to go back to the drawing board?
Larry Witner and Kathleen Simons
2005 - On January 7, 2005, President Bush established the
President’s Advisory Panel on Federal Tax Reform. He
asked the advisory panel to recommend reforms that would promote
simplicity, fairness, and economic growth. More specifically,
he wanted reforms that would—
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
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.
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.
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.
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 federal tax system comprises the following components:
An individual income tax with progressive rates;
separate tax on corporations;
and estate taxes on the transfer of wealth;
taxes on the manufacture and sale of certain goods;
wage taxes to fund the Social Security and Medicare programs;
federal agency (the IRS) to administer and enforce tax
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.
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%.
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.
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.
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.
Panel’s Findings Regarding the Current Tax System
April 13, 2005, the advisory panel released its findings
(2005 TNT 71-71) regarding the state of the current tax
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
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
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.
to Modify the Tax System
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.
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.
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.
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%).
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
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%.
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.
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%.
to Replace the Current System with a Consumption Tax
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
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.)
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.
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.
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.
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.
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.
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
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.
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%.
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).
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.
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.
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.
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.
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.
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.
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.
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.
Dealing with International Taxation
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.
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’
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.
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.
for a Fix
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.
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
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%)
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.
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.
Witner, LLM, CPA, is an associate professor, and
Kathleen Simons, DBA, CPA, is a professor,
both at Bryant University, Smithfield, R.I.