The foregoing is further compounded by two matters that are most disturbing. One is the special legislation which is becoming increasingly evident in the law, with provisions clearly designed to benefit only one taxpayer. The other--and perhaps most important because it affects so many taxpayers--is the high cost of complying with complex provisions. Some of these provisions are at best highly theoretical, and, at worst, are a bad formulation of what the tax law should be. That is to say, in a quest for revenue without increased tax rates, provisions have been written into the law which theoretically will produce additional tax, but which, in fact, require inordinate effort by taxpayers if they are to make reasonable efforts to comply.

Another concern is the low level of audit coverage presently accomplished by the IRS. This is not a criticism of the IRS, but, rather, recognition that they have limited resources. The point, however, is that even with considerably higher audit coverage, a tax law in our country must essentially be self-administered. For self- assessment to work, taxpayers must have: 1) faith in the system; 2) confidence in the soundness and integrity of the tax laws; and 3) a general understanding of what the law and the regulations interpreting the law mean in order to make a reasonably sound attempt to plan business transactions and to file proper returns. Again, this does not suggest that there will not be different interpretations of the law, nor does it mean to imply that there would not be situations where taxpayers take an aggressive position--as the IRS sometimes does--to try to prove a point or to extend the law in one direction or another. Nevertheless, if there is no confidence on the part of almost all taxpayers to make them want to file what they believe to be a proper and fair tax return, albeit in some cases an aggressive one, the tax system will fail.

The current condition calls for immediate attention and thoughtful change in the process by which tax laws and the related regulations are written. The entire matter needs careful and urgent consideration on the part of taxpayers, tax practitioners, Treasury and IRS personnel, and members of Congress.

What is an Income Tax?

The income tax was originally conceived to be a tax payable based on the taxpayer's "income," presumably a reflection of the ability to pay tax based on economic circumstances. For such a tax to have credibility, therefore, the definition of business taxable income is critical and should be determined as much as possible by the sound application of good economic and accounting theory.

Over the years, many incentives and disincentives have found their way into the law, as well as limitations and favoritism for various industries and various classes of taxpayers. It is not suggested that these will suddenly disappear but that such items should be more clearly labeled and applied more broadly. (1)

More troublesome to me as a CPA in tax practice has been the recent tendency to change the tax law's definition of taxable income with the principal or sole purpose of raising revenue. This has the undesirable effect of redefining taxable income, not particularly to favor or restrict a group or a particular industry, but simply to make the definition of taxable income produce a higher amount of income. Thus, with no change in tax rate, greater revenue is produced.

This recent development is exacerbated by the constraint of a desire to produce a smaller deficit (or perhaps even a balanced budget) in a period when Congress, the Executive branch, and the public are unwilling to reduce government expenditures and yet are not prepared to increase tax rates. This "no increase in tax" approach has been circumvented by continually redefining taxable income and creating an ever-increasing tax base.

It seems clear to me that the definition of business taxable income must be carefully reexamined if we are to maintain the notion that we are imposing an income tax. If we wish simply to make this a tax on a computed number, then we should stop calling it an income tax. If we do that, however, I fear there would be no restraint on what the base could be, and I worry about where the political process might then take us.

Accordingly, I think it is important that we return to an attempt to establish the base as being a fairly and properly determined definition of business income, considering economic rules and accounting rules with respect to determination of that income. One may argue that GAAP does not always come up with the best answers, but I submit that it comes up with a better definition of income than one driven principally by the desire to produce more revenue.

Classic Rules Regarding Taxation

One is reminded of the classic rules set forth by Adam Smith more than 200 years ago (2) with regard to the principles to be followed with respect to any tax system. His discussion suggested that tax laws should be:

* Fair;

* Economically efficient--the tax laws should be neutral;

* Certain and not arbitrary; and

* Administrable--compliance should be convenient and not burdensome.

If we were to examine our present tax law against these criteria, I believe we would find it woefully deficient, and clearly so with respect to the final point. Therefore, the time is long past due for our country to take a fresh, hard look at the process by which our income tax law is developed and administered so that the system will not collapse.

This is not intended to be a technical analysis of provisions of the tax law but, rather, a philosophical discussion of how the tax law currently affects taxpayers in the U.S. It should be noted too that, due to inflation, the tax law now has a significantly broader impact than it did when enacted in 1913. It will, therefore, be helpful to look at a few particular provisions to see what has happened and what should be done in the future. (3)

Distortion of the Definition of Taxable Income

The current meddling with the definition of taxable income is found in a variety of provisions, and is quite contrary to what Congress attempted to do in 1954. In 1955 Secs. 452 and 462 were repealed retroactively. These sections had been intended to conform taxable income more nearly to the GAAP definition of income. Despite the repeal, Congress nevertheless said that it would reexamine the subject to try to accomplish such conformity. Sad to say, some 35 years later, not only has Congress failed to accomplish that objective, but it has gone very much in the opposite direction.

A clear example of this misdirection of effort is Sec. 263A, (4) which mandates uniform rules regarding capitalization of costs with respect to inventory, as well as self-constructed fixed assets. Rules have now been developed for federal income tax purposes which the SEC and the accounting profession do not accept as appropriate for use with regard to financial statements of operating businesses. Accordingly, significant additional compliance effort is required, possibly involving a complete redesign of the taxpayer's cost accounting system. All this, despite long-standing language in the Regulations to the effect that inventory ". . . must conform as nearly as may be to the best accounting practice in the trade or business" (Reg. Sec. 1.471-2). A simple excise tax on inventory might have been designed to provide the same tax revenue.

Another example is the elimination of bad debt reserve deductions. (5) Under GAAP, it is not appropriate to issue financial statements without a proper estimation of the bad debt experience anticipated with respect to receivables included in the financial statements. It serves no purpose to argue that some provisions are overstated; while that may be true, by the same token, some are understated. The point is that some provision is appropriate. The "Black Motor" formula used by the IRS was widely accepted and easy to apply. Let an examination of the facts determine what the correct amount of the provision should be. We could all agree that in some cases it might be different from the amount in the financial statements.

A similar example exists with respect to the elimination in 1987, following limitations placed thereon in 1986, of vacation pay accruals. (6) Vacation pay accrual is a proper charge to the year in which services are rendered which "earn" the vacation. Limiting the deduction on the basis of when the vacation is in fact taken by the employee, or allowing it only when it is paid, distorts the definition of taxable income. If there is concern about the time-value of money, then perhaps the amount of the vacation pay accrual should be modified; however, the entire accrual should not be eliminated.

A comment is in order regarding the time-value of money. Congress seems to express great concern about the time-value of money only where it results in increasing income or reducing deductions. Note that Congress has failed to recognize that an account receivable which is non-interest bearing and not collectible for 20 or 30 days--or for considerably longer periods--should not be included in income at face amount but, rather, should be included in income at discounted present value. It seems clear that the principal reason discounting is not permitted is that it would reduce taxable income and defer collection of taxes. Such a provision would be administrable, even allowing for some lack of consensus in determining the amount of discount.

All this leads inevitably to the conclusion that there is a kind of arrogance on the part of Congress and its staff that they have the best definition of income. I stated previously that GAAP does not always come up with perfect answers. Neither does Congress. It would be interesting, however, to debate whether, over the years, the accounting profession has done a better job of defining income than the politically motivated individuals whose principal objective seems to be to increase the base of what is called "income" simply to increase the amount of tax revenue collected in one year. It is true that all do not agree with each GAAP requirement, especially some of the more recent FASB pronouncements. I do not, however, advocate lock-step conformity, but rather encourage thoughtful consideration of the alternatives. The solution to dispute GAAP is to work to improve financial accounting by discussion and persuasion and not to ignore it because if fails to satisfy a particular financial or tax objective.

In summary, the rules have been changed to cause premature recognition of income while at the same time to defer the recognition of expenses. This is by no means an accrual method of determining income. It is a political method of doing so. No doubt this is encouraged by federal government accounting which is done using the cash method despite many recommendations to the contrary. Nevertheless, this does not excuse what has happened to the tax law.

Alternative Minimum Tax (AMT)

A further example of the assault on a proper definition of income for tax purposes is the AMT, which, in addition to definitional problems, imposes an unreasonable burden in that taxpayers, who, though they may not in fact pay AMT in one year, must keep all the records required to determine whether they might be subject to it in another year. (7) This requires determination of at least two separate amounts of "taxable income," (in addition, of course, to the determination of financial income and also of separate calculations under the tax laws of various states)--for the dubious purpose of trying to make certain that everyone pays a fair share of tax. Further, one must wonder, when looking at the definition of the AMT base, whether Congress has in fact met its stated goals.

Penalty Provisions

The greatest concern to many practitioners who truly wish to comply with respect to encouraging proper behavior by taxpayers, is the outrageous penalty provision structure which now exists, although Congress, in fact, is currently reexamining this matter. The record indicates that some penalty provisions were labeled as revenue raisers. Penalty provisions should be designed to punish those who willfully fail to prepare proper returns with the object, to the extent possible, of encouraging appropriate compliance with the law. Penalty provisions should not punish the innocent, and should not be used to raise revenue; rather they should try "to make the punishment fit the crime." (8) To the extent they do not do this, they will further foster an attitude that the system is unfair, rather than encouraging compliance. Accordingly, fewer people will try to comply and more will try to beat the system.

Regulatory Process

The regulatory process also leaves much to be desired with respect to lack of regulations where they are needed (9) and alternatively, with regard to those which are unduly detailed and complicated. (10) Many regulations test the ability of qualified practitioners to understand them. To be fair, much of the blame for this is due to the incredible frequency of change in the tax law and the outragenous complexity that has been incorporated into the law itself with the mistaken notion that this would make it a better law. One authority has cited as cause for concern the enactment of 27 major revenue acts significantly affecting the tax law in the last 25 years. (11) Reasonable people must agree that this is overwhelming. As a result of the frequency of change, neither practitioners nor tax administrators are able to stay current. Furthermore, the legislative process cannot give appropriate consideration to proposed changes when revisions are made with such frequency. This is particularly so when a statutory amendments is made on the basis of a newspaper article which brings instant, overnight, reaction from Congress. It is not practicable to try to eliminate every potential abuse, particularly when the revenue loss may be minimal. Since the law is written in this manner, however, every taxpayer must study those provisions--or pay a practitioner to do so--to determine whether for some reason they might be applicable.

The foregoing, the recent proposal to depart from the long established practice of issuing comfort rulings is most disturbing. Although the proposal is currently being reconsidered, and while acknowledging current budgetary constraints, it must be recognized that the whole legislative/regulatory system needs improvement. Eliminating comfort rulings is hardly a step in the right direction.

Effective Dates

If the law were amended less frequently--three of five year intervals might be appropriate--then effective dates of the changes would not require several pages of listing. If the law as enacted is considered reasonable, then when it is amended it should have one effective date applying to all provisions. Perhaps some few taxpayers will take advantage of an expiring provision, perhaps some few taxpayers will use what is now called a "loophole" even though it was not a "loophole" when enacted. Is this so serious as to require all taxpayers to be confused by a multitude of effective dates which often do not even find their way into the Code, but which must be searched out in other statutes?

A word is in order here regarding so-called "loopholes." Congress has, over the years, enacted many incentives such as the investment credit. If later experience indicates over-use of the provision, then it should be modified or repealed; the investment credit has been added "permanently" to the tax law three different times. So too, depreciation allowances have been designed to encourage investment. A separate calculation under the AMT is not the way to modify what has been done; the depreciation rates should be changed for all taxpayers. Similarly, the dividends received deduction (not a loophole in my view) was originally enacted to eliminate double taxation of income at the corporate level. A change in corporate tax rates is no reason to change the amount of the dividends received deduction. This simply is a subordination of principle to a desire to collect more taxes.

The Political Process

While the problem is not limited to the tax law, it seems clear that the proliferation of political contributions, honoraria and other methods of "compensating" those in political office gives the appearance, if not the fact, of a corrupting influence on the system. Others have written on the subject. (12) It is worth noting here, however, that the amount of political contributions continues to increase, that contributions to members of the tax writing committees of Congress seem to outpace those going to other members of Congress, and that many political contributions apparently go to some members of Congress who run virtually unopposed. The conclusion is inescapable that our system may well reach the point where it will serve primarily special interests and will no longer function properly. This is a matter of concern for all citizens since it affects the current and future structure of the tax law which applies to everyone. In any event, one might hope that with reforms such as less frequent changes in the statute and elimination of provisions that apply solely to one taxpayer, the undue influence--or the appearance thereof--of such political contributions and honoraria would be diminished, if not eliminated.

Recent Discussions Regarding Capital Gains and

the Budget Process

One recent example of the unhappy effect of the current emphasis on revenue neutrality is the discussion about the taxation of capital gains. One may reasonably argue whether a capital gain should be taxed as other income is or whether there should be a rate differential or a method by which the cost of a capital asset is indexed based on date of acquisition. Furthermore, one may reasonably argue whether there are other items which also need adjustment due to the changing value of the dollar. One might even argue whether there should be different adjustments with respect to different holding periods. In a country which prides itself on a fair system of taxation, however, one would hardly expect most of the discussion to center on the question of whether a change in taxation of capital gains would increase or decrease revenue in the short run, with no particular concern for long range economic effects nor for what might be considered fair.

While I do not wish to take a position on this matter, (although, of course, I have my own personally held strong opinion) the point of my discussion is that we must not become hostages to the budget system. The desire that every tax bill should be revenue neutral--whatever that really means--may yield unfortunate results. If there is a change in the tax law, it should be to produce a better tax law; those proposing a revenue reducing amendment should not be burdened with the need to come up with equal and offsetting revenue.

The cost to society of understanding the tax law, and of complying with its difficult and obscure provisions, does not enter into the determination of the budget deficit. It is, nevertheless, a real cost burden to all, both as taxpayers and as members of a society forced to divert such resources from its many other problems.

What Should be Done?

A recitation of the problems as I see them perhaps in itself suggests some solutions. Let me, however, summarize what I think is necessary for our income tax system to return to the position of respect which I believe it had some years ago, and which seems essential for self- assessment to function properly.

We must do the following:

1. Redefine accrual basis business taxable income. Make it our objective to enact into law the best definition of accrual basis business taxable income, rather than raising revenue by keeping rates flat or low and changing the tax base. While this may be politically difficult, it will be more honest than what we are now doing by distorting the definition of accrual basis taxable income. Base broadening for non-business taxpayers is not in conflict with this objective. The definition of individual taxable income is political, not constrained by economic rules. For example, the amount of sales tax paid by a taxpayer and the allowance for dependents affect the individual taxpayer, but such items have noting to do with a proper definition of economic income because they reflect decisions based on social policy.

2. Eliminate the AMT. Eliminate the AMT so that the income tax will have one base for determining income. If we have provisions in the law which seem to give undue advantage to some taxpayers, then we should repeal or modify those provisions.

3. Produce clear regulations promptly. Produce regulations promptly, with clear subdivisions minimizing the need for all to read portions which only apply in certain narrow situations, and attempt to have such regulations deal more with standards than with specific rules. This assumes that the law will, in the first instance, be clearly written and not itself so rule-oriented as to require the same "rule" approach of its regulations.

4. Examine penalty provisions. Take a hard look at penalty provisions so that they do in fact punish where appropriate, but impose only minor costs for less significant infractions. For example, maybe the current anomaly of taxing interest income while not allowing a deduction for interest on a personal tax deficiency is sufficient for many situations.

5. Require Congressional evaluation of the cost of compliance to taxpayers. Require Congress to evaluate any proposed provision to see what the real cost of compliance will be for both large and small taxpayers, and only have recordkeeping differences which vary from what is needed for financial accounting where the benefit significantly outweighs the cost of compliance.

6. Provide one effective date. Have one effective date for one statute, and have it apply to all taxpayers--if transition relief is appropriate, then it should also apply to all taxpayers. We should not favor taxpayers in a particular group, or particular taxpayers. Our desire to eliminate every loophole is something that we as a mature society should put into better perspective. It is not possible to have perfect justice for each of many millions of transactions a year.

7. Give needed attention to the political process. With regard to the political process, concerns obviously are much more broadly applicable than just with respect to the tax law. Based on recent history, they also may be much more difficult to resolve. They need attention soon, however; failure to eliminate what may seem to be corrupting influences in our legislative process may result in a society which, like others around the world, will no longer respect the law. If that happens no number of revenue agents, no number of enforcement individuals, no number of courts, no number of penalty provisions would be enough to prevent a breakdown of our system. The fact that a substantial underground economy already exists in this country should distrub us all. We have only to look at many other nations to see how an economy may function with little or no regard to the tax system or to other legislative constraints.

Looking Ahead

Many efforts have been made, and continue to be made, to improve the tax law. A major contribution was made in 1978 when a Conference on Federal Income Tax Simplification was held. (13) In the coming year, an "Invitational Conference on Reduction of Income Tax Complexity" will be conducted in Washington, DC. (14) These and similar activities, if heeded by Congress and its staff, should be helpful. Strong support by all tax practitioners, and by other concerned citizens, is essential. It may also be that the difficulties with an income tax law are such that other revenue sources, such as a value-added tax, would be more appropriate. Whatever the solution, continuation of present conditions seems destined to lead to a failed system.

Some may not agree with my views; if so, I hope this will result in a dialogue regarding the matters discussed. It is not too late for change, but we must act now. Let us be guided by the wisdom of Justice Holmes.

(1) See, for example, statement by Senator Lloyd Bentsen, Chairman of the Senate Finance Committee, regarding limitations on special interest legislation and disclosure of those benefited by particular sections of the law (New York Times, Tuesday, June 13, 1989).

(2) Note discussion in The Wealth of Nations, Adam Smith (1776), Book V Of the Revenue of the Sovereign or Commonwealth.

(3) Many other provisions could also be discussed, but would make this article too long. For example, however, note the following:

(a) The complexity in computing the foreign tax credit;

(b) The recordkeeping to compute allowable personal interest deductions and distinguish them from business interest expense;

(c) The injustice of disallowing proper employee business expenses unless they exceed a 2% "floor," not comparable to the medical expense "floor" since medical expenses are not paid to generate income;

(d) The arbitrary disallowance of a portion of business expenses in Sec. 274. The expenses are proper or not--and all the income, not just a percentage, is subject to tax.

(4) Sec. 263A--"Capitalization and Inclusion in Inventory Costs of Certain Expenses" was added to the Code in 1986 by Sec. 803 of Public Law 99-514, of which Sec. 803(d)(5) contained a "one taxpayer only" relief provision. Note that Thor Power Tool Co. v. Commr, 439 U.S. 522(1979), which was decided adversely to the taxpayer and to GAAP guidelines, dealt with inventory reserves, not with the question of what should be included in determining the cost of inventory.

(5) Sec. 166(c) was repealed by Sec. 805(a) of Public Law 99-514 (1986), although "a reasonable addition to a reserve for bad debts" had been allowed in the tax law for many years without being questioned in principle.

(6) Sec. 463 was repealed by Sec. 10201(a) of Public Law 100-203 (1987) after having been modified in 1986 to limit deductions to those payments with respect to vacation paid within 81/2 months after year end.

(7) For a more detailed discussion of the burdens and complications of AMT see "The Alternative Minimum Tax From a Practical Perspective: Its Role in the Income Tax Structure Under Current Law, and Its Possible Role in Future Deficit Reduction Legislation," by Kendyl K. Monroe in the Columbia Business Law Review, Volume 1988, Number 2, pp. 341-358.

(8) W. S. Gilbert, "The Mikado," Act II.

(9) Sec. 385--"Treatment of Certain Interest In Corporations as Stock Or Indebtedness" was enacted in 1969 (Sec. 415(a) of Public Law 91-172), but after a long period of proposed and withdrawn regulations now appears destined never to be supported by any regulations.

(10) An example is what has been done in an attempt to define "Passive Activity" under Sec. 469.

(1) Remarks by then Commissioner of Internal Revenue Lawrence B. Gibbs on August 25, 1988, before the National Association of Enrolled Agents in Washington, D.C.

(12) See, for example, an article published in "Tax Notes" on November 28, 1988, entitled "The Market For Tax Reform: Public Pain for Private Gain," by Richard L. doernberg. The title suggests the author's message. See also a first page article in "The Wall Street Journal" of August 4, 1989, entitled "Sudden Sanctimony--Congress Gets Ethical, Shuns Any Hint It Is In Debt to Big Givers." Despite the title, the story suggests that in many situations it is still "business as usual."

(13) See "Federal Income Tax Simplification," 1979, edited by Charles H. Gustafson, published by ALI-ABA Committee on Continuing Education.

(14) H. Stewart Dunn, Jr. and I are co-chairmen of the Steering Committee for that conference. However, the opinions expressed in this article are mine alone.