/GGD-95-232, Sept.  26, 1995). 

\6 See Tax Administration:  Erroneous Dependent and Filing Status
Claims (GAO/GGD-93-60, Mar.  19, 1993).  We were 95-percent confident
that the true percentage of these taxpayers with inadequate records
was between 33 percent and 52 percent. 


      LEVEL OF SIMPLICITY OR
      COMPLEXITY
------------------------------------------------------ Appendix II:2.3

The forms that taxpayers need to file vary with the circumstances, as
does the use of paid preparers.  In 1994, we reported that IRS
publishes about 400 tax forms and accompanying instructions each
year.  More detailed guidance is provided in about 100
publications.\7 Still, as reflected in table II.4, most individuals
file relatively basic forms, such as the estimated 71 percent of
about 115 million individual filers for tax year 1993 (almost 81
million) that took the standard deduction as opposed to itemizing
deductions and needing a separate schedule. 

As shown in table II.5, for tax year 1993, 48 million of 115 million
individuals (42 percent) filed the Form 1040EZ or the Form 1040A
instead of the standard Form 1040.  As table II.5 further shows,
although these individuals filed income tax returns designed to be
easier than the standard return, they still sometimes paid preparers
to complete them.  In all, about half of all individual tax returns
had a paid preparer's signature on them.  Some of the taxpayers who
filed the simpler forms and claimed the earned income credit may have
paid a preparer simply as a way to file their returns electronically
and get their credit early. 



                               Table II.5
                
                 Individual Tax Returns Showing a Paid
                  Preparer's Signature, Tax Year 1993

                                            Number with
                                                   paid     Percentage
                            Number filed     preparer's      with paid
                                     (in  signature (in     preparer's
Form                         millions)\a      millions)      signature
-------------------------  -------------  -------------  -------------
1040EZ                              20.4            1.5             7%
1040A                               27.9            5.8             21
1040                                66.4           49.2             74
Total                              114.6           56.6            49%
----------------------------------------------------------------------
Note:  Numbers do not add to total because of rounding. 

\a These numbers are estimates based on samples. 

Source:  IRS, SOI Bulletin (Winter 1995-1996). 

The complexity of the tax code, itself, is a major reason why federal
tax compliance is burdensome.  It stems from areas such as
depreciation requirements, which all 17 businesses we interviewed for
testimony told us caused them to keep some detailed records solely
for tax purposes; uniform capitalization rules and the AMT requiring
time-consuming calculations; and inventory, foreign income, and
capital gains calculations.\8 In 1994 testimony, IRS noted that the
code had grown from 504 pages in 1939 to over 2,700 pages, and this
did not include implementing regulations.  A guiding principle we
have stated regarding tax rules and compliance is "the simpler .  . 
.  the better."\9

Much of the complexity of the tax code stems from the difficulties
faced in defining income and determining when to recognize it on the
tax return.  For instance, the complexity surrounding calculations
and records needed for determining capital income is great, creating
accompanying compliance and administrative costs.  To determine
capital income, taxpayers must separate capital gains from ordinary
income, determine depreciation, and decide if expenses are deductible
or must be capitalized.  Complexity is also created by the tension
between the ideal economic definition of income--changes from one
year to the next in asset value--and the need to recognize income
only when it is actually realized--in a market transaction, such as a
sale of stock.  For instance, the tax law has provisions to keep
taxpayers from borrowing money to buy assets, deducting the interest,
and not paying current tax on the assets' appreciation.  This
contributes to different kinds of interest expense being treated
differently for tax purposes.\10


--------------------
\7 See Tax Administration:  IRS Efforts to Improve Forms and
Publications (GAO/GGD-95-34, Dec.  7, 1994). 

\8 See Tax System Burden:  Tax Compliance Burden Faced by Business
Taxpayers (GAO/T-GGD-95-42, Dec.  9, 1994). 

\9 See Taxpayer Compliance:  Reducing the Income Tax Gap
(GAO/T-GGD-95-176, June 6, 1995). 

\10 Henry J.  Aaron and Harvey Galper, Assessing Tax Reform
(Washington, D.C.:  The Brookings Institution, 1985), pp.  22-24. 


      INTERACTION OF TAXPAYERS AND
      TAX ADMINISTRATORS
------------------------------------------------------ Appendix II:2.4

A final aspect of the current system's (and any system's) burden on
taxpayers is the amount and nature of interaction the public has with
tax administrators.  As we allude to later, taxpayers annually
experience millions of IRS notices; more than a million examinations;
when delinquent, hundreds of thousands of tax liens placed against
their assets; and millions of unanswered telephone calls.  Neither we
nor IRS know the level of any alleged IRS "abuse" of taxpayers
through the public's interactions with IRS employees.  When we
studied the issue in 1996, IRS, while improving certain controls, had
not yet established a capability to capture management information
that is needed to ensure that abuse is identified and addressed.\11


--------------------
\11 See Tax Administration:  IRS Is Improving Its Controls for
Ensuring That Taxpayers Are Treated Properly (GAO/GGD-96-176, Aug. 
30, 1996). 


      ESTIMATES OF COMPLIANCE
      COSTS FOR EXISTING TAXES
------------------------------------------------------ Appendix II:2.5

As described in appendix III, compliance cost studies in general have
been limited by different factors.  These factors include the
difficulty in differentiating between recordkeeping for tax purposes
from recordkeeping that would have been done anyway and the
difficulty in generalizing to all taxpayers from surveys with low
response rates. 

Because of the importance of the issue of compliance costs and their
possible magnitude, various efforts have been made to measure
compliance costs.  These included several academic studies of
compliance costs for U.S.  income taxes, a study of paperwork burden
of U.S.  taxes done for IRS, and recent estimates based on the
IRS-sponsored burden study. 


         STUDIES OF COMPLIANCE
         COSTS OF U.S.  TAXES
---------------------------------------------------- Appendix II:2.5.1

Several compliance cost studies have been done by Joel Slemrod of the
University of Michigan and co-authors.\12 Two studies were done on
compliance costs for the individual income tax, and one study was
done on compliance costs for large corporations, all using mailed
questionnaires.  The studies of the individual income tax surveyed
Minnesota residents; the more recent of the two studies found that on
average taxpayers spent about 27 hours on federal and state income
tax matters and spent about $66 on tax assistance and other expenses. 
The study also obtained information on the wages of the respondents
to place a value on the time spent on taxes. 

The consulting firm Arthur D.  Little studied paperwork burden for
IRS in 1984.\13 The Little study used questionnaires to gather
information on how much time individuals and businesses spent in 1983
to meet tax filing requirements.  Individual costs were also measured
through a diary study, in which taxpayers were asked to
contemporaneously record costs as they occurred rather than recall
costs.  For businesses, burden categories included recordkeeping,
getting advice and learning about filing requirements, obtaining
materials, finding and using tax preparation services, preparing the
tax return, and filing the tax return.  For individuals, burden
categories included recordkeeping; learning about the tax law;
preparing the tax return; and copying, assembling, and sending the
return to IRS.  Little obtained a 65-percent response rate from the
individual questionnaire and a 37-percent response rate to the
business questionnaire. 

The purpose of the Little study was to gather data and develop a
methodology that IRS could use to estimate the average number of
hours taxpayers spend to complete particular tax forms.  To do this,
Little used a statistical analysis to find variables, such as the
number of lines on a tax form and associated worksheets and the
number of attachments required, that could predict the level of
burden found in the questionnaires.\14

While several models were evaluated, the models ultimately chosen
were those that could be easily updated by IRS rather than those that
best predicted the survey results.  The study noted that "in a few
instances significant accuracy was sacrificed by selecting a
simplified model" over a more complicated and accurate model.  As a
result, IRS estimates of recordkeeping burden for a business tax form
are only dependent on the number of lines on the form and associated
worksheets, and the estimated time for preparing a form is dependent
on the number of lines on the form and worksheets, the number of
references in the instructions to the Internal Revenue Code and
accompanying regulations, and the number of attachments that are
requested.  One researcher has called these models "transparently
implausible" and also pointed out that the model estimates of burden
for corporations and partnerships in 1983 were five times higher than
the results found in the survey for the same year.\15


--------------------
\12 See Joel Slemrod and Nikki Sorum, "The Compliance Cost of the
U.S.  Individual Income Tax System," National Tax Journal, Vol. 
XXXVII, No.  4 (Dec.  1984), pp.  461-74; Marsha Blumenthal and Joel
Slemrod, "The Compliance Cost of the U.S.  Individual Income Tax
System:  A Second Look After Tax Reform," National Tax Journal, Vol. 
XLV, No.  2 (June 1992), pp.  185-202; and Joel Slemrod and Marsha
Blumenthal, "The Income Tax Compliance Cost of Big Business," Public
Finance Quarterly, Vol.  24, No.  4 (Oct.  1996), pp.  411-38.  Also
see Joel Slemrod, "Which Is the Simplest Tax System of Them All?" in
Henry J.  Aaron and William G.  Gale, eds., Economic Effects of
Fundamental Tax Reform (Washington D.C.:  Brookings Institution
Press, 1996) for a summary of the strengths and limitations of this
work. 

\13 The methodology of the Little study is reviewed in Slemrod
(1996). 

\14 Little adjusted the individual questionnaire results to reflect
the generally lower cost estimates found in the diary study. 

\15 Slemrod (1996), pp.  383-84. 


         RECENT ESTIMATES OF
         COMPLIANCE COSTS OF
         CURRENT TAX SYSTEM
---------------------------------------------------- Appendix II:2.5.2

Two authors have used the paperwork burden hours estimates from the
IRS models to estimate income tax compliance costs in terms of both
hours and dollars.  To convert hours of burden into an estimate of
the dollar value of these hours, the authors generally multiplied the
hours estimate by an amount representing the time value of each hour. 
The estimates therefore rely on the underlying IRS methodology and
are sensitive to the hourly dollar amount used.  In theory, the
dollar value chosen should represent the opportunity cost of spending
an hour on tax matters; for individuals, for example, this could be
an additional hour of wages, the value of an hour spent in a leisure
activity, or the hourly amount that an individual would be willing to
pay to not have to calculate taxes. 

Arthur Hall of the Tax Foundation, citing IRS and Office of
Management and Budget historical data, recently estimated that
taxpayers would spend about 5.3 billion hours complying with federal
tax laws in 1996.  Hall then applied an hourly rate of $42.40 to this
hours estimate to obtain an estimate of $224.7 billion of compliance
costs for the entire federal tax system.\16 Based on his
calculations, he asserted that at least 70 percent of this cost was
due to the income tax.  Applying this 70 percent to the total burden
would make income tax compliance costs $157 billion for 1996.  Hall
estimated that business compliance costs would be $105 billion,
leaving individual compliance costs at about $52 billion. 

In his book and in testimony before the Ways and Means Committee,
James Payne also made estimates of compliance burden resulting from
the tax system.  In his 1993 book, Payne estimated that federal
compliance costs in 1985 amounted to $159.42 billion.\17 This
estimate was made by multiplying the Little model estimates of 5.4
billion taxpayer burden hours for 1985 by an hourly value of $28.31
(an average of IRS and Arthur Andersen labor costs) and adding an
estimate for tax preparer costs.  In 1995 testimony, Payne estimated
that taxpayer burden in terms of hours for 1995 was 10.2 billion
hours.\18

The increase in the estimate reflected, in part, increases in the
number of taxpayers and an increase in total burden of 3.7 percent in
each year from 1985 through 1995, based on findings in Blumenthal and
Slemrod (1992) that individual burden had increased by 26 percent
from 1982 to 1989. 

Recently, Slemrod offered what he described as "back-of-the-envelope"
estimates of the compliance costs of the income tax, based on his
views on the strengths and weaknesses of the existing evidence.\19
Adjusting the results from the 1989 Blumenthal and Slemrod survey of
individual taxpayers and using $15 for the per hour cost, Slemrod
estimated that the cost of the individual income tax was probably
around $50 billion.  He also estimated that businesses (partnerships
and corporations) spend about 800 million hours complying with taxes,
a figure in line with the results of the Little survey rather than
derived from the IRS model estimates.  Valuing business hours at $25
per hour, Slemrod estimated the cost of compliance for these
businesses at about $20 billion. 


--------------------
\16 See Arthur P.  Hall, "Compliance Costs of Alternative Tax
Systems," Tax Notes, Vol.  71, No.  8 (May 20, 1996), pp.  1081-89. 

\17 James L.  Payne, Costly Returns:  The Burdens of the U.S.  Tax
System, (San Francisco:  Institute for Contemporary Studies, 1993). 

\18 Statement of James L.  Payne prepared for the House Ways and
Means Committee Hearings on Replacing the Federal Income Tax, June 6,
7, and 8, 1995. 

\19 See Slemrod (1996). 


   IMPACT ON TAX ADMINISTRATORS
-------------------------------------------------------- Appendix II:3

Table II.6 summarizes some of the key impacts of the current income
tax system on tax administrators. 



                               Table II.6
                
                   Summary of Some Key Impacts of the
                Current Income Tax on Tax Administrators

Item                Characteristics of the current income tax
------------------  --------------------------------------------------
Number of returns   Hundreds of millions of returns and other
processed           materials received

Refund processing   92 million refunds issued in fiscal year 1995

Examination         Tax returns matched with information returns;
approach            fiscal year 1995 examination coverage at 1.36
                    percent, with corporate audits taking longer than
                    individuals' audits

Compliance          Compliance problems related to income definition,
problems            unreported income, and more specific issues
                    identified in areas such as transfer pricing,
                    depreciation, deductibility of business expenses,
                    small businesses, independent contractors, and the
                    underground economy\a

Collections from    Millions of taxpayer delinquent investigations and
tax delinquents     accounts disposed of, with most of the latter
                    being for individuals and most business
                    dispositions covering employment taxes

Individuals'        Millions of taxpayer inquiries fielded, covering a
questions received  wide variety of questions
----------------------------------------------------------------------
\a Transfer prices are prices companies charge related parties for
goods and services.  Inaccurate transfer pricing can result in
improper allocation of income among interrelated companies. 

Source:  GAO analysis of available information about the current
income tax. 

Table II.7 shows IRS' fiscal year 1996 actual budget along functional
lines to help put the discussion that follows into perspective. 



                               Table II.7
                
                Summary of IRS' Fiscal Year 1996 Budget

                         Full-time equivalent
                              positions             Budget dollars
                        ----------------------  ----------------------
                                    Percentage  Amount (in  Percentage
IRS function                Number    of total   millions)    of total
----------------------  ----------  ----------  ----------  ----------
Returns processing          20,460         19%        $781         11%
Document matching            2,086           2          73           1
Examination                 27,327          26       1,555          22
Collection                  17,916          17         855          12
Taxpayer services            8,031           8         492           7
Other                       30,822          29       3,461          48
======================================================================
Total                      106,642        100%      $7,217        100%
----------------------------------------------------------------------
Note 1:  Percentages do not add to totals due to rounding. 

Note 2:  The budget for IRS' appeals function is included in the
counsel part of the "other" category, as opposed to the examination
category where IRS put it for fiscal year 1997.  Counsel's fiscal
year 1996 budget was 4,999 full-time equivalents and $362 million. 
"Other" also included positions and funds supporting functions such
as examination and collection. 

Source:  IRS fiscal year 1998 budget estimates, Feb.  6, 1997. 


      PROCESSING OF RETURNS
------------------------------------------------------ Appendix II:3.1

When IRS annually receives the hundreds of millions of returns,
remittances, and other materials from taxpayers and others, the first
thing it must do is process them.  Returns processing includes (1)
receiving, sorting, and establishing controls over the materials; (2)
editing, perfecting, and coding them for transcription onto computer
tape; (3) transcribing, verifying, and correcting tax document
information; (4) maintaining accounting records for assessments,
collections, receivables, refunds, and other transactions affecting
taxpayer accounts; and (5) preparing correspondence to taxpayers. 
IRS' fiscal year 1996 budget for returns processing was almost $800
million for more than 20,000 full-time equivalent positions. 

IRS' returns processing workload is primarily affected by the number
of returns filed and the work needed to prepare those returns for
posting to taxpayer accounts.  For instance, according to IRS data,
it takes significantly fewer keystrokes to enter data into the
computer from a paper Form 1040EZ and Form 1040A than from an average
Form 1040.  Although generally more and more tax returns are being
filed electronically and processed by computer, thus minimizing the
human effort needed to prepare them for posting, the vast majority of
returns are still filed on paper and processed manually by IRS. 
Consequently, a significant part of IRS' returns processing effort
involves error correction because returns filed on paper and
processed manually are more prone to errors by both preparers of the
returns and the IRS staff processing them. 

Statistics on the number of notices sent and refunds given to
taxpayers illustrate the level of IRS activity involved in processing
returns.  For instance, as we noted in a 1994 report, IRS sent more
than 60 million notices to taxpayers in 1993 concerning the status of
their tax accounts.\20 (Recently, IRS announced a dramatic reduction
in the number of notices to be sent.) Similarly, in fiscal year 1995,
IRS issued 92 million refunds to taxpayers. 


--------------------
\20 See Tax Administration:  IRS Notices Can Be Improved
(GAO/GGD-95-6, Dec.  7, 1994). 


      MATCHING AND EXAMINATION
      PROGRAMS
------------------------------------------------------ Appendix II:3.2

A taxpayer's most likely enforcement contact with IRS is receiving
word about a computer match of income reported on his or her return
with information returns provided to IRS by third parties.  These
third parties include employers and payers of interest and dividends. 
Discrepancies between the amounts reported on the tax return and the
information return indicate potential underreporter cases.  When a
tax return is not filed for income that is reported on an information
return, IRS is to establish a nonfiler case.  IRS' fiscal year 1996
budget for document matching was $73 million and about 2,100
full-time equivalent positions. 

As another part of its enforcement efforts, IRS' examination
function, funded in fiscal year 1996 at almost $1.6 billion and about
27,000 full-time equivalents, administers a nationwide audit program
to see if taxpayers correctly determined their tax liabilities.  One
of the ways IRS selects returns to audit is by using a system that
scores each return's audit potential.  After learning the results of
an audit, taxpayers may agree with the findings, appeal them through
IRS' appeals function, or take IRS to court.  As shown in table II.8,
in fiscal year 1995, IRS had many different kinds of examinations,
with an overall examination coverage rate of 1.36 percent.  Although
many more examinations were done of individuals than of corporations,
corporate examinations took much longer. 



                               Table II.8
                
                   IRS' Fiscal Year 1995 Examination
                                Coverage

                         (Numbers in thousands)

                                   Returns                  Percentage
                                  filed in                          of
                                  calendar         Total   examination
Category of tax return           year 1994  examinations      coverage
----------------------------  ------------  ============  ------------
Individual                         114,683         1,919         1.67%
Corporation                          2,530            52          2.05
Fiduciary, estate, and gift          3,384            18          0.52
Employment                          29,298            54          0.18
Excise, partnership, S               4,399            57          1.30
 corporation, and other
======================================================================
Total                              154,294         2,100         1.36%
----------------------------------------------------------------------
Note:  Percentages do not always compute exactly due to rounding of
other numbers. 

Source:  IRS, 1995 Data Book. 

Although IRS does not generally track noncompliance by subject matter
through its examination program, it does know quite a bit about
taxpayer noncompliance.  Its knowledge comes from its random, though
dated, detailed audits of tax returns through its Taxpayer Compliance
Measurement Program and from other sources.  As we testified using
1988 IRS estimates of tax year 1992 compliance, individuals
voluntarily paid 83 percent of the income taxes they owed, and
corporations remitted 81 percent.\21 In addition, as shown in table
II.9, according to IRS estimates, compliance was not uniform across
groups of taxpayers.  IRS data show that compliance was highest for
individuals where there was tax withholding, a little lower where
there was information reporting to IRS, and much lower where there
was neither.  The complexity of tax rules was another factor
influencing the level of compliance, with a more complicated tax code
allowing more opportunities for disagreement over the "fine points"
of the law. 



                               Table II.9
                
                   Percentage of Earnings Categories
                 Reported by Different Taxpayer Groups

                                          Is
                           Percentage of  information    Is
                           earnings       reporting      withholding
                           category       generally      generally
Taxpayer group             reported       required?      required?
-------------------------  -------------  -------------  -------------
Wage earners               97 percent of  Yes            Yes
                           their wages

Interest recipients        90 percent of  Yes            No
                           their
                           interest
                           income

Dividend recipients        87 percent of  Yes            No
                           their
                           dividend
                           income

Self-employed (sole        36 percent of  No             No
proprietors)               their income

Informal suppliers (self-  11 percent of  No             No
employed individuals       their income
operating on a cash
basis)
----------------------------------------------------------------------
Note:  These percentages take into account individuals who did not
file tax returns. 

Source:  GAO/T-GGD-95-176. 

Variations in compliance patterns also existed in the corporate
sector.  Small corporations, whose compliance level for 2.3 million
firms was 61 percent for tax year 1987 (down from 81 percent for a
smaller number of tax year 1980 firms), tended to mirror the
compliance patterns of sole proprietors.  Underreported income was
the biggest compliance problem and enough documentation was often a
difficulty.  Large corporations, in contrast, tended to have issues
associated with the ambiguity and complexity of the tax code.  Table
II.10 shows, as of late 1995, the largest open examination issues in
the examination program covering various tax years for the nation's
largest corporations. 



                              Table II.10
                
                  Largest Open Examination Issues for
                Largest Corporations as of December 12,
                                  1995

                         (Dollars in billions)

                                           Proposed IRS adjustments to
Issue                                               income and credits
----------------------------------------  ----------------------------
Transfer pricing                                                  $7.2
Availability of the installment method                             5.9
 of income recognition
Deductibility of trade or business                                 3.4
 expenses
Deductibility of capital expenditures                              3.4
Depreciation                                                       1.9
----------------------------------------------------------------------
Note:  According to an IRS official, these dollar figures are not
precise because they include only the top 10 issues in the
corporations being audited and reflect conservative estimates of case
managers. 

Source:  IRS. 

In 1988, IRS estimated a "tax gap" of as much as $127 billion between
tax year 1992 income taxes owed on income from legal sources and
income taxes voluntarily remitted.  This gap did not include taxes
that go uncollected from illegal activities, such as drug dealing and
prostitution.  Thus, the gap reflected part of the underground
economy--the legal transactions that occurred without being reported
to the tax agency--but not the other part--the illegal transactions. 
As shown in table II.11, IRS attributed about three-fourths of the
tax gap to individuals and about one-fourth to corporations. 



                              Table II.11
                
                1988 Gross Tax Gap Estimate for Tax Year
                                  1992

                         (Dollars in millions)

                                                               Tax gap
                                                          distribution
Source of tax gap                   Tax gap amount           (percent)
------------------------------  ------------------  ------------------
Individual tax gap                         $93,994               73.9%
Corporate tax gap                           33,135                26.1
Small corporations                           6,999                 5.5
Large corporations                          23,716                18.7
Other                                          420                 0.3
Corporate remittance gap                     2,000                 1.6
======================================================================
Total tax gap                             $127,129              100.0%
----------------------------------------------------------------------
Source:  Income Tax Compliance Research, IRS Publication 1415 (7-88)
and Income Tax Compliance Research:  Net Tax Gap and Remittance Gap
Estimates, IRS Publication 1415 (4-90). 

In 1996, IRS presented new estimates of the individual income tax
gap, this time using compliance data for tax years 1985 and 1988, as
opposed to 1982.  The gap consisted of a nonfiling gap, or tax
liability owed by those not filing required returns voluntarily and
in a timely manner; an underreporting gap, or liability not
voluntarily reported by filers; and an underpayment gap, or liability
reported but not paid voluntarily and in a timely manner. 

As shown in table II.12, the largest dollar components of the
underreporting part of the individual tax gap (covering underreported
income and overstated deductions and credits) were ranges related to
nonfarm proprietor income and informal supplier income.  The items
with the highest reporting noncompliance, as shown by the ranges of
net misreporting percentages, were informal supplier income, tax
credits (reflecting overreporting of the earned income credit),
nonfarm proprietor income, farm income, and income from the sale of
business property. 



                              Table II.12
                
                1996 Ranges of Estimates of the Tax Year
                     1992 Gross Individual Tax Gap

                         (Dollars in billions)

                                                             Net
                                                         misreporting
                                        Dollar amount    percentage\a
                                        --------------  --------------
Gross tax gap component                    Low    High  Low     High
--------------------------------------  ------  ------  ------  ------
Nonfiling gap                            $13.5   $13.8  N/A     N/A

Underpayment gap                           8.4     8.4  N/A     N/A

Underreporting gap                        71.3    73.1  N/A     N/A

Capital gains                              2.4     2.5  6.9%    7.2%

Income from sales of business property     0.7     0.7  27.1    28.0

Nonfarm proprietor income                 16.4    16.9  31.3    32.3

Informal supplier income                  12.3    12.3  81.4    81.4

Farm income                                3.3     3.4  31.3    32.2

Rents and royalties                        3.6     3.7  16.6    17.2

Tax credits                                6.0     6.2  38.9    40.2

Other items                               26.6    27.3  N/A     N/A
----------------------------------------------------------------------
Legend:  N/A = Not applicable or not available. 

\a Net misreporting percentage is the ratio of the net amount of
income misreported on the tax return in the taxpayer's favor to the
sum of the absolute values of what should have been reported. 

Source:  Federal Tax Compliance Research:  Individual Income Tax Gap
Estimates for 1985, 1988, and 1992, IRS Publication 1415 (4-96). 

According to a 1993 IRS report on the employment tax gap,
noncompliance with employment taxes was relatively low except in the
self-employment area.  For self-employment taxes estimated for tax
year 1987, the tax liability not paid voluntarily was more than half
the "true" tax liability.  This estimated ratio of unpaid liability
to true liability was projected to remain relatively stable for tax
years 1984 through 1997. 

Although for FICA taxes the equivalent 1987 estimated ratio of
unremitted liability to true liability was only about 4 percent,
almost all of the underreported wage and salary part of the FICA tax
gap was attributable to misclassification of employees.  In June
1996, we testified that from fiscal year 1988 through fiscal year
1995, IRS' almost 13,000 Employment Tax Examination Program audits
resulted in reclassifying 527,000 workers from independent
contractors to employees.\22 Common-law rules for classifying workers
as employees or independent contractors were unclear and subject to
conflicting interpretations.  IRS' strategy is to reduce independent
contractor noncompliance by requiring businesses to treat
misclassified independent contractors as employees subject to
withholding taxes.  Efforts to improve the misclassification
situation were continuing during our review. 

Just because IRS proposes adjustments does not mean taxpayers will
agree.  In 1993, we reported on the most prevalent issues appealed by
taxpayers.  As of September 30, 1992, out of about 12,000 disputed
relatively large issues that IRS stated were predominately corporate,
almost a quarter involved trade or business deductions, gross income,
or depreciation.\23 Similarly, of all the cases contained in Tax
Analysts' Index to U.S.  Tax Court Petitions and Complaints Filed in
the Court of Federal Claims and the 94 U.S.  District Courts During
1993, about a third of the pages of listings involved just two
Internal Revenue Code sections--those dealing with gross income and
trade or business expense deductions.  When we analyzed appealed
trade or business deductions in a separate report, we found that
large corporate taxpayers disagreed with IRS most frequently over the
issue of capital expenditures, more specifically over whether large
expenses were immediately deductible.\24 IRS was unable to provide us
with a breakdown by subject matter of all 219,000 cases closed by its
Chief Counsel in fiscal year 1994. 


--------------------
\21 See GAO/T-GGD-95-176.  In 1996, IRS also reported that the tax
year 1992 noncompliance estimate as a percentage of the "true" tax
liability for individuals was about 83 percent. 

\22 See Tax Administration:  Issues in Classifying Workers as
Employees or Independent Contractors (GAO/T-GGD-96-130, June 20,
1996). 

\23 See Tax Administration:  Recurring Tax Issues Tracked by IRS'
Office of Appeals (GAO/GGD-93-101, May 4, 1993). 

\24 See GAO/GGD-95-232. 


      COLLECTION ACTIVITIES
------------------------------------------------------ Appendix II:3.3

With a fiscal year 1996 budget of almost 18,000 full-time equivalent
positions and about $850 million, IRS' collection function is
responsible for collecting taxes from taxpayers who did not file
required returns or those who filed returns but did not remit the
required tax.  Its first step is to notify taxpayers in writing and
ask them either to remit outstanding taxes or to file unfiled
returns.  If taxpayers do not respond at the notification stage, IRS
generally refers the cases to its automated call sites, where IRS
employees may telephone taxpayers to ask for remittance.  At that
time, balance-due accounts are referred to as taxpayer delinquent
accounts (TDA), and nonfiler cases are called taxpayer delinquency
investigations (TDI).  If telephone calls are not successful, IRS
revenue officers must try to collect higher priority cases through
personal visits to taxpayers and other collection enforcement
actions.  The cases may be resolved in many ways, ranging from
taxpayers' voluntarily making full remittances to IRS' taking actions
involving liens, levies, or seizures.  As an example of the volume of
activity that is involved, in fiscal year 1995, IRS issued about
800,000 notices of tax liens, sent out 2.7 million notices of levies,
and made 11,000 seizures. 

IRS is involved with millions of TDA and TDI cases, although not all
of them eventually need the attention of IRS collection officials. 
In fiscal year 1995, IRS disposed of 4.2 million TDAs and 1.7 million
TDIs.  About two-thirds of the accounts were for individuals, and
about three-quarters of the business accounts related to employment
tax returns.  The business returns most commonly resulting in
investigations were also employment tax returns.  According to an IRS
official, businesses holding employment taxes are tempted to keep
them to overcome cash shortfalls. 

Our high-risk series 1995 report on IRS' accounts receivable
illustrates how the problems in different IRS functions affect each
other and therefore how a change in problem levels can affect a tax
administrator's other operations.\25 We pointed out that if returns
processing did not properly account for a taxpayer's remittance,
collection personnel may have to try resolving an invalid account
receivable.\26 Similarly, if an IRS compliance effort overstated a
taxpayer's liability, it would make additional work for collection
personnel with no guarantee of revenue generation. 

Concerning IRS' accounts receivable, we reported that individual
taxpayers with primarily nonwage income owed about three-quarters of
IRS' September 30, 1993, tax debt owed by individual taxpayers of
$79.2 billion.  Half of the total debt was owed by taxpayers whose
primary source of income was from self-employment (27 percent) or
from interest and dividends (23 percent).\27


--------------------
\25 See High-Risk Series:  Internal Revenue Service Receivables
(GAO/HR-95-6, Feb.  1995). 

\26 According to a recent report, Tax Administration:  Alternative
Filing Systems (GAO/GGD-97-6, Oct.  16, 1996), when IRS investigated
1.8 million potential 1991 underreporter cases in certain categories,
about half resulted in no change to the taxpayers' tax liabilities. 

\27 See Tax Administration:  Tax Compliance of Nonwage Earners
(GAO/GGD-96-165, Aug.  28, 1996). 


      TAXPAYER SERVICES
------------------------------------------------------ Appendix II:3.4

With a fiscal year 1996 taxpayer services budget of about 8,000
full-time equivalents and $500 million, IRS did various things to try
to help taxpayers comply with tax laws.  In fiscal year 1995, for
example, it answered the telephone in almost 111 million instances to
provide various forms of assistance.  For instance, although IRS
received many more calls than it was able to answer, IRS personnel
staffing its toll-free system did respond to almost 38 million
procedural, account, and tax law calls.  Of these contacts, IRS
disposed of over 29 million account calls concerning tax bills and
notices, and it handled almost 8 million calls on tax law matters,
which included technical tax information related to specific laws and
regulations.  IRS estimated that 8 different categories each covered
almost 10 percent of the tax law calls, with each call being counted
only once.  These categories were (1) filing information; (2)
dependents, exemptions, and filing status; (3) individual income; (4)
individual business income and deductions; (5) capital gains and
losses; (6) pensions and deferred compensation; (7) individual
deductions and adjustments; and (8) tax computation, credits, and
payments.  Thus, not only did the tax law calls fall into a number of
similarly sized categories, but also each category comprised only a
very small percentage of the 38 million toll-free calls answered. 

Tele-tax is another form of IRS telephone assistance, one through
which taxpayers can receive recorded tax information on the status of
their refunds and on many tax law issues.  In fiscal year 1995, IRS
counted about 61 million "hits," or tape menus accessed by callers,
about double the year before.  According to an IRS official, 80 to 90
percent of these hits involved questions about refunds.  Refunds were
especially problematic in 1995 when IRS enhanced its efforts to
ensure the appropriateness of refund claims, resulting in millions of
refunds being delayed and much adverse reaction.  For the hits that
did not involve refunds, IRS supplied us with lists of topics
accessed by taxpayers for the years ended in June 1994 and June 1995. 
Other than general subjects, topics receiving more than 75,000 calls
and thus ranking in the top 15 of the 1995 list were (1) electronic
filing; (2) dependents; (3) medical and dental expenses; (4) earned
income credit; (5) menu of filing requirements, filing status, and
exemptions; (6) filing status; (7) which form--1040, 1040A, or
1040EZ; (8) business entertainment expense; (9) moving expenses; (10)
child and dependent care credit; and (11) collection issues. 

In fiscal year 1995, IRS also provided over 4.2 million people with
taxpayer education programs.  It reached over 80 percent of them
through the Volunteer Income Tax Assistance and Tax Counseling for
the Elderly Programs and the rest of them through a community
outreach program, small business workshops, and tax practitioner
institutes. 


OVERVIEW OF ALTERNATIVE TAX
SYSTEMS AND DESIGN ISSUES
========================================================= Appendix III

In recent years, 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. 

If Congress were to decide to fundamentally reform the tax system, it
would have to make choices on several basic issues, all of which have
ramifications for tax compliance and administration.  First, should
the tax base be income or consumption or, as under the current
system, contain elements of both?  Second, should taxes be levied on
businesses, individuals, or both?  Third, should the preferential tax
treatment now given certain goods and services and types of income be
maintained or eliminated, thereby affecting not only the economic and
social purposes for which they were established but also the ease of
tax compliance and administration?  Fourth, if consumption is chosen
as the appropriate base for taxation, what issues arise in making the
transition to a new tax base, and how should certain types of
consumption that are difficult to tax be treated?  Fifth, how should
a new system be designed to balance other goals for the tax system
with the goals of minimizing administration costs and taxpayers'
costs of compliance? 

This appendix provides some information to clarify these issues.  To
summarize, the fundamental difference between income and consumption
taxes lies in the treatment of saving and investment.  A broad-based
income tax would tax all income, regardless of how it is used and
regardless of its source.  In particular, a broad-based income tax
would tax income regardless of whether it is used for consumption or
for saving and investment and would tax all income earned from saving
and investment.  In contrast, consumption taxes are designed to tax
only income used for consumption, exempting from tax income used for
saving and investment.  Under certain conditions, this is equivalent
to exempting income earned from saving and investment.  As a result,
different consumption taxes can in effect exempt saving and
investment in different ways, so taxes that appear to be different
may actually tax the same base--consumption. 

Either income or consumption taxes could be levied on individuals,
businesses, or both.  The choice of level of tax (or collection
point) alone does not determine the base of a tax or who will bear
its economic burden.  The choice does affect how equitable and how
complicated a tax may be because it determines whether a tax can
treat different individuals differently.  A tax levied on
individuals, whether income- or consumption-based, can tax different
individuals at different rates or allow for adjustments such as
standard deductions or exemptions for dependent children.  Such
provisions may make a tax system more equitable but may also make it
more complicated.  A tax levied solely on businesses (corporations,
partnerships, and sole proprietorships) may be simpler to administer
and less costly for taxpayers to comply with because the number of
tax return filers may be substantially reduced and because only
businesses would be burdened with tax-related recordkeeping and
accounting tasks.  Businesses may keep some of the same records for
nontax purposes and are likely to be more efficient at recordkeeping
and accounting than individuals.  However, taxes levied solely on
businesses are generally less able to make distinctions between
individuals for reasons of equity. 

The current income tax is actually a hybrid tax because it exempts or
lightly taxes some types of saving and investment from tax but fully
taxes other forms.  The current tax also grants preferential
treatment to some types of consumption, such as employer-provided
health insurance.  A reformed tax system could treat saving and
investment more uniformly, either by taxing all saving and investment
(income tax) or by exempting all saving and investment (consumption
tax).  A reformed tax system could also eliminate the current tax
code preferences for certain items of consumption, or it could
maintain them. 

Any tax reform that replaces the current income tax with a
consumption tax would have to address transition issues.  In
particular, the decision on whether to tax existing wealth could
raise issues of fairness and administrability, as well as revenue. 
Moving to a consumption tax would also raise issues involving the
taxation of some types of goods and services that could be difficult
to tax from an administrative viewpoint.  In particular, decisions
would have to be made on whether to tax and how to tax financial
services, housing, fringe benefits, and goods and services produced
by governments and nonprofit organizations.  Some of these items are
also difficult to tax under an income tax. 

While some information is readily available on administration costs,
policymakers have little quantitative evidence on compliance costs
available to help them design new tax systems.  Compliance costs are
costs that individuals and businesses incur, in terms of both time
and money directly spent, because of the requirements of the tax
system.  Compliance and administrative costs are interrelated because
some of the tasks that need to be done to collect taxes can be done
by the public sector or by the private sector.  As a result, costs
can be shifted from one sector to another.  The distribution of
compliance costs among different businesses and individuals is also
important for understanding the full effects of a tax system.  A
major difficulty in measuring compliance costs is disentangling
accounting and recordkeeping costs due to taxes from the costs that
would have been incurred in the absence of the tax system.  As a
result, the reliability of the results of most compliance cost
studies that have been done to date is limited. 


   DIFFERENCES BETWEEN INCOME AND
   CONSUMPTION TAXES
------------------------------------------------------- Appendix III:1

The fundamental difference between income and consumption taxes lies
in their treatment of saving and investment.\1 Income can be used for
either consumption or saving and investment, so if income used for
saving and investment can be exempted from tax, the result will be a
tax only on consumption.  As described below, the exemption of saving
and investment can be done in different ways, so consumption taxes
can be structured differently and yet still have the same overall tax
base.  In contrast, income taxes do impose a tax on income used for
saving and investment.  The current tax system is considered to be a
hybrid between a pure income tax and a pure consumption tax because
it effectively exempts some types of saving and investment from tax
but taxes other forms of saving and investment. 


--------------------
\1 For a similar discussion, see Joel Slemrod and Jon Bakija, Taxing
Ourselves:  A Citizen's Guide to the Great Debate Over Tax Reform
(Cambridge, Mass.:  The MIT Press, 1996), pp.  168-71. 


      TAX TREATMENT OF SAVING AND
      INVESTMENT
----------------------------------------------------- Appendix III:1.1

Consumption taxes exempt income used for saving and investment in one
of two ways.  First, tax could be levied only on income used to buy
consumption goods and services.  This could be done by either taxing
the sale of goods and services to consumers or by allowing
individuals to deduct the amount that they saved from their income. 
Under either method, the income that an individual saved or invested
would not be taxed until it was used to buy goods and services for
consumption. 

A second way to in effect exempt saving and investment from tax would
be to exempt income earned by saving and investment.  Over time, not
taxing the earnings from savings can be economically equivalent to
not taxing the amount saved originally.  As shown below, under
certain conditions, these two methods are equivalent in that what
individuals earn through saving, the rate of return to saving and
investing, is the same under these seemingly different taxes.\2

In contrast to consumption taxes, a broad-based income tax would levy
tax on income from all sources and tax income regardless of whether
it is used for consumption or saving.  In particular, all income
earned from saving and investment would be taxed, and income used for
saving and investment would not be deductible. 

A simple example focusing on the treatment of saving under
alternative taxes is shown in table III.1.  The example compares an
income tax to two forms of consumption taxes and also illustrates the
equivalence between a consumption tax that exempts saving and a tax
that exempts the income earned by saving.  The three cases all assume
that $100 of wage income is earned in the first year, all after-tax
income is saved the first year and used for consumption in the second
year, the interest rate is 10 percent, and the tax rate is 20
percent. 



                              Table III.1
                
                Tax Treatment of Saving Under Income and
                           Consumption Taxes

                                            Consumption
                                             tax income    Consumption
                                            from saving     tax saving
                              Income tax      not taxed      not taxed
-------------------------  -------------  -------------  -------------
First year
----------------------------------------------------------------------
Wages                               $100           $100           $100
Tax                                   20             20              0
Amount saved or invested              80             80            100

Second year
----------------------------------------------------------------------
Additional income from                $8             $8            $10
 saving or investment
Tax                                  1.6              0             22
 After-tax return on             8%            10%            10%
 saving
Present value of taxes            $21.45            $20            $20
----------------------------------------------------------------------
Source:  GAO analysis of alternative taxes. 

The first column shows how a person would be taxed under an income
tax.  In the first year, the individual pays $20 in tax and saves the
balance ($80).  In the second year, the individual earns $8 in income
from saving, and pays $1.60 in tax on this income, leaving $86.40
available for consumption.  Because the earnings from saving were
subject to income tax, the after-tax rate of return on the
individual's saving is 8 percent ($6.40 of $80) instead of the
10-percent rate ($8 of $80) that would be earned without the income
tax. 

The second column shows how the same individual would be taxed under
a consumption tax that does not tax the earnings from saving.  In the
first year, the individual would be taxed on all income ($100), so as
in the income tax case, $20 would be paid in tax and $80 would be
available for saving.  Once saved, the $80 would earn a 10-percent
rate of return ($8), as in the income tax case, but the earnings from
saving would not be taxed.  Thus, in the second year, the individual
has $80 in saving and $8 in earnings on saving available for
consumption, for a total of $88.  In comparison to the income tax,
which reduced the after-tax return to saving, the rate of return on
saving is not changed by the consumption tax, so incentives to
consume today or save for the future are not affected by the tax. 

The third column shows how the individual would be taxed if a
deduction from income for saving were allowed and all income was
taxable when used for consumption.  In the first year, the individual
owes no tax because all income is saved.  The $100 saved earns a
10-percent rate of return, so in the second year $110 would be
available for consumption before tax.  The individual would owe $22
in tax (20 percent of $110), leaving $88 for consumption after tax,
the same amount as under the first consumption tax.  \3

While the two consumption taxes differ in the timing of the tax
payment, as shown under this simple scenario, they would be
equivalent in terms of the present value of the taxes owed.  Under
the first consumption tax, the individual owes $20 in tax the first
year and none in the second; under the alternative consumption tax,
the individual owes no tax in the first year and $22 in the second. 
In this case, having no tax liability in the first year would enable
the person to save an additional $20 and therefore earn an additional
$2, just enough to pay the additional tax in the second year. 
Therefore, under the consumption tax in column 2, the individual
effectively prepays the consumption tax in the first year by paying
$20; the individual has paid an amount that if saved, would earn just
enough to pay the tax owed when the income was actually used for
consumption. 


--------------------
\2 Michael Graetz, "Expenditure Tax Design," in Joseph A.  Pechman,
ed., What Should Be Taxed:  Income or Expenditure?  (Washington,
D.C.:  The Brookings Institution, 1980), pp.  172-73, lists the
conditions that must hold for the taxes to be equivalent.  For
example, the tax rate an individual faces must be constant over time,
taxpayers must consume all the income they earn during their
lifetime, and individuals must be able to borrow and lend unlimited
amounts at a constant rate of interest.  Consumption taxes
effectively exempt the "normal" or competitive rate of return on
investment but can tax rates of return above this level.  For a
discussion of whether consumption taxes exempt the return for
risk-taking, see William M.  Gentry and R.  Glenn Hubbard,
"Distributional Implications of Introducing a Broad-Based Consumption
Tax," in James M.  Poterba, ed., Tax Policy and the Economy, Volume
11 (Cambridge, Mass.:  MIT Press, 1997). 

\3 Alternatively, the same $22 tax liability could be expressed as 25
percent of consumption.  Since RSTs are computed as a percentage of
consumption rather than as a percentage of income (less saving), the
appropriate RST rate would be 25 percent.  The result would be the
same--under either an RST or a personal consumption tax, income (less
saving) would be reduced by 20 percent by the tax, and the tax
liability would amount to 25 percent of consumption. 


   INCOME AND CONSUMPTION TAXES
   CAN BE LEVIED ON INDIVIDUALS OR
   BUSINESSES
------------------------------------------------------- Appendix III:2

Both income and consumption taxes can be levied on individuals or
businesses.  Whether collected from individuals or businesses,
ultimately, individuals will bear the economic burden of any tax.\4
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 tax rates. 
Individual-level taxes can allow for distinctions between different
individuals; for example, standard deductions and/or graduated rates
can be used to tax individuals with low income (or consumption) at a
lower rate than individuals with greater income (consumption).  Other
individual characteristics can also be taken into account.  For
example, adjustments can be made for family size, and additional
deductions could be allowed for individuals who have very large
medical expenditures.  However, individual-level taxes require more
tax returns, impose higher costs to comply with the tax laws, and
would generally require a larger tax administration system. 

Table III.2 shows alternative income and consumption taxes that are
levied on businesses only, individuals only, or both.  The current
tax, while including a separate corporate income tax, could be
considered primarily an individual tax because most types of income
are taxed under the individual tax.  As mentioned earlier, the
current tax is somewhere in between a pure income and pure
consumption tax because under the current tax some forms of income
from saving are taxed, while others, particularly income from saving
for retirement, are not taxed.  We describe each of the alternative
taxes in the next two sections. 



                              Table III.2
                
                Alternative Income and Consumption Taxes
                            by Level of Tax

Level of tax/features           Consumption type    Income type
------------------------------  ------------------  ------------------
Business level                  National RST        Income VAT

Tax collected at source         Consumption VAT

No filing by individuals        Credit method

No way to vary tax rates or     Subtraction method
base according to
characteristics of individuals

Mixed business/individual       Flat tax            Comprehensive
                                                    Business Income
Many parts of tax base                              Tax discussed by
collected at source                                 Treasury,
                                                    augmented with
Simplified individual tax                           wage tax at
base                                                individual level

Standard deductions or
exemptions can be used for
progressivity, but no way to
apply different rates to
entire tax base

Individual level                Personal            Integrated
                                consumption tax     individual income
Tax levied on individuals                           tax

Business must allocate income
or consumption to individuals;
may also withhold and remit
tax

Tax rates can vary according
to individual characteristics
----------------------------------------------------------------------
Source:  GAO analysis of alternative tax systems; also, see Joel
Slemrod, "Deconstructing the Income Tax," The American Economic
Review, Vol.  87, No.  2 (May 1997), pp.  151-55. 


--------------------
\4 For example, most economists would agree that the economic burden
of a tax on wages would be generally borne by workers, regardless of
whether workers directly remit tax (send a payment) to the
government, businesses withhold tax from paychecks and remit the tax,
or businesses are required to remit tax on wages they paid. 
Alternatively, because taxes can be shifted through price changes and
changes in income, the statutory incidence of a tax (who is legally
responsible to remit tax to the government) "tells us essentially
nothing" about economic incidence (whose real income is changed as a
result of the tax).  See Harvey Rosen, Public Finance, 3rd ed.  (Burr
Ridge, Illinois:  Irwin, 1992), pp.  274-77. 


      ALTERNATIVE TYPES OF
      CONSUMPTION TAXES
----------------------------------------------------- Appendix III:2.1

The second column of table III.2 shows two business-level consumption
taxes (a national RST and a VAT), a mixed business/individual-level
consumption tax (a flat tax), and an individual-level consumption tax
(a personal consumption tax).  Table III.3 shows an overview of the
major components of the alternative consumption taxes and details the
major differences between them.  While the taxes differ because they
tax consumption at different levels, they ultimately all tax the same
base. 



                              Table III.3
                
                 Components of Alternative Consumption
                                 Taxes

                                                              Personal
                                National                    consumptio
Component                            RST     VAT  Flat tax       n tax
------------------------------  --------  ------  --------  ----------
Business level
----------------------------------------------------------------------

Included
----------------------------------------------------------------------
Sales of consumption goods and        --      --        --
 services
Sales of goods and services to                --        --
 other businesses, including
 investment goods

Deducted
----------------------------------------------------------------------
Purchases of goods and                        --        --
 services from businesses,
 including investment goods
Wages                                                   --

Individual level
----------------------------------------------------------------------

Included
----------------------------------------------------------------------
Wages                                                   --          --
Cash flows received: interest                                       --
 and dividend income, funds
 from asset sales, withdrawals
 from accounts, borrowed funds
Distributions from sole                                             --
 proprietorships, partnerships

Deducted
----------------------------------------------------------------------
New saving: purchases of                                            --
 stock, bonds; deposits in
 accounts, repayment of debt
Contributions to sole                                               --
 proprietorships, partnerships
----------------------------------------------------------------------
Source:  GAO analysis and compilation of available information on
alternative consumption taxes. 


         NATIONAL RETAIL SALES TAX
--------------------------------------------------- Appendix III:2.1.1

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. 


         VALUE-ADDED TAX
--------------------------------------------------- Appendix III:2.1.2

The second column in table III.3 shows the components of a 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. 


         FLAT TAX
--------------------------------------------------- Appendix III:2.1.3

The flat tax was developed in the early 1980s by economists Robert
Hall and Alvin Rabushka.\5 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. 


--------------------
\5 See Robert E.  Hall and Alvin Rabushka, The Flat Tax, 2nd ed. 
(Stanford, Calif.:  Hoover Press, 1995). 


         PERSONAL CONSUMPTION TAX
--------------------------------------------------- Appendix III:2.1.4

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.\6


--------------------
\6 To 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. 
See appendix VIII for more details. 


         ALTERNATIVE TYPES OF
         INCOME TAXES
--------------------------------------------------- Appendix III:2.1.5

Table III.2 also shows three alternative integrated income taxes:  a
business-level tax (income VAT), a mixed business/individual-level
tax (Comprehensive Business Income Tax (CBIT)), and an
individual-level income tax (integrated individual income tax). 

All income taxes, including the current tax, differ from consumption
taxes in their treatment of investment.  To produce the goods and
services they sell to customers, businesses purchase a variety of
goods and services themselves.  While some of the goods and services
that businesses buy are used up immediately in production, other
goods and services, such as plant and equipment, for example, can be
used for production over time.  The purchase of goods and services of
this type is referred to as investment, and such goods and services
are also referred to as business assets. 

Under consumption taxes, investment is either exempt from tax or
deducted immediately (expensed).  In fact, all business purchases of
goods and services, regardless of how long they are used in
production, are exempted or expensed because business purchases
generally do not represent consumption.\7

Investment is treated differently under an income tax.  Under an
income tax, income is calculated by deducting costs from revenue;
therefore, the costs that businesses incur from purchasing goods and
services, including the costs from owning assets, should be
deductible.  For goods and services that are used up or become
worthless in the same year as they were purchased, the economic cost
to the business will be the entire amount they paid for the goods and
services, and therefore the entire amount should be deductible
immediately (in the same tax year as the goods or services were
purchased).  However, business assets do not lose all their value
immediately; rather, they wear out or become obsolete over time (the
assets depreciate).  The economic cost incurred by owning an asset
during a particular year is the reduction in the value of the asset
during that year, so under an income tax businesses should be allowed
a deduction for depreciation that reflects this reduction in value. 
Depending on the rate at which an asset loses economic value, a
proportion of the amount originally paid for the asset can be
deducted for depreciation each year until the total amount deducted
over time is equal to the amount originally paid.\8

The current income tax differs from the other three income tax
options in that the current corporate income tax is not integrated
with the personal income tax.  For example, under the current tax,
corporations cannot deduct dividends paid to shareholders, and
shareholders pay tax on the dividends they receive.  Noncorporate
income, however, is taxed only once, at the individual level.  The
three options would tax all forms of business income, corporate and
noncorporate, once. 

Table III.4 shows the components of the current tax and three
alternative income taxes that would integrate the business and
individual taxes.  The alternative income taxes differ in that they
would tax income at different levels.  The income VAT would tax all
income at the business level.  Wage income would be taxed at the
business level by denying businesses a deduction for wages.  The CBIT
option would tax business income, including profits and the interest
income earned by lenders, at the business level.  Wage income would
be taxed at the individual level. 



                              Table III.4
                
                 Components of Alternative Income Taxes

                                                            Integrated
                                 Current    Income          individual
Component                            tax       VAT    CBIT  income tax
------------------------------  --------  --------  ------  ----------
Business level
----------------------------------------------------------------------

Included
----------------------------------------------------------------------
Sales of goods and services           --        --      --
Interest, dividend income             --

Deducted
----------------------------------------------------------------------
Purchases of goods and                --        --      --
 services, except investment
 goods
Depreciation on investment            --        --      --
 assets
Wages                                 --                --
Interest paid                         --
Dividends paid

Individual level
----------------------------------------------------------------------

Included
----------------------------------------------------------------------
Wages                                 --                --          --
Interest income                       --                            --
Dividend income                       --                            --
Capital gains                         --                --          --
Income from sole                      --                            --
 proprietorships, partnerships
Share of undistributed                                              --
 corporate income
----------------------------------------------------------------------
Source:  GAO analysis and compilation of available information on
alternative income taxes. 


--------------------
\7 Investment in plant and equipment, like the purchase of financial
assets such as corporate stock or bonds, is a form of saving.  By
investing in assets like plant and equipment and using them over time
to earn income from the production and sale of goods and services,
owners of businesses postpone consumption today to make possible
additional consumption in the future. 

\8 This tax treatment would be appropriate if there is no inflation. 
In appendix IV, we discuss how inflation creates problems in
measuring depreciation. 


         INTEGRATED INDIVIDUAL
         INCOME TAX
--------------------------------------------------- Appendix III:2.1.6

An integrated individual-level income tax would be much like the
current tax.  Individuals would be responsible for filing returns
containing information on all taxable forms of income.  The taxation
of business income would change so that all business income,
corporate and noncorporate, would be taxed at the individual level. 
The tax rate would apply to all forms of income that an individual
receives, and individuals could be taxed according to graduated rates
if desired.  Other taxpayer characteristics, such as the number of
dependent family members, could be taken into account. 


         CBIT
--------------------------------------------------- Appendix III:2.1.7

The CBIT option would move much of the taxation of business income to
the business level, leaving a simplified individual tax return
(primarily wages).  Business deductions for interest and dividends
would not be allowed, so this form of income would be taxed at the
business level.  The business tax would effectively withhold tax on
business income at the tax rate that was applied to the business. 
Since individuals would file returns, standard deductions and
dependency exemptions could be part of the system.  A flat rate could
be levied at the individual level, or multiple rates chosen, but the
multiple rates would only apply to the simplified base. 


         INCOME VALUE-ADDED TAX
--------------------------------------------------- Appendix III:2.1.8

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. 


   HOW CONSUMPTION TAXES OR A
   REFORMED INCOME TAX COULD
   AFFECT TAX EXPENDITURES AND
   THEREFORE THE TAX BASE
------------------------------------------------------- Appendix III:3

If Congress decides to reform the current tax, it could incorporate
existing tax preferences into a new tax system or eliminate the
current preferences and replace them with direct expenditure
programs.  These preferences are referred to as "tax expenditures"
because they can be thought of as alternatives to direct outlay
programs.  They may take the form of exclusions, credits, deductions,
preferential tax rates, or deferral of tax liability.\9


--------------------
\9 For a more extensive classification of current tax expenditures
according to whether current tax treatment would be automatically
provided for under consumption taxes, see Martin A.  Sullivan, Flat
Taxes and Consumption Taxes:  A Guide to the Debate (New York: 
American Institute of Certified Public Accountants, Dec.  1995), pp. 
91-96. 


      TAX EXPENDITURES FOR SAVING
      AND INVESTMENT
----------------------------------------------------- Appendix III:3.1

The current tax system taxes some types of income from saving and
investment but exempts others.  The alternative tax systems would
treat all types of income from saving and investment uniformly either
by exempting all types of income from saving or by taxing all types
of income from saving.  Consumption tax proposals would expand
existing incentives and narrow the tax base by effectively exempting
all saving and investment from tax, and an income tax reform could
end the incentives by including income from all forms of saving and
investment in the tax base. 

Table III.5 shows a list of major projected fiscal year 1997 tax
expenditures for saving and investment in the current tax code.  For
instance, under current law, some forms of saving, such as those
producing pension and certain interest income, are already
effectively exempt from tax.  A move to a broad-based consumption tax
would effectively exempt all saving, treating it like pension or
tax-exempt interest income is treated today.  While some types of
investment are granted relatively favorable tax treatment currently,
under a consumption tax all investment would be expensed (deducted
immediately).  A tax reform designed to tax all income would also
move toward uniformity by removing the relative preference now given
to some forms of saving and investment to tax income of all types
equally. 



                              Table III.5
                
                 Fiscal Year 1997 Saving and Investment
                        Income Tax Expenditures

                                                            Amount (in
Tax expenditure category                                     billions)
--------------------------------------------------  ------------------
Exclusion of employer plan pension earnings and                  $70.5
 contributions
Exclusion of investment income on life insurance                  21.6
 and annuity contracts
Deferral of gain on sale of owner-occupied housing                18.6
Exclusion of $125,000 of capital gains from sale                   4.9
 of principal residences for persons age 55 and
 over
Exclusion of capital gains at death                               15.5
Maximum 28-percent rate on long-term capital gains                10.5
IRAs                                                               9.3
Keogh plans                                                        3.7
Exclusion of interest on public purpose state and                 14.1
 local government debt
Exclusion of interest on state and local                           1.7
 government bonds for private nonprofit
 hospitals\a
Exclusion of interest on state and local                           3.0
 government bonds for rental and owner-occupied
 housing
Reduced rate on first $10 million of corporate                     4.1
 taxable income
Expensing of certain depreciable property\b                        1.0
Expensing of research and experimental                             2.4
 expenditures\c
Accelerated depreciation for equipment                            28.7
Accelerated depreciation for structures                            4.6
----------------------------------------------------------------------
\a Tax expenditures of $1 billion or less would also be potentially
eliminated for tax-exempt bonds for each of the following purposes: 
industrial development; community development; and sewage, water,
hazardous waste, and other facilities. 

\b Investments in the following categories are also expensed:  (1)
certain fuel, mineral, and timber development costs; (2) agricultural
costs; and (3) others.  The estimated revenue loss for each of these
tax expenditures is less than $500 million annually. 

\c The tax credit for qualified research expenditures, as well as
credits for certain other investments, could potentially be
eliminated under consumption taxes. 

Source:  Joint Committee on Taxation data on tax expenditures;
Sullivan, p.  93; and GAO analysis of consumption tax proposals. 


      OTHER CURRENT TAX
      EXPENDITURES
----------------------------------------------------- Appendix III:3.2

Table III.6 shows a number of other tax expenditures under current
law and fiscal year 1997 revenue loss estimates associated with them. 
Both income and consumption tax reform could eliminate these
preferences, thereby broadening the tax base.  Any tax reform would
have to decide whether to continue the relative tax preference for
certain fringe benefits, government benefits, and a number of other
items. 



                              Table III.6
                
                 Other Current Tax Expenditures, Fiscal
                          Year 1997 Estimates

                                                            Amount (in
Tax expenditure category/provision                           billions)
--------------------------------------------------  ------------------
Fringe benefits (other than pensions)
----------------------------------------------------------------------
Exclusion of employer contributions for health                   $51.5
 insurance, medical care
Exclusion of benefits provided under cafeteria                     5.0
 plans
Exclusion of miscellaneous fringe benefits                         5.5
Exclusion of premiums on group term life insurance                 1.7
Exclusion of employer-paid transportation benefits                 3.1

Government benefits
----------------------------------------------------------------------
Exclusion of Social Security and Railroad                         25.3
 Retirement benefits
Exclusion of Medicare hospital insurance benefits                 12.2
Exclusion of Medicare supplementary insurance                      5.5
 benefits
Exclusion of workers' compensation                                 3.8

Other
----------------------------------------------------------------------
Deduction of nonbusiness state and local                          27.3
 government income and personal property taxes
Mortgage interest deduction for owner-occupied                    41.3
 residences
Deduction for property taxes on owner-occupied                    15.6
 residences
Charitable deductions for social services                         16.1
Charitable deductions for education                                3.0
Charitable deductions for health                                   2.2
Deduction for medical expenses and long-term care                  4.3
Earned income credit (not including direct                         3.5
 outlays)
Low-income housing tax credit                                      2.8
Credit for child care and dependent care expenses                  2.8
Additional standard deduction for the blind,                       1.9
 elderly
Tax credit for Puerto Rico and possession income                   3.2
----------------------------------------------------------------------
Source:  Joint Committee on Taxation data on tax expenditures;
Sullivan, pp.  95-96; and GAO analysis of alternative consumption
taxes. 


   CONSUMPTION TAX DESIGN ISSUES
   AFFECTING TAX ADMINISTRATION
------------------------------------------------------- Appendix III:4

In addition to the issue of whether currently tax-favored items
should maintain some tax preference in a new system, some other
issues in the design of a potential consumption tax would have an
effect on tax administration.  A transition from the current tax to a
consumption tax base could raise significant administration issues. 
In addition, if a consumption tax base is chosen, important decisions
would have to be made regarding whether particular hard-to-tax goods
and services are included in the tax base. 


      IMPLEMENTING A CONSUMPTION
      TAX MAY TAX EXISTING WEALTH
----------------------------------------------------- Appendix III:4.1

Under an income tax, no deduction for saving is allowed, and the
income from saving is taxed as it is earned by the saver.  However,
the amount that was saved is not subject to further tax.  For
example, a bondholder will pay tax on interest income but does not
owe tax on the principal when it is repaid. 

If the income tax was replaced by a consumption tax, the saving that
has been done in the past using taxed funds might be subject to tax
again.  For example, suppose that an individual buys a bond while the
income tax is in effect.  Then suppose that the income tax is
replaced by a national RST, and the bondholder receives interest
income and the principal is returned as the bond matures.  If the
bondholder uses all of these funds for consumption, all--interest
income and principal--would be subject to tax.  In this way,
replacing the income tax with a consumption tax could levy a one-time
additional tax on saving done before the tax change. 

If it is thought to be unfair to subject prior saving to tax again,
transition rules would have to be written so that prior saving could
be recovered tax-free, as it would have been under the income tax. 
One difficulty is that to replicate the treatment that saving and
income from saving would have received under the income tax, income
from saving would have to be separated from the return of the
original amount saved.  Otherwise, taxpayers might get a windfall
gain if they were able to get their previous capital income back
tax-free along with their prior saving.  The particular
administrative challenges that would have to be addressed for a
transition to the alternative consumption taxes are briefly discussed
in appendixes V through VIII. 


      A CONSUMPTION TAX MAY BE
      DIFFICULT TO ADMINISTER FOR
      CERTAIN GOODS AND SERVICES
----------------------------------------------------- Appendix III:4.2

Any consumption tax proposal would have to address several areas
where levying tax might be difficult in terms of compliance and
administration.  These items can be taxed if special rules are
developed and taxpayers and administrators devote resources to
compliance.  Including these items would broaden the base of a
consumption tax, enabling the same amount of revenue to be raised at
a lower rate than otherwise.  Exempting these items would also be
possible, but exempting some goods and services while taxing others
would create administrative difficulties.\10


--------------------
\10 For a discussion of the specific items in this section in the
context of a VAT, see Congressional Budget Office (CBO), Effects of
Adopting a Value-Added Tax (Feb.  1992). 


         FRINGE BENEFITS
--------------------------------------------------- Appendix III:4.2.1

Some fringe benefits can be thought of as consumption that takes
place within a business.  As such, no separate transaction between an
individual and a business takes place that would be subject to tax
under the normal rules for an RST or a VAT, and there is no cash flow
to an individual that would normally be included under a personal
consumption tax.  The same difficulties are present for the current
income tax and would be present for any modification of the income
tax that sought to broaden the income tax base. 

To illustrate, consider employer-provided health insurance, perhaps
the most significant fringe benefit aside from employer-provided
pensions.  The purchase of an employer- provided health insurance
plan is a business-to-business transaction, and the payment of
medical bills by insurance companies is also a business-to-business
transaction.  Ordinarily, business-to-business transactions are
ignored under an RST and deductible (or creditable) under a VAT, so
under normal rules, the consumption of medical services would not be
taxed. 

If the purchase of health insurance was to be taxed under tax reform
proposals, exceptions to the general rules would have to be written. 
Under a national RST, the purchase of health insurance or medical
services could be taxable regardless of whether they were purchased
by an individual or a business.  For a VAT, the purchase of health
insurance or payments for medical services by businesses for their
employees could be nondeductible (or noncreditable).  In either case,
the taxable transactions or purchases that would not be deductible
would have to be specified. 

Similarly, under the personal consumption tax, a business-to-business
transaction would never be reflected in an individual's cash flow, so
under general rules, the consumption would not be taxed.  To include
this consumption in the tax base, the value of the fringe benefit
would have to be imputed or allocated to the employee so that it
could be included in taxable receipts.  The same steps would have to
be taken to include the value of this form of compensation for income
tax purposes. 


         FINANCIAL SERVICES
--------------------------------------------------- Appendix III:4.2.2

Financial services can be difficult to tax under a consumption tax
because the recipients of the services are not always charged
explicit service fees.  Financial institutions typically do not
charge explicit service fees for maintaining checking and saving
accounts and for arranging loans.  Instead, they charge higher
interest rates on loans and offer lower rates on deposits than
otherwise.  To include financial services in the tax base,
consumption taxes that do not include all types of cash flows in the
tax base (such as an RST, VAT, or flat tax) would include some rules
to impute the value of the sale of the financial service.\11


--------------------
\11 See David F.  Bradford, "Treatment of Financial Services Under
Income and Consumption Taxes," in Henry J.  Aaron and William G. 
Gale, Economic Effects of Fundamental Tax Reform (Washington, D.C.: 
Brookings Institution Press, 1996) and references he cites for
arguments on whether financial services should be included in a
consumption tax base.  Bradford also points out that financial
services pose similar difficulties for income taxes as well as for
consumption taxes. 


         HOUSING
--------------------------------------------------- Appendix III:4.2.3

Taxing the consumption of services from owner-occupied housing poses
a potential problem for consumption taxes.\12 Housing, like other
durable consumption goods, provides consumption services over time. 
For rental housing, this is not a problem; rent could be taxed like
any other consumption item because there is a transaction between an
individual and a business (owner of the rental unit), so the normal
rules can apply.  For owner-occupied housing, the individual
consuming housing services and the supplier of the house are the same
person, so there is no transaction to tax. 

Consumption taxes could overcome this problem by subjecting the full
purchase price of owner-occupied housing to tax at time of purchase,
even though the house will not be consumed all at once.  This
essentially prepays the consumption tax.  However, this raises
potential problems of liquidity (the one-time payment of tax may be
very large), and taxing existing housing, as well as new housing, may
be difficult.  To tax new housing, a business (the developer, for
example) could charge tax on the purchase price of the house. 


--------------------
\12 Housing services may be more difficult to tax under an income tax
than a consumption tax.  See appendix IV for information on the
treatment of housing under an income tax. 


         GOVERNMENT AND NONPROFIT
         SERVICES
--------------------------------------------------- Appendix III:4.2.4

As under income taxes, consumption taxes must include rules for sales
and purchases of goods and services by government entities and
nonprofit organizations.  In theory, consumption taxes could tax all
goods and services used for consumption in the same way, regardless
of whether they are produced by governments and nonprofit
organizations or by private for-profit businesses.  However, because
governments and nonprofit organizations do not charge a price for
many of the goods and services they provide, these goods and services
would be undertaxed relative to those sold by the private sector
under the normal application of an RST or VAT.  Under an RST, goods
and services produced by governments and nonprofit organizations
could be implicitly taxed to some extent by treating these entities
as consumers rather than businesses.  This would tax the purchases
they make from businesses.  Under a credit method VAT, governments
and nonprofit organizations could be exempted from tax; this means
that they would be unable to obtain credits for taxes they paid on
purchases they made from businesses. 

Under the flat tax, governmental entities, nonprofit organizations,
and businesses could be treated more uniformly than under the RST and
VATs because wages paid to employees of all these organizations can
be taxable and government entities and nonprofit organizations would
be taxed on fringe benefits provided for workers.  A personal
consumption tax could tax state and local government services by not
allowing a deduction for state and local taxes.\13


--------------------
\13 For more details on these issues, see Joint Committee on
Taxation, Impact on State and Local Governments and Tax-Exempt
Organizations of Replacing the Federal Income Tax (JCS-4-96), April
30, 1996.  Also, for a discussion of whether state and local business
taxes should be deductible under consumption tax alternatives and
other issues, see Douglas Holtz-Eakin, "Fundamental Tax Reform and
State and Local Governments," National Tax Journal Vol.  XLIX, No.  3
( Sept.  1996), pp.  475-86. 


   DEFINITION AND MEASUREMENT OF
   COMPLIANCE COSTS
------------------------------------------------------- Appendix III:5

Taxes impose three types of costs on society as a whole as resources
are transferred from the private sector to the public sector.  First,
taxpayers must use resources to comply with the requirements of the
tax system (compliance costs).  Second, resources must be provided to
the public sector to administer the tax, including collecting the
revenue and ensuring that taxpayers comply with the requirements
(administration costs).  Third, taxes can also distort economic
behavior, leading to a misallocation of resources (excess burden). 
Ideally, in determining the amount of revenue to be raised and the
type of tax used to raise the revenue, the level and distribution of
each of these costs would be weighed against the benefits derived
from the use of the revenue by the public sector.\14

Compliance costs are costs that individuals and businesses incur, in
terms of both time and money directly spent, because of the
requirements of the tax system.  Ideally, compliance costs should be
measured by calculating the value of the time and the resources used
doing tax-related tasks in their best alternative use (opportunity
cost) net of any value derived from the information produced by
complying with the requirements.\15

Compliance costs and administrative costs are interrelated because
some of the tasks that need to be done to collect taxes can be done
by the public sector or by the private sector.  As a result, costs
can be shifted from one sector to another.  For example, in the
United States, businesses take on some responsibilities that
encourage compliance by withholding tax on wages and providing
information returns on payments of interest and dividend income.  As
a result, a high level of compliance on those forms of income may be
achieved at lower administrative cost because matching information
returns with tax returns can substitute for large numbers of audits. 
Also under the current system, taxpayers receive information and help
with their tax filing responsibilities through both the private
sector paid preparer industry and IRS taxpayer service activities. 

The distribution of compliance costs among different businesses and
individuals is also important for understanding the full effects of a
tax system.  For example, withholding tax on wages and providing
information returns are costly tasks for businesses, but receiving
these documents lowers compliance costs for individuals.\16 Some
studies have indicated that small businesses may bear higher
compliance costs as a percentage of sales than larger businesses, and
some businesses may receive cash flow benefits from being able to
retain tax they collect for a period until remittance to the
government is required.  A full analysis of the distributional
effects of different tax policies would take these effects of
compliance costs into account. 


--------------------
\14 Compliance cost assessments are done in the United Kingdom for
major tax provisions.  For examples of these assessments and
summaries of several recent studies on compliance costs, see Cedric
Sandford, ed., Tax Compliance Costs:  Measurement and Policy
(Perrymead, England:  Fiscal Publications in association with the
Institute for Fiscal Studies, 1995). 

\15 Some experts believe that some businesses may derive managerial
benefits from accounting information produced for tax purposes.  See
Cedric Sandford, Administrative and Compliance Costs of Taxation
(Perrymead, England:  Fiscal Publications, 1989), p.  13. 

\16 The economic burden of these costs may not reduce business
profits if they result in higher prices, lower wages, or lower
interest payments. 


      MEASUREMENT OF COMPLIANCE
      COSTS
----------------------------------------------------- Appendix III:5.1

A major difficulty in measuring compliance costs is disentangling
accounting and recordkeeping costs due to taxes from the costs that
would have been incurred in the absence of the tax system.  For
example, where the rules regarding the calculation of income for tax
purposes coincide with rules for determining income for financial
statement or regulatory purposes, the additional costs of taxation
can be minimal.  Because public corporations must report financial
statement income under the rules of the Securities and Exchange
Commission, some recordkeeping useful in calculating tax liability
may be done for nontax purposes.  For other businesses, calculating
financial statement income may be required by banks or other
potential lenders.  Some individuals may need to calculate their
income in order to apply for mortgages or financial aid for college. 
However, significant compliance costs may arise when the tax code
requires businesses or individuals to keep records and calculate
income differently than they do for other purposes. 

A related issue is whether other government agencies would require
taxpayers to produce the same or similar information if it is not
required for tax purposes.  For example, the federal government might
need a measure of individuals' income to determine eligibility for
means-tested transfer programs, and state and local governments that
now rely on federal income tax records might need to have similar
information for their own tax and transfer programs even if the
federal income tax were eliminated.  To the extent that income tax
requirements would be recreated by other government agencies if the
income tax were repealed, compliance costs would have to be
considered to be government compliance costs rather than stemming
solely from the tax system. 

The reliability of the results of most compliance cost studies that
have been done to date is limited by several factors, which are
commonly acknowledged by the authors of the studies.  First, written
or telephone questionnaires have generally been used to ask
individuals or businesses how much money or time they spend on tax
matters.  In evaluating these studies, it is difficult to know
whether respondents can differentiate between recordkeeping that
would have been done anyway and recordkeeping that is only done for
tax purposes.  Reported compliance costs may be exaggerated if
respondents include costs for nontax purposes.  In addition, it is
not known whether respondents did everything required to fully comply
with the tax law.  For example, if a particular tax rule was so
complex that taxpayers did not even attempt to comply, respondents
might truthfully answer that they spent no time or money to comply
with the rule.  The compliance costs as measured by the survey would
be zero, so the results of the survey would not give an indication of
just how complex the rule really is.  Finally, response rates for
these studies have generally been low, so the results from the
surveys may not reliably estimate costs for taxpayers in general. 


INCOME TAX REFORM OPTIONS
========================================================== Appendix IV


   DESCRIPTION
-------------------------------------------------------- Appendix IV:1

In this appendix, we describe several options for reforming the
income tax and also the administrative issues that would be important
if these options were considered.  The four options we describe are
based on past and current proposals and academic discussions and
analyses.  The options were chosen to best describe the trade-offs
and choices that would have to be made in reforming the income tax
and to best facilitate comparisons of income tax reform options and
consumption tax proposals. 

The goal of each of the four income tax reform options we discuss is
to have a more comprehensive and accurately measured income tax base
than under the current income tax.  To do this, all of the reform
options could make three major changes to the current system.  First,
the income tax base could be broadened so that most forms of income
would be taxed annually.  This could be done by including more types
of income in the tax base and by eliminating some adjustments,
credits, and deductions.  Second, the calculation of income could
include explicit inflation adjustments so that the tax base would
better measure the real income of individuals and businesses.  Under
the current tax, inflation can lead to an overstatement or an
understatement of real income.  Third, the corporate and personal
income taxes could be integrated so that business income would be
taxed once annually, regardless of the legal form of the business. 
Under the current tax, corporate income is taxed differently than the
income of noncorporate businesses, such as sole proprietorships and
partnerships. 

The income tax options we discuss would integrate the corporate and
personal taxes but would do so in different ways.  Just as
consumption taxes can be levied on businesses, individuals, or both,
the income tax options would levy the income tax at different levels. 
Two options would tax individuals directly on most or all of their
income.  These options, like the current system, would allow for many
individual characteristics to be taken into account when determining
tax liability.  Administration of these options would also be similar
to that under the current system, with individuals filing returns and
information returns used to check compliance.  Two other options
would tax most or all income at the business level, essentially
withholding tax before income is received by individuals.  These
options could reduce the need for individual returns and information
reporting; administration efforts would be focused primarily on
business returns.  These options would not be as able to take
individuals' characteristics into account and would be facilitated by
a flatter tax rate structure. 

This appendix first describes the changes that any of the four income
tax reform options could make to more comprehensively and accurately
measure income and elaborates on the options themselves.  Then, it
discusses the potential impact of these options on taxpayers'
compliance burden and on tax administration. 


      BROADENING THE INCOME TAX
      BASE
------------------------------------------------------ Appendix IV:1.1

The income tax base could be broadened by taxing certain types of
income that are now exempt from tax and by eliminating some
adjustments, deductions, and credits.  Broad- based taxes can offer
several advantages in meeting the goals of the tax system-- promoting
economic efficiency and equity and reducing taxpayer compliance
burden and administration costs.  By making fewer distinctions among
activities, a broad-based tax can be simpler and easier to
administer, and because under a broad base a given amount of revenue
can be raised with a relatively low tax rate, economic efficiency may
be enhanced.  However, a more narrowly defined tax base, while
generally requiring higher tax rates to raise the same amount of
revenue, could be preferable to a broad tax base if exemptions,
credits, or deductions promote economic efficiency and equity or
simplify compliance and administration to a sufficient extent. 

Broadening the tax base could in some respects increase the
complexity of the tax system, but it could simplify it in other
respects.  For example, including some forms of income in the tax
base could in some circumstances complicate compliance and
administration, particularly if these forms of income are difficult
for taxpayers to calculate and administrators to verify.  However, if
one form of income was exempted and other forms were taxed, rules and
definitions would have to be developed to differentiate one form of
income from the others.  These rules would have to be followed by
taxpayers and compliance with the rules checked by tax
administrators. 


         TAXING ADDITIONAL TYPES
         OF INCOME
---------------------------------------------------- Appendix IV:1.1.1

Table IV.1 shows major types of income that are currently reported on
Form 1040 and the number of returns that reported some amount of each
type of income in tax year 1993.  It also shows how the tax treatment
of some items that are currently reported could change under a more
broadly based tax, and it shows some additional income items that are
not taxed or reported under current law.  The major changes from the
current system are discussed following the table. 



                               Table IV.1
                
                   Income Items and Number of Returns
                     Reporting Them, Tax Year 1993

                                                    Millio
                                                     ns of
                                                    return
                                                         s  Possible
                                                    report  reformed
                                       Current tax     ing  income tax
Item                                   treatment      item  treatment
-------------------------------------  -----------  ------  ----------
Currently reported items
----------------------------------------------------------------------
Salaries and wages                     Taxed          98.0  Taxed

Taxable interest                       Taxed          65.2  Taxed,
                                                            adjusted
                                                            for
                                                            inflation

Tax-exempt interest                    Taxed under     4.7  Taxed,
                                       some                 adjusted
                                       circumstanc          for
                                       es                   inflation

Dividends                              Taxed          24.7  Taxed

Net capital gain or loss               Taxed when     18.4  Taxed on
                                       realized,            accrual
                                       nominal              basis,
                                       gain                 indexed
                                       included             for
                                                            inflation

Distributions from pensions and        All            17.4  Not taxed
annuities                              distributio
                                       ns taxed

Unemployment compensation              Taxed           9.7  Taxed

Social Security benefits               Taxed under     5.7  Amounts
                                       some                 above
                                       circumstanc          contributi
                                       es                   ons taxed

Business or profession net income or   Taxed          15.6  Taxed
loss (sole proprietorships)

Rental and royalty net income or loss  Taxed          11.0  Taxed

Partnership and S corporation net      Taxed           5.5  Taxed
income less loss

Estate and trust net income less loss  Taxed           0.5  Taxed

Farm net income less loss              Taxed           2.3  Taxed


Additional income items
----------------------------------------------------------------------
Contributions to pension plans;        Not taxed       N/A  Taxed
earnings from life insurance,
annuity, and pension plan reserves

Employer-paid fringe benefits (other   Not taxed       N/A  Taxed
than pensions)

Government benefits (Medicare,         Not taxed       N/A  Taxed
workers' compensation)

Imputed service value of owner-        Not taxed       N/A  Taxed
occupied housing and other household
durables
----------------------------------------------------------------------
Legend:  N/A = not applicable. 

Sources:  IRS, Statistics of Income Division, Individual Income Tax
Returns 1993.  Additional income items from David Bradford,
Untangling the Income Tax (Cambridge, Mass.:  Harvard University
Press, 1986), pp.  33-34. 

Tax-exempt interest income.  Current law allows interest income from
bonds issued by state and local governments and tax-exempt
organizations to be exempt from tax if the bonds are used for certain
purposes.  While in some circumstances this interest income can be
taxable and is therefore reported on tax forms, it is not subject to
information reporting.  The income tax base could be broadened by
removing the tax exemption for this interest income. 

Accrued capital gains.  Under current law, capital gains are
generally subject to tax only when assets are sold or otherwise
disposed of.  Owners of assets that have appreciated in value over
the course of a year but have not been sold generally do not report
the increase in asset value as income.  Since such income is not
reported until the asset is sold, tax on this income is deferred.\1

Capital gains could in effect be taxed as they are earned (on an
accrual basis) in two ways.  First, the owner of the asset could
calculate the difference between the value of the asset at the end of
the year and the value of the asset at the beginning of the year. 
Tax would be paid on the amount of the difference, regardless of
whether the asset was actually sold.  This could be done most readily
for assets that are bought and sold frequently, such as publicly
traded corporate stock, because the market values of the assets would
be relatively easy to obtain and check.  Under a second approach,
taxation of gains could occur only when assets are sold, as under
current law.  However, an interest charge could be imputed and added
to the gain so that the tax saving from the deferral of income would
be offset.\2 This approach could be applied to assets for which
market values are not readily available because they are bought and
sold infrequently, or for all assets generally. 

Contributions to pension plans and retirement accounts; earnings from
retirement accounts and life insurance, annuity, and pension plan
reserves.  In general under an income tax, income that is saved is
taxed, and income from saving is taxed when it is earned.  Under the
current tax, there are significant exceptions to this general rule,
and in some cases saving is treated as it would be under a
consumption tax.  In particular, contributions to pension plans and
certain individual retirement arrangements (IRA) are not included in
an individual's income, and earnings in these plans are not taxed
until they are distributed.  In addition, earnings in certain life
insurance and annuity plans are not taxed until they are distributed. 
The income tax base could be broadened by taxing contributions to
pension plans and IRAs, and by taxing earnings in pension, IRA, life
insurance, and annuity plans when they are earned. 

Employer-paid fringe benefits.  In addition to pensions, under
current law businesses can provide several types of fringe benefits
to employees on a tax-favored basis.\3 Qualified expenditures on
these fringe benefits, including premiums paid for employer-provided
health insurance, are deductible for the business as are other forms
of compensation.  However, unlike many other forms of compensation,
the value of the benefits is not taxable to the employee. 

The income tax base could be broadened either by making expenditures
for fringe benefits nondeductible for businesses or by including the
value of the benefits in the taxable income of the employee.  If
benefits were not deductible, they would in effect be taxed at the
tax rate that the business faces.  If benefits were included in the
taxable income of the individual, they would be taxed at the
individual's tax rate. 

Government benefits.  Currently, several types of government benefits
are not taxed, including Medicare benefits and workers' compensation. 
Also, Social Security benefits under a certain level are not taxed
when they are received.  The income tax base could be broadened by
including more of these benefits in taxable income. 

Income from owner-occupied housing.  Under the current tax and income
taxes in general, income earned through the ownership of assets is
generally subject to tax, and the costs of earning the income are
deductible.  However, under the current tax, the treatment of
owner-occupied housing represents a significant exception to the
general rule.  If a home is rented, the income earned by the owner of
the home is taxed much like the income earned from owning other
assets is taxed.  In this case, the owner of the house would receive
rent in exchange for the housing services provided to the renter. 
The rent received by the owner would be taxable, and costs, such as
depreciation, maintenance, and interest expense, would be deductible. 
In contrast, if the homeowner occupies the house, the value of the
housing services received by the owner is not included as income, and
maintenance and depreciation are not deductible.  However, mortgage
interest is deductible. 

Most analysts believe that it would be very difficult to tax income
from owner-occupied housing precisely.  The major administrative
difficulty in taxing income from owner-occupied housing like income
from other investments is the lack of a transaction, the rent
payment, that would measure the income earned.  An amount would have
to be estimated, or imputed, possibly based on the market value of
the house.  Estimating market values for housing on an annual basis
is a challenge for local property tax administration.  Here, too, the
problem is a lack of a transaction on which to base a measurement
because only a fraction of houses are sold within a given year.\4


--------------------
\1 The current tax code contains several provisions to force the
recognition of income to prevent deferral of gain in some
circumstances.  Shuldiner notes that Internal Revenue Code sections
475 and 1256 require mark-to-market for the inventory of security
dealers and certain financial instruments; sections 453A and 1291
impose interest charges on deferral.  Reed Shuldiner, "Indexing the
Tax Code," Tax Law Review, Vol.  48 (1993), pp.  556-57, notes 70,
72. 

\2 For details of such an approach, see Alan J.  Auerbach,
"Retrospective Capital Gains Taxation," The American Economic Review,
Vol.  81, No.  1 (Mar.  1991), pp.  167-78.  Also, see David J. 
Shakow, "Taxation Without Realization:  A Proposal For Accrual
Taxation," University of Pennsylvania Law Review, Vol.  134, No.  5
(June 1986), pp.  1111-1205. 

\3 More detail on the tax treatment of fringe benefits is presented
in Tax Policy:  Effects of Changing the Tax Treatment of Fringe
Benefits (GAO/GGD-92-43, Apr.  7, 1992). 

\4 Several European countries that also tax net wealth have, at
certain times, levied a tax on imputed rent by including a certain
fraction of the assessed value of a house in the income tax base. 
See OECD Studies in Taxation, The Personal Income Tax Base:  A
Comparative Survey (Paris:  1990). 


         ELIMINATING SOME
         DEDUCTIONS AND CREDITS
---------------------------------------------------- Appendix IV:1.1.2

As noted in Treasury's 1984 study of tax reform, broadening the
income tax base by eliminating certain adjustments, deductions, and
credits would also be possible.\5 To measure income accurately, an
income tax should allow deductions for the costs of earning income,
and the current income tax allows some costs to be deducted.  Other
adjustments, deductions, and credits represent subsidies designed to
encourage certain types of spending thought to be socially
beneficial.  Still, others represent additional modifications of the
income tax base to better measure an individual's ability to pay tax. 
For example, individuals with sufficiently large medical expenditures
may not be as able to pay tax as individuals without such
expenditures.  Table IV.2 shows adjustments, deductions, and credits
in the current tax code and how these items might be treated under an
income tax with a broader base.  Items that are considered to be tax
expenditures could be eliminated, while items that can be considered
costs of earning income could be deductible.  Other items, such as
the standard deduction and the foreign tax credit, could be retained
as a part of the overall structure of the income tax. 



                               Table IV.2
                
                     Current Tax Code Adjustments,
                Deductions, and Credits for Individuals,
                 Tax Year 1993, and Possible Treatment
                      Under a Reformed Income Tax

                                       Millions of  Possible treatment
                                individual returns  under reformed
Item                                reporting item  income tax
------------------------------  ------------------  ------------------
Adjustments
----------------------------------------------------------------------
IRA deduction                                  5.8  Eliminated
Deductions for self-                           0.9  Eliminated
 employment retirement plans
 (Keogh and simplified
 employee pension plans)
Deduction for self-employment                 12.5  Possibly
 tax                                                 deductible
Self-employment health                         2.9  Eliminated
 insurance

Deductions
----------------------------------------------------------------------
Standard deduction                            80.8  Retained
Additional standard deduction                 10.5  Eliminated
 for age 65 or blindness
Itemized deductions:                          32.8
Medical and dental expense                     5.5  Eliminated
Taxes paid                                    32.3  Eliminated
Mortgage interest paid                        27.2  Deduction
                                                     retained,
                                                     adjusted for
                                                     inflation if
                                                     income from
                                                     owner-occupied
                                                     housing is taxed;
                                                     otherwise,
                                                     deduction
                                                     eliminated
Investment interest                            1.5  Deduction
                                                     retained,
                                                     adjusted for
                                                     inflation
Charitable contributions                      29.8  Eliminated
Unreimbursed employee business                 9.3  Retained
 expenses

Credits
----------------------------------------------------------------------
Earned income                                 15.1  Possibly
                                                     eliminated
Child care                                     6.1  Possibly
                                                     deductible
Elderly or disabled                            0.2  Eliminated
Foreign tax                                    1.3  Retained
General business                               0.3  Eliminated
Alternative minimum tax                        0.3  Eliminated
----------------------------------------------------------------------
Sources:  Data on number of returns with line item:  IRS, Statistics
of Income Division, Individual Income Tax Returns 1993.  Possible
changes from Joint Committee on Taxation, Estimates of Federal Tax
Expenditures for Fiscal Years 1997-2001 (JCS-11-96), Nov.  26, 1996;
and Joint Committee on Taxation, Impact on State and Local
Governments and Tax-Exempt Organizations of Replacing the Federal
Income Tax (JCS-4-96), Apr.  30, 1996; and Bradford (1986), pp. 
33-34. 


--------------------
\5 U.S.  Department of the Treasury, Tax Reform for Fairness,
Simplicity, and Economic Growth Vol.  1 (1984), pp.  viii-ix. 


      INDEXING THE TAX SYSTEM FOR
      INFLATION
------------------------------------------------------ Appendix IV:1.2

The current tax code does not include explicit adjustments to take
inflation into account in calculating business income.  As several
studies, including the Department of the Treasury's 1984 proposal for
tax reform, have shown, without adjustments for inflation (indexing),
taxable income could be overstated or understated relative to the
real income of the taxpayer.  That study and others have concluded
that business income would be better measured if inventories,
depreciation, interest income, interest expense, and capital gains
were all indexed for inflation.\6 Some analysts have stated that
concern about added complexity was one reason why indexing was not
adopted in the Tax Reform Act of 1986.\7

An example can illustrate the income mismeasurement problem caused by
inflation.  Suppose a business bought equipment for $1,000 in 1985. 
Suppose also that the equipment was expected to be used for 10 years,
and the business was allowed a deduction for depreciation over the
course of the 10 years.  The total amount deducted over time would
add up to $1,000, the historical cost or purchase price of the
equipment.  Suppose further that the business could deduct $100 in
each of the 10 years for depreciation.  With inflation, the value of
the deduction for depreciation erodes over time because the $1,000 is
fixed in terms of 1985 dollars.  In other words, a $100-deduction in
1995 would understate the real economic cost of operating the
equipment because $100 was not worth as much in 1995 as it was in
1985.  Thus, the income of the business would be overstated because
its costs as calculated would not represent the real costs to the
business. 

While inflation adjustments could correct this problem, the tax code
has featured accelerated depreciation to indirectly offset inflation. 
If an inflation adjustment for the historical cost of the machine
were made, the $1,000 historical cost figure would be increased to
reflect inflation each year, and the deduction for depreciation would
therefore be increased so that it reflected the real economic cost of
operating the equipment.  Instead, the tax code has allowed
accelerated depreciation (allowing relatively larger deductions in
the first few years after the asset is purchased) but kept historical
basis calculations.  While it is possible to develop accelerated
depreciation schedules that offset the effects of a given rate of
inflation, depreciation schedules would have to be changed to prevent
renewed overstatement or understatement of income if the rate of
inflation changes. 

A similar problem exists in the calculation of capital gains.  As
noted above, capital gains on the sale of assets are taxed when
assets are sold.  To calculate gain or loss, the sale price of the
asset is compared to the price that was originally paid for the
asset.\8 Part of this gain may be the result of inflation.  Assets
that have lost value on an inflation-adjusted basis could show a gain
when the effect of inflation is ignored.  This problem is one
justification for applying a preferential tax rate to capital gains
income to, albeit imperfectly, offset the overstatement of income. 
However, having a preferential tax rate, in turn, creates incentives
for taxpayers to structure transactions so that income is
characterized as a capital gain rather than as ordinary income, and
further rules are designed to prevent or limit this activity.\9


--------------------
\6 For a more detailed analysis of indexing, see Shuldiner (1993);
Bradford (1986), Ch.  3; Daniel Halperin and Eugene Steuerle,
"Indexing the Tax System for Inflation," in Henry J.  Aaron, Harvey
Galper, and Joseph A.  Pechman, eds., Uneasy Compromise:  Problems of
a Hybrid Income-Consumption Tax (Washington, D.C.:  The Brookings
Institution, 1988); and Joel Slemrod and Jon Bakija, Taxing
Ourselves:  A Citizen's Guide to the Great Debate Over Tax Reform
(Cambridge, Mass.:  The MIT Press, 1996), Ch.  8.  For information
about foreign experience with indexation provisions, see Milka
Casanegra de Jantscher, Isaias Coelho, and Arturo Fernandez, "Tax
Administration and Inflation," in Richard M.  Bird and Milka
Casanegra de Jantscher, eds., Improving Tax Administration in
Developing Countries (Washington, D.C.:  International Monetary Fund,
1992). 

\7 Shuldiner (1993), p.  598, and Slemrod and Bakija (1996), p.  238. 

\8 For depreciable assets, the calculation of gain or loss would also
take into account depreciation deductions taken over time. 

\9 See Treasury, pp.  180-81. 


      INTEGRATING THE CORPORATE
      AND INDIVIDUAL INCOME TAX
------------------------------------------------------ Appendix IV:1.3

Another objective of income tax reform could be the integration of
the corporate and individual income taxes.\10 The differences in the
current tax code between the tax treatment of corporations and
noncorporate businesses, such as partnerships and sole
proprietorships, have long been criticized.  Some forms of corporate
income can be taxed twice, while income earned by noncorporate
businesses is taxed once.  Under the current tax, corporate income
paid out as dividends to individual shareholders is taxed twice; it
is first taxed in effect at the corporate level because dividend
payments are not deductible, and it is generally taxed again when
shareholders receive the dividend payment as income. 

Table IV.3 details several options for integrating the corporate tax
with the individual tax so that all business income, whether earned
by a corporation or a noncorporate business, would be taxed once
annually.  Under all the income tax reform options, business income
would be taxed at either the business level or the individual level,
but the same income would not be taxed at both levels.  In contrast
to the consumption tax options that would allow an immediate
deduction for investment spending, each income tax option would allow
a deduction for depreciation of investment assets over time.  The
income tax options differ in the degree to which income would be
taxed at the business level or the individual level. 



                               Table IV.3
                
                   Overview of Alternative Income Tax
                             Reform Options

                                                              Integrat
                                                    Integrat        ed
                                                          ed  individu
                                                    corporat        al
                              Curren  Income        e income    income
Item                           t tax     VAT  CBIT       tax       tax
----------------------------  ------  ------  ----  --------  --------
Business level
----------------------------------------------------------------------

Included
----------------------------------------------------------------------
Sales of goods and services       --      --    --        --
Interest, dividend income         --                      --

Deducted
----------------------------------------------------------------------
Purchases of goods and            --      --    --        --
 services, except investment
 goods
Depreciation on investment        --      --    --        --
 assets
Wages                             --            --        --
Interest paid                     --                      --
Dividends paid                                            --

Individual level
----------------------------------------------------------------------

Included
----------------------------------------------------------------------
Wages                             --            --        --        --
Interest income                   --                      --        --
Dividend income                   --                      --        --
Capital gains                     --            --        --        --
Income from sole                  --                      --        --
 proprietorships,
 partnerships
Share of undistributed                                              --
 corporate income
----------------------------------------------------------------------
Source:  GAO analysis of alternative income tax reform options. 


--------------------
\10 For a comprehensive study of the issue of integration, see U.S. 
Department of the Treasury, Integration of the Individual and
Corporate Tax Systems:  Taxing Business Income Once (Jan.  1992). 


         INTEGRATION OPTIONS THAT
         TAX MOST TYPES OF INCOME
         AT THE INDIVIDUAL LEVEL
---------------------------------------------------- Appendix IV:1.3.1

Two options would be similar to the current tax in that most types of
income would be taxed at the individual level.  Like the current
income tax, the structure of these taxes would allow for any
combination of rates and standard deductions and exemptions.  Large
standard deductions and a single rate would be possible, or the tax
could feature graduated tax rates and subsidies such as the earned
income credit.  Family size and individual circumstances, such as
being over 65 or blind, could be taken into account if desired. 

Integrated Individual Income Tax.  Under an integrated individual
income tax, all corporate income would be taxed at the individual
level at the individual's tax rate.  As under the current tax, income
earned by corporations and distributed to shareholders as dividends
would be taxed at the individual level.  Undistributed corporate
income would be allocated to shareholders and taxable to them much as
income earned by partnerships and S corporations is taxed currently. 
If the tax base was broadened, fringe benefits would be similarly
allocated to the employees receiving the benefits. 

Integrated Corporate Income Tax.  An integrated corporate income tax
would differ from the integrated individual tax in that undistributed
corporate income would not be allocated to shareholders; rather, it
would be taxed separately at the corporate level.  Corporations would
be allowed to deduct dividends paid to shareholders, and shareholders
would pay tax on dividends they receive.  Deductions for expenditures
on fringe benefits could be disallowed, effectively taxing this
income at the corporate level rather than as income to employees. 
Compared to the integrated individual tax, this option would tax more
types of corporate income at the corporate level at the tax rate that
applies to corporations rather than at the individual's tax rate. 


         INTEGRATION OPTIONS THAT
         TAX MOST TYPES OF INCOME
         AT THE BUSINESS LEVEL
---------------------------------------------------- Appendix IV:1.3.2

The other two options would move the taxation of most types of income
to the business level.  Many of the simplifications made in the
consumption tax proposals come about because more of the tax base is
taxed at the business level than at the individual level.  For
example, the national retail sales tax (RST) and value-added taxes
(VAT) have no individual filing, and the flat tax reduces the number
of items taxed at the individual level substantially.  Taxing all or
most of the tax base at the business level could also be done while
maintaining an income tax, eliminating or substantially reducing the
scope for individual filing.  Any income or consumption tax that is
levied primarily at the business level gains simplicity for
individuals but sacrifices the ability to tax individuals according
to their individual circumstances. 

Income VAT.  It would be possible to tax income with only a
business-level tax by using an income VAT.  The difference between an
income VAT and the consumption VATs we describe in appendix VI is the
treatment of purchases of capital assets.  Under the consumption
VATs, these investments are deducted immediately, or expensed.  Under
an income VAT, businesses would depreciate capital goods over time,
as they now do under the income tax.  Wages, interest, and dividends
would not be deductible, so these forms of income would effectively
be taxed at source.  Under such a system, as under a consumption VAT,
individuals would not have to file returns themselves, and tax
administration would be limited to business returns.  Also, like a
consumption VAT, individual characteristics could not be taken into
account to make the tax more progressive or better reflect ability to
pay. 

Comprehensive Business Income Tax (CBIT).  It would be possible to
tax most types of income at the business level and have a simplified
individual tax that included only a few income items.  For example,
one of the prototypes for corporate integration analyzed by the
Treasury Department, the CBIT would not allow deductions at the
business level for interest and dividends, essentially collecting tax
on these forms of income at the business level.  Under such a system,
individuals would pay tax on only wages and certain capital gains.\11
The CBIT would modify the income VAT by allowing a deduction for
wages at the business level and taxing wages at the individual level. 
Including personal exemptions, a standard deduction, and other
features in the individual tax could then make the tax more
progressive than an income VAT. 


--------------------
\11 "Certain capital gains" are increases in the value of stock that
are unrelated to undistributed business income, which is already
taxed at the business level under the CBIT.  Such increases in the
value of stock might result from anticipation of increases in future
earnings or from increases in the value of assets owned by the
business itself.  See Treasury (1992) Ch.  8 for more details on how
capital gains might be taxed under different corporate tax
integration options. 


   POTENTIAL IMPACT ON TAXPAYERS'
   COMPLIANCE BURDEN
-------------------------------------------------------- Appendix IV:2

Table IV.4 summarizes some of the ways in which a reformed income tax
could affect taxpayers, and a more detailed discussion follows. 



                               Table IV.4
                
                Summary of Some Key Potential Impacts of
                 Income Tax Reform Options on Taxpayers

                                Characteristics of
                                taxpayer
                                compliance burden   Impact of income
                                under the current   tax reform options
Burden                          income tax          on taxpayers
------------------------------  ------------------  ------------------
                                Burden on           Impact on
                                individual          individual
                                taxpayers           taxpayers

Return filing                   116 million         Individual taxes:
                                returns filed in    Broader base; more
                                1995                individuals
                                                    possibly filing,
                                                    depending on
                                                    standard deduction
                                                    amount and amounts
                                                    of tax withheld

                                                    CBIT: Limited
                                                    base; fewer filers
                                                    possible

                                                    Income VAT: No
                                                    individuals filing

Records kept                    Records supporting  Individual taxes:
                                tax returns         Records reduced by
                                supposed to be      eliminating some
                                kept--e.g.,         deductions and
                                receipts, proof of  credits; increased
                                payment, and        by adding other
                                documentation       types of income to
                                supporting          base
                                deductions and
                                credits; burden     CBIT: Reduced;
                                alleviated by       many types of
                                information         income no longer
                                reports given to    taxable
                                individuals
                                                    Income VAT:
                                                    Eliminated

Calculations made               Complicated         Individual taxes:
                                calculations for    Calculations added
                                some taxpayers      by indexation,
                                included for        taxing accrued
                                provisions such as  capital gains;
                                dependency tests    reduced by
                                and capital gains   eliminating
                                                    deductions,
                                                    credits

                                                    CBIT: Made for
                                                    certain capital
                                                    gains only

                                                    Income VAT:
                                                    Eliminated

Complexity faced                Many pages of       Individual taxes:
                                instructions        Complexity
                                involved and        increased by
                                millions of         indexing, need to
                                supplemental forms  accrue capital
                                and schedules       gains taxes;
                                filed--e.g., 33     reduced by
                                million schedules   treating income,
                                of itemized         expenses, and
                                deductions for tax  savings more
                                year 1994;          uniformly
                                difficulties
                                existing in         CBIT: Capital
                                defining and        gains complexity
                                recognizing         only
                                income; however,
                                in actual           Income VAT:
                                practice, minimal   Eliminated
                                complexity faced
                                by millions of
                                individuals

                                Burden on business  Impact on business
                                taxpayers           taxpayers

Return filing                   24 million returns  All options:
                                filed in 1995       Returns filed by
                                                    all businesses,
                                                    either paying tax
                                                    separately or
                                                    allocating income
                                                    to owners.
                                                    Withholding on
                                                    wages eliminated
                                                    under income VAT

Records kept                    Records supporting  All options:
                                income and          Records needed for
                                expenses supposed   revenues;
                                to be kept          expenses,
                                                    including
                                                    depreciation;
                                                    fringe benefits--
                                                    allocated or
                                                    nondeductible

                                                    Integrated
                                                    individual: Added
                                                    records for
                                                    allocation of
                                                    income to
                                                    shareholders

Calculations made               Complicated         All options:
                                calculations        Calculations added
                                included for        by indexation,
                                provisions such as  reduced if AMT
                                depreciation, the   eliminated
                                alternative
                                minimum tax, and
                                the foreign tax
                                credit

Complexity faced                Detailed rules      All options:
                                involved;           Income
                                complexity          measurement,
                                reflected in areas  international
                                such as             issues remain; AMT
                                depreciation, the   possibly
                                alternative         eliminated, debt
                                minimum tax, and    versus equity
                                the foreign tax     distinctions not
                                credit;             as important
                                difficulties
                                existing in
                                defining and
                                recognizing income

Requirement to furnish          1.1 billion         Integrated
information returns             information and     individual tax:
                                withholding         Possible need for
                                documents filed     returns showing
                                                    allocation of
                                                    corporate income,
                                                    fringe benefits

                                                    CBIT: No need for
                                                    returns on
                                                    dividends,
                                                    interest

                                                    Income VAT: None
                                                    related to
                                                    individuals
----------------------------------------------------------------------
Source:  GAO analysis of available information about alternative
income tax reform options. 


      NUMBER OF TAX RETURNS
------------------------------------------------------ Appendix IV:2.1

Under the individual tax options, as under the current income tax,
both businesses and individuals might file returns.  Under current
law, individuals must file returns if their gross income exceeds
certain thresholds.  These thresholds vary according to filing status
and are determined by the amount of the applicable standard deduction
and the value of personal exemptions.  If individuals with gross
income below these thresholds have had tax withheld during the year,
they can file a return to claim a refund.  If these thresholds were
unchanged by tax reform and the income tax were broadened to include
more types of income, more individual returns might be filed.  For
example, individuals who have small amounts of wage income and some
tax-exempt interest income might not have to file a return under
current law; these individuals might have to file a return under the
individual income tax options because all interest income would be
taxable.  However, if the additional revenue acquired from broadening
the tax base were used to increase standard deduction or personal
exemption amounts, the number of filers might be reduced. 

Business filing under these options could be similar to the current
system.  Sole- proprietorship income could be included with
individual tax returns.  Partnerships could continue to file
information returns, and partners would report their share of the
income earned by the partnership on their individual returns. 
Depending on the type of corporate integration reform adopted,
corporations would either pay tax separately or file partnership-like
information returns that allocate corporate income to shareholders. 

The number of information returns would be greater than under the
current system if such reporting were extended to newly taxable
income.  Currently, interest on tax-exempt bonds is not subject to
information reporting like taxable interest income; information
reporting might be extended to all forms of interest income.  The
value of fringe benefits received by employees and income earned in
pension fund reserves could also be reported. 

In contrast to the individual tax options, the number of individuals
filing returns could fall under the CBIT.  Rather than increasing the
number of types of income subject to tax at the individual level, the
CBIT would reduce the number of types of income reported by
individuals to wages and certain capital gains, and other forms of
income would be taxed at the business level.  Therefore, individuals
whose income is limited to interest, dividends, and small amounts of
wage income would not have to file returns.  If taxes continued to be
withheld on wages, for many individuals the amount of tax withheld
could very closely match their annual tax liability.  As under the
flat tax, a return-free filing system would be more feasible. 

Under the CBIT, all businesses, including sole proprietorships, would
have to file tax returns, withhold tax on wages paid to employees,
and file certain information returns.  If interest on bonds issued by
governments and nonprofit organizations were made taxable, these
entities would have to file returns and remit tax on interest on any
debt they had issued.  Governments and nonprofit organizations would
also have to withhold tax on wages paid to employees.  However,
businesses, governments, and nonprofit organizations would not have
to file information returns for interest or dividend income. 

An income VAT could reduce the number of tax returns still further. 
Businesses, governments, and nonprofit organizations would remit tax
and file returns, but no individual filing would be required.  As a
consequence, information returns related to individuals' receipt of
interest or dividends would not be needed. 


      RECORDKEEPING
------------------------------------------------------ Appendix IV:2.2

Under either of the individual income tax reform options, broadening
the tax base would both increase the need for recordkeeping in some
areas and possibly decrease it in other areas.  Eliminating various
tax credits and deductions in the current tax code would reduce
individuals' need to keep records on these items.  For example,
broadening the tax base by eliminating deductions for state and local
taxes, charitable contributions, health insurance payments, and large
medical expenditures would eliminate the need for taxpayers who now
itemize deductions to keep records on these expenditures. 

However, broadening the tax base by taxing additional types of income
could lead to additional recordkeeping.  For example, records might
have to be kept by individuals for interest income that is currently
tax-exempt, pension earnings, fringe benefits, and government
benefits, particularly if information reporting is not extended to
these types of income.  If owners of assets were required to pay
capital gains tax on increases in the value of an asset, regardless
of whether it was sold, they would have to obtain information to
determine or estimate the value of the asset.  This requirement would
increase burden relative to the current tax, but the need to keep
records over long periods of time might be reduced because capital
gains from prior years would have already been subject to tax. 

In some areas, however, including additional types of income might
eliminate the need to distinguish between different types of income,
reducing the need for recordkeeping.  For example, currently
taxpayers must use separate accounts for IRAs and other saving.  A
reformed income tax could treat savings more uniformly, eliminating
the need for separate accounts and the associated recordkeeping. 
Similarly, under current law, interest expenses must be characterized
according to many different rules to prevent taxpayers from deducting
interest expense from debt used to generate tax-exempt income.  A
more uniform treatment of income may in turn allow for a simpler,
more uniform treatment of interest expense. 

Although a more uniform treatment of all forms of income might
require more complicated rules for some forms of income, it might
also reduce incentives for tax planning and reduce the number of
transactions undertaken for tax reasons.  For example, the Tax Reform
Act of 1986 instituted some complex rules to reduce the
attractiveness of tax shelters.  While complying with these rules may
be burdensome and costly, if they succeed in reducing the amount of
resources used in structuring tax shelters, the result might be that
overall, fewer resources will be used complying with the tax code and
attempting to minimize tax liability. 

If many of the tax preferences in the current tax code were
eliminated and if tax rules measured economic income more accurately,
Congress might conclude that the corporate or individual alternative
minimum taxes (AMT) were no longer needed.  Under the AMT, taxpayers
must account for a number of items differently than they do for
regular tax or financial statement purposes.  The requirements to
keep two or more sets of records for certain items and make special
calculations might be eliminated if Congress decided that an AMT was
no longer needed after income tax reform.\12

The need for individuals and businesses to keep records under a
reformed income tax would also depend on the option chosen.  For the
individual taxes, the integrated individual tax would require
corporations to allocate all their income to shareholders.  This
would likely lead to additional recordkeeping, especially for widely
held corporations whose shareholders may have owned stock only
briefly during a year.  Integrating the corporate tax by allowing a
deduction for dividends might not significantly complicate the tax
system.  Both integration plans would reduce the need to distinguish
between debt (for which interest payments are currently deductible)
and equity (for which dividend payments are currently not
deductible). 

The CBIT option would reduce recordkeeping requirements for
individuals.  Since taxes on wages could continue to be withheld,
other forms of compensation would be in effect taxed at the business
level, and interest and dividend income would not be taxable to
individuals, individuals' recordkeeping responsibilities would be
limited to certain capital gains.  If the income tax base was also
broadened to include fringe benefits, businesses would need to keep
records that identified business expenditures that could be
considered nonwage compensation of employees because these expenses
would not be deductible.  The distinction between debt and equity
would not have to be made under the CBIT because neither interest nor
dividends would be deductible. 

The income VAT would eliminate all recordkeeping for individuals.  If
the tax base was broadened, all compensation would be nondeductible
for businesses, so records would not have to distinguish between
forms of compensation for income tax purposes.  However, businesses
would have to distinguish between compensation and other expenses
that would be deductible.  Businesses would not be required to
withhold income tax on wages; however, withholding for payroll taxes
would still have to be done unless the payroll tax was eliminated as
a part of tax reform. 


--------------------
\12 Under the reformed income options that include a business-level
tax and indexing, taxable income as measured by tax rules would be
different from income reported on financial statements.  Congress
would need to decide whether an AMT was needed to ensure that
corporations that reported income to shareholders in a particular
year also paid tax in that year. 


      CALCULATIONS REQUIRED
------------------------------------------------------ Appendix IV:2.3

Both the introduction of indexing the tax base for inflation and
taxing capital gains on an accrual basis would affect the
calculations required for computing income tax liability.  Under all
the tax reform options we are discussing, depreciation and
inventories could be indexed.  For the options that tax capital gains
or interest income at the individual level, these items could be
indexed as well.  For individuals, indexation would make the
calculation of capital gains more complicated, and adopting a system
of taxing capital gains as they accrue could increase the frequency
with which capital gains calculations would need to be made. 
Indexing interest income might add to individuals' calculations
unless it was actually done for individuals by businesses or
financial institutions.  For businesses, indexation would also
increase the number of calculations required for depreciation and
inventories, and under some options for interest expense deductions
and interest income.  These calculations are not done for financial
reporting purposes. 

Under the CBIT option, individuals would have to make capital gains
calculations, but since interest income would not be taxable for
individuals, no indexing calculations would have to be made for
interest income.  For businesses, inflation adjustments would be
needed for depreciation and inventories, but inflation adjustments
for interest expenses would not be needed because neither real nor
nominal interest expense would be deductible. 

The income VAT would eliminate taxes on individuals, so no
calculations would have to be made by individuals.  Businesses would
also have fewer calculations.  The calculations for computing tax
liability would be similar to those for the CBIT except that
calculations related to deductions for wages and withholding tax on
wages would not be needed for income tax purposes. 


      EFFECTS OF INCOME TAX REFORM
      ON COMPLIANCE COSTS
------------------------------------------------------ Appendix IV:2.4

Joel Slemrod recently estimated potential compliance cost savings
from a reformed income tax similar to the integrated corporate income
tax option.\13 The reformed income tax he described would simplify
the income tax base by eliminating itemized deductions except for the
mortgage interest deduction; restricting business deductions for
fringe benefits; and ending the child care and elderly credit, the
tax-exempt status for interest on state and local government bonds,
and savings incentive programs like IRAs and Keogh plans.  AMTs would
be eliminated, and a dividend credit would be established to
integrate the corporate and individual taxes.  A 10-percent tax rate
would apply to about 75 percent of individual taxpayers, and
withholding would be extended to interest payments, making tax return
filing unnecessary for many taxpayers.  Slemrod estimated that such
reforms could reduce individual compliance costs by at most 15
percent and business compliance costs by about 5 percent. 


--------------------
\13 See Slemrod (1996), pp.  377-80, for further details. 


   POTENTIAL IMPACT ON TAX
   ADMINISTRATORS
-------------------------------------------------------- Appendix IV:3

Table IV.5 shows some of the effects that various income tax options
could have on tax administrators, and a more detailed discussion of
those effects follows. 



                               Table IV.5
                
                Summary of Some Key Potential Impacts of
                    Income Tax Reform Options on Tax
                             Administrators

                                                    Income tax reform
Item                            Current income tax  options
------------------------------  ------------------  ------------------
Impact on number of returns     Hundreds of         Individual taxes:
processed                       millions of         Possibly similar
                                returns and other   to current tax,
                                materials received  increased number
                                                    of information
                                                    returns

                                                    CBIT: Fewer
                                                    individual returns
                                                    and information
                                                    returns

                                                    Income VAT: No
                                                    individual returns
                                                    or information
                                                    returns related to
                                                    individuals

Impact on refund processing     92 million refunds  Individual taxes:
                                issued in fiscal    Possibly increased
                                year 1995           if no withholding
                                                    on other forms of
                                                    income

                                                    CBIT: Possibly
                                                    fewer refunds with
                                                    more accurate
                                                    withholding

                                                    Income VAT:
                                                    Individual refunds
                                                    eliminated

Impact on examination approach  Tax returns         Individual taxes:
                                matched with        Similar to current
                                information         system; audits and
                                returns; fiscal     matching
                                year 1995           information
                                examination         returns with
                                coverage at 1.36    individual
                                percent, with       returns
                                corporate audits
                                taking longer than  CBIT: Scope of
                                individuals'        individual
                                audits              examinations,
                                                    matching reduced

                                                    Income VAT:
                                                    Examination of
                                                    businesses only

Continuation of old compliance  Compliance          All options:
problems                        problems related    Compliance
                                to income           problems continued
                                definition,         with unreported
                                unreported income,  business income,
                                and more specific   deductibility of
                                issues identified   business expenses,
                                in areas such as    depreciation,
                                transfer pricing,   small businesses,
                                depreciation,       transfer pricing
                                deductibility of
                                business expenses,
                                small businesses,
                                independent
                                contractors, and
                                the underground
                                economy

Resolution of old compliance    Not applicable      All options:
problems                                            Compliance issues
                                                    for some
                                                    deductions,
                                                    credits
                                                    eliminated; debt
                                                    versus equity
                                                    distinction
                                                    reduced in
                                                    importance

Creation of new compliance      Not applicable      All options:
problems                                            Indexing
                                                    calculations

                                                    Individual taxes:
                                                    Accrual of capital
                                                    gains, reporting
                                                    of additional
                                                    income items

                                                    CBIT: Capital
                                                    gains only

Impact on collections from tax  Millions of         Individual
delinquents                     taxpayer            options: Possibly
                                delinquent          increased if more
                                investigations and  balance-due
                                accounts disposed   returns
                                of, with most of
                                the latter being    CBIT: Fewer
                                for individuals     delinquent
                                and most business   accounts for
                                dispositions        individuals
                                covering
                                employment taxes    Income VAT:
                                                    Individual
                                                    accounts
                                                    eliminated

Impact on individuals'          Millions of         Individual taxes:
questions received              taxpayer inquiries  Most questions
                                fielded, covering   continued and new
                                a wide variety of   questions added
                                questions
                                                    CBIT: Many
                                                    questions no
                                                    longer applicable

                                                    Income VAT: Only
                                                    questions related
                                                    to business remain
----------------------------------------------------------------------
Source:  GAO analysis of available information about income tax
options. 


      PROCESSING OF RETURNS
------------------------------------------------------ Appendix IV:3.1

The individual tax reform options, combined with a broadened income
tax base, would have several effects on the need to process returns. 
Broadening the tax base by adding income items would lead to some
additional line items and perhaps some additional schedules and more
information returns.  These changes would, by themselves, increase
returns processing workloads.  However, the elimination of some
deductions, adjustments, and tax credits would eliminate some line
items, reducing the workload.  In addition, if added revenue from a
broadened tax base were used to increase the standard deduction, the
number of taxpayers required to file could decrease, which would also
reduce the processing workload. 

The CBIT option would be more likely to reduce returns processing
workload because the number of individual tax returns could be
reduced, the individual tax return would contain fewer line items,
and fewer information returns might be needed.  While taxing
additional types of income, such as accrued capital gains, could
generate additional schedules and information returns as mentioned
above, other types of income, such as interest and dividends, would
no longer be reported on individual returns.  Information returns for
these types of income would not be needed, so the need to process
them and match them with tax returns would be eliminated. 

An income VAT would have the most significant impact on the returns
processing workload because individual returns and most information
returns would be eliminated.  Returns would need to be processed for
businesses (approximately 24 million in 1995) and nonprofit
organizations and government entities. 


      NONCOMPLIANCE AND
      ENFORCEMENT
------------------------------------------------------ Appendix IV:3.2

Income tax reform, like the other tax reform alternatives, could
resolve some compliance and enforcement issues, create some new
issues, and leave some issues unresolved.  In general, issues
concerning the measurement of income from saving and investment would
remain because the reforms would continue to tax this income.  As
under the consumption tax alternatives, unreported sales or income
would remain an issue for tax administration, as would separating
deductible business expense from personal consumption in areas like
automobile use and meals and entertainment deductions.  Issues
involving differential treatment of some types of capital income
would be resolved, although the added calculations used to uniformly
measure capital income would have to be checked. 

Under any of the income tax options, a broadened tax base would
eliminate some administrative tasks but create others.  The
elimination of some credits and deductions would simplify
administration.  Because mortgage interest is the only deduction
currently covered by information reporting, the elimination of other
deductions would not reduce the need to match information returns
with tax returns, but would reduce the need to audit tax returns. 
However, taxing some additional types of income would increase
administrative tasks.  Some types of income such as currently
tax-exempt interest income and pension income could be subject to
information reporting, so the identification of underreporting of
these types of income could result from matching.  To identify
unreported or underreported accrued capital gains, audits would be
necessary unless information returns were filed for owners of assets,
not just for the sellers of assets as is done currently. 

As under the current tax, issues involving the calculation of income
from saving and investment would remain because the tax base would
include these types of income.  The capitalization or deductibility
of business expenses, contentious in cases where it is difficult to
determine whether a business expenditure creates an asset for the
business, would likely remain an issue for tax administration. 
However, issues that arise because of differences in the tax
treatment of certain types of income from saving and investment may
be reduced because this income would be treated more uniformly.  For
example, checking that the rules and limitations on IRA, 401(k), and
pension accounts had been followed would not be necessary. 

Under all the income tax options, as well as all the alternative
consumption taxes, identifying unreported or underreported amounts
would remain a major concern for tax administration.  Issues
involving consumption in a business, as under consumption taxes, also
would continue under any reformed income tax. 

The CBIT and income VAT options would simplify examination by
eliminating the need to verify many types of income for individuals. 
Under the CBIT, the compliance of individuals could be checked
largely through information return matching on wages.  Identification
of certain capital gain income would also be necessary, as would the
verification of filing status and the proper number of dependents. 
However, the identification of other forms of income and verification
of deductions would not be needed, and administrators could focus
relatively more attention on business returns.  Under an income VAT,
clearly all examination and compliance efforts would involve business
returns. 


      COLLECTIONS
------------------------------------------------------ Appendix IV:3.3

As under the current income tax, under any of the reform options,
there would likely be taxpayers who do not file returns or who file
but do not pay the correct amount of tax.  Under the individual
income tax options, the number of such balance-due or delinquent
accounts might increase for two reasons.  First, if withholding is
generally limited to wages as it is currently, the amount withheld
might not be as close to the actual tax liability because additional
types of income would be subject to tax.  Second, some of the types
of income that might be taxed under a reformed income tax, such as
accrued capital gains, are not received as cash.  Unless individuals
carefully adjusted their withholding to take this additional income
into account, more individuals might have to pay tax when they filed. 
These individuals might not pay the correct amount or might not file
if they do not have cash available to pay the tax.  However, if a
broadened income tax was accompanied by lower tax rates, some
individuals who have difficulty paying their tax liability currently
might be able to pay the tax they owe. 

Collections activity might fall under the CBIT option simply because
fewer individuals would be liable for tax and, for individuals, fewer
types of income would be subject to tax.  As noted in appendix II, in
1995, about two-thirds of delinquent accounts were individual
accounts.  Under the CBIT option, tax withheld on wages might closely
match actual tax liability, especially for taxpayers without capital
gains income.  An income VAT would do away with individual payments;
businesses would be responsible for remitting all tax.  Therefore,
collections activity would be focused on business tax liability. 


      TAXPAYER SERVICES
------------------------------------------------------ Appendix IV:3.4

In terms of taxpayer calls to IRS for assistance, most calls now
received concern procedural issues, refunds, notices, and other
account information.  Additional calls concern filing status,
dependents, and exemptions.  The extent to which this assistance
would still be needed under the various reform options would depend
on the number of individual taxpayers filing returns under each
option. 

The tax reform options would likely generate additional demand for
taxpayer services and education in the areas of indexation (how to
make adjustments for inflation) and calculations of accrued capital
gains.  On the other hand, some currently asked questions concerning
pensions and deferred compensation and individual adjustments and
deductions might no longer be asked if the tax base was broadened to
tax income more uniformly. 


   OTHER ISSUES
-------------------------------------------------------- Appendix IV:4


      TRANSITION ISSUES
------------------------------------------------------ Appendix IV:4.1

While transition issues would likely arise from any type of tax
reform, some issues that could be particularly significant in a
transition from the current tax to a consumption tax might not be as
significant under income tax reform.  The tax treatment of existing
business assets, a significant issue in transition to a consumption
tax, would not be as significant an issue for income tax reform.  For
example, indexing depreciation deductions for inflation would be a
less significant change than adopting expensing as under most of the
consumption taxes.  Existing business net operating loss
carryforwards could continue with a new system. 

Some other transition issues raised by income tax reform could be
significant and could create administrative problems.  If pension
income were made taxable and if the old treatment was maintained for
existing pension assets, taxpayers would have to segregate old from
new accounts, and administrators would have to check these accounts. 
Individuals receiving dividends could receive a windfall gain if
dividend taxes were eliminated or if dividend deductibility was
granted; again maintaining the old system for current equity shares
would be difficult.  Under the CBIT option, ending the deduction for
interest at the corporate level and ending the taxation of interest
at the personal level is an issue that could be handled through tax
rules or might be ignored if it was thought that the private sector
would renegotiate the terms of the debt. 


      FEDERAL/STATE ISSUES
------------------------------------------------------ Appendix IV:4.2

Currently, 38 states and the District of Columbia levy income taxes
that conform to some degree with the federal income tax.  Many states
also rely on federal enforcement efforts and information to
administer their income taxes.\14 If the federal income tax were
changed, the states could make adjustments in their income taxes to
conform to the reformed federal tax.  Under the income tax options
that include an individual-level tax, the states that now follow the
federal tax could continue to tax individual income and rely on
federal administration efforts.  The inclusion of additional income
items could expand state and local income tax bases if those
governments chose to conform with the federal tax base.  On the other
hand, under the CBIT or income VAT, the ability of states to tax
individual income would be reduced, as would be the case with the
VAT, national RST, or flat tax, because much of the information, such
as information returns, that are currently used to administer the
federal individual income tax would no longer be available. 


--------------------
\14 Joint Committee on Taxation, Impact on State and Local
Governments and Tax-Exempt Organizations of Replacing the Federal
Income Tax (JCS-4-96), Apr.  30, 1996, pp.  6-8. 


      INTERNATIONAL ISSUES
------------------------------------------------------ Appendix IV:4.3

Under the current income tax, the income of U.S.  citizens and
corporations is subject to tax wherever it is earned--that is, income
is taxed on a worldwide basis.  Income earned abroad may also be
taxed by foreign governments, so the United States provides a limited
credit for foreign income taxes paid (the foreign tax credit) to
prevent double taxation.  Income earned in the United States by
foreign corporations and foreign residents is also taxed, and
withholding taxes are levied on certain interest and dividends paid
to foreign investors.  These withholding taxes are commonly reduced
through income tax treaties with foreign governments.\15

Under current law, income earned abroad by U.S.  corporations may not
be subject to U.S.  tax until it is distributed to the United States
(repatriated).  However, taxpayers' ability to defer tax by retaining
income abroad is limited for some types of income by the so-called
subpart F rules.  If income tax reform included taxing accrued
capital gains for domestic assets, it would be consistent to tax all
types of income earned abroad when they are earned rather than when
repatriated.  The current rules to limit deferral are considered
complex, but extending these rules might reduce tax planning by
treating different types of income uniformly, might simplify the
foreign tax credit, and might reduce transfer pricing controversies
for U.S.  corporations with foreign operations.\16

For foreign corporations operating in the United States, transfer
pricing would likely continue to be a difficult area for taxpayers
and tax administration as long as the U.S.- source income of these
corporations is taxed.  A related policy issue would arise regarding
whether the benefits of corporate tax integration should be extended
to foreign corporations and investors automatically or through
treaty.  The integrated individual tax option (by eliminating the
corporate-level tax) and the integrated corporate tax (by allowing a
deduction for dividends) would pass integration benefits to foreign
shareholders automatically.  On the other hand, the CBIT and income
VAT options would retain a corporate-level tax and replace an
explicit withholding tax on certain distributions to foreigners with
implicit withholding through the nondeductibility of interest and
dividends.\17


--------------------
\15 For a summary of U.S.  international tax rules and policies, see
Hugh J.  Ault and David F.  Bradford, "Taxing International Income: 
An Analysis of the U.S.  System and Its Economic Premises," in Assaf
Razin and Joel Slemrod, eds., Taxation in the Global Economy,
(Chicago:  University of Chicago Press, 1990). 

\16 For further details, see U.S.  Department of the Treasury,
International Tax Reform:  An Interim Report (Jan.  15, 1993). 

\17 In its report on corporate tax integration, the Treasury
recommended integration options that did not automatically pass
benefits to foreigners because these provisions might simply transfer
tax revenue from the United States to foreign governments.  See
Treasury (1992), Ch.  7, for a detailed discussion of international
issues regarding corporate tax integration. 


NATIONAL RETAIL SALES TAX
=========================================================== Appendix V


   DESCRIPTION
--------------------------------------------------------- Appendix V:1

As the name implies, a retail sales tax (RST) is levied on the retail
price of goods or services sold to final consumers.  The tax is
familiar to most Americans, originating in many states in the 1930s
and now found in 45 states, the District of Columbia, and thousands
of local tax jurisdictions.  The federal government currently
administers excise taxes, which are related to an RST, but differ
from it in important respects.\1 Few industrialized countries have
attempted to institute a nationwide RST, although many have adopted
the related value-added tax (VAT). 

Some proponents of a national RST have suggested that it should be
administered primarily by the states.  One reason for this is that
states have already identified and registered many businesses selling
to final consumers.  In addition, they might be able to expand their
existing systems with less effort devoted to fundamental retraining
and systems development because of their experience in administering
sales taxes.  Even if states became the primary administrators, the
federal government could be required to coordinate and audit the
states' programs, administer any taxes not replaced by the national
RST, and act as the primary administrator in the five states without
sales tax systems and in other states that do not agree to be the
primary administrator. 

As illustrated in table V.1, a national RST would be a consumption
tax because it is collected only on goods and services that are
consumed.  Only business elements are addressed because individuals
generally have no filing responsibilities under an RST, although they
typically pay the taxes collected by businesses on sales of goods and
services. 



                               Table V.1
                
                Treatment of Businesses Under a National
                RST Compared With the Current Income Tax

Tax base element                Current income tax  National RST
------------------------------  ------------------  ------------------
Sales of goods and services     Included            Included (retail
                                                    sales only)

Sales of business assets        Gain included       Not included

Sales of financial assets       Gain included       Not included

Loans and new stock issues      Not included        Not included

Purchases of goods and          Deducted            Not included
services for business use

Purchases of capital goods      Depreciated over    Not included
                                time

Wages paid                      Deducted            Not included

Fringe benefits                 Deducted            Not included

Interest paid                   Deducted            Not included

Dividends paid                  Not deducted        Not included
----------------------------------------------------------------------
Source:  GAO analysis of state and proposed national RSTs. 

Based on recent proposals, a national RST might replace, rather than
supplement, existing federal income, gift, estate, and excise taxes,
which together yielded about $805 billion in fiscal year 1995. 
Raising these revenues under a national RST would require a
relatively high tax rate compared with state RST rates, which
generally range from 3 to 7 percent, except for higher rates on
selected items in some states.\2 Taxing most or all personal
consumption, which totaled $4.9 trillion in 1995, would tend to
reduce the required tax rate.  However, such a tax might encompass
retail categories generally excluded under state systems, including
housing, medical care, financial intermediation, and other services. 
A narrower tax base that excludes certain categories, transition
rules to deal with preenactment savings, or tax rebates would tend to
increase the required rate. 


--------------------
\1 Unlike an RST, excise taxes are levied on relatively few items;
generally, they apply to preretail stages of production or
distribution and do not exempt business purchasers in those cases
where they are applied to retail sales (such as the communications
services tax). 

\2 Proponents have suggested that a rate of 15 to 17 percent would be
required in a national RST, assuming a broad-based tax. 


      NATIONAL RST DESIGN FEATURES
------------------------------------------------------- Appendix V:1.1

Administration of a national RST would be distinguished from the
income tax by a fundamentally different tax collection mechanism. 
Under an RST, businesses collect taxes from retail consumers and
periodically send their collections to the government.  Unlike the
income tax, individuals generally have no tax reporting
responsibility, although, as with other taxes, they are the actual
taxpayers.  An RST's complexity and its impact on administrative and
compliance burdens depend on the extent of its tax base exemptions
and exclusions.  One type of exemption--items purchased for use in a
business--would be required to avoid the unintended economic effects
that result from taxing not only goods and services sold at retail
but also the costs of producing those goods and services. 

Without a mechanism to obtain information on individuals, a national
RST could not incorporate exemptions or credits based on personal or
family status.\3 Ways of modifying an RST's tax base have instead
included statutorily excluding or exempting certain goods and
services or business, nonprofit, or government purchasers.  Some
states also levy reduced sales tax rates on certain goods or
services, such as motor vehicles or certain production goods.  As
noted in Treasury's 1984 tax reform report, multiple rates introduce
administrative complexities similar to those discussed below for
exemptions.\4 Another approach, using automatic rebates to in effect
exclude a certain level of individual purchases, has been proposed at
the national level. 

Most states exempt designated goods and exclude sales of real estate
and a wide range of services, including medical, legal, and financial
services, although three states--New Mexico, South Dakota, and
Hawaii--tax both goods and services broadly.  Almost all states
exempt certain business purchases, and most exempt sales to
government and nonprofit organizations.  Vendors apply exemptions at
the point of sale based on their understanding of the exemption
criteria for designated goods and services, or evidence, in the form
of an exemption certificate, of a purchaser's exempt status. 

In theory, according to various descriptions of sales taxes, RST
systems need to exempt valid business purchases if they are to avoid
the unintended economic effects of tax pyramiding and not tax capital
income.  Pyramiding occurs when a sales tax is applied to business
purchases of items intended for resale or used in the production of
retail products, and then applied again to the final retail sale.  It
results in a preretail tax component that is not visible to consumers
and that varies, in an unintended manner, depending on how a product
is developed.  Total taxes applied to an item would increase with the
number of intercompany transactions involved in its development,
resulting in a competitive advantage for firms that consolidate
production and distribution operations internally.  Likewise,
imported goods whose inputs are not taxed would have a tax advantage
over domestically produced goods.  State RSTs result in significant
pyramiding because business exemptions are often limited to items
purchased for resale or directly incorporated into final products. 
Other business and production costs--such as fuel, utilities, and
various business services--are taxed in many states. 

Another aspect of a national RST is that it would tax retail
purchases by foreigners in this country and could also be assessed on
U.S.  citizens' foreign purchases that are used or consumed in this
country.  The latter feature would parallel "use" taxes under some
state RSTs, which apply to out-of-state purchases used or consumed in
the purchaser's state of residence. 


--------------------
\3 In theory, some personal exemptions could be administered under an
RST using technology such as computerized identification cards, which
might be encoded with an individual's age or disability status and
applied at the point of sale. 

\4 See U.S.  Department of the Treasury, Tax Reform for Fairness,
Simplicity, and Economic Growth, Vol.  1 (1984), p.  217. 


      NATIONAL RST VERSUS VAT: 
      SIMILARITIES AND DIFFERENCES
------------------------------------------------------- Appendix V:1.2

A national RST and credit VAT with the same tax base and a common
rate would appear identical to final consumers, provided that both
were itemized on sales invoices.  Moreover, given identical
compliance rates, they would yield the same amount of revenue.  They
differ primarily in their methods of avoiding tax pyramiding.  An RST
depends on the use of exemption certificates that businesses provide
to their suppliers, whereas a VAT allows businesses to credit taxes
paid on their purchases against the taxes collected on their sales. 
A VAT appears to offer an administrative advantage for exemption of
business purchases because it requires businesses to maintain
purchasing records supporting their claimed credits and thereby
provides an audit trail for verifying these claims.  Under a national
RST, by contrast, auditors might need information from all of a
business' suppliers, who retain exemption certificates to document
their own tax-exempt sales. 

An RST also concentrates the entire tax collection burden on
businesses selling to final consumers, while a VAT spreads
collections across a broader range of businesses.  Some commentators
maintain that a national RST would therefore be more susceptible to
noncompliance because many vendors are small businesses, which have
been relatively noncompliant under the current income tax. 
Enforcement efforts under a national RST, however, could be focused
on a somewhat smaller population of filers, excluding businesses that
do not sell at retail. 

In addition, businesses under a credit VAT might be less likely to
underreport their sales, knowing that another business is likely to
keep records of the sale to support its claimed credits.  However,
this "self-enforcing" mechanism, which does not exist in an RST, also
does not apply to the retail sales stage of a VAT, since final
consumers are not eligible for credits and are generally not required
to keep records of their purchases.  Another purported enforcement
advantage of a credit VAT is that it provides greater incentives for
businesses to file in order to claim credits on their purchases.\5
However, this argument does not apply with equal weight to some
businesses--such as some small service providers--who make minimal
purchases from other businesses. 


--------------------
\5 See Bruce Bartlett, "Replacing Federal Taxes With a Sales Tax,"
Tax Notes, Vol.  68, No.  8 (Aug.  21, 1995), p.  1001; and Charles
E.  McLure, Jr., "State and Local Implications of a Federal
Value-Added Tax," Tax Notes, Vol.  38, No.  13 (Mar.  28, 1988), p. 
1520. 


   POTENTIAL IMPACT ON TAXPAYERS'
   COMPLIANCE BURDEN
--------------------------------------------------------- Appendix V:2

A national RST replacing the income tax would reduce the number of
entities filing returns.  Compliance burdens would depend on the
system's design, particularly the extent of exemptions provided and
degree of consolidation with state systems, and might in some
circumstances fall on individuals as well as on business filers. 
Some of the ways in which an RST might affect businesses are
summarized in table V.2, followed by additional information on these
and other considerations. 



                               Table V.2
                
                Summary of Some Key Potential Impacts of
                  a National RST on Business Taxpayers

                                Characteristics of
                                taxpayer
                                compliance burden   Impact of a
                                under the current   national RST on
Burden                          income tax          business taxpayers
------------------------------  ------------------  ------------------
Return filing                   24 million returns  Vendors the only
                                filed in 1995       businesses to be
                                                    included

Records kept                    Records supporting  Records of sales
                                income and          and exemptions
                                expenses supposed   needed but not
                                to be kept          records for items
                                                    such as
                                                    depreciation

Calculations made               Complicated         Calculations for
                                calculations        depreciation,
                                included for        alternative
                                provisions such as  minimum tax, and
                                depreciation, the   the foreign tax
                                alternative         credit not needed;
                                minimum tax, and    state return forms
                                the foreign tax     require
                                credit              calculation of net
                                                    taxable sales

Complexity faced                Detailed rules      Rules for
                                involved;           characterization
                                complexity          and timing of
                                reflected in areas  income, and items
                                such as             such as
                                depreciation, the   depreciation, the
                                alternative         alternative
                                minimum tax, and    minimum tax, and
                                the foreign tax     the foreign tax
                                credit;             credit eliminated,
                                difficulties        but determining
                                existing in         exemptions and
                                defining and        multiple sales tax
                                recognizing income  rates and
                                                    harmonizing with
                                                    state systems
                                                    possibly added

Requirement to furnish          1.1 billion         Information
information returns             information and     returns generally
                                withholding         eliminated
                                documents filed
----------------------------------------------------------------------
Source:  GAO analysis of available information about state and
proposed national RSTs. 


      NUMBER OF TAX FILERS
------------------------------------------------------- Appendix V:2.1

A national RST that exempted business purchases would limit routine
filing requirements to vendors--that is, entities selling to final
consumers.  Thus, the number of filers would be less than the 24
million businesses that filed income tax returns in 1995 and a
fraction of total filers.  Below this upper limit, the actual number
of filers under a national system would depend on its design.  The
number would decrease to the extent that vendors in some industries
are excluded from the tax base--for example, most states exclude many
service providers.  However, the number would increase somewhat if
the system required a separate return from each outlet of
multilocation retailers.\6 Many states allow consolidated filing but
require location-specific data. 

Estimation of potential filers under a national RST is also hampered
by limited data on the number of businesses acting as vendors.  IRS
classifies business returns into one of nine industrial sectors based
on their primary business activity, as shown in table V.3.  However,
the classification generally does not distinguish vendors from
nonvendors, except in the retail sector, which is limited to vendors
by definition, and the service sector, which primarily consists of
vendors except for a "business services" subsector.\7

Together, these sectors, excluding business services, represent
roughly 10 million potential filers under a national RST.  The number
of retail vendors in other sectors is unknown but potentially large. 
The construction sector, for example, includes general contractors as
well as self-employed plumbers and electricians who might serve
either final consumers or businesses, or both.  Even manufacturers
might maintain retail outlets as a secondary activity not captured
under IRS' current classification system. 



                                    Table V.3
                     
                        Income Tax Returns by Business and
                           Industry Category as of 1993

                                  (In thousands)

                           Business category
          ----------------------------------------------------
Industry              Sole
group      proprietorships      Corporations      Partnerships             Total
--------  ----------------  ----------------  ----------------  ================
Retail               2,444               729               134             3,307
 goods
Services             7,718             1,158               256             9,132
[Busines           [1,820]             [349]              [51]           [2,219]
 s
 service
 s
 subgrou
 p]
Construc             1,927               417                62             2,406
 tion
Finance,             1,273               641               793             2,707
 insuran
 ce, and
 real
 estate
Transpor               711               176                21               908
 tation
 and
 utiliti
 es
Agricult           2,425\a               141               120             2,686
 ure,
 forestr
 y, and
 fishing
Mining                 124                35                32               191
Wholesal               416               338                19               773
 e trade
Manufact               472               307                25               805
 uring
Not                    265                21                 7               293
 allocab
 le
================================================================================
Total               17,776             3,965             1,468            23,208
--------------------------------------------------------------------------------
Note:  Totals do not add because of rounding. 

\a Includes 1.9 million farmers filing Schedule F with their Form
1040. 

Source:  IRS Statistics of Income published data. 

As with corporate tax revenue, most RST revenue could come from
relatively few businesses.  Based on IRS data, in 1992, corporations
and partnerships took in about 86 percent of the business receipts in
the retail and service sectors, and 80 percent of this amount was
taken in by about 286,000 entities.  In addition, as shown in table
V.3, corporations and partnerships comprised only about 18 percent of
the businesses in these sectors.  This concentration is consistent
with the states' experience--New York and California, for example,
derive about 90 percent of their sales tax revenues from 10 percent
of their filers. 


--------------------
\6 Census data indicate that the number of outlets of retail
companies exceeded the number of retail companies by about 20 percent
in 1992, although some of these additional outlets may already be
filing separate returns. 

\7 The business services subsector includes advertising, janitorial,
photocopying, and other services provided to business purchasers. 


      COMPLIANCE BURDENS
------------------------------------------------------- Appendix V:2.2

A national RST replacing the income tax could eliminate many existing
recordkeeping and filing burdens and introduce a different set of
requirements focused on vendors.  Taxpayers would no longer need to
cope with complex tax provisions such as those associated with the
characterization and timing of income, depreciation of business
assets, foreign tax credits, or calculation of the alternative
minimum tax.  And they presumably could dispense with filing most
existing information returns.  Under a national RST, vendors could be
required to register as sales tax collectors, collect taxes and apply
any exemption criteria, retain appropriate records, and file periodic
sales tax returns.  Except in some circumstances, individuals would
not need to maintain records or file returns.  Of course, taxpayer
burdens would increase if a national RST supplemented rather than
replaced existing income taxes. 


         VENDOR BURDENS
----------------------------------------------------- Appendix V:2.2.1

Vendors under a national RST would presumably face burdens similar in
nature to those encountered under state RST systems.  A vendor's
initial burden in state systems is completing a registration form,
which is generally one or two pages long and identifies the business,
its nature, owners, and level of expected sales.  Only registered
vendors are permitted to act as the state's collection agents or, in
some states, obtain the exemption certificates required to make
tax-free business purchases.  The states are about evenly split on
allowing consolidated registration versus requiring each outlet of
multilocation businesses to register separately. 

One of a vendor's major compliance efforts is that needed to
interpret and apply exemption criteria when collecting taxes at the
point of sale.  This task often falls on the cash register operator,
who, for example, may need to distinguish the appropriate tax
treatment of marshmallows in a state that exempts small marshmallows
as food but taxes large marshmallows as candy.\8 The register
operator must also obtain exemption certificates from exempt
purchasers.  In many states, vendors must check the reasonableness of
claimed business exemptions to avoid liability for the uncollected
taxes when exemption certificates are misused. 

Vendors' recordkeeping requirements also depend on the extent of an
RST's exemptions.  To substantiate exempt and taxable sales, vendors
must retain exemption certificates accepted in addition to sales
invoices.  Some states require vendors to use a system matching each
exemption certificate to its related sales invoice. 

Costs of complying with a national RST are unclear.  Vendors' cost of
complying with state systems in 1990 averaged about 3.5 percent of
revenues collected, according to a study sponsored by the American
Retail Education Foundation.\9 Converting this percentage to dollars,
adding an amount for compliance costs related to service
transactions, and factoring in an increase in inflation-adjusted
retail sales, one author estimated 1996 compliance costs for a
particular national RST to be about $8 billion.\10

According to another author, because a national RST rate would have
to be substantially higher than current state RST rates, incentives
to evade taxes would increase.  Retailers would have to be
increasingly vigilant in distinguishing between taxable and exempt
items and between retail sales and sales to companies.\11

The effort required to prepare sales tax returns is influenced by
filing frequency and the type of information required.  Filing
intervals in most states depend on a vendor's sales volume, generally
ranging from monthly for the largest to semiannually or annually for
the smallest.  Intervals are shorter for large filers to minimize
forgone interest and the size of potential losses in delinquent
accounts.  Most states use one- or two-page return forms, although
the number of line items on the forms ranges widely, depending on
whether itemization of exempt sales is required.\12 For example,
Connecticut devoted 56 lines to itemizing nontaxable transactions in
1995.  However, some states limit their return forms to 10 to 12
lines by summarizing exempt sales under one line item.  Aside from
address and subtotal lines, the following basic items are required on
state returns: 

  -- gross sales,

  -- total deductions,

  -- net taxable sales,

  -- tax due,

  -- penalty due, and

  -- interest due. 

Some states have begun to implement electronic or telefiling systems,
which could ease some filing burdens. 


--------------------
\8 Scanning cash registers used by some businesses can be programmed
to recognize exempt items and thereby reduce the burden on register
operators. 

\9 Price Waterhouse, Study to Estimate the Cost of Collecting State
and Local Sales and Use Tax (Washington, D.C.:  Aug.  30, 1990). 

\10 See Arthur P.  Hall, "Compliance Costs of Alternative Tax
Systems," Tax Notes, Vol.  71, No.  8 (May 20, 1996), pp.  1088-89. 

\11 Joel Slemrod, "Which Is the Simplest Tax System of Them All?" in
Henry J.  Aaron and William G.  Gale, eds., Economic Effects of
Fundamental Tax Reform (Washington, D.C.:  Brookings Institution
Press, 1996), pp.  368-70. 

\12 Many lines are also allotted for local tax allocations in some
states that collect taxes for local governments. 


         ADDED DIFFICULTY OF
         COMPLYING WITH MORE THAN
         ONE RST
----------------------------------------------------- Appendix V:2.2.2

A national RST would increase vendors' compliance burdens beyond
those associated with state RSTs to the degree that state and federal
tax bases and administrative requirements differed.  The current
difficulties associated with state exemptions would be compounded if
the federal system introduced additional tax base exemptions or
defined exempt categories differently.  Differences in filing
intervals, penalties, appeals, and other administrative procedures
could also entail added confusion and compliance costs. 


         POTENTIAL BURDENS ON
         INDIVIDUALS
----------------------------------------------------- Appendix V:2.2.3

Some compliance burdens could extend to individuals as well as
businesses, depending on how a national RST is structured.  For
example, taxpayers may need to keep records in some circumstances if
provisions are included to tax real estate or items purchased in
foreign countries but consumed in the United States or to relieve
sales taxes when savings already subjected to the income tax are
spent on goods and services.  Also, if instead of receiving automatic
rebates as has been proposed at the national level, individuals had
to apply for them, as has happened at the state level, they would
face a new compliance burden. 


   POTENTIAL IMPACT ON TAX
   ADMINISTRATION
--------------------------------------------------------- Appendix V:3

The states' experience indicates the types of administrative
processes and hurdles that might apply to a national RST. 
Administration in the states includes identifying and registering
vendors and returns processing, enforcement, collection, and taxpayer
service functions.  Within these functions, administrative procedures
and potential hurdles differ somewhat from those of the income tax. 
Some key administrative differences are highlighted in table V.4,
followed by additional information on these and other considerations. 



                               Table V.4
                
                Summary of Some Key Potential Impacts of
                  a National RST on Tax Administrators

Item                            Current income tax  National RST
------------------------------  ------------------  ------------------
Impact on number of returns     Hundreds of         Returns simplified
processed                       millions of         and number of
                                returns and other   filers
                                materials received  substantially
                                                    reduced, although
                                                    filing likely more
                                                    frequent

Impact on refund processing     92 million refunds  Refunding of
                                issued in fiscal    overpayments
                                year 1995           required and
                                                    possibly rebates
                                                    to consumers

Impact on examination approach  Tax returns         In states,
                                matched with        verifying taxable
                                information         and exempt sales
                                returns; fiscal     emphasized
                                year 1995
                                examination
                                coverage at 1.36
                                percent, with
                                corporate audits
                                taking longer than
                                individuals'
                                audits

Continuation of old compliance  Compliance          Compliance
problems                        problems related    problems with
                                to income           business expenses,
                                definition,         independent
                                unreported income,  contractors,
                                and more specific   underreporting,
                                issues identified   and underground
                                in areas such as    economy continued;
                                transfer pricing,   small businesses
                                depreciation,       problematic
                                deductibility of
                                business expenses,
                                small businesses,
                                independent
                                contractors, and
                                the underground
                                economy

Resolution of old compliance    Not applicable      Compliance
problems                                            problems with
                                                    characterization
                                                    and timing of
                                                    income,
                                                    depreciation, and
                                                    transfer pricing
                                                    resolved

Creation of new compliance      Not applicable      Noncompliance risk
problems                                            raised by
                                                    possibility of
                                                    high rates, lack
                                                    of withholding and
                                                    information
                                                    reports, and
                                                    exemptions

Impact on collections from tax  Millions of         Delinquencies
delinquents                     taxpayer            problematic,
                                delinquent          particularly if
                                investigations and  rate relatively
                                accounts disposed   high and
                                of, with most of    businesses tempted
                                the latter being    to use tax
                                for individuals     collections as
                                and most business   working capital
                                dispositions
                                covering
                                employment taxes

Impact on individuals'          Millions of         Number of
questions received              taxpayer inquiries  inquiries reduced
                                fielded, covering   by large reduction
                                a wide variety of   in number of
                                questions           filers
----------------------------------------------------------------------
Source:  GAO analysis of available information about state and
proposed national RSTs. 


      REGISTRATION OF VENDORS
------------------------------------------------------- Appendix V:3.1

Administrators of a national RST might need to obtain certain
information on millions of businesses to identify expected filers and
their filing deadlines and those who file late or not at all.  To
this end, the states have required businesses to provide certain
information in registration applications, as noted above.  Many
states attempt to identify unregistered businesses by matching their
registration files against alternative business listings, such as
telephone directories or local licensing records.  Some states use
the registration system to attempt to limit misuse of business
exemption certificates.  For example, New Mexico issues such
certificates only to registered vendors who apply for them and
includes vendor identification numbers on the certificates to provide
a means for tracking their use. 

National administrators might ground a database of potential vendors
on state registration files and prior income tax records.  However,
the state information would omit many vendors--particularly in the
service sector--that might be included in a national tax base, and
federal income tax records might not provide enough information on
the nature of a business to determine whether it makes retail
sales.\13 In any case, some mechanism would be required to identify
and enlist new businesses arising in the future. 


--------------------
\13 See Federation of Tax Administrators, Sales Taxation of Services: 
An Update (Washington, D.C.:  1994); and U.S.  Department of the
Treasury, IRS, "Application for Employer Identification Number," Form
SS-4, revised Dec.  1995. 


      PROCESSING OF RETURNS
------------------------------------------------------- Appendix V:3.2

A national RST would presumably entail returns processing steps
similar to those followed by the states.  Some state administrators
send return forms to registered vendors shortly before their filing
deadlines, which can vary in frequency from monthly to annually
depending on their sales volume.  Other states provide an annual
supply of forms in a return booklet.  Typically, once returns are
filed, selected return data--often only gross sales, total
deductions, taxable sales, and tax paid--are transcribed into a
computer database.  Some states use optical scanning equipment to
capture all return form details.  The database is used to identify
delinquent filers, create accounts receivable listings, and select
accounts for audit.  A few states have contracted with banks to
receive returns and process checks.  At least one state, New York,
has also contracted out the transcribing of return data. 

As with the income tax, significant administrative effort under a
national RST could be required to resolve late or unfiled returns,
underpayments, and other discrepancies.  For example, according to a
New York tax official, about 7 percent of New York's sales tax
returns for tax year 1994 required administrative follow-up owing to
discrepancies detected by computer checks. 

Refunding of overpayments is also required, but less frequently than
under the income tax, where excess wage withholdings are commonly
refunded.  Sales tax refunds in the states can result from
inadvertent overpayments and amended returns.  In Florida, according
to its Department of Revenue, about 2 percent of returns received
annually resulted in refundable credit balances, but almost all
filers chose to apply the credit against their next tax liability. 

A national RST could involve a much larger and fundamentally
different refund program than is found in the states if, as has been
proposed, the system provides for automatic tax rebates to consumers. 
As proposed, such rebates--designed to reduce the sales tax burden on
low-income consumers--would generally be provided to all wage earners
by adjusting the Social Security taxes withheld from their paychecks. 
Other provisions would have to be made for the unemployed. 


      ENFORCEMENT EFFORTS
------------------------------------------------------- Appendix V:3.3

The general audit procedures now used by the states could also apply
at the national level.  However, a national enforcement program could
face noncompliance issues that differ somewhat in nature and severity
from those encountered under either the federal income tax or state
RSTs. 


         AUDIT PROCEDURES
----------------------------------------------------- Appendix V:3.3.1

Compared to the income tax, audits under a national RST could be
focused on a much smaller population, basically limited to
businesses.  State sales tax audits emphasize verification of a
vendor's total taxable sales.  According to state officials we
contacted and sales taxation materials we reviewed, auditors
typically compare reported sales against sales noted in a business'
accounting records and verify that untaxed sales for resale are
substantiated by exemption certificates obtained from purchasers.  As
a secondary check on reported sales, auditors sometimes review sales
reported on income tax returns or use purchase records to estimate
sales volume.  Auditors might also try to verify the proper use of an
exemption certificate, particularly if it appears questionable, by
contacting the purchaser who used it.  Substantial audit effort is
also devoted to checking a vendor's remittance of "use" taxes and
collection of local taxes.\14 Auditors might need to address similar
issues under a national RST--that is, vendors' remittance of use
taxes on foreign purchases, if not considered exempt business
purchases, and interstate vendors' allocation of state taxes.  Those
audited are selected based on a variety of criteria, including sales
volume, compliance history, results of computer data matches, and
random selection.  In allocating audit resources, state
administrators are faced with a sharp disconnect between the
incidence of noncompliance--highest among small filers--and its
potential revenue impact--greatest among large filers.  Audits of
small vendors are less resource-intensive, per audit, than those of
large vendors, but they are more often complicated by the filer's
failure to keep adequate tax records. 


--------------------
\14 Most states also administer sales taxes imposed by local
governments. 


         ENFORCEMENT TRADE-OFFS
----------------------------------------------------- Appendix V:3.3.2

A national RST could raise some additional enforcement hurdles,
compared to the federal income tax, while reducing others.  Because
businesses would no longer have the compliance burden of income tax
withholding and information reporting under a national RST, the
absence of withholding could tend to increase evasion opportunities,
and the lack of information reporting could tend to decrease the
perceived risks of detection.  In addition, businesses would
generally be responsible for remitting to the government more tax
revenue than currently if an RST replaced existing individual and
corporate income taxes.\15 Small businesses in particular have been
relatively noncompliant under the current system and might be tempted
to use their collections as a source of business capital. 

A national RST--particularly one with few exemptions--could, however,
be simpler than the current income tax because some existing sources
of complexity, such as correctly measuring capital income, would be
eliminated.  A relatively simple tax could reduce intentional
noncompliance by limiting opportunities for willful evaders to claim
misunderstanding or ignorance of the rules.  In that case, would-be
evaders might be deterred by a greater risk of facing the stiffer
penalties associated with intentional evasion.  A simpler, clearer
tax would also tend to reduce unintentional noncompliance resulting
from misinterpretation of the rules.  The income tax gap for large
corporations, estimated at $24 billion for tax year 1992, was largely
attributable to tax code complexity and ambiguity and illustrates the
impact of these factors on noncompliance.  In addition, businesses
under a national RST could face a greater likelihood of being
audited, if audit resources now devoted to individual filers were
applied to businesses. 

The question of whether a national RST could be enforced to a greater
degree than the current income tax on participants in the underground
economy also requires careful consideration.  The answer appears to
depend on whether the registration system and associated enforcement
efforts would be more effective than IRS' current nonfiler program at
identifying and enlisting legal enterprises operating outside the tax
system.  Illegal enterprises, however, might tend to escape
identification if, for example, their identification depended on
cross-matching registration files against licensing records and
business directories. 

One argument holds that a national RST would inherently capture more
underground revenue than the income tax, because underground vendors
who pay no income taxes would at least pay taxes on their purchases. 
However, the tax collection point would switch from income to
purchases under a national RST.  Purchases from underground vendors
would be untaxed under a national RST just as income from underground
sales is untaxed now. 


--------------------
\15 Some large retailers who have little or no income tax obligation
currently could be responsible for collecting taxes on billions of
dollars in retail sales under a national RST. 


         POTENTIAL NONCOMPLIANCE
         ISSUES
----------------------------------------------------- Appendix V:3.3.3

The nature and severity of the noncompliance problems administrators
might encounter under a national RST would depend on its design,
particularly its tax rate and available exemptions.  We found little
data quantifying noncompliance in the states, either in terms of rate
of occurrence or resulting revenue losses.  Audit assessments, which
do not measure total noncompliance, accounted for 1 to 3 percent of
sales tax revenues in 22 of 28 states responding to a 1992 survey by
the state of New York.\16 Noncompliance issues encountered in state
sales tax audits include those arising from a misunderstanding of
system requirements as well as intentional evasion. 

Based on our, Treasury, and academic analyses, it appears that a
relatively high national RST rate would tend to increase evasion
incentives and associated administrative difficulties beyond those
arising under state RSTs, assuming the perceived risks of detection
by administrators remained constant.  An RST also lacks certain
deterrents to evasion found in a credit VAT (see app.  VI).  Some
commentators have suggested that the resulting evasion would
completely undermine a national system.\17 However, we found no data
allowing a quantified estimate of the impact of higher RST rates on
noncompliance.  The impact on the incidence of noncompliance would
depend largely on the behavior of the more numerous small filers,
while revenue effects would depend more on large filers, who account
for most potential revenues, as noted above. 

Exemptions, such as for food or medicine, would add complexity and
ambiguity to a national RST and could lead to both unintentional and
intentional noncompliance.  Vendors might inadvertently misapply an
exemption to an item that fell in a gray area under the statutory
criteria.  For example, cashiers might face a decision on how to
identify products with medicinal value if nonprescription drugs were
exempt.  In other cases, some business purchasers have intentionally
misused their exemption certificates to acquire items for personal
use, and some sellers have falsified certificates to inflate their
apparent exempt sales.  A study by the state of Florida estimated
that about 5 percent of tax-free business purchases involved abuse or
misuse of business exemption certificates, based on a sample limited
to selected business sectors.\18

Under a national RST, a relatively high tax rate could increase
incentives for business exemptions abuse.  For example, according to
the Florida Department of Revenue, "paper" businesses might be
created solely as a means of obtaining business exemption
certificates and avoiding taxes on purchases intended for personal
use.  Another potential difficulty is controlling the use of business
exemptions for business purchases of services, as state experience
indicates that distinguishing business purchases of services from
personal purchases can be difficult.  Also, business exemptions might
be used to purchase tax-free fringe benefits for employees in lieu of
an equivalent amount of wages, raising an issue now encountered under
the income tax.  This would tend to reduce the effective tax base
inasmuch as the benefits would have been taxed if purchased directly
by the employee. 

While a broad-based national RST could limit the noncompliance
associated with exemptions, it could also complicate administration
by involving more service providers, including many independent
contractors, who have been particularly noncompliant under the
current income tax.  State RSTs do not broadly tax service providers. 
However, small vendors, particularly those operating on a cash basis,
account for a large share of the noncompliance incidents detected
with some state RSTs.  Noncompliance among small vendors may be
associated with state findings that they more often fail to keep
adequate records of their taxable and exempt sales.  Small vendors
have also been known to use their tax collections as a source of
business capital, even though the amount held in trust currently is
relatively small compared with what it would be under a higher
national rate.  They may then go bankrupt or otherwise fail to repay
the "borrowed" collections. 

Although small vendors could be responsible for a relatively small
share of total taxable sales, their noncompliance might nonetheless
cause significant revenue losses if it occurred frequently enough. 
Under the current system, IRS estimated in 1996 that noncompliant
sole proprietorships were responsible for about $29 billion of the
gross individual tax gap for tax year 1992.  Further, IRS estimated
in 1993 that sole proprietorships for tax year 1987 paid less than
half their self-employment tax liabilities. 

Some administrative and compliance burdens, however, could be reduced
under a broad-based national RST that included the service sector. 
For example, the requirement in many states to distinguish between
untaxed repair labor and taxable repair parts would not apply at the
federal level if repair services were taxed the same as repair parts. 

Another potential noncompliance problem under a national RST could
mirror, at the international level, difficulties states have
experienced with their interstate use taxes.  The states have often
been unable to enforce use taxes on sales to their residents from
out-of-state vendors, including mail order sales.  Similar problems
could arise under a national RST.  For example, absent an additional
enforcement mechanism, residents could escape the U.S.  sales tax by
shopping in other countries, such as Canada or Mexico.  Taxation of
services obtained from foreign vendors through the Internet or other
electronic media could raise another enforcement problem. 

Finally, special provisions in a national RST could raise additional
enforcement considerations.  For example, provisions to either limit
taxation when previously taxed preenactment savings are consumed,
exempt some level of foreign purchases, or rebate certain amounts to
individuals could all have enforcement consequences.  These
consequences would depend on a specific proposal's design.  For
instance, if individuals had to apply for rebates, the tax
administrator would have to devise a mechanism to reduce the number
of fraudulent applications. 


--------------------
\16 New York State Department of Taxation and Finance, Survey of
State Sales Tax Compliance Problems and Programs (Jan.  1993). 

\17 See Joel B.  Slemrod, "The Simplification Potential of
Alternatives to the Income Tax," Tax Notes, Vol.  66, No.  9 (Feb. 
27, 1995), p.  1332; and Bartlett, p.  997. 

\18 Florida Department of Revenue, Examination of Resale
Abuse/Misuse:  Summary of Findings (June 1994). 


      COLLECTIONS
------------------------------------------------------- Appendix V:3.4

Based on the states' experience, collection of late, miscalculated,
and underpaid liabilities could require a major administrative effort
under a national RST.  At least one delinquency notice is required
for about 13 percent of the returns due each filing period, on
average, based on data limited to 38 states and the period 1989
through 1991.\19 Most states issue two or three notices of increasing
sternness before initiating collection action, which can take the
form of a lien against the delinquent's assets.  About 10 percent of
the sales tax returns processed by Florida in 1995 required
assessment notices.  Collection efforts in some states have
reportedly been complicated by instances where businesses "borrow"
sales tax collections when they are short of cash and are later
unable to pay their tax liabilities--a problem that could worsen
under a higher tax rate. 


--------------------
\19 John F.  Due and John L.  Mikesell, Sales Taxation:  State and
Local Structure and Administration, 2nd ed.  (Washington, D.C.:  The
Urban Institute Press, 1994), p.  187. 


      TAXPAYER SERVICES
------------------------------------------------------- Appendix V:3.5

Taxpayer assistance under a national RST would focus on businesses,
as individuals would generally not file returns.  Nonetheless, a
significant education effort may be required under a national RST
owing to an infusion of new filers--if services are taxed
broadly--and the potential confusion arising if state and federal
requirements differ or special transition provisions are introduced. 
Sales tax filers in the states, particularly small businesses,
require assistance to interpret exemption criteria and understand
other system requirements.  Assistance is provided through state
programs to educate new filers and through toll-free telephone help
lines. 


   OTHER ISSUES
--------------------------------------------------------- Appendix V:4

Other aspects of a national RST could raise additional administrative
issues.  These include potential transition mechanisms, the system's
impact on state taxes, and international considerations. 


      TRANSITION ISSUES
------------------------------------------------------- Appendix V:4.1

Moving to a consumption tax, such as a national RST, could result in
unintended consequences for taxpayers, and if transition rules
intended to limit these effects were adopted, they could entail added
administrative burdens.  For example, as a by-product of the
transition to a national RST, savings accrued from after-tax dollars
under the income tax might be taxed again when spent under a national
RST, while savings accrued after enactment of the RST would be taxed
only when spent.  Other transition concerns might include unintended
business losses owing to the discontinuation of existing provisions,
such as allowances for business depreciation and net operating losses
carried forward from prior years.  Transition rules designed to
mitigate these effects could eliminate a substantial portion of the
RST's tax base, thereby increasing the required rate and the evasion
incentive noted above. 

Aside from these structural changes, the transition to a national RST
could also involve technical changes, such as requirements for new
forms or different data processing systems, which would entail added
administrative effort initially.  These potential requirements are
discussed in more detail in appendix VI.  Some requirements might not
apply in the same degree to a national RST if states are the
administrators and are able to adapt their existing systems to the
requirements of a national RST. 


      POTENTIAL IMPACT ON THE
      STATES
------------------------------------------------------- Appendix V:4.2

Replacing the federal income tax with a national RST could
effectively force states to abandon their own income tax systems
because they depend on the federal tax infrastructure.  For example,
states depend on IRS' information reporting, use income reported on
federal returns as a starting point on state returns, and generally
rely on federal definitions.\20 If these states were forced to depend
more on their sales tax revenues after abandoning their income taxes,
the combined federal-state rate would be higher than otherwise,
exacerbating any compliance and administrative problems.  However, if
states maintained their own income tax systems without a federal
lead, multistate businesses might face growing differences among the
states' laws, regulations, and policies. 

Obviously, the states would face additional hurdles if they were to
administer the federal RST.  These added burdens would be minimized
to the degree that federal and state tax bases and/or administrative
systems were consolidated.  Even in a consolidated approach,
taxpayers in different states could be treated differently--more or
less aggressively--depending on each state's enforcement policies. 

Federal oversight might be required to minimize these differences. 
The federal government, or a neighboring state, might also have to
administer a national RST in the five states that have no sales tax
of their own or in other states that do not agree to be the primary
administrator.\21

A national RST could also have some positive effects on state tax
administration.  If federal and state systems were consolidated, the
result would be greater uniformity among state systems, reducing the
compliance burdens of businesses collecting taxes in multiple states. 
Also, coordinating the administration of a national RST with existing
state RSTs might lead to resolution of current interstate tax
allocation problems, as in the case of mail-order sales. 


--------------------
\20 Without federal information reporting, states attempting to
develop their own systems may have no legal basis for requiring
information returns from out-of-state entities generating income for
state residents. 

\21 Alaska, Delaware, Montana, New Hampshire, and Oregon do not have
state sales taxes and in some cases have rejected such taxes by
popular vote.  Together, these states contain about 2 percent of the
U.S.  population. 


      INTERNATIONAL ISSUES
------------------------------------------------------- Appendix V:4.3

A national RST, limited to taxing final consumption, would tax
imports when sold at retail in this country and would not tax
exports.  Foreign income would not need to be defined.  As a result,
the existing tax code's rules for sourcing the income of
multinational businesses and for allocating expenses against this
income, could be eliminated.  Also, rules to credit taxes remitted in
foreign countries--currently a source of substantial
complexity--would be unnecessary.  Enforcement problems stemming from
noncompliance with these rules, such as transfer pricing abuses,
would also be eliminated in this country.\22

Under an RST that eliminated tax pyramiding, the border adjustments
required under a VAT as described in appendix VI would not be needed. 
If pyramiding was eliminated, businesses would not pay taxes on their
inputs and, therefore, there would be no need to remove the cost of
these taxes from exports as under a VAT.  However, to the degree that
pyramiding occurs in a national RST, exports would tend to carry
embedded sales tax costs, which would be difficult to quantify and
extract at the border. 

Most provisions of bilateral U.S.  tax treaties apply only to income
taxes.  If the United States eliminated its income tax, the future of
these treaties would be unclear. 


--------------------
\22 However, eliminating the U.S.  income tax could aggravate
transfer pricing problems in other countries by creating an incentive
for multinational firms to shift more of their income into the United
States for tax purposes. 


CREDIT AND SUBTRACTION VALUE-ADDED
TAXES
========================================================== Appendix VI


   DESCRIPTION
-------------------------------------------------------- Appendix VI:1

Value-added taxes (VAT) are consumption taxes in which taxes are paid
on the value a business adds to a product.  Two forms of VAT are
commonly discussed, the credit-invoice (or credit) VAT and the
subtraction VAT, which refer to different methods for calculating the
amount of tax owed.  With either the credit or subtraction VAT, a
business pays tax only on the value added at its stage in the
production or distribution process.  The credit VAT is used as a
major revenue source by most industrialized countries. 

With either the credit or subtraction VAT, businesses of all kinds
would be responsible for reporting and remitting the tax to the tax
agency, and most tax revenue would be remitted by only a relatively
few taxpayers.  If a VAT replaces the income tax, individual
taxpayers would not be responsible for reporting or remitting taxes
to the government.  However, individuals generally would end up
paying the tax, passed on to them by business. 

With a credit VAT, the tax is calculated on the difference between
the tax the business collected on its sales and the tax it paid on
business purchases, including capital goods.  The business, which
sold the goods, pays tax on its purchases and remits the difference
to the tax agency.  Thus, the business' records of the taxes
collected on each transaction, or alternatively on gross receipts,
form the basis from which it can calculate the tax collected.  The
business would also need its records of the taxes it paid on
transactions with other businesses. 

With a subtraction VAT, the tax is calculated on the aggregate value
of a business' transactions, rather than on the individual
transactions.  That is, the business that bought and sold goods
calculates the tax on the difference between its total receipts from
sales and total purchases of goods and services (including
expenditures for investment or capital purchases), rather than on the
individual transactions. 

A comparison of the base under a VAT with the business tax base under
the current business income tax is shown in table VI.1.  VATs are
paid only at the business level, so the individual-level elements
that apply to other taxes do not apply here.  Both credit-invoice and
subtraction VATs are consumption taxes because (1) they are paid only
on goods and services that are consumed and (2) businesses' capital
investment is expensed when it is purchased, rather than depreciated
over time. 



                               Table VI.1
                
                          Key Elements of VATs

                                                    Credit and
Business-level item             Current income tax  subtraction VATs
------------------------------  ------------------  ------------------
Sales of goods and services     Included            Included

Sales of business assets        Gain included       Included

Sales of financial assets       Gain included       Not included

Loans and new stock issues      Not included        Not included

Purchases of goods and          Deducted            Deducted
services for business purposes

Purchase of capital goods       Depreciated over    Deducted
                                time                immediately
                                                    (expensed)

Wages paid                      Deducted            Not deducted

Fringe benefits                 Deducted            Not deducted

Interest paid                   Deducted            Not deducted

Dividends paid                  Not deducted        Not deducted
----------------------------------------------------------------------
Source:  Joint Committee on Taxation and GAO analysis of VATs. 

The two VATs, though similar in appearance, can be quite different in
practice.  For this reason, we address the credit and subtraction
VATs separately.  If a simple, single-rate, broad-based VAT includes
all businesses and all goods and services, there should be little or
no difference between the credit and the subtraction methods of
calculation in their economic effects or their administration. 
However, if a VAT base is narrowed to exclude some businesses or
goods and services or more rates are added, the credit and
subtraction VATs are quite different in both economic effects and
ease of administration.  In this report, we concentrate on the
administration issues. 


      REGRESSIVITY, EXEMPTIONS,
      AND RATES
------------------------------------------------------ Appendix VI:1.1

Because a VAT is remitted by businesses rather than individuals, it
cannot readily include the type of standard deduction or personal
allowance that is available with an income tax to alleviate the tax
burden on the low-income taxpayer, and policymakers may feel the
problem of regressivity should be addressed.\1 International
experience indicates that in most countries, exemptions or lower
rates for specific goods and services are given to offset the
regressivity; regressivity can also be countered, as in Canada, by
direct payments to those with low income.\2 If the VAT is complicated
by exemptions or multiple rates, there can be substantial differences
between the credit and subtraction VATs.  A significant distinction
between them is that only the credit VAT has the flexibility to
readily accommodate a variety of rates or exemptions commonly used to
offset regressivity, and even with the credit VAT, compliance and
administration costs escalate if multiple rates or exemptions are
used. 

Credits to individuals, such as the earned income credit, which is
intended to offset taxes paid by the low-income working population,
are not viable within either VAT system--if either replaces the
current income tax system.  A mechanism would have to be in place to
process claims, verify eligibility, and issue the credit.  In some
countries, the income tax serves this purpose.  In the United States,
the employment tax could be used by giving a credit to offset
employment taxes to be paid, although another mechanism would be
needed for those not working. 

Methods commonly used internationally for eliminating taxation on
businesses or on specific goods under a VAT are a business exemption
and exemption by zero-rating.  A business exemption eliminates the
tax by categorizing the business as exempt.  However, if taxes have
been paid by the exempt business to other businesses in the
production and distribution chain, the business would not have a way
to recover them.  This problem is addressed through a mechanism known
as zero-rating, which allows these businesses to be refunded the
taxes they paid to others.  Zero-rating removes the tax by charging a
zero rate--that is, no tax--on the business' sales and still allows
the business to claim credit for taxes it paid on goods and services
used in the business' production or distribution. 

Three ways used for tax exemption with VATs are as follows: 

  -- exemption by zero-rating specific goods and services at the
     retail or final level, such as food or medical services;

  -- exemption for a specific size of business, such as businesses
     with less than a certain amount in gross receipts per year; and

  -- exemption by zero-rating goods that are exported. 

The first of these exemptions is feasible with either the credit or
subtraction VAT if (1) it is applied at the retail or final level or
(2) all of a firm's sales are zero-rated.  It is practical with the
credit VAT even if taxes are applied only to some of a firm's sales. 
Because a credit VAT is collected at the point where value is added
in the production chain, businesses or goods or services can be
omitted from the tax at any point in the chain without loss of
revenue.  A subtraction VAT is much less flexible for making such
adjustments except at the retail level, where an item simply can be
untaxed.\3

As we pointed out in 1993, the second type of exemption commonly used
may eliminate the burden for small businesses and lessen the cost of
administration.\4 Most European VATs were established with small
business exemptions.  Typically, in countries with these VATs, small
businesses do not have to file returns or remit tax if their gross
receipts are low, for example, less than $25,000 per year.  They may,
however, have to register with a tax agency.  Exempt small businesses
in these countries also lose the opportunity to claim the credit for
the tax they pay to other businesses in the production and
distribution chain.  The same kind of exemption may be used to exempt
a particular type of business, such as banks, from a VAT.  In some
cases, however, businesses have joined the system, if the option is
available, preferring to pay the tax so they can take the credit for
taxes paid to other businesses. 

An important feature of a VAT is border adjustments for exports, the
third type of exemption.  Taxing items at their place of use, rather
than their place of production, is known as the destination
principle.  Under this principle, taxes are imposed on imports and
rebated on exports.  Under either a credit or a subtraction VAT,
businesses that export goods can claim credit for taxes they paid on
these goods by zero-rating the exported goods.  If the taxes paid on
the inputs to exported goods exceed the value of the taxes collected
on domestic sales, the business can be entitled to a credit or
refund. 

In 1996, the standard VAT rates in most of the world's industrialized
countries ranged between 15 and 25 percent.\5 Most of these countries
had different rates for necessities and/or luxuries.  Most of these
countries also relied on an income tax, as well as the credit VAT,
for their revenues. 

If the United States were to enact a VAT, it might draw on the
experience of these countries.  However, if a VAT fully replaced U.S. 
income taxes, and perhaps employment taxes, a higher rate than those
of other countries might be necessary to produce the amount of
revenue currently generated by those taxes.  Furthermore, in most
states, a VAT would be added to the state and local sales taxes,
making the combined rates still higher.  For this reason, other
countries' experiences may be less applicable in predicting future
U.S.  experience with such things as tax evasion, tax collection, or
fraud.  If a VAT was administered along with an income tax, the
burden on both the taxpayers and the tax agency would increase,
although it probably would not double the current level.\6

Services, which now represent more than 50 percent of the U.S. 
economy, can present special taxation problems.  While most services
probably would be taxed with a credit VAT, international experience
shows that some services escape taxation.  Because of the complexity
of establishing value for such things as life insurance premiums or
financial intermediation services, they generally are not in the
system.  Various ways to accommodate these items have been considered
by tax policymakers, but during our review most countries exempted
them. 


--------------------
\1 Regressivity in a tax system means low-income taxpayers pay a
disproportionate share of their income in taxes.  The perceived need
to address regressivity assumes the VAT is a replacement tax for the
income tax.  If an income tax is retained, a variety of ways to
address regressivity are available. 

\2 In our analysis, we used data about international VATs from the
Organization of Economic Cooperation and Development and information
from the International Monetary Fund and international tax
specialists.  See also Tax Policy:  Value-Added Tax:  Administrative
Costs Vary With Complexity and Number of Businesses (GAO/GGD-93-78,
May 3, 1993); Tax Policy:  State Tax Officials Have Concerns About a
Federal Consumption Tax (GAO/GGD-90-50, Mar.  21, 1990); Tax Policy: 
Value-Added Tax Issues for U.S.  Tax Policymakers (GAO/GGD-89-125BR,
Sept.  15, 1989); Tax Policy:  Tax-Credit and Subtraction Methods of
Calculating a Value-Added Tax (GAO/GGD-89-87, June 20, 1989); Tax
Policy:  Choosing Among Consumption Taxes (GAO/GGD-86-91, Aug.  20,
1986); The Value-Added Tax--What Else Should We Know About It? 
(GAO/PAD-81-60, Mar.  3, 1981); and The Value-Added Tax in the
European Economic Community (GAO/ID-81-2, Dec.  5, 1980). 

\3 See Martin A.  Sullivan, Flat Taxes and Consumption Taxes:  A
Guide to the Debate (New York:  American Institute of Certified
Public Accountants, Dec.  1995), pp.  35, 36. 

\4 See GAO/GGD-93-78, p.  61. 

\5 The exceptions were Canada, with a rate of 7 percent; Switzerland,
with 6.5 percent; and New Zealand, with a rate of 12.5 percent on a
very broad base.  Japan had a subtraction VAT, which is gradually
being changed and more closely resembles a credit VAT, with a rate of
3 percent, rising to 5 percent in 1997. 

\6 See GAO/GGD-93-78. 


   OTHER ISSUES
-------------------------------------------------------- Appendix VI:2


      TRANSITION ISSUES
------------------------------------------------------ Appendix VI:2.1

If a transition were thought desirable, problems with transitioning
to a VAT could arise, as with any consumption tax.  For example,
since individuals would pay the tax when they spend money, the
portion of their savings, which was taxed as income before conversion
to the VAT, would be taxed again.  Special transition rules might be
designed to take into account individuals' interest and dividends,
which otherwise would be taxed doubly, first as income (earlier), and
later as consumption. 

Also, businesses that are taking depreciation under the income tax
system would not have the opportunity to continue depreciating their
capital goods unless special provisions were made to continue it
under a VAT.  Similarly, problems could arise with businesses'
carrying forward net operating losses and recovering unclaimed tax
credits. 

Transition to any new tax would require both time and government
resources.  Educating businesses would be important for future
compliance, and time for educating the public and the resources to do
it would be needed. 

The transition effort needed for a VAT may include education of the
public about the impact at the retail level, of businesses about the
legal aspects and compliance procedures necessary, and of tax
preparers.  In addition to designing new educational programs, some
estimates would be needed of the support services required once the
tax took effect.  Seminars, telephone assistance, publications, and
media advertisements would likely be used to reach the public. 
Enlisting private trade associations and professional groups and
taking advantage of free public service announcements and programs to
assist in the education effort could help. 


      FEDERAL/STATE ISSUES
------------------------------------------------------ Appendix VI:2.2

The interaction between federal and state governments is an important
aspect of a VAT, particularly the credit VAT.  First of all, the
credit VAT is a transaction tax that appears at the retail level,
which states traditionally have considered to be their domain for tax
purposes.\7 Second, many of the state income tax systems are built
upon the federal system and rely on the income tax information
reported to the federal government.  If a VAT replaced the income
tax, the states would lose this source of information.  Third, five
states currently do not have a retail sales tax (RST) and might not
cooperate in the administration of a VAT.  (For a more complete
discussion of federal/state issues, see app.  V on the national RST.)


--------------------
\7 The VAT may or may not be visible to the customer, depending on
the way it is established, but the effect would be evident. 


      INTERNATIONAL ISSUES
------------------------------------------------------ Appendix VI:2.3

Destination-basis VATs use border adjustments to create a level
playing field internationally for imports and exports.  Border
adjustments--taxing imports and refunding taxes paid on
exports--could be included in a U.S.  VAT.\8 Various concerns with
administering border adjustments are discussed in the enforcement
area of this appendix. 

Since VATs are not levied on individuals, problems of taxing
individuals' foreign-source income or of establishing U.S.  residency
of foreigners are eliminated.  For businesses, some current complex
laws governing U.S.  and foreign corporations operating outside their
country would no longer be necessary.  The complexities of transfer
pricing problems would disappear, as well as the need for foreign tax
credits. 

Other problems and tax avoidance issues could be created, such as
identifying nondeductible foreign services since domestic service is
deductible.  Mechanisms would be needed, as they were in Europe, to
counteract incentives to buy certain foreign, as opposed to domestic,
services to avoid paying VAT.  Further, moving to a VAT, or other
consumption tax, could make the future of U.S.  bilateral income tax
treaties unclear. 


--------------------
\8 Many economists think the border adjustments would not affect the
trade balance in the long run due to the adjustment of exchange
rates; however, as noted by Sullivan, p.  63, there could be a
differential impact across industries. 


   CREDIT VAT
-------------------------------------------------------- Appendix VI:3


      DESCRIPTION
------------------------------------------------------ Appendix VI:3.1

The credit VAT is used throughout the world, although most developed
countries also rely on an income tax.  Adopting a credit VAT would
either move our tax system to a consumption type, transaction-based
system or, if an income tax was retained, to more of a hybrid tax
system.  In this appendix, we discuss the tax alternatives as
replacing the current income tax system. 

As with all consumption taxes, a credit VAT would not tax saving
until spent, and it would eliminate the portions of the individual
income tax that are designed to encourage saving (IRAs and 401(k)
plans).  The current business income tax, in which assets can be
depreciated over a period, would change to allow immediate expensing
of all asset investments.  Tax preferences could be built into a
credit VAT by imposing different rates for different goods; this is
more difficult to do with a subtraction VAT. 

A credit VAT and an RST are similar in appearance--for individuals,
they are both taxes that they pay on transactions at the retail
level.  Certain features of a credit VAT are useful tax mechanisms. 
These features are (1) the VAT's crediting mechanism, whereby the tax
paid is based on a cross-check of the sales of goods or services with
the records of the purchasers; (2) the dispersion of tax collection
throughout all business levels rather than collection only by
retailers, who are typically small and may go in and out of business
quickly; and (3) the ability of the credit VAT to exempt from
taxation small businesses, which are more likely to try to evade
taxes, as opposed to the RST, in which so much of the revenue is
collected from small businesses. 

Credit VATs in foreign countries are imposed on the sale of taxable
goods and services by businesses.  A broad-based tax may include
food, housing, medical and pharmaceutical sales and services, and
educational sales.  Typically, several tax rates--a standard one,
plus at least one for necessities and one for luxury goods--are used
to counter concerns about fairness.  Having only one rate, however,
eases the burdens of compliance and administration.  New Zealand's
VAT is often cited by tax experts as an exemplary tax because it is a
simple VAT with a single tax rate imposed on a very broad base of
goods and services. 

To offset the impact of the tax on low-income persons, some countries
exempt or zero-rate some of these items.  With a credit VAT,
narrowing the base by excluding items from the tax has several
effects:  (1) a higher tax rate on the remaining items is necessary
to raise a given amount of money, (2) it becomes more complex for
both the taxpayer and the tax administrator because definitional
distinctions might have to be made,\9 and (3) the intended population
may not be the only group sharing in the benefits. 

Issues arise with a credit VAT that are not a concern with the
current income tax, such as how to tax a broad range of services. 
While a credit VAT can be very broad-based, including virtually all
goods and services, some items, such as financial intermediation
services, which are difficult to tax, may or may not be included even
in a broad tax base.  In recent years, issues about the taxation of
international services have taken on more importance because of the
increasingly global nature of economic interaction.  Tax policymakers
have been considering whether and how international services--for
example, architectural services or telecommunications--should be
taxed.  Consideration of a credit VAT in the United States might
include such concerns. 


--------------------
\9 For example, distinctions might have to be made between food that
is candy and food used for home cooking. 


      POTENTIAL IMPACT ON
      TAXPAYERS' COMPLIANCE BURDEN
------------------------------------------------------ Appendix VI:3.2

A summary of some potential impacts of a credit VAT on business
taxpayers is shown in table VI.2 and elaborated on afterward. 



                               Table VI.2
                
                Summary of Some Key Potential Impacts of
                   a Credit VAT on Business Taxpayers

                                Characteristics of
                                taxpayer
                                compliance burden   Impact of the
                                under the current   credit VAT on
Burden                          income tax          business taxpayers
------------------------------  ------------------  ------------------
Return filing                   24 million returns  All businesses
                                filed in 1995       included unless
                                                    specifically
                                                    exempted

Records kept                    Records supporting  Records of taxes
                                income and          paid to other
                                expenses supposed   businesses and
                                to be kept          collected from
                                                    them required;
                                                    records for items
                                                    such as
                                                    depreciation not
                                                    needed except for
                                                    possible
                                                    transition

Calculations made               Complicated         Fewer
                                calculations        calculations, such
                                included for        as for
                                provisions such as  depreciation,
                                depreciation, the   required
                                alternative
                                minimum tax, and
                                the foreign tax
                                credit

Complexity faced                Detailed rules      Complexity
                                involved;           possibly reduced
                                complexity          by simpler tax but
                                reflected in areas  added by
                                such as             exemptions or
                                depreciation, the   multiple rates;
                                alternative         base harmonization
                                minimum tax, and    with state sales
                                the foreign tax     taxes needed
                                credit;
                                difficulties
                                existing in
                                defining and
                                recognizing income

Requirement to furnish          1.1 billion         Information
information returns             information and     returns eliminated
                                withholding
                                documents filed
----------------------------------------------------------------------
Source:  GAO analysis of available information about credit VATs. 


         NUMBER OF TAXPAYERS
---------------------------------------------------- Appendix VI:3.2.1

A credit VAT taxes all businesses, which in 1995 included about 24
million corporations, partnerships, and sole proprietors filing
returns.  This is substantially less than the 122 million
taxpayers--businesses and individuals--who recorded information and
filed tax returns with IRS in 1995. 

If the United States followed the lead of many other industrialized
countries and created an exemption for small businesses, the number
remitting tax could be substantially smaller, while the dollars
collected would decrease very little because the largest corporations
remit most of the tax.  For example, as described in appendix II,
with the current corporate income tax structure, 96 percent of income
year 1993 corporate revenues came from only 2 percent of the
corporations.  However, because most small businesses at the retail
level in the United States are familiar with remitting state and
local RSTs, small businesses may not need special treatment under a
U.S.  VAT. 


         INFORMATION REPORTED AND
         FILING FREQUENCY
---------------------------------------------------- Appendix VI:3.2.2

With a credit VAT, the following information is needed by a
registered business to calculate and file its VAT return and by the
tax agency to verify the accuracy of the amount remitted: 

  -- VAT paid on purchases of goods and services (inputs), including
     capital goods, investment, and imports;

  -- VAT received on sales;

  -- amount of goods and services exported (assuming destination
     principle);

  -- any credits carried forward; and

  -- credits for adjustments on purchases from the previous period. 

A broad-based, single-rate credit VAT replacing the current income
tax should alleviate some burden on businesses by requiring fewer
records, calculations, and information returns, whether or not small
businesses are exempted.  A business paying a credit VAT would be
required to maintain sales transaction records (or records of its
gross sales from which it could figure the taxes collected) and the
records of taxes it paid to other businesses for its purchases,
including investment and capital goods purchases.  The difference
(i.e., taxes collected on sales minus taxes paid on purchases) would
be remitted to the tax agency, and a tax return and accompanying
records would be kept relating to that difference.  In practice,
transactions between businesses would likely be aggregated over a
period (e.g., week or month) as with current billing procedures so
that one invoice might cover many transactions.  In cases in which
small businesses have been required to file returns under a VAT,
countries have used simpler systems than for larger firms to try to
ease compliance burden. 

Calculations of items such as depreciation, alternative minimum tax,
foreign-source income, and foreign tax credits, and accrual
accounting methods would not be necessary for a VAT.  However,
complexities could be created if there was a period of transition in
which calculations for both a VAT and an income tax would be
required. 

If a credit VAT replaced the current income tax, businesses,
particularly in the retail sector, might be responsible for
collecting more "over-the-counter" tax dollars than they currently
do, increasing the attendant liability and accountability,
particularly for small firms.  In contrast to an RST, however, the
credit VAT would spread the collection of the tax dollars over a much
broader spectrum of businesses that buy or sell goods or services, so
some of the concerns about an RST are not as valid with a VAT. 

State RSTs likely would continue to be collected by retailers, and if
the bases of the federal and state taxes were not harmonized, that
is, if the same goods and services were not given equivalent tax
treatment, retailers could be dealing with two separate taxes--each,
perhaps, with its own rates and base.  The confusion could escalate
the burden for both businesses and consumers, and proper
recordkeeping and reporting could be difficult; thus, state and
federal harmonization of tax bases would be desirable.  Zero-rating
of goods would seem to be a bit easier to handle, although here,
also, distinctions between goods that are taxed at the state level
and goods that escape taxation at the federal level (or vice versa)
could be confusing and burdensome. 

How often a business remits a VAT could vary with the size of
business and the amount of tax owed, ranging from annually to monthly
to, perhaps, more often for very large corporations.  The form for
filing a very simple credit VAT might have only 16 lines of tax
information on it, and as described in the next section, filing might
be more automated than it is now.  Filing of returns could be
required on a less frequent timetable, similar to current
requirements, with estimated amounts to be sent between filings.  New
businesses could be required to file more frequently until a basis
for estimating the tax due has been established. 


         CREDIT VAT COMPLIANCE
         COSTS
---------------------------------------------------- Appendix VI:3.2.3

The experience of other countries with credit VATs provides some
information about their compliance costs.\10 However, studies of
compliance costs, in general, have limitations similar to those
discussed in appendix III, and those mentioned here vary widely in
their approach and methodology, as well as the years they cover.  The
costs compared here are based on a percentage of revenue, but a
limitation of this approach is that at higher tax rates, compliance
costs should be a lower percentage of revenue, unless noncompliance
rises accordingly.  Because VATs are collected by businesses,
individuals do not have to file, thus eliminating their compliance
burden.  Some estimates of compliance costs for businesses are 2.5
percent of tax revenue in Sweden, 3.7 percent in the United Kingdom,
and 4 percent in the Netherlands.  The European VATs, however, have
multiple rates and are less simple and more costly to operate than an
ideal VAT.  The Congressional Budget Office estimated costs for a
U.S.  VAT designed with a single low rate to be a similar share of
revenue as European VATs.\11 However, comparing costs with the
current, complex U.S.  income tax is difficult.  As with any
consumption tax, costs of compliance would vary depending on whether
regressivity is addressed and whether some form of an income tax is
retained for a transition period or longer. 

A recurring finding of these and other studies is that compliance
costs for VATs are regressive--small businesses bear a much heavier
burden than large businesses.  A 1986-87 study of United Kingdom
costs showed compliance costs for the smallest firms to be more than
200 times the compliance costs for the largest firms.\12


--------------------
\10 Cedric Sandford, ed., Tax Compliance Costs:  Measurement and
Policy, (Perrymead, England:  Fiscal Publications in association with
the Institute for Fiscal Studies, 1995). 

\11 Joel Slemrod, "Which Is the Simplest Tax of Them All?" in Henry
J.  Aaron and William G.  Gale, eds., Economic Effects of Fundamental
Tax Reform (Washington, D.C.:  Brookings Institution Press, 1996), p. 
374, citing the Congressional Budget Office. 

\12 Cedric Sandford, "The Administrative and Compliance Costs of the
United Kingdom's Value-Added Tax," Canadian Tax Journal, Vol.  38,
No.  1 (Jan./Feb.  1990), pp.  10-12. 


      POTENTIAL IMPACT ON TAX
      ADMINISTRATORS
------------------------------------------------------ Appendix VI:3.3

A summary of some potential impacts of a credit VAT on tax
administrators is shown in table VI.3 and elaborated on afterward. 



                               Table VI.3
                
                Summary of Some Key Potential Impacts of
                   a Credit VAT on Tax Administrators

Item                      Current income tax     Credit VAT
------------------------  ---------------------  ---------------------
Impact on number of       Hundreds of millions   Returns simplified;
returns processed         of returns and other   only businesses
                          materials received     included, and
                                                 information returns
                                                 unneeded; if a small
                                                 business threshold,
                                                 large number of
                                                 businesses excluded

Impact on refund          92 million refunds     Refunds for excess
processing                issued in fiscal year  estimated remittances
                          1995                   required;
                                                 verification needed
                                                 for refunds of taxes
                                                 paid on exports and
                                                 for taxes paid
                                                 exceeding taxes
                                                 credited

Impact on examination     Tax returns matched    Self-enforcing
approach                  with information       mechanism encouraging
                          returns; fiscal year   compliance; audits
                          1995 examination       probably shorter and
                          coverage at 1.36       more frequent
                          percent, with
                          corporate audits
                          taking longer than
                          individuals' audits

Continuation of old       Compliance problems    Compliance problems
compliance problems       related to income      continued with
                          definition,            business and personal
                          unreported income,     expense distinctions,
                          and more specific      independent
                          issues identified in   contractors,
                          areas such as          unreported receipts,
                          transfer pricing,      and underground
                          depreciation,          economy; small
                          deductibility of       business possibly
                          business expenses,     exempt or audits
                          small businesses,      increased
                          independent
                          contractors, and the
                          underground economy

Resolution of old         Not applicable         Compliance problems
compliance problems                              with transfer pricing
                                                 and depreciation
                                                 eliminated

Creation of new           Not applicable         Compliance
compliance problems                              complicated if there
                                                 are exemptions and
                                                 multiple rates and
                                                 for verifying export
                                                 claims

Impact on collections     Millions of taxpayer   Collections
from tax delinquents      delinquent             complicated if high
                          investigations and     rates put large cash
                          accounts disposed of,  amounts in hands of
                          with most of the       small businesses,
                          latter being for       unless exempted;
                          individuals and most   small business
                          business dispositions  problems possibly
                          covering employment    mirroring current
                          taxes                  employment tax
                                                 collection problems

Impact on individuals'    Millions of taxpayer   Individuals not
questions received        inquiries fielded,     responsible for
                          covering a wide        filing returns
                          variety of questions
----------------------------------------------------------------------
Source:  GAO analysis of available information about credit VATs. 


         TAX RATES
---------------------------------------------------- Appendix VI:3.3.1

If a credit VAT, collected at the various stages of production and
distribution (including retail), replaced the income and employment
taxes, the rate could be as high or higher than the common rates of
15 to 25 percent currently in effect in industrialized countries.\13

The rate assessed with a credit VAT could have a major bearing on the
administrative burden.  High VAT rates could complicate
administration because high rates generally raise incentives to avoid
taxes, and businesses would more likely handle large amounts of tax
money that could be diverted to their own cash flow needs.  This
could make tax collection more difficult for the agency.\14 However,
unlike an RST, in which collection of all tax dollars falls on the
retailer, the collection points are distributed along the production
and distribution chain, and thus the amount of taxes owed to the
government is spread among more entities. 

Most commonly, countries impose different rates on luxury goods than
on necessities.  Multiple tax rates--that is, different rates for
different goods and services--are used in many countries to address
the problem of regressivity.  However, having more than one rate
complicates tax administration and increases administrative costs,
because verifications have to be made of the taxes paid on goods and
services taxed at varying rates. 


--------------------
\13 See Sullivan, pp.  88-89, and Organization for Economic
Cooperation and Development, Consumption Tax Trends (Paris:  1995),
p.  16. 

\14 See GAO/GGD-93-78. 


         PROCESSING OF RETURNS
---------------------------------------------------- Appendix VI:3.3.2

If the VAT replaced the current income tax, fewer tax returns would
need processing, and this would relieve the burden on the tax agency
because only about 24 million businesses--and no individuals--would
file returns.  This would be approximately 98 million fewer filers
than with the current system.  Initial registration of most of these
businesses probably could be accomplished through current tax
records, but additional effort would be required to register new
businesses and any others, such as nonprofit organizations, not in
the current system but included under a VAT.  Cooperation with the
states could be very useful, since they may work in concert with
local governments that license businesses. 

The number of returns and remittances to be processed would depend on
the number of taxpayers and how often businesses were required to
file or remit.  As we noted in 1993, if small businesses with less
than $25,000 in annual gross receipts were exempt from the VAT, about
50-percent fewer businesses would remit the VAT, thus alleviating
both taxpayer and tax agency burden and costs.\15 Many countries
establish a threshold for small businesses but allow them the option
of joining the system by filing and remitting the VAT in order to
receive the tax credits or refunds on taxes they paid on purchases of
goods and services.  These credits or refunds, as well as any refunds
for excess estimated remittances, could require processing and
monitoring for verification of the amounts claimed, however. 

Reporting of information by the taxpayer to the tax agency could be
done less frequently than the remittance of taxes.  Reporting for
smaller businesses might be done annually, as it is now with the
individual income tax, while remittance frequency would likely depend
on the size of business and tax owed, similar to the current system. 
Higher tax rates with a VAT and more revenues being collected by
businesses might result in more frequent remittances being required
than with the current income tax.  A purpose of this would be to
capture tax revenues quickly to allay the temptation for a business
to use the money to bolster its cash flow.  This would affect the
administrative burden, but the estimate of 24 million business
taxpayers would seem to result in a much lighter agency processing
load than under the current system. 

A tax agency collecting the VAT could use the same general process
now used for income tax returns, although it presumably could rely
more on automation.  Because filers of a VAT are limited to
businesses, they may be able to accommodate automated systems.  In
Canada, a one-time allowance was given to cover the additional cost
to small businesses for necessary equipment purchases.  Special
rules, such as a requirement for electronic filing, might be enacted
to expedite relatively error-free processing, and scanning equipment
might enter the data into the computer system.  The status of the tax
systems modernization effort at the time a new tax is put in place
could have a major bearing on a tax agency's ability to institute and
assess the tax. 

Most information returns, which now are used to report earnings and
also savings and investment returns to taxpayers, would no longer be
necessary with a credit VAT since these income items would not be
taxed.  This means that the processing of hundreds of millions of
documents, mostly electronic and some paper, would be eliminated. 

A tax agency would also have to be prepared to process refunds and
credit claims.  With a VAT, these are likely to be for exports
(discussed in a later section on these claims).  If an earned income
credit or other similar credit was used to refund taxes to the
low-income population, some mechanism to do this would need to be in
place. 


--------------------
\15 GAO/GGD-93-78, p.  67. 


         ENFORCEMENT--AUDIT
---------------------------------------------------- Appendix VI:3.3.3

Enforcement with a credit VAT would be quite different from
enforcement with the current income tax.  With a VAT, the taxes
collected by businesses minus those paid to other businesses are
remitted to the tax agency; however, with an income tax, business
taxes are based on profits and losses, rather than on sales and
purchases.  The difference makes the joint enforcement of the taxes
more problematic if both were in effect, though for large
corporations, auditing the two taxes together might be done using
information derived from auditing one to verify the other.  Of
course, certain elements of the income tax, such as depreciation,
give rise to specialized audit problems.  Some issues, such as
differentiating between business and personal expenses, might be the
same, while others, such as transfer pricing issues, would disappear
for the United States with a border-adjustable VAT.\16

As we mentioned in 1993, a simple VAT, with a broad base and one
rate, or very few, and without exemptions, is by far the easiest to
enforce.  Efforts to offset the regressivity of a credit VAT by
having a tier of rates or by exempting goods and services will
escalate the costs to administer the VAT.\17

The chain of tax payment and tax receipt, available only in the
credit VAT, creates a mechanism thought by some to encourage or force
compliance with the tax system.\18

Because each business is required to provide receipts for taxes paid
on its sales and the business making the purchase needs these
receipts to verify that it paid the taxes, there seems to be a
self-enforcing mechanism within the system.  However, there is not
general agreement in the tax literature as to the effectiveness of
this approach in preventing noncompliance.  Theoretically, a tax
agency could require that all pertinent documents be turned over to
it for audit purposes, but the sheer volume of data makes it unlikely
that a tax agency would attempt to match documents.  Nevertheless,
businesses would need to retain gross receipts records and records of
transactions on taxes paid on purchases of goods and services.  Even
Japan, which started its own unique version of a VAT in 1989 without
substantial recordkeeping requirements, recently has started
requiring businesses to maintain records that substantiate their
claims for credits.\19

As we pointed out in 1993, other countries' experiences with a credit
VAT indicate that auditing would require less time but more frequent
visits by auditors to businesses than with an income tax.\20 Also,
other countries' experiences indicate that while VAT audits may be
done very quickly, the time required increases if any complexity is
introduced.  Frequent auditors' visits to businesses may be used to
quickly capture taxes due and to discourage businesses from using the
tax funds in their cash flow.  The number and frequency of audits of
small businesses, who have proven to be the most noncompliant under
the current system, might be increased by a tax agency.  Further,
specially trained people may be needed for fraud detection,
particularly for verification of exports for border tax adjustments. 

The United Kingdom's planned audit rate of VAT taxpayers was 6.5
percent (in 1992), compared with IRS' corporate income tax audit rate
of 2.0 percent (in fiscal year 1995).  Time for a VAT audit is highly
variable, depending on the size of the business.  IRS' experience
with the income tax indicates that larger firms employ tax
specialists and are less likely to make basic errors than are smaller
firms. 


--------------------
\16 See Joint Committee on Taxation, Impact on Small Business of
Replacing the Federal Income Tax (JCS-3-96), Apr.  23, 1996, p.  79;
and Harry Grubert and T.  Scott Newlon, "The International
Implications of Consumption Tax Proposals," National Tax Journal,
Vol.  XLVIII, No.  4 (Dec.  1995), p.  637. 

\17 See GAO/GGD-93-78, pp.  79-80. 

\18 For discussion of this concept, see GAO/GGD-93-78, p.  44, and
Sullivan, p.  24. 

\19 See Alan Schenk, "Japanese Consumption Tax After Six Years:  A
Unique VAT Matures," Tax Notes, Vol.  69, No.  7 (Nov.  13, 1995),
pp.  899-911. 

\20 See GAO/GGD-93-78, pp.  42 and 46. 


         OTHER ISSUES IN
         ENFORCEMENT
---------------------------------------------------- Appendix VI:3.3.4

Underground Economy.  No easy formula seems to exist to solve the
problem of collecting taxes from the underground economy.  With a
VAT, some taxes still would escape collection, including the tax on
the value added by the labor of sole proprietors who, as mentioned in
appendix II, have had extremely poor compliance histories.  A
Canadian study reports the potential for "skimming" (underrreporting)
or nonreporting of legitimate business receipts with the Canadian VAT
is greatest in the service sector, similar to the U.S.  income
tax.\21 Similarly, illegal goods and services would likely continue
to escape taxation with a VAT, although the amount of these is
unknown. 

The credit VAT has the advantage of creating incentives for
businesses to file in order to get credit for taxes they have paid. 
With a credit VAT, even if sole proprietors do not file, they
probably would pay some tax on goods and services they purchase for
business use. 

As with the current system, the tax agency likely would want to
develop methods of audit selection, such as the scheme currently used
for income tax returns.  The resulting selection might be quite
different from those now used with the income tax, and it would
require some years of experience with a U.S.  VAT to develop and
refine the patterns and indicators of noncompliance. 

Credits/Refunds.  Because a new business' initial costs of starting
up would probably exceed its sales for some time, it would likely
have larger claims for credits than an established business would. 
In this situation, the business could claim a substantial amount of
money to be refunded.  Some countries handle these claims as credits
that are carried forward to be used with the next tax due, but new
businesses may need the money quickly for operating funds.  A credit
or refund mechanism would need to be established to address these
possible cash flow problems, but the tax agency would be burdened
with the necessity of checking the validity of these claims before
refunding large amounts.  Fraudulent claims could be a problem for
the tax agency when there are requests for speedy refunds. 

As we described in 1993, border adjustments, done by zero-rating
exported goods, require special attention from auditors to ensure
that the credits claimed for exports are correct.\22 Auditing,
verifying, and processing these claims so that the businesses receive
their refunds in a timely manner adds to the cost of administering a
VAT.  For a tax agency to make adjustments for taxes paid on inputs
to exported goods, verification of claims would be required to ensure
that the goods were, in fact, exported and that the claim for taxes
paid was correct.  Most companies export only a portion of the goods
they produce, complicating the tax for the company and the agency,
because records must separate the goods sold domestically from the
goods exported to establish the proper claim for credit.  Other
countries' experiences indicate that fraudulent claims could be a big
problem because they might generate large dollar refund claims. 
Furthermore, quick payment of these claims could relieve the exporter
of cash flow problems, but these claims would have to be verified
before payment.  An enforcement mechanism would be needed that
prevents or exposes fraudulent claims.  Transaction records available
with a credit VAT would provide the needed verification, but an
economy dominated by exporters could require significant tax agency
resources.  The potential for businesses to overstate claims of
exports to obtain credits would have to be addressed.  The burden for
this may or may not fall entirely on the tax agency, and in the
United States, the Customs Service, which currently administers
import duties, might assume that role in cooperation with the tax
agency. 


--------------------
\21 Statistics Canada, National Accounts and Environment Division,
"The Size of the Underground Economy:  A Statistics Canada View,"
Discussion Paper, Feb.  1994. 

\22 See GAO/GGD-93-78, p.  46. 


         ENFORCEMENT--COLLECTIONS
---------------------------------------------------- Appendix VI:3.3.5

Collection functions may not change significantly from those required
for the current income tax, and whether delinquencies would increase
or decrease with a VAT is unclear.  However, if a VAT replaced the
income tax, the relatively high tax rates necessary for revenue
neutrality could involve businesses' handling more tax revenues than
they do now and, therefore, make the collection functions more
important.  The temptation would exist for businesses--as it does now
with employment taxes--to divert taxes collected to working capital,
especially in times of business downturn.  Businesses, particularly
smaller ones, could either move or close to escape the tax collector
and, with high rates, the benefits of doing so could be attractive. 
Collections could be time-consuming and costly, and a collecting
agency may need more resources for these functions than with the
current business income tax.  As described in appendix II, the most
problematic business taxes under the current collection process are
employment taxes--taxes that are collected in a way similar to how a
VAT would be collected. 


         TAXPAYER SERVICES
---------------------------------------------------- Appendix VI:3.3.6

Relieving individuals of the responsibility for filing returns would
greatly decrease the number of entities requiring taxpayer services
but would increase the administration burden for ensuring compliance
by businesses.  Tax agency efforts during the transition to a credit
VAT would be needed to educate current taxpayers as well as new
businesses, and continuing educational services would be needed for
new businesses even after the transition.  Taxpayer education
programs for VATs in other countries include such techniques as
seminars, special publications targeted to various business sectors,
and automated or personal assistance through taxpayer inquiries via
telecommunications.  Personal attention with visits to individual
businesses was thought to be effective in some other countries'
transition to a credit VAT. 

If special rules were used to avoid large gains or losses in the
transition between the old and new systems, such as continuing to
allow depreciation for a number of years, the tax would be
complicated and would require more extensive taxpayer education and
services. 


   SUBTRACTION VAT
-------------------------------------------------------- Appendix VI:4


      DESCRIPTION
------------------------------------------------------ Appendix VI:4.1

A subtraction VAT is a tax on consumption, remitted to the government
by businesses; it is similar to a credit VAT but is calculated on the
difference between the total receipts from sales and total purchases
of goods and services from other businesses, including expenditures
for capital purchases.  The VAT rate is then applied to this
difference to determine the tax owed. 

Even though a subtraction VAT would be levied on businesses at each
stage of production and distribution, it is the consumer who would
ultimately pay the tax.  A subtraction VAT might not be as visible to
the consumer as the credit VAT because each transaction would not
have to be tracked at the retail level; but it would likely be
reflected in the price charged, nonetheless. 

A subtraction VAT would be imposed on the sale of taxable goods and
services by businesses, and unlike a credit VAT, the base would have
to be very broad to be administrable.  To facilitate its
administration, there should be no multiple rates nor any exemptions
of goods and services before the retail level, even for such a
purpose as offsetting regressivity.  Although using multiple rates
and exemptions with a credit VAT is possible, it would be difficult
administratively with a subtraction VAT.  (Some think this is an
advantage because, at least theoretically, it could keep a
subtraction VAT from being subject to added complexities.) If
exemptions existed at the retail level, the tax would become more
like current RSTs, and some of the same problems, such as making
definitional distinctions between similar items with different tax
rates, could be troublesome. 

To be administrable, a subtraction VAT should have only one rate. 
Although multiple rates add complexity to a credit VAT, with a
subtraction VAT businesses simply could not keep track of the rates
paid at the intermediate production stages.  If more than one rate
applied, the net difference between sales and purchases could not be
the basis for calculating the tax.  Further, if multiple rates were
used with a subtraction VAT, the tax agency administering the tax
would have no reliable way to confirm a business' claims for the
volume of goods sold at lower rates, since the business, itself,
would furnish the audit information. 

A credit VAT, because it relies on records of transactions, is
adaptable for the taxation of small retail services, such as
automobile mechanics or hairdressers, which are labor-intensive. 
With a subtraction VAT, however, it would be easy to understate the
value added in labor for the service provided, because the amounts
reported are based on the business' own records, and there is no
checking mechanism in the system as there is with a credit VAT. 

Enforcement advantages of a credit VAT are not present with a
subtraction VAT:  (1) checks and balances of a credit VAT are not
available and (2) businesses do not have the incentive to enter the
system to receive credits for taxes paid as with a credit VAT. 

As discussed in appendix III, financial intermediation services may
be difficult to include in any consumption tax, including a
subtraction VAT.  Treatment of housing is a concern with any
consumption tax, and international VATs generally tax the sale of new
housing.  As mentioned, any narrowing of the base of a VAT
complicates the tax and raises the cost to both the taxpayer and tax
administrator. 

Consumption taxes generally tax fringe benefits by not including them
in the items that can be deducted as business purchases.\23 However,
any business purchases that are used for personal consumption, such
as large gifts to employees that could be considered fringe benefits,
would escape taxation with the subtraction VAT.  Business purchases
might readily be abused by claims for tax credits for items used for
personal purposes.  Identifying these items in an audit could be
time-consuming. 


--------------------
\23 A flat tax can tax fringe benefits through the individual or
through the business, depending on the way it is set up. 


      POTENTIAL IMPACT ON
      TAXPAYERS' COMPLIANCE BURDEN
------------------------------------------------------ Appendix VI:4.2

A summary of some impacts of a subtraction VAT on business taxpayers
is shown in table VI.4 and elaborated on afterward. 



                               Table VI.4
                
                Summary of Some Key Potential Impacts of
                a Subtraction VAT on Business Taxpayers

                                Characteristics of
                                taxpayer
                                compliance burden   Impact of the
                                under the current   subtraction VAT on
Item                            income tax          business taxpayers
------------------------------  ------------------  ------------------
Return filing                   24 million returns  All businesses
                                filed in 1995       included

Records kept                    Records supporting  Reliance on normal
                                income and          business
                                expenses supposed   recordkeeping;
                                to be kept          records for items
                                                    like depreciation
                                                    not needed except
                                                    for possible
                                                    transition

Calculations made               Complicated         Fewer
                                calculations        calculations, such
                                included for        as for
                                provisions such as  depreciation,
                                depreciation, the   required
                                alternative
                                minimum tax, and
                                the foreign tax
                                credit

Complexity faced                Complexity          Without exemptions
                                reflected in areas  and multiple
                                such as             rates, which are
                                depreciation, the   unsuitable, tax
                                alternative         simplified
                                minimum tax, and
                                the foreign tax
                                credit;
                                difficulties
                                existing in
                                defining and
                                recognizing income

Requirement to furnish          1.1 billion         Information
information returns             information and     returns eliminated
                                withholding
                                documents filed
----------------------------------------------------------------------
Source:  GAO analysis of available information about subtraction
VATs. 


         NUMBER OF TAXPAYERS
---------------------------------------------------- Appendix VI:4.2.1

A subtraction VAT taxing all businesses would include many fewer than
the 122 million taxpayers (all types of businesses and individuals)
that filed in 1995.  As we described in a 1989 report, an exemption
for small businesses could be used with the subtraction VAT if the
tax agency could be certain the businesses indeed qualified as
small.\24


--------------------
\24 See GAO/GGD-89-87, pp.  35-37. 


         INFORMATION REPORTED AND
         DOCUMENTS RETAINED
---------------------------------------------------- Appendix VI:4.2.2

Under a subtraction VAT, a business would likely need to keep fewer
records than with either the current income tax system or a credit
VAT requiring transaction records.  With a subtraction VAT, a
business would need records for the following: 

  -- gross receipts from sales;

  -- gross amount of purchases of goods and services (inputs),
     including capital investment;

  -- amount of exports (assuming destination principle);

  -- any credits carried forward; and

  -- credits for adjustments on purchases from previous period. 

The tax reported and remitted would be calculated by a business on
the difference between the gross receipts from sales minus the cost
of goods and services purchased, including capital investment.\25
With a subtraction VAT, a business with good, standard accounting
practices should be able to rely on its normal cash flow
recordkeeping for its tax calculations and records and would not have
to do accrual accounting calculations for tax purposes.  However, the
business would have to distinguish between purchases from other
businesses, which would be deductible, and its own internal costs,
which would not be deductible.  Some items would be critical to a
taxpayer's records, specifically proof of the business' domestic
versus foreign sales.  These would be necessary for claiming refund
credits for exports and would be a likely target if the business were
audited. 

With a subtraction VAT, calculations no longer would be necessary for
such things as depreciation, alternative minimum tax, foreign
operations, and passive investment activity, unless they were
required during a transition period.  A form for reporting to a tax
agency might be similar to that of a credit VAT, which is optimally
no longer than 16 lines of tax information. 

At least one study notes that a subtraction VAT would be less
burdensome to the taxpayer than a credit VAT, although "this
simplification .  .  .  comes at the cost of increased potential for
evasion and less flexibility."\26 Fiscal responsibility would be
required, particularly of a retail business taxpayer, inasmuch as tax
liability could get high very quickly if tax rates are high;
seasonally sensitive businesses could be especially subject to
difficulties. 

Frequency of remittance and filing would likely be similar to the
current system in which the schedules may vary from annually to
semiweekly, based on the size of a business' liability and the type
of tax.  As with a credit VAT, filing methods might be limited to
electronic, since only businesses are subject to the tax.  Tax
remittances probably would be estimated and made more often than
returns filed.  Whether or not higher tax rates prevailed, businesses
would likely be handling more money, creating more liability for
themselves, and the filing and remittance burdens could be more
demanding than with the current income tax.  Some sole proprietors
and partnerships who currently file income tax returns and remit
annually might be interacting with the tax agency more frequently,
similar to the current employment tax, although without an individual
income tax, businesses' requirements for information returns would
decline. 

A transition period to the new tax could add to businesses'
recordkeeping and tax calculations and the administrative burden and
costs.  If an income tax were in effect in addition to the
subtraction VAT, the recordkeeping burden would escalate somewhat,
but current accounting methods likely could be the basis for both and
be supplemented to make VAT distinctions. 


--------------------
\25 As with a credit VAT, interest and income from other financial
flows between businesses would not be taxed. 

\26 Sullivan, p.  35. 


         SUBTRACTION VAT
         COMPLIANCE COSTS
---------------------------------------------------- Appendix VI:4.2.3

As opposed to the credit VAT, which is widely used, no country except
Japan has tried a subtraction VAT,\27 and little information is
available to judge compliance burden and costs with any precision. 
Since individuals would not file returns with a subtraction VAT, they
would not deal with compliance or experience the associated costs. 
Similarities between the subtraction VAT and the business tax under
the flat tax indicate their compliance costs for businesses could be
similar.  Based on a major reduction in paperwork over the current
system, the time necessary for compliance would be greatly reduced,
according to one estimate based on the Arthur D.  Little study, which
has limitations as described in appendix II.\28


--------------------
\27 Japan's VAT has variations that make it unlike the alternatives
we consider; also, recent changes are moving it toward a credit VAT. 

\28 Arthur P.  Hall, "Compliance Costs of Alternative Tax Systems,"
Tax Notes, Vol.  71, No.  8 (May 20, 1996), pp.  1087-88. 


      IMPACT ON TAX ADMINISTRATORS
------------------------------------------------------ Appendix VI:4.3

A summary of some impacts of a subtraction VAT on tax administrators
is shown in table VI.5 and elaborated on afterward. 



                               Table VI.5
                
                Summary of Some Key Potential Impacts of
                a Subtraction VAT on Tax Administrators

Item                            Current income tax  Subtraction VAT
------------------------------  ------------------  ------------------
Impact on number of returns     Hundreds of         Returns
processed                       millions of         simplified; only
                                returns and other   businesses
                                materials received  included, and
                                                    information
                                                    returns unneeded;
                                                    if a small
                                                    business
                                                    threshold, large
                                                    number of
                                                    businesses
                                                    excluded

Impact on refund processing     92 million refunds  Refunds for excess
                                issued in fiscal    estimated
                                year 1995           remittance
                                                    required;
                                                    verification
                                                    needed for refunds
                                                    relating to
                                                    exports and costs
                                                    exceeding sales

Impact on examination approach  Tax returns         Self-enforcing
                                matched with        mechanism not
                                information         available, making
                                returns; fiscal     audits of
                                year 1995           business' own
                                examination         records more
                                coverage at 1.36    complicated than
                                percent, with       for credit VAT;
                                corporate audits    audit frequency
                                taking longer than  possibly increased
                                individuals'
                                audits

Continuation of old compliance  Compliance          Compliance
problems                        problems related    problems with
                                to income           business and
                                definition,         personal expense
                                unreported income,  distinctions,
                                and more specific   independent
                                issues identified   contractors,
                                in areas such as    unreported
                                transfer pricing,   receipts, and
                                depreciation,       underground
                                deductibility of    economy continued;
                                business expenses,  collections from
                                small businesses,   small businesses
                                independent         problematic but
                                contractors, and    less than under
                                the underground     retail sales tax
                                economy

Resolution of old compliance    Not applicable      Compliance
problems                                            problems with
                                                    transfer pricing
                                                    and depreciation
                                                    eliminated

Creation of new compliance      Not applicable      Compliance
problems                                            complicated by
                                                    underreported
                                                    sales and for
                                                    verifying export
                                                    claims;
                                                    administration
                                                    difficulties
                                                    increased if
                                                    exemptions or
                                                    multiple rates
                                                    used

Impact on collections from tax  Millions of         Collections
delinquents                     taxpayer            complicated if
                                delinquent          high rates put
                                investigations and  large cash amounts
                                accounts closed,    in hands of small
                                with most of the    businesses; small
                                latter being for    business problems
                                individuals and     possibly mirroring
                                most business       employment tax
                                dispositions        collection
                                covering            problems
                                employment taxes

Impact on individuals'          Millions of         Individuals not
questions received              taxpayer inquiries  responsible for
                                fielded, covering   filing returns
                                a wide variety of
                                questions
----------------------------------------------------------------------
Source:  GAO analysis of available information about subtraction
VATs. 


         TAX RATES
---------------------------------------------------- Appendix VI:4.3.1

As with other consumption taxes, the tax rate with a subtraction VAT
probably would be determined by the amount of revenue needed to be
raised.  If a subtraction VAT replaced the current income and
employment taxes, the tax rate necessary to obtain a given level of
revenue would be greater than if it were imposed in addition to the
income and/or employment taxes.  The rates, which might be levied in
addition to the state sales taxes, could complicate administration of
the tax, in part because small businesses, such as retailers and sole
proprietors handling large amounts of tax money, could be tempted to
dip into them for their own cash flow purposes. 

Multiple rates, frequently used with a credit VAT to address
regressivity by imposing a variety of tax rates on such things as
necessities and luxuries, could not readily be used with a
subtraction VAT except at the retail level because it would be
virtually impossible for a tax agency to administer them.  With a
subtraction VAT, businesses would not be required to keep detailed
records of purchases, and if a business' goods and services were
purchased at varying tax rates, tax administrators could find it very
difficult to ascertain the accuracy of the apportionment of the
purchases to the differing rates.  Some tax policymakers think a
subtraction VAT that did not have a variety of rates would have a
distinct advantage over a credit VAT or other consumption tax that
did because the tax would not be as complex.  If a lower tax rate
resulted from the broader base and rate structure, the administrative
burden might be eased. 


         NUMBER OF TAXPAYERS
---------------------------------------------------- Appendix VI:4.3.2

About 24 million taxpayers--all taxpayers filing as corporations,
partnerships, and sole proprietors in 1995--would be subject to the
subtraction VAT.  This number could be reduced if small businesses
were exempted, but administering a subtraction VAT that attempted to
exempt small businesses could be time-consuming and costly if the
auditor had to review an inordinate number of records to confirm the
validity of the exemption.  Also, small businesses could spring up if
larger companies split up their firms for tax avoidance purposes. 


         PROCESSING OF RETURNS
---------------------------------------------------- Appendix VI:4.3.3

Processing of tax returns and remittances for 24 million businesses
of all types should require far fewer resources than the processing
required for the 122 million individual and business taxpayers in the
tax system in 1995.  Because the many items that have entered the
current tax code for social and economic reasons would not be
required to be reported or itemized in a subtraction VAT, the tax
would be much simpler.  However, more frequent filing and certainly
more frequent remittance, probably through estimated remittances,
could be required because more dollars would be collected by even
small businesses.  (Quickly retrieving tax dollars from businesses is
important when much money is at stake.) Much simpler returns would
make generally accurate data entry into the computer system possible
with scanning equipment and electronic filing since all taxpayers
would be businesses.  Automated systems such as these should reduce
costs and increase the speed for processing the returns, so that
auditors could receive the necessary information in a timely manner. 

Currently, hundreds of millions of information documents (Forms W-2
and 1099) reporting wages and investment income are submitted to IRS,
mostly electronically and through other nonpaper means but also by
paper, and subsequently processed.  This information reporting and
processing would not be necessary with a subtraction VAT, since these
items would no longer be used in tax calculations. 

Similar to a credit VAT, if refunds and credits were given, a method
for processing them would have to be designed.  And as with a credit
VAT, registration would be especially important for new businesses,
in order to get them into the tax system, and for others that are not
now in the tax system but that would be included under a VAT. 
Incentives to register, however, would be lacking. 


         ENFORCEMENT--AUDIT/COLLECTIONS
---------------------------------------------------- Appendix VI:4.3.4

With a subtraction VAT, auditing a business with adequate records
could be similar to auditing a credit VAT, depending on the
simplicity or complexity of the tax design.  Records of receipts or
payment invoices might have to be checked to ascertain the validity
of the amounts reported.  Without multiple rates or exemptions, the
tax agency burden should be limited to straightforward verification
of business records.  Since these are the audited business' own
records, as opposed to the credit VAT's tax receipts from other
businesses, their validity may be questioned, lengthening the audit
and raising audit costs compared with those of a credit VAT. 

With multiple rates or exemptions, a business could calculate the tax
to be remitted, but verification could be difficult because the
records the business used to determine its taxes would be its own
accounts of purchases and deductions.  (While this also happens with
the business side of the current income tax, a much smaller
proportion of tax revenues is derived from that tax, and so the
problem is not as perilous.) Tax evasion, which appears to be easy to
do with a subtraction VAT having multiple rates or exemptions, could
jeopardize large amounts of tax dollars. 

Auditing a subtraction VAT with a broad base and a single rate would
probably be simpler than auditing the current income tax and its
complexities.  As with the credit VAT, auditing could be less
time-consuming and done more often than with the current income tax. 
The importance of having auditors visit businesses frequently to
identify any problems before large amounts of taxes become due would
be similar with both the subtraction and credit VATs.  Fraud
detection would require diligence with a subtraction VAT,
particularly in identifying underreported or unreported income that
could be readily hidden in a business' books.  Also, distinguishing
between business and personal expenses would still be a problem.\29

A new system would need to be developed for audit selection.  Some
years of experience with a subtraction VAT might be necessary before
patterns of noncompliance could be identified, developed, and
refined, particularly since no country now has experience with one. 

A subtraction VAT could have problems with businesses that do not
record their sales or that understate them.  With a credit VAT,
because these businesses may want to claim the credits due them, they
may record both their sales and their purchases; however, with a
subtraction VAT, there would be little to prevent a business from
ignoring or understating sales.  With a credit VAT, businesses making
retail sales would be the ones chiefly at risk of not remitting the
VAT, since the businesses at the prior level in the production or
distribution chain would want to claim the credit for their purchases
and therefore would report them. 

As with a credit VAT, the collection of a subtraction VAT would not
fall entirely onto the retailer, and thus the burden and liability
would be spread through all businesses.  This would be a distinct
advantage over a national RST in which there are so many small
retailers whose records may be difficult to check or who may go out
of business or otherwise evade taxation.  As described in appendix
II, small businesses have had significant compliance problems. 


--------------------
\29 See Joint Committee on Taxation, p.  79. 


         OTHER ISSUES UNDER
         ENFORCEMENT
---------------------------------------------------- Appendix VI:4.3.5

Underground economy.  The underground economy should escape taxation
about as well with the subtraction VAT as with other systems; in
other words, there is no obvious reason that chances of collecting
from the underground economy are better here than with most tax
systems.  In fact, since there is no incentive to register, as there
is with the credit VAT, it might be more difficult to collect the tax
from that segment of the economy. 

Credits/Refunds.  As with a credit VAT, border adjustments, which tax
imports of goods and services and refund exports by zero-rating
exported goods, could be a source of particular concern for
administrators.  To make these adjustments, a mechanism would be
needed for crediting or refunding businesses with taxes paid on
exports; in the United States, the Customs Service might have
responsibility for administering some of it.  Businesses that are
large exporters probably would need cash refunds, rather than
credits, promptly disbursed, complicating administration.  Fraudulent
claims for amounts of goods sold have presented difficulties for
other countries to identify before they paid out refunds.  Auditors
would have to ensure that credits claimed by exporters were correct,
including claims made by companies who sell both domestically and
internationally, to ensure that the VAT credit claimed for the
exports was not inflated. 

If a business remitted more tax than was due, a system for carrying
forward the credit or paying the refund would be needed.  Large
credits or refunds claimed by new businesses to offset startup costs
or claims of capital investment costs exceeding sales would have to
be verified before payment.  These claims could pose problems for a
tax agency, since the timeliness of the validation would be critical. 
Likewise, an exemption for small businesses could be used with the
subtraction VAT only if the tax agency could be certain the
businesses, indeed, qualified as small, which probably would be
difficult for an audit agency to pursue. 


         ENFORCEMENT--COLLECTIONS
---------------------------------------------------- Appendix VI:4.3.6

Collections functions with a subtraction VAT might be similar to
those for the current income tax, and it is unclear whether
delinquencies would increase.  However, collections could mirror
current collections for employment taxes, rather than the current
income tax, because the processes seem similar.  If this were the
case, collection problems and costs could escalate, particularly with
some businesses, such as sole proprietors, who are difficult to
collect from.  Furthermore, noncompliance with employment taxes was
relatively low except in the self-employment area.  Collections might
be more problematic because, with the high tax rates likely needed to
achieve revenue neutrality, businesses likely would be handling more
tax dollars than they currently do.  Small retail businesses, known
to have a short life expectancy, could be tempted to avoid remitting
the tax and to use the funds for other purposes. 


         TAXPAYER SERVICES
---------------------------------------------------- Appendix VI:4.3.7

A new tax system is likely to require significant resources for
educating the public, but probably less so with a simple subtraction
VAT than with the credit VAT or more complicated tax.  With a
subtraction VAT, more effort would be devoted to educating businesses
than the general public, and business associations might be enlisted
to help with the effort.  A tax agency would likely target businesses
through seminars and electronic and other means.  There still would
be some education necessary for the general public so that they would
know what to expect at the retail level.  Measures designed to
improve the transition to a subtraction VAT, such as extension of
depreciation, could complicate the taxpayer services effort and
escalate its costs. 


FLAT TAX
========================================================= Appendix VII


   DESCRIPTION
------------------------------------------------------- Appendix VII:1

The term "flat tax" as used in the current tax environment may refer
to a single, or "flat," tax rate with either an income or a
consumption tax base.  The single rate does not include what is, in
effect, a zero tax rate in the form of a standard deduction and
exemption allowances.  In this report, flat tax refers to the type of
tax outlined by Hall and Rabushka.\1 This version taxes individuals
and businesses at a single rate and eliminates many specific
deductions and credits.  Although the individual flat tax may appear
to resemble an income tax because individuals file and pay taxes, the
flat tax is a type of consumption tax because returns on savings and
investment are not taxed and business' investment is expensed. 
Unlike the credit value-added tax (VAT) or the retail sales tax
(RST), the flat tax is not collected on individual transactions.\2

The individual flat tax is a wage tax, which taxes only wages,
salaries, and pension and retirement income.  Fringe benefits
received by individuals would be taxed at the business level because
the employer would not be allowed to deduct them.  This type of flat
tax has no tax credits and no deductions for specific items, such as
home mortgages and charitable contributions.  Instead, regressivity
is addressed through personal allowances based on the individual's
filing status and additional deductions for dependents. 

The business side of the flat tax would be remitted by businesses on
their total receipts from sales of goods and services, minus total
purchases of goods and services from other businesses, and
expenditures for capital purchases, minus wages, salaries, and
pension and retirement benefits.  Fringe benefits paid to workers,
other than pension and retirement benefits, would not be deductible
to businesses, and thus they would be taxed.  All businesses,
including all corporations, sole proprietorships, and partnerships,
would remit the business tax.  The business flat tax resembles a
subtraction VAT, as described in appendix VI, except that the
taxation of wages and salaries is shifted to the individual. 
Therefore, many of the effects of a flat tax on businesses and on the
tax administration of those businesses also resemble the effects of a
subtraction VAT.\3

A comparison of the base under a flat tax with the base under the
current income tax is shown in table VII.1.  Because a business'
investment purchases are expensed, rather than depreciated over time,
this flat tax is a consumption tax.  It is a flat tax because there
is only one rate applied to all levels of both the personal and
business tax base. 



                              Table VII.1
                
                      Key Elements of the Flat Tax

Item                            Current income tax  Flat tax
------------------------------  ------------------  ------------------
Personal level
----------------------------------------------------------------------
Wages                           Included            Included

Interest income received        Included            Not included

Dividends received              Included            Not included

Pension income                  Included when       Included when
                                received            received

Loan proceeds                   Not included        Not included

Sales of assets                 Capital gain        Not included
                                included

New saving                      Generally not       Not deducted
                                deducted

Fringe benefits                 Not included        Not included

Job expenses                    Certain costs       Not deducted
                                deducted by
                                itemizers


Business level
----------------------------------------------------------------------
Sales of goods and services     Included            Included

Sales of business assets        Gain included       Included

Sales of financial assets       Gain included       Not included

Loans and new stock issues      Not included        Not included

Purchases of goods and          Deducted            Deducted
services for business purposes

Purchase of capital goods       Depreciated over    Deducted
                                time                immediately
                                                    (expensed)

Wages paid                      Deducted            Deducted

Fringe benefits                 Deducted            Not deducted

Interest paid                   Deducted            Not deducted

Dividends paid                  Not deducted        Not deducted
----------------------------------------------------------------------
Source:  Joint Committee on Taxation and GAO analysis of the flat tax
outlined by Hall and Rabushka. 


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

\2 Variations of the Hall-Rabushka flat tax model include the "X-tax"
proposed by David Bradford.  The base of both the individual and
business taxes is the same with both models, but the X-tax would have
graduated rates for individuals and the tax rate for businesses would
equal the top rate for individuals.  Certain deductions and credits
for individual taxes could be retained.  See David F.  Bradford, "On
the Incidence of Consumption Taxes," in Charls E.  Walker and Mark A. 
Bloomfield, eds., The Consumption Tax:  A Better Alternative? 
(Cambridge, Mass.:  Ballinger Publishing Company, 1987). 

\3 The flat tax also resembles the business cash flow consumption tax
described in appendix III, except that with the cash flow tax, new
borrowing is taxed and wages are not taxed at the business level. 


   TAXATION OF INDIVIDUAL
   TAXPAYERS AND POTENTIAL IMPACT
   ON INDIVIDUAL TAXPAYERS'
   COMPLIANCE BURDEN
------------------------------------------------------- Appendix VII:2

A summary of some of the potential impacts of the flat tax on
individual taxpayers is shown in table VII.2 and elaborated on
afterward. 



                              Table VII.2
                
                Summary of Some Key Potential Impacts of
                   a Flat Tax on Individual Taxpayers

                                Characteristics of
                                taxpayer
                                compliance burden   Impact of the flat
                                under the current   tax on individual
Burden                          income tax          taxpayers
------------------------------  ------------------  ------------------
Return filing                   116 million         Assuming
                                returns filed in    withholding still
                                1995                required, number
                                                    possibly lower
                                                    than now,
                                                    depending on
                                                    personal
                                                    deductions or
                                                    allowances;
                                                    separate
                                                    individual and
                                                    business returns
                                                    possibly filed by
                                                    self-employed
                                                    individuals

Records kept                    Records supporting  Information
                                tax returns         returns kept as
                                supposed to be      primary source of
                                kept--e.g.,         information for
                                receipts, proof of  wages but not
                                payment, and        needed for
                                documentation       savings;
                                supporting          individuals
                                deductions and      responsible if
                                credits; burden     companies do not
                                alleviated by       furnish
                                information         information
                                reports given to
                                individuals

Calculations made               Complicated         Dependency
                                calculations for    calculations still
                                some taxpayers      needed but
                                included for        computations for
                                provisions such as  eliminated items,
                                dependency tests    such as capital
                                and capital gains   gains, not needed

Complexity faced                Many pages of       Complexity reduced
                                instructions        because many
                                involved and        income and all
                                millions of         itemized deduction
                                supplemental forms  items eliminated;
                                and schedules       complexity added
                                filed--e.g., 33     if broad range of
                                million schedules   fringe benefits
                                of itemized         taxed at
                                deductions for tax  individual level;
                                year 1994;          difficulties in
                                difficulties        defining and
                                existing in         recognizing income
                                defining and        reduced
                                recognizing
                                income; however,
                                in actual
                                practice, minimal
                                complexity faced
                                by millions of
                                individuals
----------------------------------------------------------------------
Source:  GAO analysis of available information about the
Hall-Rabushka flat tax. 


      TAX BASE
----------------------------------------------------- Appendix VII:2.1

The principal differences in the base of the individual flat tax and
the base of the individual income tax are that the Hall-Rabushka flat
tax (1) eliminates taxation of savings and investment earnings at the
individual level, including interest, dividends, and capital gains;
and (2) excludes deductions or credits, such as those for home
mortgage interest, charitable contributions, and child and dependent
care.\4 The reduction in complexity of the tax base resulting from
eliminating the itemization of income items and deductions should
relieve the burden on some individual taxpayers by ridding the system
of complex rules and supplemental forms accompanying the eliminated
items. 

Hall and Rabushka advocate taxing all types of nonsavings income,
particularly all fringe benefits including the employer's Social
Security contribution, in order to have the lowest possible tax
rates.  The Hall-Rabushka approach accomplishes this by not allowing
a deduction for fringe benefits at the business level.  However, Hall
and Rabushka advocate that fringe benefits other than retirement
benefits no longer be furnished by businesses but, instead, be
purchased by individuals.  Whether the individual's compensation
would be increased to offset this is not clear, but Hall and Rabushka
assert that "Were the tax system neutral, with equal taxes on fringes
and cash, workers would rather take their income in cash and make
their own decisions about health and life insurance, parking,
exercise facilities, and all the other things they now get from their
employers without much choice."\5 There are, however, reasons why
businesses may want to provide fringe benefits, and whether the many
varieties of fringe benefits would, in fact, be eliminated or taxed
at the business level under a flat tax is uncertain. 

Administration of these fringe benefits under the Hall-Rabushka tax
could be problematic.  Tax-exempt entities might have to remit tax on
the value of employees' fringe benefits, or if an approach not
advocated by Hall and Rabushka were adopted and the employee paid the
tax on fringe benefits, businesses could have to report their value
to both the tax agency and the taxpayer.  In this report, we identify
areas where the treatment of fringe benefits might be troublesome for
the taxpayer or the tax administrator. 


--------------------
\4 Fringe benefits are taxed in the Hall-Rabushka flat tax, but not
at the individual level. 

\5 Hall and Rabushka, p.  63.  Also, one tax preparer--Vernon Hoven,
"Flat Tax As Seen by a Tax Preparer," Tax Notes, Vol.  68, No.  6
(Aug.  7, 1995), pp.  747-55--cites as an example of the difficulties
that might be involved a parking lot purchased for use by
employees--the land, which may be deductible as a business expense,
might no longer be deductible because it becomes a fringe benefit. 
The question, then, could be whether the employees would be required
to pay tax on the fringe benefit, in which case their burden, as well
as the burden for the business, which would have to calculate and
report the value to the individuals, and the burden for the tax
administrators would be increased. 


      NUMBER OF INDIVIDUAL
      TAXPAYERS
----------------------------------------------------- Appendix VII:2.2

The individual side of the flat tax likely would include no more than
the number of individuals reporting under the current income tax--a
maximum of 116 million taxpayers (in 1995 terms), depending on the
threshold level for personal deductions and allowances.  Some of
these individuals might report as businesses--sole proprietorships,
partnerships, and S corporations--under the flat tax, but they also
might want to report some part of their income as wages to obtain the
personal allowances.  The individual tax could be set up so that only
those with income above a threshold level (including deductions and
personal allowances) or who are due a refund would be required to
file and pay the tax, similar to the current system.  The
Hall-Rabushka flat tax framework has personal allowances of $16,500
for married couples filing jointly, $9,500 for single filers, $14,000
for single heads of household, and a $4,500-deduction for each
dependent.\6 All are higher than the current allowances.  In 1993,
the likely maximum number of filers would have been 65 million with
the Hall-Rabushka allowances, based on the number of taxpayers who
had wage or pension income above the personal allowance levels that
year. 


--------------------
\6 Hall and Rabushka, p.  59. 


      INFORMATION REPORTED AND
      FILING FREQUENCY
----------------------------------------------------- Appendix VII:2.3

Unlike the RST and the VAT, the flat tax would require individuals to
keep records, file returns, and pay taxes.  However, the form for
individuals could be much simpler than the current income tax form,
assuming no specific deductions were introduced, but individuals
would be required to do the calculations necessary to claim
deductions and personal allowances.  Because, however, individuals
would not have to report earnings from interest, dividends, and
capital gains, their difficulties in defining and recognizing income
would be reduced.  With a flat tax, an individual would report the
following: 

  -- wages,

  -- salaries,

  -- pension income, and

  -- retirement benefits when received. 

Retirement benefits would be included in the wage tax, but other
fringe benefits probably would be taxed under the business tax. 
However, if contrary to the apparent Hall-Rabushka approach, a
variety of fringe benefits were included in individual taxes,
individual taxpayers would have to report them to the tax agency,
increasing their burden and the burden for businesses, which would
probably be required to provide taxpayer information to the taxpayer
and the tax agency. 

Information reporting by employers, which is currently done with
duplicate records of the amounts paid being sent to the taxpayer and
the government, likely would alleviate the need for further
recordkeeping for most individual taxpayers.  With a flat tax of this
type, a return-free filing system possibly could be designed so that
some individuals might have only limited contact with the tax agency. 

Filing and payment of a flat tax likely could be on a schedule much
similar to the current income tax--filing annually and paying through
payroll deduction or quarterly estimated taxes.  With automated
information reporting by employers to individuals, probably few
documents would need to be retained.  And if individuals filed
simpler forms, greater possibilities for automation advancements,
such as telefile, might follow. 


      TAX RATES
----------------------------------------------------- Appendix VII:2.4

A single tax rate would be applied to all individuals having incomes
above levels of personal allowances and deductions for dependents. 
Individuals would be required to make the calculations to determine
deductions, and thus, properly claiming dependents, which has proven
troublesome in the current system, would continue as a problem area. 

The one rate necessary to raise the same amount of revenue as the
current multiple-rate income tax coupled with the tax base changes
could result in considerable change for some individual taxpayers.\7
However, as the Congressional Research Service has alluded to, there
would be little compliance burden change for those individuals who
currently take the standard deduction and pay no tax or are taxed at
the 15-percent rate.\8 Evasion incentives would vary, depending on
the impact of the changes, but the simplicity of the tax plus
information reporting of wages might deter some evasion. 


--------------------
\7 Hall and Rabushka suggested a rate of 19 percent.  Other proposals
range from 17 to 20 percent. 

\8 Congressional Research Service, Flat Taxes:  Simplification and
Compliance Issues (May 10, 1996). 


      CREDITS/REFUNDS
----------------------------------------------------- Appendix VII:2.5

Under the Hall-Rabushka flat tax, refunds would be available for
those whose personal allowances and deductions exceed their income. 
For those tax filers with salary and wage income, refunds may not be
difficult for the tax agency to verify if information returns reflect
both the wages and the taxes withheld. 


   TAXATION OF BUSINESS TAXPAYERS
   AND POTENTIAL IMPACT ON
   BUSINESS TAXPAYERS' COMPLIANCE
   BURDEN
------------------------------------------------------- Appendix VII:3

A summary of some of the potential impacts of a flat tax on business
taxpayers is shown in table VII.3 and elaborated on afterward. 



                              Table VII.3
                
                Summary of Some Key Potential Impacts of
                    a Flat Tax on Business Taxpayers

                                Characteristics of
                                taxpayer
                                compliance burden   Impact of the flat
                                under the current   tax on business
Burden                          income tax          taxpayers
------------------------------  ------------------  ------------------
Return filing                   24 million returns  All businesses
                                filed in 1995       included

Records kept                    Records supporting  Businesses
                                income and          responsible for
                                expenses supposed   wage reporting to
                                to be kept          individuals;
                                                    records for items
                                                    such as
                                                    depreciation not
                                                    needed except for
                                                    possible
                                                    transition

Calculations made               Complicated         Fewer
                                calculations        calculations, such
                                included for        as for
                                provisions such as  depreciation and
                                depreciation, the   multiple rates,
                                alternative         required; possible
                                minimum tax, and    fringe benefit
                                the foreign tax     calculations
                                credit

Complexity faced                Detailed rules      Without exemptions
                                involved;           and multiple
                                complexity          rates, tax
                                reflected in areas  simplified; fringe
                                such as             benefits
                                depreciation, the   calculations
                                alternative         complicated, if
                                minimum tax, and    broad range taxed
                                the foreign tax     at individual
                                credit;             level
                                difficulties
                                existing in
                                defining and
                                recognizing income

Requirement to furnish          1.1 billion         Returns still
information returns             information and     needed for wages,
                                withholding         but not for
                                documents filed     investment
                                                    earnings;
                                                    withholding
                                                    possibly still
                                                    required
----------------------------------------------------------------------
Source:  GAO analysis of available information about the
Hall-Rabushka flat tax. 


      TAX BASE
----------------------------------------------------- Appendix VII:3.1

A business remitting a flat tax would calculate, report, and remit
taxes on its gross receipts (or sales) minus the cost of goods and
services (or purchases), including investments for capital goods,
minus wages, salaries, and pensions and retirement benefits. 


      NUMBER OF BUSINESS TAXPAYERS
----------------------------------------------------- Appendix VII:3.2

A maximum of about 24 million taxpayers (as of 1995) would be
included in the business flat tax if all corporations, partnerships,
and nonfarm and farm sole proprietors remitted as businesses.  Sole
proprietors might want to pay themselves a wage in order to take the
personal allowance deductions available with the individual tax, and
they might take all income earned as commissions, for example, as
personal wages.  Nevertheless, most would probably file as businesses
to deduct their expenses--that is, purchases of goods and services,
purchases of capital equipment, and wages paid. 


      INFORMATION REPORTING AND
      FILING FREQUENCY
----------------------------------------------------- Appendix VII:3.3

With a Hall-Rabushka style of flat tax, a business would need records
for the following: 

  -- gross receipts from sales;

  -- gross amount of purchases or inputs (goods and services),
     including capital investment;

  -- amount of employee wages and salaries; and

  -- amount of employee pensions and retirement benefits. 

Businesses likely would be required to submit to both their employees
and the tax agency information returns, similar to the present W-2
forms, showing employees' wages and salaries.  In addition, pensions
and retirement benefits (and perhaps other fringe benefits) would
have to be calculated and reported.  With a flat tax, preparation of
Forms 1099 for investments could be eliminated for returns from
savings and investments.  Furthermore, calculations of items such as
depreciation, alternative minimum tax, and foreign-source income and
foreign tax credits would be eliminated, unless there was a period of
transition in which calculations for both a flat tax and an income
tax would be required.  Businesses, of course, might continue to
calculate depreciation for their own financial statements or other
business reasons. 

Accounting methods for a flat tax could mirror current standard
accounting methods and accrual accounting would not be required for
tax purposes.  Even for self-employed individuals, reporting of the
above items would seem to duplicate information businesses should
keep on hand.  However, if contrary to Hall and Rabushka, fringe
benefits were taxed on the individual level, estimating and reporting
their value could be difficult for companies, as well as tax-exempt
entities, providing a wide array of employee benefits, such as
insurance, stock options, gym facilities, parking privileges,
cafeteria plans, and other items that are difficult to evaluate. 

Businesses probably would be required to file tax returns and make
tax remittances on schedules similar to the current business income
and employment tax schedules, which vary based on the type and amount
of tax.  Special rules might apply to new businesses until a basis
for the amount of tax due is determined. 


      TAX RATES
----------------------------------------------------- Appendix VII:3.4

With a flat tax, one tax rate other than a zero rate would apply to
both individuals and businesses, making it generally futile for
either type of taxpayer to attempt to shift income.  Businesses,
however, would have an incentive to shift income to individuals in
the form of wages so the individuals could take advantage of personal
allowances. 


      CREDITS/REFUNDS
----------------------------------------------------- Appendix VII:3.5

Businesses starting or expanding operations would likely have large
capital investment expenditures deductible from their gross receipts,
which could put them into negative tax situations.  Under the
Hall-Rabushka flat tax, no refunds would be given when a business'
start-up costs exceed its income, but the losses could be carried
forward indefinitely and a market rate of interest would be paid on
them by the government.  End-of-year purchases of inventory also
could reduce taxes and create refund carryover situations.  The tax
agency would have the burden of administering these carryover
credits. 

The Hall-Rabushka model is an origin-based tax, which taxes only a
business' domestic operations and provides no border adjustments for
exports as is done now with VATs.  While this does not address the
concerns of major exporters who wish to recover their export taxes,
it relieves the tax agency from administering border adjustments, a
cost saving to the administrator.  (See app.  VI for a discussion of
administering border adjustments with a VAT.)


   FLAT TAX COMPLIANCE COSTS
------------------------------------------------------- Appendix VII:4

A flat tax requiring both businesses and individuals to file returns
would not have as great an impact on alleviating the compliance
burden as would a tax, such as a VAT, which requires only businesses
to comply.  If all individuals were required to file, if only to
establish personal deductions for tax exemption, a certain amount of
compliance burden would be continued.  Nevertheless, a flat tax,
unencumbered by exemptions and multiple rates, by virtue of its
simplicity would offer the possibility of substantial reduction from
the current income tax in compliance burden for both individuals and
businesses--some of which might also be possible with simplification
of the current tax. 

No reliable data exist with which to evaluate with any precision the
compliance burden of a potential flat tax.  Slemrod estimated the
compliance costs overall at about half of his rough estimate for the
current system--cutting business compliance costs by about one-third
and personal compliance costs by 70 percent.\9 Hall estimated a lower
cost than Slemrod, using the model developed for IRS, which had the
limitations described in appendix II.\10

The treatment of fringe benefits--whether or not a business or
individual has to determine the value of fringe benefits in order to
pay tax on them--would affect the degree of simplicity and costs of
compliance with a flat tax.  Another concern that would influence
compliance costs is the type of transition, if any, from an income
tax to a flat tax.  While individuals might not be affected by double
taxation of existing savings, which could occur with some consumption
taxes, a transition period might be needed to shelter existing
capital assets of businesses.  If there were a transition period,
many businesses could find themselves complying with both a new flat
tax and the remaining elements of the existing income tax. 


--------------------
\9 See Joel Slemrod, "Which Is the Simplest Tax System of Them All?"
in Henry J.  Aaron and William G.  Gale, eds., Economic Effects of
Fundamental Tax Reform (Washington, D.C.:  Brookings Institution
Press, 1996), pp.  374-75. 

\10 See Arthur P.  Hall, "Compliance Costs of Alternative Tax
Systems," Tax Notes, Vol.  71, No.  8 (May 20, 1996), pp.  1088-89. 


   POTENTIAL IMPACT ON TAX
   ADMINISTRATORS
------------------------------------------------------- Appendix VII:5

A summary of some of the potential impacts of a flat tax on tax
administrators is shown in table VII.4 and elaborated on afterward. 



                              Table VII.4
                
                Summary of Some Key Potential Impacts of
                    a Flat Tax on Tax Administrators

Item                        Current income tax    Flat tax
--------------------------  --------------------  --------------------
Impact on number of         Hundreds of millions  Returns simplified;
returns processed           of returns and other  assuming withholding
                            materials received    still required,
                                                  number of tax
                                                  returns possibly
                                                  almost the same, but
                                                  number of
                                                  information returns
                                                  needed much lower
                                                  because interest and
                                                  dividends not taxed

Impact on refund            92 million refunds    Refunds for excess
processing                  issued in fiscal      payment required for
                            year 1995             individuals;
                                                  verification needed

Impact on examination       Tax returns matched   Verifying
approach                    with information      individuals' taxes
                            returns; fiscal year  simplified, but
                            1995 examination      auditing business'
                            coverage at 1.36      own records still
                            percent, with         needed
                            corporate audits
                            taking longer than
                            individuals' audits

Continuation of old         Compliance problems   Compliance problems
compliance problems         related to income     with transfer
                            definition,           pricing, business
                            unreported income,    and personal expense
                            and more specific     distinctions,
                            issues identified in  independent
                            other areas such as   contractors, small
                            transfer pricing,     businesses,
                            depreciation,         unreported income,
                            deductibility of      and underground
                            business expenses,    economy continued
                            small businesses,
                            independent
                            contractors, and the
                            underground economy

Resolution of old           Not applicable        Compliance problems
compliance problems                               with depreciation
                                                  and related to
                                                  income definition
                                                  eliminated

Creation of new compliance  Not applicable        Tax avoidance
problems                                          encouraged for
                                                  employees paid in
                                                  ways other than cash
                                                  and sales
                                                  characterized as
                                                  interest received;
                                                  possible fringe
                                                  benefits audits
                                                  complicated

Impact on collections from  Millions of taxpayer  Need for collection
tax delinquents             delinquent            follow-up for
                            investigations and    individual taxpayers
                            accounts disposed     reduced by less
                            of, with most of the  information matching
                            latter being for      and elimination of
                            individuals and most  audit issues; small
                            business              business problems
                            dispositions          possibly mirroring
                            covering employment   current employment
                            taxes                 tax collection
                                                  problems

Impact on individuals'      Millions of taxpayer  Some types of
questions received          inquiries fielded,    taxpayer questions
                            covering a wide       eliminated when
                            variety of questions  income and deduction
                                                  items eliminated
----------------------------------------------------------------------
Source:  GAO analysis of available information about the
Hall-Rabushka flat tax. 


      PROCESSING OF RETURNS
----------------------------------------------------- Appendix VII:5.1

With a flat tax, a tax agency might process almost the same number of
tax returns as the 122 million in the current system (in 1995), since
both individuals and businesses would continue to file returns and
remit taxes; however, the level of personal allowances and deductions
available could affect that number considerably.  Filing and
remittance schedules could mirror the present system, with filing
required annually and remittance at intervals, depending on the type
of taxpayer and amount of tax to be remitted.  Forms, such as W-2s
submitted by businesses for each employee, would require processing
and document matching.  However, the information now reported on Form
1099 would not be needed by the tax agency because savings and
investment earnings would not be taxed. 

Eliminating the many deductions now itemized by some taxpayers
simplifies the return so that individual taxpayers would only submit
a form with about 12 lines, and businesses only 10 lines.  Return
processing should be simpler as a result.  Any variations from the
Hall-Rabushka flat tax design, by introducing other deductions or
credits, could complicate the administration of the tax. 

The large numbers of taxpayers and returns would require retaining
the current emphasis on such uses of automation as scanning and
electronic filing.  The much simpler form would seem to facilitate
automation of data entry and document matching, making the process
less error-prone and costly and providing timely data for auditors. 
As with other tax proposals, the status of IRS' Tax Systems
Modernization at the time of the inception of a new tax would be
critical for its administration.  Hall and Rabushka do not suggest
exempting small businesses from tax, as is done in some countries'
VAT systems to alleviate taxpayer and tax agency burden.  Claims for
credits might not be a significant processing item, but as discussed
above, other types of refunds or credits might be claimed by both
individuals and businesses. 


      AUDIT/EXAMINATION
----------------------------------------------------- Appendix VII:5.2

Given the current success in collecting taxes through withholding,
tax avoidance would seem to be difficult for individual wage earners
whose companies reported earnings and taxes withheld, thus performing
a compliance function the government would have to do otherwise.  The
personal allowances and dependent deductions would seem to have less
room for cheating if Social Security numbers were required for
claiming dependents, as is done now with the income tax.  Auditing
could get complicated, however, depending on the extent that the
system was circumvented by paying employees in ways other than cash
or by transforming payments into savings or investments. 

Verification of businesses' records of sales and purchases and their
payments to employees probably would be the largest component of a
tax agency's audit effort.  As in the current system, these records
are kept by the businesses themselves, and the opportunity for
erroneous reporting is present.  Checking for such things as
underreported sales or overreported purchases can be time-consuming
and difficult for a tax agency to audit.  As the 1995 study published
by the American Institute of Certified Public Accountants pointed
out, claims of business expenses (deductible) may be difficult to
separate from personal expenses (nondeductible), similar to the
current situation.\11

Validity of these expense claims has been one of IRS' ongoing audit
and post-audit problems and probably would not be improved with a
flat tax.  Depending on the prevailing tax rate, such problems could
be exacerbated.  For self-employed individuals, the self-reporting of
earnings could be problematic.  Reporting by sole proprietors has
been shown to be particularly troublesome in the current system. 

A scoring system, such as IRS has now for identifying which returns
to audit by looking at audit potential, would probably have to be
developed for a flat tax.  Since no country has tried a flat tax
similar to the Hall-Rabushka model, the United States has no other
experience to rely upon beyond the current income tax system, and it
could take some time to fully develop a scoring system. 

From a tax administration viewpoint, any complications through
multiple rates or further deductions to address regressivity or other
concerns are likely to be costly and very difficult to administer
with a flat tax, similar to a subtraction VAT, which we previously
said would not function properly with multiple rates.\12 Excluding
individuals with incomes below specified levels from paying taxes,
receiving refunds, and filing returns alleviates taxpayer burdens and
reduces the number of returns to be processed; however, tax
administrators may still need to verify claims for exclusion. 
Conversely, if any programs such as the earned income credit were
administered, they might be delivered to low-income recipients
through the tax system, as is done here and internationally through
income tax systems, increasing the number and complexity of returns
filed as well as the cost of administration.  Similarly, small
businesses might be excluded from a flat tax, as is done with
international consumption taxes, but administratively, ascertaining
the validity of a business' claim for exemption could be very
difficult, similar to a subtraction VAT.  None of these variations is
in the Hall-Rabushka tax design. 

Enforcement efforts probably would still need to emphasize many of
the current areas of noncompliance.  There is no credit/invoice
system, such as exists with a credit VAT, to give at least an
appearance of automatic enforcement.  Issues of noncompliance, such
as with sole proprietors/independent contractors, now troublesome to
IRS, would not likely change much with a flat tax, and there is
nothing apparent in this tax system that would solve the current
problems with underreported or unreported income, particularly of
small businesses.  Abusive transfer pricing, long an enforcement
concern for IRS, also would continue to be a problem with the flat
tax, as Grubert and Newlon have noted.\13

Abusive transfer pricing occurs when prices claimed for transactions
between related companies operating in different jurisdictions are
set too high or too low, and income is, in effect, shifted from one
jurisdiction to another, resulting in tax underremittance. 

New noncompliance problems could arise, similar to those found in
other consumption tax situations.  For example, as alluded to in the
1996 Economic Report of the President, an incentive would exist for
businesses to characterize part of their sales as interest payments
payable by buyers by reducing the sales price (taxable) and
offsetting this by raising the interest paid (nontaxable to the
businesses).  Shifting sales to interest payments would give the
business a tax advantage, and detecting this through enforcement
efforts could be difficult. 

An underground economy would seem to be able to operate in much the
same way with a flat tax as with the current system, because no
obvious deterrent would seem to be available to prevent both legal
and illegal transactions from occurring outside the tax system.  It
is difficult to determine the impact any consumption tax would have
on the underground economy. 


--------------------
\11 Martin A.  Sullivan, Flat Taxes and Consumption Taxes:  A Guide
to the Debate (New York:  American Institute of Certified Public
Accountants, Dec.  1995), p.  111. 

\12 See Tax Policy:  Tax-Credit and Subtraction Methods of
Calculating a Value-Added Tax (GAO/GGD-89-87, June 20, 1989), p.  5. 

\13 Harry Grubert and T.  Scott Newlon, "The International
Implications of Consumption Tax Proposals," National Tax Journal,
Vol.  XLVIII, No.  4 (Dec.  1995), p.  637. 


      CREDITS/REFUNDS
----------------------------------------------------- Appendix VII:5.3

With a flat tax, as with VATs, new businesses could have purchases
and employee compensation costs exceeding sales.  This could put the
new business into a negative cash flow situation, potentially
detrimental to the business' future.  Not only would the business
need to be able to claim a refund, but, as we assumed in an earlier
study, it would also likely prefer the refund to be in cash, rather
than as a carry-forward credit as specified by Hall and Rabushka.\14
If, contrary to Hall and Rabushka, refunds were allowed, a tax agency
would need to have a system that could rebate the money quickly
without jeopardizing government funds. 

Unlike VATs used internationally, the flat tax as outlined by Hall
and Rabushka would not include border adjustments to tax imports and
rebate taxes on exports.  This would eliminate a potentially
difficult administrative responsibility, including identifying
fraudulent claims of exports that we pointed out in our 1993 VAT
study.\15 However, transfer pricing, mentioned above as a large audit
issue in the current system, would remain. 


--------------------
\14 See Tax Policy:  Value-Added Tax:  Administrative Costs Vary With
Complexity and Number of Businesses (GAO/GGD-93-78, May 3, 1993), p. 
115. 

\15 See GAO/GGD-93-78, pp.  33 and 57. 


      COLLECTIONS
----------------------------------------------------- Appendix VII:5.4

Collection efforts might change somewhat with a flat tax.  If
information reports of earnings from savings and investments (Forms
1099) were no longer necessary and if audit issues associated with
capital gains and itemized deductions disappeared, matches with
taxpayer data and related audit issues and findings should also
decline.  This, in turn, would affect the need for collection
follow-up with individuals, where most of the collection issues have
arisen. 


      TAXPAYER SERVICES
----------------------------------------------------- Appendix VII:5.5

As with any new system, taxpayer services would require an initial
education period, with additional resources required for
publications, assistance through telephones and other
telecommunications, and taxpayer education programs.  The individual
component of the flat tax, however, would appear to be simple enough
in many ways so that taxpayers could have less difficulty
understanding it than the current income tax.  Entire areas of
questions, such as those for capital gains and losses and medical
expenses, might virtually disappear, although others, such as those
for dependents and filing status, would likely continue. 

Information about IRS' current taxpayer services effort, discussed in
appendix II, shows that about 10 percent of the tax law questions
received by IRS' technical support staff concerned the dependent or
exemption or filing status of taxpayers.  Many of these questions
would likely continue with the flat tax.  Some frequent stumbling
blocks, such as inquiries about capital gains and losses, could be
eliminated by the flat tax. 

The business part of the tax could require initial education effort
and auditor time for some period to ensure maximum clarity and,
hopefully, compliance.  Education is thought by many to be the key to
compliance, and efforts along these lines should not be undervalued
for any tax change. 

The transition to a flat tax likely would require taxpayer education
because a flat tax would change the way such things as capital
investment would be treated--that is, by expensing on a current basis
rather than depreciating over a longer period.  If the transition
occurred while features of the income tax were still operative,
taxpayers might have to comply with both systems for a period of time
and likely would require more extensive taxpayer education and
services. 


   OTHER ISSUES
------------------------------------------------------- Appendix VII:6


      TRANSITION
----------------------------------------------------- Appendix VII:6.1

The familiarity of taxpayers with the current tax system should ease
a transition to a flat tax if a transition were desired. 
Nevertheless, accounting and reporting requirements with a flat tax
would require time for businesses to convert to the new system. 
Furthermore, some portions of the current system might be continued
during a transition period.  For example, businesses that under the
current system had been depreciating their capital expenditures would
be subject to immediate expensing with a flat tax.  However, the
negative ramifications of this might be offset by continuing to
depreciate assets during a transition period, making the transition
more difficult and lengthy for the business taxpayer and complicating
auditing and collections for the tax administrator.  A transition to
a flat tax also could be designed to continue carrying forward
existing net operating losses, and existing tax credits could be
phased out during a transition period.  Even though earnings from
savings are not taxed with a flat tax, moving to a consumption tax
could result in some individuals' preenactment savings being taxed
when earned (as income), and also when spent (as consumption) under
the flat tax unless some special provisions were designed for this. 
Such adjustments could occur during transition. 

The tax agency would need some time and resources for educating the
public about the changes, particularly for business taxpayers.  If,
as proposed, wages and pensions were generally the only items taxed
to individuals, transition for individuals would be much simplified. 
Overall, the flat tax, with one rate and no exemptions, would seem to
be less cumbersome to introduce than would a more complicated tax
system. 


      FEDERAL/STATE ISSUES
----------------------------------------------------- Appendix VII:6.2

Because a flat tax would operate much like the current tax system, it
probably would cause fewer areas of uncertainty than a more drastic
change to a transaction tax, such as a credit VAT, discussed in
appendix VI, or a national RST, discussed in appendix V.  However,
the base of the individual tax, with only wages and pensions, would
affect the amount of collections in states that based their taxes on
the current broad base of the federal system unless they adjusted
their rates to compensate for the loss.  States could devise ways to
accommodate the new system, such as by adjusting their income tax
base to conform with the flat tax and raising the rate to compensate
for the narrower base. 


      INTERNATIONAL ISSUES
----------------------------------------------------- Appendix VII:6.3

In Hall and Rabushka's opinion, the flat tax would be desirable
because their proposed "low" tax rate of 19 percent would attract
international businesses, even though overseas earnings of American
workers and businesses would not be taxed.\16 Although Hall and
Rabushka would not tax the foreign earnings of Americans, all
earnings from work in the United States would be taxed, regardless of
the worker's citizenship. 

The flat tax, as envisioned by Hall and Rabushka, uses the origin
principle for international taxation, rather than the destination
principle now used widely with VATs.  Under the origin principle,
imports are exempt from taxes and exports are taxable; thus, transfer
pricing problems would continue.  However, problems administering the
foreign tax credit would disappear.  The future of U.S.  bilateral
income tax treaties would be unclear, and other countries might
consider changing their own international taxation rules. 


--------------------
\16 Hall and Rabushka, p.  77. 


PERSONAL CONSUMPTION TAX
======================================================== Appendix VIII


   DESCRIPTION
------------------------------------------------------ Appendix VIII:1

Of the proposals that would replace the income tax with a consumption
tax, a personal consumption tax would look most like the current
personal income tax.  In general, under a personal consumption tax,
taxpayers add up all the funds they have received during the year and
then deduct the amount they saved.  The remaining amount is a measure
of the taxpayer's spending on goods and services for consumption over
the year, and this amount is subject to tax. 

Table VIII.1 shows some of the principal similarities and differences
between a personal consumption tax and the current individual income
tax.  The most basic similarity is that both are individual taxes, so
both can include features such as a standard deduction, personal
exemptions, and graduated tax rates.  The two taxes are also similar
in that many types of income now included under the current tax would
also be included in the personal consumption tax base.  In
particular, wages, pension income, and interest and dividend income
would be taxed under a personal consumption tax.\1



                              Table VIII.1
                
                  Comparison of the Current Income Tax
                    With a Personal Consumption Tax

                                                    Personal
Item                            Current income tax  consumption tax
------------------------------  ------------------  ------------------
Personal level
----------------------------------------------------------------------
Wages                           Included            Included

Interest income received        Included            Included

Dividends received              Included            Included

Pension income                  Included when       Included when
                                received            received

Loan proceeds                   Not included        Included

Sales of assets                 Capital gain        Proceeds included
                                included

New saving (purchases of        Generally not       Deducted
assets, deposits in qualified   deducted
accounts, loan repayments)

Job expenses (cost of earning   Certain costs       Deducted
income)                         deducted by
                                itemizers

Fringe benefits                 Not included        Allocated to
                                                    individuals by
                                                    business (if no
                                                    separate business
                                                    tax)
----------------------------------------------------------------------
Source:  GAO analysis of a personal consumption tax. 

The major difference between the two taxes lies in the treatment of
saving.  Under the current income tax, saving is generally not
deductible, and borrowed funds are not taxed.  Under a personal
consumption tax, new saving would generally be deductible.  For
example, amounts deposited in savings accounts or used to purchase
corporate stock or bonds could be deducted.  In addition, the
repayment of principal and the payment of interest on borrowed funds
would be deductible as saving.  However, under most personal
consumption tax proposals, borrowed funds would be taxable because
they could be used for consumption.  Similarly, upon the sale of an
asset, the entire proceeds of the sale would be taxable rather than
the gain (or loss) from the sale as under an income tax. 

Business purchases of consumer goods and services could pose problems
for a personal consumption tax, as they do under an income tax.\2 For
example, business purchases of automobiles, meals, entertainment, and
fringe benefits could represent consumption by the employees or
owners of the business and not really represent a cost of operating a
business.  Without some rules, there would be an incentive for
businesses to purchase these kinds of goods and services for their
owners and employees in order to avoid tax under the personal
consumption tax. 

This potential problem could be handled in two ways.  First,
businesses could be required to allocate spending on such consumption
items to the individuals receiving the benefits, and the individuals
could report this amount on their consumption tax returns.  The tax
rate applied to this form of consumption would then depend on the
individual's tax bracket.  This type of tax treatment is reflected in
the last line of table VIII.1 for fringe benefits. 

Alternatively, all businesses could be made subject to a cash flow
tax for which consumption-type expenditures would not be
deductible.\3 Under a cash flow tax, inflows of cash would generally
be taxable and outflows of cash would generally be deductible. 
Inflows would include business receipts, proceeds of sales of assets,
and borrowing.  As under a consumption value-added tax (VAT),
business purchases of goods and services used for business purposes
would be deductible, and purchases of investment goods, such as plant
and equipment, would be deductible immediately rather than
depreciated over time.  In addition, wages, dividends, and payments
for interest and repayment of borrowed funds would also be
deductible.  However, business purchases of consumption goods without
a business purpose would not be deductible, so consumption done at
the business level would effectively be taxed at the business' tax
rate.\4

Table VIII.2 compares a personal consumption tax and business cash
flow tax with the current income tax for both individuals and
businesses.  As under the personal consumption tax, and unlike an
income tax, the cash flow tax would include borrowed funds and all
the proceeds from asset sales rather than only capital gain or loss. 
Like the VAT and flat tax, and unlike an income tax, the purchase of
investment goods would be deductible immediately rather than
depreciated over time. 



                              Table VIII.2
                
                  Comparison of the Current Income Tax
                  With a Personal Consumption Tax and
                     Business Cash Flow Tax System

                                                    Personal
                                                    consumption tax
                                                    and business cash
Item                            Current income tax  flow tax
------------------------------  ------------------  ------------------
Business level
----------------------------------------------------------------------
Sales of goods and services     Included            Included

Sales of assets                 Gain included       Proceeds included

Loan proceeds                   Not included        Included

Purchases of goods and          Deducted            Deducted
services

Purchase of capital goods       Depreciated over    Deducted
                                time                immediately

Wages paid                      Deducted            Deducted

Fringe benefits                 Deducted            Not deducted

Interest paid                   Deducted            Deducted

Dividends paid                  Not deducted        Not deducted\a


Personal level
----------------------------------------------------------------------
Wages                           Included            Included

Interest income received        Included            Included

Dividends received              Included            Included

Pension income                  Included when       Included when
                                received            received

Loan proceeds                   Not included        Included

Sales of assets                 Capital gain        Proceeds included
                                included

New saving (purchases of        Generally not       Deducted
assets, deposits in qualified   deducted
accounts, loan repayments)

Job expenses (cost of earning   Certain costs       Deducted
income)                         deducted by
                                itemizers

Fringe benefits                 Not included        Not included
----------------------------------------------------------------------
\a Alternatively, the business cash flow tax could include proceeds
from new stock issues and allow a deduction for dividends paid. 

Source:  GAO analysis of a personal consumption tax and business cash
flow tax. 


--------------------
\1 For additional details on personal consumption taxes, see U.S. 
Department of the Treasury, Tax Reform for Fairness, Simplicity, and
Economic Growth, Ch.  9, "Consumed Income Tax," Vol.  1 (1984); David
F.  Bradford and the U.S.  Treasury Tax Policy Staff, Blueprints for
Basic Tax Reform, 2nd ed., revised (Arlington, Va.:  Tax Analysts,
1984); The Institute for Fiscal Studies, The Structure and Reform of
Direct Taxation:  Report of a Committee Chaired by Professor J.E. 
Meade (London:  George Allen and Unwin, 1978); Henry J.  Aaron and
Harvey Galper, Assessing Tax Reform (Washington, D.C.:  The Brookings
Institution, 1985); David F.  Bradford, Untangling the Income Tax,
Ch.  5, "Personal Consumption Taxes" (Cambridge, Mass.:  Harvard
University Press, 1986); and Michael J.  Graetz, "Expenditure Tax
Design," in Joseph A.  Pechman, ed., What Should Be Taxed:  Income or
Expenditure?  (Washington, D.C.:  The Brookings Institution, 1980). 

\2 See Aaron and Galper, p.  79. 

\3 For noncorporate businesses, the business cash flow tax rules
could be reflected in the individual tax return.  For example, sole
proprietorships could include the receipts and expenditures of the
business in their personal return, much like sole proprietors now
report their income on Schedule C of their personal income tax
return.  Alternatively, the business tax could be kept separate from
the individual tax.  All businesses (corporate and noncorporate)
would pay a cash flow tax and file separate returns, as under the
flat tax. 

\4 A business cash flow tax could serve several additional purposes. 
First, if transition rules are desired in converting to a consumption
tax, the business-level cash flow tax could allow businesses to claim
currently unused tax credits and deduct depreciation on existing
assets and net operating losses.  Second, the tax would tax
extraordinary returns to investment.  Third, the tax could be used to
tax U.S.-source activity of foreign corporations operating in the
United States. 


   POTENTIAL IMPACT ON TAXPAYERS'
   COMPLIANCE BURDEN
------------------------------------------------------ Appendix VIII:2

Table VIII.3 summarizes how a personal consumption/business cash flow
tax could affect taxpayers, and a more detailed discussion follows. 



                              Table VIII.3
                
                Summary of Some Key Potential Impacts of
                a Personal Consumption and Business Cash
                         Flow Tax on Taxpayers

                                Characteristics of  Impact of the
                                taxpayer            personal
                                compliance burden   consumption and
                                under the current   business cash flow
Burden                          income tax          tax on taxpayers
------------------------------  ------------------  ------------------
                                Burden on           Impact on
                                individual          individual
                                taxpayers           taxpayers

Return filing                   116 million         Number of returns
                                returns filed in    possibly increased
                                1995                with borrowing
                                                    included in the
                                                    tax base

Records kept                    Records supporting  Additional records
                                tax returns         needed on amounts
                                supposed to be      borrowed and
                                kept--e.g.,         amounts saved
                                receipts, proof of
                                payment, and
                                documentation
                                supporting
                                deductions and
                                credits; burden
                                alleviated by
                                information
                                reports given to
                                individuals

Calculations made               Complicated         Calculations of
                                calculations for    capital gains
                                some taxpayers      eliminated
                                included for
                                provisions such as
                                dependency tests
                                and capital gains

Complexity faced                Many pages of       New rules required
                                instructions        for saving
                                involved and        deduction and
                                millions of         inclusion of
                                supplemental forms  borrowing;
                                and schedules       measurement of
                                filed--e.g., 33     capital income
                                million schedules   simplified
                                of itemized
                                deductions for tax
                                year 1994;
                                difficulties
                                existing in
                                defining and
                                recognizing
                                income; however,
                                in actual
                                practice, minimal
                                complexity faced
                                by millions of
                                individuals

                                Burden on business  Impact on business
                                taxpayers           taxpayers

Return filing                   24 million returns  Similar number of
                                filed in 1995       returns, filing
                                                    frequency the same

Records kept                    Records supporting  Accrual accounting
                                income and          and depreciation
                                expenses supposed   records eliminated
                                to be kept          for tax purposes;
                                                    additional records
                                                    needed for
                                                    borrowing and
                                                    lending

Calculations made               Complicated         Accrual accounting
                                calculations        and depreciation
                                included for        calculations
                                provisions such as  eliminated for tax
                                depreciation, the   purposes
                                alternative
                                minimum tax, and
                                the foreign tax
                                credit

Complexity faced                Detailed rules      Accrual accounting
                                involved;           and depreciation
                                complexity          eliminated for tax
                                reflected in areas  purposes;
                                such as             alternative
                                depreciation, the   minimum tax and
                                alternative         foreign tax credit
                                minimum tax, and    eliminated
                                the foreign tax
                                credit;
                                difficulties
                                existing in
                                defining and
                                recognizing income

Requirement to furnish          1.1 billion         Reporting possibly
information returns             information and     more extensive
                                withholding
                                documents filed
----------------------------------------------------------------------
Source:  GAO analysis of available information about a personal
consumption and business cash flow tax. 


      FILING REQUIREMENTS
---------------------------------------------------- Appendix VIII:2.1

Under the current income tax system, filing requirements are
reflected in rules regarding filing status, the size of the standard
deduction, and personal exemptions.  The number of returns filed
depends on these rules and the extent of withholding.  Currently,
taxpayers file returns based on their filing status, which can be
single; head of household; married, filing jointly; married, filing
separately; or qualifying widow(er) with dependent child.  Taxpayers
are not required to file a return if they received less gross income
than the applicable standard deduction amount plus the value of the
minimum number of allowed personal exemptions.  However, taxpayers
with less income than these thresholds may still file a return to
claim a refund if taxes have been withheld during the year or if they
are eligible for a refundable credit such as the earned income tax
credit. 

Filing requirements for individual taxpayers under a personal
consumption tax could be very similar to current requirements.  For
example, the rules regarding filing status could remain the same as
under current law.  Similarly, taxpayers reporting less consumption
(or gross income) than the standard deduction and the value of
personal exemptions could be excused from annual filing.  In general,
the larger the standard deduction and value of personal exemptions,
the greater the number of taxpayers who could arrange to have no tax
withheld and would therefore not need to file.  However, taxpayers
who would not otherwise have to file could still find it advantageous
to file if a refundable credit program like the earned income credit
was retained. 

Apart from possible changes in the size of the standard deduction or
personal exemptions, a change in the tax base from income to
consumption could have an effect on the number of taxpayers filing
returns unless changes in withholding were also made.  For taxpayers
with primarily wage income who do little saving or borrowing, the
likelihood that they would have to file and the size of any remaining
tax payment or refund might not be very different than under the
current system.  However, as the Department of the Treasury pointed
out in its 1984 report on tax reform, for taxpayers who sold assets
or borrowed funds for consumption, withholding tax on wages alone
might not match their annual tax liability as closely as under the
current system.\5 Unless taxpayers adjusted the amount of tax
withheld, they might be more likely to have to file returns or pay
estimated taxes during the year.  Other taxpayers who saved
significant portions of their wage income could be entitled to
relatively large refunds and therefore might have to file.  This
situation could be addressed by extending withholding to asset sales
and borrowing, but this approach would put additional burden on the
businesses that would have to withhold tax. 


--------------------
\5 Treasury, pp.  202-03. 


      RECORDKEEPING REQUIREMENTS
---------------------------------------------------- Appendix VIII:2.2

Moving from the current income tax to a personal consumption tax
could lead to additional recordkeeping requirements for some
financial assets, reduce some requirements to maintain records over
time, and leave recordkeeping requirements for certain deductions
essentially unchanged.  Moving to a business cash flow tax could
substantially change how businesses keep records for tax purposes. 


         FINANCIAL ASSETS AND
         LIABILITIES
-------------------------------------------------- Appendix VIII:2.2.1

Many analysts believe that individual taxpayers would have to keep
more records under a personal consumption tax than under the current
system.\6 Unless information reporting was expanded, taxpayers would
need to keep records on amounts borrowed and saved during the year. 
Taxpayers do not have to keep records for these items under the
current system. 

Some discussions of potential personal consumption taxes have
suggested that for compliance reasons, only saving done through
qualified accounts in financial institutions should qualify for
deductions.\7 Qualified accounts would be similar to IRA accounts
under current law.  Other forms of saving, such as direct loans to
other individuals, would not be deductible, but repayments of such
saving would not be taxed.  If this approach was used, individuals
might be required to keep separate records on qualified and
nonqualified assets and liabilities. 

However, as Treasury noted in 1984, the need for taxpayers to keep
some records for long periods may decrease.\8 Under current law,
individuals must keep records on the original purchase price of
assets in order to calculate capital gains tax when assets are sold. 
Under a consumption tax, the original purchase price of an asset is
irrelevant for tax calculations because all sale proceeds are subject
to tax, so records related to the original purchase would not have to
be kept. 


--------------------
\6 See Treasury, p.  201; Harvey S.  Rosen, Public Finance, 3rd. 
ed., Ch.  20, "Taxes on Consumption and Wealth" (Burr Ridge, Ill.: 
Irwin, 1992), p.  509; and Charles E.  McLure, Jr., and George R. 
Zodrow, "Administrative Advantages of the Individual Tax Prepayment
Approach to the Direct Taxation of Consumption," in Manfred Rose,
ed., Heidelberg Congress on Taxing Consumption (June 28-30, 1989), p. 
347. 

\7 Treasury, p.  194. 

\8 Treasury, p.  196. 


         HOUSING
-------------------------------------------------- Appendix VIII:2.2.2

One of the more difficult issues for consumption taxation is the
taxation of consumer durable goods.\9 These goods can serve both as
consumption goods and as a form of saving.  A significant example of
this type of good is owner-occupied housing, which generates
consumption services for the owner and is a major investment for many
individuals.  If housing was treated like other saving or investment
under a personal consumption tax, the purchase of the house would be
deductible as saving and the income from the investment would then be
taxable.  In the case of owner-occupied housing, the income from the
investment is the value of the consumption services received by the
owner--the amount the owner would pay to rent the house.  However,
since there is no rent transaction for owner-occupied housing, a
value would have to be imputed either through appraisals or through
some approximation method.\10 Allowing a deduction for the purchase
of housing and ignoring the rental value of housing would undertax
owner-occupied housing relative to rental housing and other forms of
consumption.\11

Most discussions of personal consumption taxes have supported a "tax
prepayment" treatment for owner-occupied housing, or a modified
version of this approach.\12 Under the tax prepayment approach,
consumption tax would be paid when the house is purchased because the
amount borrowed for the mortgage and the funds withdrawn from
accounts for a down payment would be taxable.  The imputed rental
value of the housing services would not be taxed, and only the
capital gain rather than the entire sale price of the house would be
taxable if the house was sold.  While this approach may be easier to
administer than taxing imputed rent, it would require a large
one-time tax payment.  A modification of this approach would levy tax
only on the down payment, but not allow a deduction for repayment of
mortgage principal or interest, reducing the one-time tax payment. 
However, this modification would treat mortgage debt and interest
payments differently than other debt and interest, and rules to
define different types of debt would be necessary, as under current
law. 

Before 1997 changes to the income tax, more homeowners than afterward
were required to keep records on their purchases and sales of homes
over their lifetime in order to calculate any capital gains tax they
may have had upon sale.  Recordkeeping requirements under a personal
consumption tax would depend on the approach taken.  If the
modification of the prepayment approach was chosen, recordkeeping
requirements for owner-occupied housing could be similar to those in
effect before the recent changes in the law. 


--------------------
\9 See Graetz, p.  184 and Rosen, p.  506. 

\10 The same difficulty in taxing the return from owner-occupied
housing arises in the income tax.  (See app.  IV.)

\11 See Aaron and Galper, pp.  90-91. 

\12 See Graetz, pp.  193-97; Aaron and Galper, pp.  90-91; and
Laurence S.  Seidman, "The USA Tax:  A Friendly Critique of Its
Design," Tax Notes, Vol.  73, No.  7 (Nov.  18, 1996), pp.  834-37
for discussions of this treatment. 


         JOB AND BUSINESS EXPENSES
-------------------------------------------------- Appendix VIII:2.2.3

Some items that currently require detailed taxpayer recordkeeping
would remain issues because they concern determining whether certain
expenditures are legitimate business expenses or personal
consumption.  For example, deductions for job expenses, business
entertainment expenses, moving expenses, and business use of
automobiles would likely remain issues under a personal consumption
tax. 


         CASH FLOW BUSINESS TAX
-------------------------------------------------- Appendix VIII:2.2.4

Like some of the other consumption tax proposals, a cash flow tax
might simplify recordkeeping for business taxpayers.  For example,
businesses would not have to keep records according to accrual
accounting principles for tax purposes.  Like other purchases of
goods and services, investments in business plant and equipment or
inventories would be deducted immediately, rather than depreciated
over time or deducted when sold as under the income tax.  Thus,
taxpayers would not have to distinguish between expenditures that can
be deducted immediately and those that must be capitalized and
depreciated over time.  However, businesses would probably still
calculate depreciation on capital assets for financial statements and
other business purposes. 

However, unlike the VAT or the business tax component of the flat
tax, a cash flow tax would include financial transactions in the base
of the tax.  Borrowed funds would be included and repayments of loans
and interest would be deductible.  A VAT would be simpler than a cash
flow tax in this sense because fewer transactions would have to be
accounted for in computing tax liability.  However, to accomplish
this simplification, rules would have to be written to differentiate
purely financial transactions from the sale of goods and services.\13
A cash flow tax would include more transactions in its base but not
require such rules. 


--------------------
\13 Transactions involving interest payments, installment sales, and
leases can feature both an exchange of goods and services and
borrowing and lending funds between the parties. 


      CALCULATIONS NEEDED TO
      COMPUTE TAX LIABILITY
---------------------------------------------------- Appendix VIII:2.3

While, as mentioned above, the need for recordkeeping may expand in
some areas under a personal consumption tax, the need for taxpayers
to do calculations may decrease in others.  For example, although the
need to compute net savings would be introduced, calculating capital
gain or loss from the sale of an asset would no longer be necessary. 
Taxpayers who sell assets would have to keep records on the proceeds
of the sale, but all the proceeds of the sale would be taxable, not
only capital gain or loss. 

More generally, businesses and individuals would not have to
differentiate between the return of capital (original amounts
invested or saved) and the return on capital (income earned from
saving or investment).  Under an income tax, the return of capital is
not taxed, but the income earned from capital is taxed.  Under a
consumption tax, this distinction is not necessary because saving and
investment is deducted immediately and both the return of capital and
the return on capital are subject to tax. 

One area in which a personal consumption tax would be simpler than a
reformed income tax involves the need to make adjustments for
inflation.  Many analysts believe that inflation adjustments should
be made in the income tax because the measurement of income can be
significantly distorted when inflation is high.  The current income
tax does not have such adjustments explicitly and requiring them
might significantly complicate the income tax.  In contrast, a
personal consumption tax would not need to include inflation
adjustments.\14 Therefore, consumption tax proponents argue that
relative to an income tax that measures income correctly, the
consumption tax would require far fewer calculations. 


--------------------
\14 See McLure and Zodrow, pp.  344-45 and Treasury, p.  197. 


   POTENTIAL IMPACT ON TAX
   ADMINISTRATORS
------------------------------------------------------ Appendix VIII:3

Table VIII.4 summarizes some of the ways in which a personal
consumption and business cash flow tax could affect tax
administrators, and a more detailed discussion follows. 



                              Table VIII.4
                
                Summary of Some Key Potential Impacts of
                a Personal Consumption and Business Cash
                     Flow Tax on Tax Administrators

                                                    Personal
                                                    consumption and
                                                    business cash flow
Item                            Current income tax  tax
------------------------------  ------------------  ------------------
Impact on number of returns     Hundreds of         Possibly more
processed                       millions of         individual,
                                returns and other   information
                                materials received  returns

Impact on refund processing     92 million refunds  If withholding
                                issued in fiscal    done only on
                                year 1995           wages, savers more
                                                    likely to get
                                                    refunds, borrowers
                                                    less likely to get
                                                    refunds

Impact on examination approach  Tax returns         Potentially
                                matched with        expanded matching
                                information         of tax returns
                                returns; fiscal     with information
                                year 1995           returns; auditing
                                examination         cash flow
                                coverage at 1.36    calculations
                                percent, with       possibly easier
                                corporate audits    than auditing
                                taking longer than  accrued income;
                                individuals'        more focus on
                                audits              identifying
                                                    unreported income

Continuation of old compliance  Compliance          Compliance
problems                        problems related    problems continued
                                to income           with certain
                                definition,         business expenses,
                                unreported income,  unreported income
                                and more specific   or receipts
                                issues identified
                                in areas such as
                                transfer pricing,
                                depreciation,
                                deductibility of
                                business expenses,
                                small businesses,
                                independent
                                contractors, and
                                the underground
                                economy

Resolution of old compliance    Not applicable      Disputes
problems                                            concerning
                                                    deduction or
                                                    capitalization of
                                                    business purchases
                                                    eliminated,
                                                    identification of
                                                    nonfilers improved
                                                    if expanded
                                                    information
                                                    reporting

Creation of new compliance      Not applicable      Increased
problems                                            incentive to not
                                                    report asset
                                                    sales, incentives
                                                    created to not
                                                    report borrowing
                                                    and to overstate
                                                    amounts saved

Impact on collections from tax  Millions of         More delinquent
delinquents                     taxpayer            taxpayers possibly
                                delinquent          identified by more
                                investigations and  information
                                accounts disposed   reporting and
                                of, with most of    matching
                                the latter being
                                for individuals
                                and most business
                                dispositions
                                covering
                                employment taxes

Impact on individuals'          Millions of         Most issues
questions received              taxpayer inquiries  generating
                                fielded, covering   questions
                                a wide variety of   continued; new
                                questions           questions
                                                    concerning
                                                    deduction of
                                                    saving and
                                                    inclusion of
                                                    borrowing likely;
                                                    capital gains no
                                                    longer relevant
----------------------------------------------------------------------
Source:  GAO analysis of available information about a personal
consumption and business cash flow tax. 


      PROCESSING OF RETURNS
---------------------------------------------------- Appendix VIII:3.1

As under the current tax administration system, the tax agency would
need to process returns from individuals and businesses under a
personal consumption tax and business cash flow tax.  Since
individuals would continue to file returns, moving to all-electronic
filing and processing would be more difficult than for a
business-only tax.  The other core tasks of returns processing, such
as sorting returns, transcribing return information to taxpayer
accounts, and maintaining those accounts, could remain the same as
under the current system. 

The number of information returns could increase because the tax base
for a personal consumption tax includes many of the items now subject
to information reporting and also includes some additional items. 
First, expanding information reporting to include loans may be
necessary since loans would be included in the tax base.  Second,
funds that are saved would also generate a deduction, so it may also
be useful for compliance reasons to require information reporting on
amounts saved.  However, additional information returns would add to
the processing workload and would add to the compliance burden of the
businesses completing and filing the returns. 


      ENFORCEMENT AND COMPLIANCE
---------------------------------------------------- Appendix VIII:3.2

Unlike the VAT and the retail sales tax, little direct evidence on
compliance with a personal consumption tax exists because neither the
United States nor any other country currently uses this tax. 
However, some relevant evidence does exist from experience with the
current income tax because it shares many features with a personal
consumption tax.  For example, the proper reporting of sales of
assets would be a major concern because the incentive to underreport
sales is much less under the income tax than it would be under the
personal consumption tax.  Under the consumption tax, the entire
proceeds of the sale would be subject to tax, not just the gain.  In
its 1984 review of a consumption tax, the Treasury Department (citing
IRS estimates) reported that 40 percent of capital gains transactions
were not reported.\15

Because many types of income now subject to tax and information
reporting would also be taxed under a personal consumption tax,
information reporting and the matching of information returns with
tax returns could continue to be a major activity for tax
administration.  To ensure sufficient compliance, information
reporting could be expanded to include borrowed funds and amounts
saved in qualified accounts.  While information reporting would
reduce the need to audit for underreported borrowing and overreported
deductions for saving, an expansion in the number of information
returns would clearly increase administration costs. 

Such expanded information reporting might improve the identification
of delinquent nonfilers.  Self-employed individuals without interest
or dividend income are less likely to be identified to IRS now
through information returns, and therefore, information returns on
borrowed funds and repayment of debt could identify these
individuals.  This could create more taxpayer delinquent accounts and
investigations for the tax administrator, but it could also decrease
the number of delinquent nonfilers and increase amounts collected
from nonfilers. 

The personal consumption tax and the business cash flow tax would
offer some simplifications that would ease enforcement relative to
the current tax.  For example, (1) ascertaining whether repayment of
debt is principal or interest, (2) determining whether business
purchases of goods and services should be deductible or represent the
acquisition of an asset that should be depreciated over time, or (3)
determining the type of interest expense may not be necessary.  As a
result of these simplifications, audit focus under a personal
consumption tax can concentrate on the underreporting of cash inflows
and overstatement of deductions. 

As mentioned above, determining whether certain expenditures are
legitimate business expenses or personal consumption would remain
issues under a consumption tax.  For example, deductions for job
expenses, business entertainment expenses, moving expenses, and
business use of a car would likely remain audit issues under a
personal consumption tax. 


--------------------
\15 See Treasury, p.  203. 


      TAXPAYER SERVICES
---------------------------------------------------- Appendix VIII:3.3

IRS data on the questions asked of an IRS official over the telephone
are not detailed enough to show clearly how the taxpayer assistance
workload would change if a personal consumption tax was adopted. 
However, the data that do exist indicate that about 17 percent of the
workload may be affected by the change since these questions deal
with income definition and calculation issues.  Seventy-nine percent
of the questions involve procedural questions, refunds, notices, and
other account issues, and 4 percent concern filing information and
filing status and rules for dependents and other exemptions. 
Questions concerning capital gains and pensions, representing 4
percent of the workload, might no longer be relevant.  Individuals
would likely have additional questions about the calculation of the
deduction for net saving. 

IRS has more detailed data from its Tele-tax telephone assistance
service, which provides recorded telephone information on about 150
tax topics.  While some topics would no longer be relevant if a
consumption tax replaced the income tax, many of the questions asked
now would still be relevant because they concern the mechanics of
filing returns, IRS procedures, or the types of income that might
still be difficult items under a consumption tax.  For example,
often-asked questions on (1) medical and dental expenses, (2) the
earned income credit, (3) business entertainment expenses, (4) moving
expenses, (5) child and dependent care credits, and (6) business use
of automobiles all might still be issues under a personal consumption
tax. 

Several analyses of consumption taxes have pointed out that
additional taxpayer education would probably be needed, especially
concerning the inclusion of loans in the tax base and the deduction
for saving.\16 The inclusion of loans and the sales proceeds of
assets in the tax base are very different from current practice, and
taxpayers would probably have to be instructed to think in terms of
consumption taxation rather than income taxation. 


--------------------
\16 See McLure and Zodrow, p.  347; Graetz, p.  183; and Treasury, p. 
201. 


   OTHER ISSUES
------------------------------------------------------ Appendix VIII:4


      TRANSITION ISSUES
---------------------------------------------------- Appendix VIII:4.1

The transition from the current income tax to a personal consumption
tax would likely raise difficult policy and administrative issues. 
For the personal consumption tax and business cash flow tax, issues
would arise regarding the treatment of existing saving, capital
gains, borrowing, and deductions for existing assets. 

If a personal consumption tax was enacted without transition rules,
any saving done before the switch would be taxed twice, once when
funds were originally saved and again when they are used for
consumption.  For example, individuals who saved by depositing funds
in bank or other accounts would pay consumption tax on all funds when
they are withdrawn.  Individuals who saved by purchasing stock or
other assets and who sold the assets after the consumption tax was
implemented would have to pay tax on all sale proceeds, rather than
only the gain from the sale.  Individuals who saved by lending funds
to others or purchasing bonds would have to pay consumption tax on
both principal and interest income paid to them by borrowers.  If an
income tax were retained, these savers would not have to pay income
tax on the original amounts deposited, used to purchase assets, or
lent.  Thus, a consumption tax could be particularly burdensome for
individuals who saved before the switch from the income tax to the
consumption tax.\17 In contrast, borrowers would be able to deduct
repayments for many types of loans in full under the consumption tax;
if the income tax was retained, they could not deduct repayments of
principal and might not be able to deduct payments of interest. 

If policymakers want to limit such windfall gains and losses,
transition rules would have to be devised and administered so that
saving done before the switch was treated as it would have been
treated under the income tax.  Under such rules, distinctions between
the return to saving (taxed) and the return of saving (not taxed)
would have to continue to be made.  In addition, the forms of saving
that are granted preferential tax treatment under the current tax
(certain IRA accounts and pensions) would have to be separately
tracked.  All distributions from these accounts should be subject to
tax because contributions were originally deducted.  Similar
distinctions for debt issued before and after the switch would have
to be made, and administrators would have to be able to track assets
shifted among different accounts. 

Businesses with assets that have not been fully depreciated and with
other unused tax deductions and credits could stand to lose
substantially without transition rules.  Since all businesses file
returns under a cash flow tax, the tax could be used for transition. 
One option would be to allow businesses to continue to deduct
depreciation on existing assets as they would have under the income
tax.  This would require the continuation of recordkeeping and
auditing that is done currently.  However, businesses would still
face a windfall loss because the value of existing assets would fall
relative to new assets, which could be deducted immediately.  This
situation creates incentives for the current owners of assets to
sell; new owners could deduct the full cost immediately as new
investment.  Developing rules to prevent this and administering them
could be difficult. 

Another option would be to allow businesses to deduct the remaining
value of their not fully depreciated assets immediately or over a few
years.  This type of transition would limit the incentive to sell
assets and eliminate the need to keep depreciation records and audit
this issue in the future.  However, the revenue loss from this type
of transition might be substantial.  If tax rates have to be
substantially higher to raise sufficient revenue, noncompliance might
be increased in other areas. 


--------------------
\17 As Treasury pointed out, taxpayers would have an incentive to
attempt to avoid double taxation by selling assets and hoarding cash
until the consumption tax became effective.  To prevent this, a new
system of money and foreign exchange controls might be necessary. 
See Treasury, pp.  210-11, for a discussion of transition problems
and options. 


      FEDERAL/STATE ISSUES
---------------------------------------------------- Appendix VIII:4.2

The states could follow the federal government and replace their
income taxes with a personal consumption tax and a business cash flow
tax.  Such a state tax should be administrable because expanded
information reporting required at the federal level could be relied
upon by the states, and federal tax audits would cover similar
issues.  States would be free to choose a rate structure and add
other features if they desired. 

It would be difficult for states to stay with an income tax base
without effectively imposing potentially large compliance burdens on
businesses.  Much of the simplification achieved by switching from
the federal income tax to a cash flow tax would be negated if
businesses continued to be required to compute income for state tax
purposes.  In addition, states would not be able to benefit from
federal tax audits concerning capital income issues because of the
change in the federal tax base. 


      INTERNATIONAL ISSUES
---------------------------------------------------- Appendix VIII:4.3

As an individual-based tax, the personal consumption tax would apply
to U.S.  residents or citizens.  This would mean that foreigners
"consuming" in the United States (tourists, for example) would not be
taxed.  The tax would probably be formulated to tax the consumption
of U.S.  residents wherever it takes place.  Unlike a value-added tax
or retail sales tax, individuals could be taxed on their consumption
regardless of whether it is done domestically or overseas. 

To do this, cash flows from abroad (income from investments and
proceeds from asset sales) would be subject to tax, and funds saved
or invested abroad would be deductible.  In contrast to the current
income tax, complex rules to account for income earned abroad but not
repatriated (brought back to the United States) might not be as
important if unrepatriated income could not be readily used for
consumption.  In such a system, foreign taxes would implicitly become
deductible, and the foreign tax credit would be eliminated.\18

For compliance purposes, tax administrators would need to be able to
identify instances where borrowing was done abroad.  Without such
information, individuals who redeposited funds would be able to get a
deduction for saving and might be able to deduct the repayment of the
loan as well.  Tax administrators would need information to ensure
that either the proceeds of borrowing done abroad are included in the
tax base or repayments of the foreign borrowing are not deducted.\19

Some analysts have also stated that a wealth transfer tax would be
needed for individuals who have accumulated assets in the United
States but intend to emigrate.\20 Without such a tax, individuals
could accumulate wealth tax-free in the United States and consume it
tax-free abroad. 

Unlike typical value-added taxes, a cash flow tax would not feature
border tax adjustments.  Sales of exports would be taxable like
domestic sales, and business purchases of imports would be
deductible.  No border tax administration would be necessary. 


--------------------
\18 This discussion is based on James R.  Hines, Jr., "Fundamental
Tax Reform in an International Setting," in Henry J.  Aaron and
William G.  Gale, eds., Economic Effects of Fundamental Tax Reform
(Washington, D.C.:  The Brookings Institution, 1996), pp.  490-92. 

\19 See Treasury, pp.  204-05. 

\20 See Treasury, p.  205; Aaron and Galper, p.  77; and Graetz, p. 
253 for discussion of this tax need. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IX


   GENERAL GOVERNMENT DIVISION,
   WASHINGTON, D.C. 
-------------------------------------------------------- Appendix IX:1

Lawrence M.  Korb, Evaluator-in-Charge, Tax Policy and Administration
 Issues
Mary G.  Phillips, Senior Evaluator
Robert R.  Floren, Senior Evaluator
Edward J.  Nannenhorn, Senior Economist


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