Federal Tax Reform
Time to go back to the drawing board?

By Larry Witner and Kathleen Simons

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• simplify tax laws, including reducing costs of compliance;
• make tax laws more fair, while recognizing the importance of home ownership and charity; and
• promote economic growth, including increasing saving and investment, while strengthening competitiveness in the global marketplace.

During its first phase of operation, the advisory panel evaluated the current tax system and found it to be flawed. During its second phase, the advisory panel considered a wide variety of tax reform proposals. President Bush requested the advisory panel to make at least one of its recommendations based on the current tax system.

This article reviews the work of the advisory panel and details the major tax reform proposals presented to it, which ranged from modifying to overhauling to replacing the current tax system. A follow-up article will report on the advisory panel’s recommendations, due to be released by September 30, 2005. The advisory panel’s activities may be followed online at www.taxreformpanel.gov.

All of the tax reform proposals are revenue neutral; that is, they claim to raise as much revenue as the current tax system. Such claims, however, are difficult to substantiate.

Information about the tax reform proposals comes from four sources: testimony before congressional committees, testimony before the advisory panel, reports of the Congressional Research Service, and other miscellaneous correspondence. Citations are to material found in Tax Notes Today (TNT), a publication of Tax Analysts.

Current Tax System

The current federal tax system comprises the following components:

• An individual income tax with progressive rates;
• A separate tax on corporations;
• Gift and estate taxes on the transfer of wealth;
• Excise taxes on the manufacture and sale of certain goods;
• Tariffs on imports;
• Separate wage taxes to fund the Social Security and Medicare programs; and
• A federal agency (the IRS) to administer and enforce tax laws.

The current tax system relies on voluntary self-assessment: the voluntary cooperation of all taxpayers to accurately report their income and deductions. This voluntary cooperation is less than complete. There is an estimated annual tax gap of $300 billion, representing the shortfall between how much federal tax is owed and how much is actually paid. This shortfall results from taxpayers deflating income, inflating deductions, underpaying taxes, or not filing.

Much of the tax system was developed decades ago when the United States dominated the global economy. This is no longer the case. According to Peter Merrill, director of the National Economic Consulting Group at Pricewaterhouse-Coopers, in testimony before the House Budget Committee (2004 TNT 142-55), in the 1960s the U.S. economy represented 40% of global gross domestic product (GDP); in 2003, it represented 30% of global GDP. With regard to cross-border investment, in the 1960s U.S. multinationals accounted for 50% of the total; in 2003 U.S. multinationals accounted for less than 22%.

The U.S. economy is far more open to international trade and investment than it was a few decades ago. According to Merrill, merchandise trade (imports plus exports) increased from less than 7% of GDP in the 1960s to almost 19% of GDP for the last four years.

The current tax system is constantly changing. Since 1986, more than 84 new tax laws have been enacted. Constant changes and additions have led to redundancies. For example, there are 16 IRA-type accounts, there are about 12 tax incentives to encourage education, and there are four tax incentives to help raise children.

Approximately 60% of all taxpayers pay a professional to prepare their tax returns. According to Joel B. Slemrod, Paul W. McCracken Collegiate Professor of Business Administration and Director, Office of Tax Policy Research, University of Michigan, Ross School of Business, in testimony before the House Ways and Means Oversight Subcommittee (2004 TNT 116-36), the annual compliance costs for individuals and businesses are $85 billion and $40 billion, respectively, for a total of $125 billion, or 14.5% of income tax receipts.

Advisory Panel’s Findings Regarding the Current Tax System

On April 13, 2005, the advisory panel released its findings (2005 TNT 71-71) regarding the state of the current tax system:

• The current tax system is too complex. Arguably, U.S. tax law is the most intricate law of all time.
• Compliance is an annual ordeal involving a “headache of burdensome recordkeeping, lengthy instructions, and complicated schedules, worksheets, and forms—often requiring multiple computations that are neither logical nor intuitive.”
• Too many taxpayers pay professionals for assistance, making the cost of compliance too high.
• There are special deductions, credits, exemptions, exclusions, deferrals, tax rates, and other preferential treatment for particular industries, groups, and individuals. These “targeted tax benefits” reduce uniformity, increase complexity, and lead to perceptions of unfairness.
• In an environment of special treatment (targeted tax benefits), normal decision making is altered. Business decisions become based on tax consequences rather than economic consequences.
• Targeted tax benefits, also known as “tax expenditures,” are difficult to evaluate. For example, IRC section 42 is a tax incentive for the construction of low-income housing. Does this tax incentive actually increase the supply of low-income housing? Because the program takes the form of a tax incentive, rather than an actual government outlay, it is impossible to determine if the program meets Congress’ expectations or if the program’s benefits outweigh its costs.
• Tax law is used inappropriately to achieve social and economic goals. For example, tax law is used to reduce poverty (earned income tax credit, IRC section 32), to reduce unemployment (work opportunity credit, IRC section 51), to accommodate the handicapped (removal of architectural barriers, IRC section 190), to encourage adoption (adoption costs expensed, IRC section 23), and to encourage research and development (R&D credit, IRC section 41). According to the advisory panel, the primary purpose of the tax system is to raise revenue to fund the government, not to carry out social and economic goals.
• Tax law is constantly changing, and the uncertainty and unpredictability make tax planning for the future difficult.
• The U.S. level of savings is so low that investment is reduced and economic growth is hindered.
• Business and personal taxes are not well integrated.
• The individual alternative minimum tax (AMT) is a growing problem. Enacted in 1969, its goal was to target a small group of high-income taxpayers that paid no tax. The AMT will ensnare about 20 million in 2005, and 50 million, or about 45% of all taxpayers, in 2015.
• The international tax rules are antiquated, extremely complex, and out of step with competitor nations.

Proposals to Modify the Tax System

Some tax reformers prefer a small fix to a drastic overhaul. Some believe that tweaking the current system will satisfy the president’s criteria of simplicity, fairness, and economic growth. Others believe that overhauling or replacing the current system is not politically possible, may cause economic disruption, would require new collection mechanisms, and could create new layers of bureaucracy.

Many proposals for modifying the current system emphasize the need to reduce complexity—that is, to increase simplicity. Sheldon S. Cohen, partner, Morgan, Lewis and Bockius, and former Commissioner, Internal Revenue Service (1965–1969), in testimony before the House Ways and Means Oversight Subcommittee (2004 TNT 116-30), wants to focus on a few areas that affect the largest number of taxpayers least able to cope with complexity. Specifically, he wants to simplify the earned income tax credit, the AMT, the definition of a “dependent,” educational benefits, and savings incentives. Simplifying these areas would, among other things, eliminate multiple provisions that confuse taxpayers and burden the IRS.

David S. Miller, partner, Cadwalader, Wickersham & Taft LLP, (2005 TNT 91-75) supports a mark-to-market tax system that would affect all publicly traded companies, private companies with $50 million or more of net assets, and individuals and married couples with $1.6 million of adjusted gross income or $5 million of publicly traded property (roughly 0.1% of individual taxpayers). He would have these taxpayers mark their publicly traded property to market value. In other words, these taxpayers would treat this property as sold and immediately repurchased. For corporations, mark-to-market gains would be taxed at no more than 35%, and mark-to-market losses would be fully deductible. For individuals, mark-to-market gains would be taxed at no more than 15%, and mark-to-market losses would be deductible against all mark-to-market gains and a portion of other income. The revenue raised would be used to repeal the AMT and to fulfill either of two goals: eliminating all tax on investment income for low-income taxpayers, or expanding 401(k) plans for all taxpayers.

Roland Boucher, chairman, United Californians for Tax Reform, (2005 TNT 91-83) supports the following: eliminating all deductions for state and local income, sales, and property taxes; eliminating all exemptions (personal and dependency); and increasing the standard deduction to $7,950 for single filers and $15,900 for joint filers. These changes would reduce the number of taxpayers that itemize their deductions from 40 million to 10 million. Boucher would also reduce the number of tax brackets from six to three (10%, 15%, and 20%).

Barry K. Rogstad, former president, American Business Conference, (2005 TNT 91-72) supports the simplified unlimited savings allowance tax (SUSAT). Under SUSAT, all businesses would be treated alike, and they would pay a tax of 8% on the first $150,000 and 12% on any excess. The tax base would be: revenue from domestic operations – export income – purchases of inventory – purchases of equipment and services. As this formula indicates, purchases of equipment would be expensed in the first year. Without being specific, Rogstad alleges that these changes would “make unnecessary the array of special interest deductions and credits that complicate business taxes today.” Under SUSAT, the tax base for individuals would be: wages + interest + dividends + sales of stock and other assets – deductions (e.g., an exemption, home mortgage interest, charitable contributions, and secondary education). Individual tax rates would be 15%, 25%, and 30%, except for dividends and capital gains, which would be taxed at 15%. Under SUSAT, there would be a universal Roth IRA, and individuals could save at any level for any purpose. There would be no deduction for contributions to a universal Roth IRA, but the previously taxed principal and earnings on principal would not be taxed when withdrawn. As a result, savings would be taxed only once, and thus encouraged.

John Podesta, President and CEO, Center for American Progress, (2005 TNT 91-73) supports equally taxing income from wealth and income from work. In other words, dividends and capital gains would be taxed at the same rate as wages and salaries. The tax rate would be 15% on the first $25,000 of income; 25% on income between $25,000 and $120,000; and 39.6% on income over $120,000. Podesta would eliminate the employee portion of the Social Security payroll tax, and he would remove the income cap on the employer side. With regard to the estate tax, he would increase the exemption to $2.5 million. He would eliminate the AMT. Without being specific, Podesta says that he would eliminate corporate and individual tax loopholes. To encourage long-term savings, individuals earning less than $1 million annually could exempt 10% of their capital gains from tax for each year the assets are held. For assets held more than five years, the exemption would not exceed 50%.

There are several different versions of a flat tax. Under Richard Armey’s, Cochairman, FreedomWorks, and former House Majortiy Leader, version (2005 TNT 91-84), all deductions and credits would be eliminated for both individuals and business, and all income would be subject to one tax rate. For individuals, the tax liability would be determined as follows: (income – personal exemption) x the tax rate. Because of the flat tax’s simplicity, its proponents boast that a tax return would fit on a postcard.

In summary, many of the proposals to modify our current system would broaden the tax base and reduce the tax rates. The Tax Reform Act of 1986 incorporated this apparent winning combination. Unfortunately, this type of tax reform is easily undone, as evidenced by the fact that in 1987 tax rates were reduced to 28%, and within one decade tax rates were back up to 40%.

Proposals to Replace the Current System with a Consumption Tax

Some tax reformers want to replace the current income-based tax system with a consumption-based system. Conceptually, individuals can do two things with their income: they can consume (spend) it, or they can save it. Reduced to a formula: income = consumption + savings. In an income-based system, both consumption and savings are taxed; in a consumption-based system, only consumption (income – savings) is taxed. Consumption taxes are very popular with governments around the globe; the United States is the only developed nation without a broad-based consumption tax at the national level (although arguably the sales taxes in most U.S. states play a similar role).

A consumption tax can be levied at either the individual level or the retail level. When it is levied at the individual level, taxpayers add up all income and subtract net savings (saving minus borrowing). The resulting figure is the consumption base upon which a tax is levied. (For an illustration of this type of tax, see Ed McCaffery’s proposal for a “consumed income tax,” below.)

When a consumption tax is levied at the retail level, it takes the form of a sales tax or a value-added tax. A sales tax is collected from the ultimate consumers. A value-added tax is collected from producers at each stage of production. Regardless of which level the tax is levied at, and regardless of the point of collection, the consumption tax is ultimately paid for by the consumers.

Consumption taxes can be direct or indirect. The “consumed income tax,” discussed later, is a direct consumption tax because it is levied at the individual level. Such taxes can be personalized through exemptions, deductions, and progressive rates. Both the national sales tax and the value-added tax are indirect consumption taxes because they are levied at the retail level. Such taxes cannot be personalized.

Some tax reformers believe that a consumption-based tax system would allow all other taxes (individual income, corporate income, gift, and estate) to be eliminated. The following discussion proceeds on this premise.

According to a Congressional Research Service report (2004 TNT 196-32), a VAT is a tax, levied at each stage of production, on the value an entity adds to a product. Such value added is the difference between an entity’s sales and its purchases of inputs from other parties. The VAT is collected by each entity at every stage of production. The entity calculates its VAT liability before setting its prices. The VAT liability is added into its prices, so each seller fully shifts the VAT liability to the buyer.

The two most common versions of VAT are the subtraction method and the credit method. Under a subtraction VAT, the taxpayer calculates its VAT liability as follows: VAT rate x value added (sales – cost of taxed inputs). Under a credit VAT, a firm calculates its VAT liability as follows: VAT on sales (VAT rate x sales) – VAT on inputs.

Under a variation called the credit-invoice method, there is an extensive paper trail. Specifically, the taxpayer shows VAT separately on all sales invoices and calculates the VAT credit on inputs by adding up the VAT shown on all purchase invoices.

Under an NST, a consumption tax is levied at only one stage of production, the retail stage. The retailer collects a specific percentage of the retail price of a good or service and remits it to the tax authorities.

To illustrate VAT and NST, consider the example used by Charles McLure, senior fellow, Hoover Institution, Stanford University (2005 TNT 91-76). The example includes a farmer, a miller, and a baker who are involved in turning wheat into bread. As the Exhibit reveals, the farmer grows wheat and sells it to the miller for $250. The miller grinds the wheat into flour and sells it to the baker for $600. The baker turns the flour into bread and sells it to the public for $900. For the sake of simplicity, assume the tax rate is 10%.

The farmer adds value of $250 and pays a VAT of $25 (rows 3 and 4, subtraction VAT). The miller adds value of $350 and pays VAT of $35. The baker adds value of $300 and pays VAT of $30. The total subtraction VAT liability is shown to be $90. Indeed, under these facts, where the tax rate (10%) is the same at all levels of production, the total tax liability for each of the three methods is the same ($90).

The subtraction VAT is appropriate when simplicity is of paramount importance and when there is only one tax rate. The credit-invoice VAT is appropriate when compliance is of paramount importance and when there is more than one tax rate. This method is used in the vast majority of the 150 nations that have a VAT (Japan is a notable exception). It is popular among governments because the detailed recordkeeping required of producers generates a paper trail that encourages compliance and discourages cheating.

With regard to an NST system, Steve King, Representative of the 5th Congressional District of Iowa, (2005 TNT 95-22) proposes a retail sales tax levied on the final sale of goods and services, along with a tax exemption for necessities through a series of rebates that would protect spending up to the poverty level. All other taxes would be eliminated, and the states would, for a fee, collect and enforce the NST when they collect and enforce their own sales tax. The filing of individual income tax returns would be eliminated, as would the IRS.

The primary disadvantage of NST (2005 TNT 91-1) is that the tax is regressive. Attempts to correct regressivity are unsatisfactory and tend to complicate NST. Because there is only one point of collection, there is potential for widespread abuse or noncompliance. No other developed nation uses an NST. Implementing an NST would require a significant political step in the repeal of the 16th Amendment to the Constitution. Finally, one more significant disadvantage is that in order for the NST to be revenue neutral, the rate would be unacceptably high. According to William Gale, senior budget analyst at the Brookings Institution, (2004 TNT 157-32), just to replace the income tax on a revenue-neutral basis over the next 10 years, the NST rate would need to be more than 26%. For the NST to replace all federal taxes, the NST rate would need to be about 60%. For these reasons, the NST is the least plausible and least attractive of the tax reform options.

Miscellaneous Proposals

Edward J. McCaffery, Robert Packard Trustee of Law and Political Science at the University of Southern California, and the Visiting Professor of Law and Economics at the California Institute of Technology, (2005 TNT 91-77) believes that individuals should pay tax when they spend, not when they work, save, give, or die. His consumed income tax plan has three parts. First, there would be a national sales tax or a value-added tax of 10% to be paid by the consumer at the cash register. To reduce the regressivity of the first item, there would be rebates of $2,000 ($20,000 x 10%), making the first $20,000 of consumption effectively exempt. Third, the wealthiest Americans would pay a supplemental consumption tax on April 15. For a family of four, the supplemental consumption tax would be 0% on spending up to $80,000; 10% on spending from $80,000 to $160,000; 20% on spending from $160,000 to $500,000; 30% on spending from $500,000 to $1 million; and 40% for spending over $1 million. The consumption base would be calculated by subtracting savings from income. Under McCaffery’s plan, there would be traditional IRA accounts to which taxpayers could make unlimited contributions and unlimited withdrawals. In essence, all contributions to such accounts would be deductible, and all withdrawals, because they would be devoted to consumption, would be taxable.

Michael Graetz, professor, Yale Law School (2005 TNT 91-81) has a four-part proposal. First, he would repeal the individual income tax and modify the AMT by raising the exemption to $50,000 for singles ($100,000 for couples), indexing the exemption for inflation, and reducing the rate to 25%. Second, he would reduce the corporate income tax rate to 25%, and he would more closely align financial accounting and tax accounting. Third, to replace revenue lost by the first two items, Graetz would impose a credit VAT of between 10% and 14%. Finally, he would replace the earned income tax credit with a refundable payroll tax offset.

Proposals for Business

Alvin Warren, Ropes and Gray Professor of Law and Director of the Fund for Tax and Fiscal Research at Harvard Law School, (2005 TNT 92-50) supports the integration of corporate and individual income taxation, so corporate earnings would not be taxed a second time as investor income. This could happen in any of three ways: shareholders could receive a credit for corporate taxes paid on dividends received; shareholders could have an exclusion for dividends received; or corporations could deduct dividends paid.

Kenneth W. Gideon, partner, Skadden, Arps, Slate, Meagher & Flom LLP, former Assistant Secretary of the Treasury (Tax Policy) and IRS Chief Counsel, (2005 TNT 92-36) supports a comprehensive business income tax (CBIT). Under CBIT, the income of all businesses, whether corporate or noncorporate, would be taxed to the entity. Thus, there would be no flow-through entities. Distributions of business income, whether as dividends or interest, would not be deductible by the business, and distributions would not be taxable to investors. Entity-level losses would not pass through to owners; rather, they would be carried over for use by the entity. According to Gideon, these provisions would eliminate distortions that favor debt financing over equity financing, the noncorporate form of business over the corporate form of business, and retained earnings over distributed earnings.

Edward D. Kleinbard, partner, Cleary, Gottlieb, Steen & Hamilton, (2005 TNT 92-42) supports a business enterprise income tax (BEIT). Under BEIT, just like CBIT, income of all businesses, whether corporate or noncorporate, would be taxed to the entity. There would be true consolidations: Affiliated entities would be treated as a single business, and the separate tax attributes of consolidated subsidiaries would not be tracked. All tax-free organization and reorganization rules would be repealed, so all transfers of business assets would be taxable transactions. BEIT would replace current law’s differing treatment of interest and dividends with a uniform annual cost of capital allowance (COCA). COCA would replace interest deductions, but not depreciation deductions.

Proposals Dealing with International Taxation

With regard to international taxation, there are two primary systems: worldwide and territorial. According to James R. Hines Jr., professor of business economics and research director, Office of Tax Policy Research at the University of Michigan, Ross School of Business, (2005 TNT 92-35), because the United States uses the worldwide system (double taxation), but other nations use the territorial system (single taxation), U.S. corporations are at a disadvantage.

Currently, the United States taxes the worldwide income of its citizens (individuals and corporations). When a foreign subsidiary of a U.S. corporation earns income abroad, the income is subject to foreign taxation. When the foreign subsidiary pays dividends to the U.S. corporation, the dividends are subject to U.S. taxation. The resulting double taxation effects are mitigated somewhat with a partial credit for tax paid to a foreign jurisdiction. Because a U.S. tax obligation does not arise until dividends are actually paid, many U.S. corporations do not repatriate their foreign subsidiaries’ earnings.

According to Hines, this system distorts the ownership of business assets in the U.S. and abroad, investment in plant and equipment, research and development spending, and the payment of dividends by foreign subsidiaries.

Because most of the international competitors of U.S. corporations are subject to a territorial system of taxation instead of worldwide system, they pay tax to the foreign jurisdiction, and they do not pay tax a second time to the home jurisdiction. Hines proposes that the United States change from a worldwide system to a territorial system, making foreign-source income exempt from U.S. taxation. U.S. corporations would then be better able compete in the global marketplace because they would be on an equal footing with foreign competitors.

Looking for a Fix

Some may look back over the last 40 years and conclude that it is impossible to simply “fix” our current tax system. Each round of tax reform seems to make matters worse (e.g., more complex). Are circumstances conducive to scraping the current tax system and replacing it with something else? According to W. Elliot Brownlee in Federal Taxation in America: A Short History (second edition, Cambridge University Press, 2004), conditions are not right for wholesale tax reform. He believes that such reform will only occur when the country is faced with a crisis. As the following paragraph indicates, that time may not be far away.

The authors concur with Bruce Bartlett, senior fellow, National Center for Policy Analysis (2004 TNT 240-20) that the need for tax reform will be overwhelmed by pressure to raise federal revenue for the following pressing needs: to reduce the deficit; to shore up Social Security, particularly as the baby boom generation retires; to pay for national defense and the war on terrorism; and, possibly, to provide health-care benefits to the uninsured. Tax reform may therefore take the form of increased taxes to raise revenue, not decreased taxes.

Advocates for an income-based tax system claim this is the best way to tax the wealthy. Advocates for a consumption-based tax system claim this is the best way to encourage savings, increase investment, and promote economic growth. Tax reform need not necessarily mean a choice between the two, but may actually involve both. As with many other nations, the United States may be forced to institute a VAT, not as a replacement for, but as a supplement to, the income tax. In the authors’ opinion, it is likely that someday we will have both an income tax and a modest (2% to 4%) value-added tax.

In any reform of the federal tax system, care must be taken not to throw the 50 state tax systems into disarray. Recent changes in state laws in the wake of the federal repeal of the estate tax illustrate the potential unintended consequences of major changes in federal tax policy. Because most state systems piggyback onto the federal system, any major overhaul of the current system would require transition rules and grandfather provisions, complicating the reform process.

Stay tuned. The advisory panel was scheduled to complete its work by September 30, 2005. A follow-up article will report on the panel’s conclusions and recommendations.