SET Tax: A Tax System for Our Future
2006 - The New York State Society of Certified Public Accountants
(NYSSCPA) has published this position paper as a guide for
our political leaders and others interested in practical issues
raised by fundamental tax reform.
paper was prepared by a special NYSSCPA Committee on Practical
Reform for the Tax System. It was approved by then–Society
President John J. Kearney. The paper represents an official
policy position of the NYSSCPA.
Committee on Practical Reform for the Tax System was chaired
by David A. Lifson. Its members were Joseph L. Charles,
Alan J. Dlugash, Robert L. Goldstein, Laurence Keiser, Leon
M. Metzger, Stephen A. Sacks, and Maryann M. Winters.
discussion of the members of the committee, which further
explains how the committee came to its position on tax reform
and how its proposal compares to the recently issued proposal
by the President’s Advisory Panel on Federal Tax Reform,
begins on page 32. A summary and analysis of the Presidential
Panel’s proposal begins on page 42.
current income tax system suffers from serious problems.
First, it has become increasingly difficult for the average
taxpayer to understand the complex rules and applications
of the Internal Revenue Code. Second, the reward for expending
more effort to comply with those complex inner workings
is often a higher tax bill. The result is a dangerously
declining compliance rate that could eventually undermine
our highly evolved self-assessment system. This system is
the linchpin that supports the functionality of our entire
income tax process. Legislators
and policymakers must act now to fix a system that has not
only become too complex but has also lost needed transparencies,
to assure taxpayers that our system of taxing the citizenry
is fair and is based on politically agreed upon social policies
of the day.
to illustrate the complexity and confusion are numerous.
Perhaps the most decried example of complexity is the alternative
minimum tax (AMT), a clear example of taxes gone wild in
a dysfunctional system. Although not intended to do so,
this provision relies upon the good faith of taxpayers to
calculate their income tax twice and to pay the higher tax,
based on two difficult calculations using two sets of rules.
Sounder tax-policy initiatives would save complex tax calculations
for tax benefits that are efficient, fair, and easily monitored.
Countless more examples of complexity and confusion are
embedded in the current Internal Revenue Code.
New York State Society of CPAs has a solution to the complexity
and confusion inherent in the current tax system. This paper
will present that solution within the context of both political
and historical perspectives. Before considering changes
for the better, all of us, even the experienced tax policy
maker, the tax professional, and the student of tax, should
review and evaluate:
The environment and people our income tax system serves;
How the system has evolved;
Critical flaws in today’s income tax system;
What goals are important to a good income tax system,
and how they stack up against where we are today—especially
since the goals exist in a constant state of changing
tension; and, only then,
How to accomplish those goals.
tax reform surfaces every decade or so, accompanied by widespread
disenchantment with the status quo, but rife with conflicting
ideas on how to change what the tax code has become.
latest reform call, one of President George W. Bush’s
second-term domestic priorities, faces a deeply polarized
electorate separated along a red-state/blue-state (Republican/Democratic)
divide. Most proposals currently vying for public attention
fail to bridge that political and philosophical division.
NYSSCPA proposes the Simple Exact Transparent Tax, or SET
Tax, as the solution to the dysfunction of the current tax
system. The SET Tax would tax all incomes over a generous
threshold established by our political leaders, reduced
by government-approved exclusions, at an economically appropriate
and socially acceptable single rate. There will be no need
for conflicting tax systems and cumbersome credits and deductions.
SET Tax appeals to both the red and the blue among us by
infusing the tax system with transparency, while leaving
intact the ability to collect revenue in order to fund according
to the social and political priorities of the day. It reduces
the “clutter” of complex tax calculations to
a simple formula that most taxpayers will be able to understand,
applies a fair and universal tax rate, and allows everyone
to know exactly what taxes the government is taking to support
identifiable programs and initiatives.
SET Tax system is a neutral tax tool for use by policymakers.
With it, they can deliver an understandable tax to the taxpaying
public. The SET Tax will provide much greater assurance
that all taxes are collected, so tax cheats will be losers
and honest taxpayers will be winners. It can also efficiently
change who is bearing our income tax burden without the
complex, difficult to understand, and sometimes highly unpredictable
results produced by the current Internal Revenue Code.
SET Tax addresses all the key issues in today’s debate
on tax reform and proposes a solution—transparency—that
could help future generations make the right decisions about
taxes. The SET Tax is fair, simple, and pro-growth.
Perhaps most important, it can remove the inappropriate
complexity and distortions out of the Code while meeting
today’s current economic need for revenue neutrality.
By addressing intentional and unintentional tax-compliance
failures, it can be designed to produce a “compliance
bonus” that can provide government with greater flexibility
in future policy decisions.
explaining the details of SET Tax implementation, it is
important to look at political influences in play today
and to review how our current system of taxation evolved.
ENVIRONMENT AND PEOPLE OUR INCOME TAX SYSTEM SERVES
State, Two States, Red States, Blue States
of recent federal elections portrays the electorate in starkly
contrasting terms as red states—where majorities vote
for Republican presidential candidates —and blue states—where
majorities vote for Democrats. (Of course, in most states
a significant minority of the opposite hue exists.) The
voting dichotomy is tied to different philosophies of government
in the red and blue states. In the red states, there is
a heartfelt belief that reliance on free enterprise and
individualism over time leads to a sounder, more prosperous
society. In contrast, the majorities in blue states believe
that the market needs to be nudged along. Blue staters have
less faith in the market, and emphasize the importance of
the role of government to support society’s less fortunate
starkly different political philosophies result in vastly
different approaches to tax and fiscal policy, typically
with red states opting for market solutions to public problems
and lower, less-progressive tax systems, while blue states
choose publicly financed policy solutions and generally
higher and more-progressive taxes.
divergent views also color the outlook of each part of the
electorate toward the other. Blue staters often emphasize
that their states are paying into the federal government
more than they receive, based upon the assumption that government
distributes the difference to the red states. Red staters,
on the other hand, look at the tax benefits blue staters
derive from itemized deductions for mortgage interest and
state and local taxes, and conclude that red states are
subsidizing the higher interest and taxes paid by blue staters.
THE SYSTEM HAS EVOLVED
the Code Is and How It Got That Way
order to understand the NYSSCPA SET Tax as the fix to address
the dysfunction in the current taxation system, it is important
to look at how taxation came about and changed over the
first few centuries of our country’s history. The
NYSSCPA SET Tax fixes the transparency that was lost as
both political issues and state and federal taxation decisions
steered the country away from a tax system based on a set
definition of income with clear deductions.
early America, the federal government relied almost exclusively
on customs receipts (tariffs) and the sale of public lands
for its revenue. In periods of emergency, such as the War
of 1812, the government added excise taxes. During the Civil
War, when customs receipts again were insufficient to support
the government, Congress imposed an income tax. By the end
of the war, a tax of 5% was imposed on income from $600
to $5,000; 7.5% from $5,000 to $10,000; and a top rate of
10% was imposed on incomes exceeding $10,000.1 Following
the Civil War, the government repealed the income tax and
returned to reliance on customs receipts and excise taxes.2
differences in how the federal government should tax are
not new. In the 19th century, the Northern states favored
the tariffs because they offered protection from European
competition. The Southern states, however, opposed the tariffs
because they added to the cost of products. Later in that
century, the South and West favored an income tax, shifting
the burden of paying taxes toward the industrial North.
This illustrates a parallel to the red/blue dichotomy of
the rise of populism and the resurgence of the post–Civil
War Democratic Party, interest in the income tax grew, and
in 1894, a coalition of Democrats and Populists pushed a
new income tax through, only to see it declared unconstitutional
by the Supreme Court. The decision hinged on an obscure
provision in the Constitution that “direct”
taxes needed to be apportioned among the states based on
their respective populations. This wouldn’t work for
an income tax, because residents of one state would find
themselves subject to tax at a different federal tax rate
than those in another state.3
push for an income tax subsided until 1909, when both major
parties agreed to enact a corporate “franchise tax”
based on corporate income. President Taft supported individual
income tax as well, but required that it first be permitted
through a Constitutional amendment. While he may have thought
that this would indefinitely delay an individual income
tax, the process took only four years, and the income tax
amendment, the Sixteenth, was added to the Constitution.
Subsequently, Congress imposed an income tax through the
Revenue Act of 1913. That law imposed a “normal”
tax of 1% on income over $3,000 ($4,000 for married couples)
and a “surtax,” ranging from 1% on net income
from $20,000 to $50,000, up to 6% for income exceeding $500,000.4
According to Bittker and Lokken, the “distinction
between the flat rate normal tax and the progressive surtax
was based on the theory that the former was a permanent
feature of the federal fiscal landscape but that the surtax
was a temporary expedient, imposed on upper-income taxpayers
only in times of special need.” The distinction was
abandoned in 1954 for individuals and in 1978 for corporations.
War I saw a renewed reliance on the income tax to fund a
war. Rates rose significantly during the war, but there
were only 4.4 million returns from a population of 59 million.
During the Roaring Twenties tax rates dropped, but not to
pre-war levels. Only 5 million returns were filed annually
from a population that ranged from 65 to 70 million. Then
in 1932, notwithstanding the aftermath of the Great Depression,
a fiscally hawkish Congress raised rates approximately to
World War I levels. The revenue of Americans had so trailed
off by that time, however, that the tax revenues dropped
from $86.8 billion in 1929 to $42.8 billion in 1932. The
year 1935 saw increased progressivity on both corporate
and personal income taxes, with corporate rates ranging
from 12.5% to 15% and individual rates as high as 75% on
incomes over $5 million. 1937 saw tax reforms targeted to
tie down certain tax avoidance schemes. These reforms included
disallowance of losses from sales between family members,
taxes on unreasonable retention of income in a corporation,
and restrictions on personal holding companies.
year 1939 was a big year for tax legislation. In that year,
the tax laws, which had been spread throughout many volumes
of federal statutes, were codified. This first Internal
Revenue Code of 1939, with occasional amendments, would
remain in force until 1954.
period from 1940 to 1945 included the use of income tax
to fund yet another war. But just as significantly, the
income tax became a tax of the masses during this time.
In 1939, fewer than 4 million returns were filed; by 1943
that number had increased to nearly 43 million returns.
1942 saw the introduction of payroll withholding at source.
With the 1939 codification and the conversion of the income
tax into a mass tax, the income tax had come of age.
is also important to note that as the roles of state and
local government have mixed over the last 50 years, the
taxes the various levels of government have relied upon
have also mixed. Up until the Great Depression and World
War II, the federal government handled defense and foreign
relations and, to a small degree, internal improvements,
while the states handled policing, regulation, education,
and other local issues. Each level of government had its
traditional revenue sources: the federal government had
tariffs and the income tax; the states had sales and property
taxes. Post–World War II and into the Great Society,
the government took a larger and larger share of what traditionally
had been state functions (public housing, education, policing)
and became less concerned about the encroachment on traditional
state sources of revenue. The erosion of the state tax deduction
is an example. Simple local taxes to provide services, state
taxes to handle major projects such as highway construction,
and federal taxes to support war efforts became marbled,
as deductions, exemptions, and credits made it more unclear
than clear where tax dollars were actually going.
tax system allows Congress to steer the economy in a direction
that is favorable for the times. For example, when Congress
believed that manufacturing needed encouragement, we had
the investment tax credit; when the residential rental market
needed a boost, depreciation rules were liberalized.
SET Tax addresses a return to transparency, while allowing
the taxation system to remain an instrument of social policy.
FLAWS IN TODAY’S INCOME TAX SYSTEM
Reinvention of the Internal Revenue Code Adds Complexity
Internal Revenue Code (the “Code” or “IRC”)5
contains the sum and substance of the federal government’s
tax systems: not just the regular income tax, but a plethora
of other taxes, including the alternative minimum tax, estate
and gift taxes, employment taxes, excise taxes, penalties,
generation or so, the Code goes through an overhaul; 1939,
1954, 1986 being perhaps the most memorable, each having
resulted in a renaming of the Code. (The Code in its present
form is the Internal Revenue Code of 1986.) Following each
overhaul, a process begins anew to tinker with the Code,
and over time, grand new tax policy ideas are added, together
with a multitude of special interest provisions. These provisions
often reflect different approaches to implementing tax policy,
such as using tax credits instead of deductions to stimulate
an activity, or caps instead of phase-outs to limit tax
following examples illustrate the kind of confusion and
complexity that exists in the current tax system.
credits versus deductions. A deduction is
a reduction to arrive at taxable income, the “base”
on which your tax is computed. A tax credit is a direct
reduction in taxes. Both these techniques are used in the
Code to stimulate a desired activity. In a progressive tax
rate system like today’s, each higher layer of income
is taxed at progressively higher rates. Deductions are therefore
generally “more valuable” to the wealthy because
they provide tax savings at a higher tax rate than do the
tax savings produced for the less fortunate at their lower
tax rates. Tax credits are perceived to be more egalitarian
because, rich or poor, a tax credit reduces the same amount
of tax regardless of income level. Calculations
become even more obtuse when Congress struggles to decide
whether the excess deduction can be carried forward or back
into another tax year’s calculation and whether the
credits are refundable, lost, or carried forward or back
if they cannot be used in the current year. The tension
between offering a credit versus offering a deduction to
deliver tax policy initiatives introduces a lot of interactive
complexity that makes today’s code needlessly obtuse
in many areas that require simplification.
in the simplest of examples, credits versus deductions at
different times with different tools and different goals
in mind can introduce unnecessary confusion. For instance,
Congress decided that it wanted to encourage businesses
to conduct research. Before 1954, the state of the law was
unclear, and taxpayers didn’t know if research expenses
could be deducted from income or if they needed to be capitalized—that
is, added to the cost of an asset, but not permitted as
section 174, which was first enacted in the Code in 1954,
permits taxpayers either to capitalize the expenses or to
write off 100% of expenditures falling within the Code’s
definition of research expenses. Moreover, if the expenses
are capitalized and the taxpayer can’t determine a
specific useful life for the expenditure, the taxpayer may
elect to amortize the research expenditure over a period
of 60 months.
further encourage research expenditures, Congress in 1981
enacted what now is section 41, which permits businesses
to take a tax credit based on the amount that their research
expenses increase from one year to the next. The credit
is 20% of the cost of any basic research plus 20% of the
increase in costs over a base year of any other research
is a good example, too, of complication in the Tax Code.
Sections 174 and 41 use different definitions for research.
Also, section 41 contains a sunset date that needs to be
reset every year or so, making it difficult to include the
economic effect of taxes in planning decisions involving
research, which tends to defeat the reason for the credit
in the first place.
versus phase-outs. A cap is an overall limit
on a deduction. An example in the Code is the limitation
on the deductibility of salary paid to highly compensated
individuals. Code section 162(m) limits to $1 million the
deduction that any publicly traded businesses may take for
compensation (other than performance-based compensation 6)
paid to any CEO or other employee whose salary must be reported
to the shareholders pursuant to the Securities Exchange
Act of 1934.
on the other hand, is a deduction or credit that vanishes
as income rises. An example of this is personal exemptions,
included in Code section 151. In 2004, taxpayers can deduct
$3,100 for every dependent in their household. However,
as taxpayers’ income rises, this deduction phases
out. The phase-out is 2% for every $2,500 (or fraction thereof)
that the taxpayer’s adjusted gross income exceeds
$142,700 ($214,050 for married taxpayers filing jointly).
So a single taxpayer whose adjusted gross income is $167,700
must reduce his or her personal exemptions by 20%: [($167,700
-- $142,700) / $2,500] x 2%. This feature of the Tax Code
also illustrates one of its unfair characteristics. In the
example, if the taxpayer’s adjusted gross income was
just $1 more, $167,701, the reduction is kicked up from
20% to 22%: [($167,701 -- $142,700) / $2,500] x 2%. 7
caps and phase-outs are combined. For instance, Code section
221 permits individuals to deduct up to $2,500 (cap) of
interest on qualified education loans. However, if the taxpayer’s
“modified adjusted gross income” exceeds $50,000
($100,000 for married taxpayers filing jointly), the deductible
interest is reduced by a fraction, the numerator of which
is the amount the modified adjusted gross income exceeds
the levels cited, and the denominator of which is $15,000
(for married filing jointly, $30,000). In other words, the
deduction phases out as the taxpayer’s modified adjusted
gross income rises from $50,000 to $65,000 (for married
filing jointly, from $100,000 to $115,000).
example also illustrates how complicated the Code has become.
Note that the personal exemption phase-out hinges on “adjusted
gross income,” while the education loan interest phase-out
depends on “modified adjusted gross income.”
When phase-out techniques are relied on in drafting tax
laws, it is important to make sure the phase-outs are applied
in a particular order so that the taxpayer can ascertain
how much of each credit is used and how much, if any, remains
available for carryback or carryforward. While it is true
that this can be deftly designed into tax-preparation software,
these tax-design approaches greatly lessen transparency,
making the Code a “bad” tax in light of the
criteria discussed later.
different tax policy approaches eventually build up a great
deal of Code clutter, which is the cause of much of the
Code’s complexity and opaqueness today.8
system of subtractions from gross income and a single tax
rate are the foundations of the SET Tax system. All the
concepts contributing to code clutter—deductions,
credits, caps, phase-outs based on multiple income measurements,
and more—can be merged into a single set of more understandable
The Phantom Menace
no specific element in the Code exemplifies the snowball
effect of clutter better than the individual alternative
minimum tax. Congress enacted the add-on minimum tax, the
predecessor of the AMT, to ensure that high-income individuals
could not use deductions and exemptions to eliminate their
tax liability altogether. Everyone whose income exceeded
a threshold would have to pay something. This exploitation
of the tax system was the result of taxpayers’ using
Congressionally approved benefits designed to encourage
specific activities. Many had argued that the benefits should
be curtailed instead of imposing an alternative tax system.
This policy justification—that everyone should pay
something in income tax—carried forward to the AMT,
which was enacted in 1978. A few years later, this needless
complication was introduced to corporate taxation, for most
of the same tax policy reasons. We will focus on the individual
AMT to show you why we call it “The Phantom Menace.”
individual AMT is no longer a net to snag a few high-income
individuals perceived as exploiting the system. Over the
years, rather than a way to catch tax avoiders, the AMT
became a system to increase taxes on those with
high incomes who already were paying taxes. It
is a separate system, parallel to the regular income tax
part of the Code, with its own complex rules and with a
flawed design. It now ensnares not just a few high-income
taxpayers paying little or no tax, but many more people
than its creators could ever have intended.
that, according to the Internal Revenue Service, in 1970
only 19,000 people paid an alternative tax (under rules
for a precursor to the AMT). Under the current AMT, that
number has proliferated to 3 million people today, and if
things don’t change, as many as 33 million taxpayers
might pay additional taxes under the AMT by 2010.
is it that so many taxpayers fall into AMT? A recent editorial
in The New York Times succinctly stated that the
AMT is triggered when taxable income—the net amount
after adjustments, deductions, and exemptions are made—surpasses
certain maximum allowances for exemptions.9 One problem
is that income brackets and exemptions designed to remove
the middle class from this tax calculation headache and
payment burden were never indexed to inflation, as so many
critics like to point out. Consequently, the AMT driftnet
snags an increasing number of individuals as our economy
grows over time. Many individuals earning economically middle-incomes
today are high-income individuals for tax purposes, making
AMT a kind of “tax out of time.”
know this is a serious problem, and from time to time, they
attempt to make quick fixes to match AMT rates to contemporary
realities. Eliminating the AMT at once would prove costly:
$600 billion over 10 years, according to a Congressional
Budget Office report.10 And there may also be institutional
resistance to stanching a reliable revenue source; AMT currently
rakes in about $18 billion. It is not surprising, then,
that alterations to the AMT exemption have been piecemeal
and often temporary.
have raised the AMT exemption several times since 1978.
Congress in 2001 determined that an individual (single,
head of household) with an adjusted gross income of $35,750
was wealthy enough to fall into the AMT. The Jobs Growth
and Tax Relief Reconciliation Act of 2003 raised that figure
to $40,250 (while setting the exemption at $58,000 for joint
filers and surviving spouses, and $29,000 for married individuals
filing separately), which reverts to the 2000 level for
2005 if Congress doesn’t move to extend the AMT exemption.
have questioned even these higher exemption figures as an
unrealistic anachronism. Bart Fooden and Lawrence Shoenthal,
both CPAs who have written about AMT, wonder how a single
parent could expect to feed, clothe, shelter, and medically
provide for a family of five and also pay the AMT, with
such a relatively low exemption.11
problems that are more fundamental vex the AMT. Its characterization
of deductions and exemptions as “loopholes”
can have the unfortunate appearance of punishing higher-income
individuals (though not the highest in today’s terms)
for earning a living. State and local tax deductions, miscellaneous
itemized deductions, and personal exemptions add up to trigger
the AMT. This has obvious ramifications for those who live
in high-tax areas or where the cost of earning a living
is onerous, making AMT a “tax out of place.”
AMT undermines the usefulness of deductions for some individuals
who deign to employ them. As Fooden and Shoenthal point
out, if an individual pays a lawyer a fee for collecting
back wages, the legal fee is a miscellaneous deduction.
But under AMT, that fee, a cost of earning income, is no
longer an expense; the deduction is negated. So if an individual
pays a lawyer $300 for collecting $1,000 of back pay, netting
$700, the AMT taxes the individual on the full $1,000.
the AMT affects a majority of individuals and families who
earn more than $100,000, its impact can be potentially damaging
to others, such as retirees on a fixed income. For example,
an employee who was compensated by his or her company in
qualified stock options, because it had no cash to pay salaries,
could owe taxes, even if the exercised stock option produced
no regular taxable income.12 Another aspect of
the AMT is that it not only increases the complexity of
the tax law, but also dramatically increases the compliance
costs. The average time to complete an individual tax return
has been estimated as 6 hours and 40 minutes. However, it
is not only those who will be required to pay the
AMT who must fill out AMT forms, it is anyone who may
be required to pay. In May 2001, Congress’ Joint Economic
Committee (“JEC”) estimated that 4.4 million
taxpayers filed the form, while only about 880,000 had to
pay additional taxes. The JEC estimates that compliance
costs were $360 million dollars, while the tax generated
$4 billion in revenue. This rate of 9% of costs as compared
to revenue is more than 5 times higher than the 1.6% rate
of preparation costs to revenue that pertains to the rest
of the income tax.13
the GAO calculates that in 1998 as few as 14,000 taxpayers
went from paying no tax to paying some tax because of the
AMT. Furthermore, in 1998, per the Joint Economic Committee,
only 3,572 of the individuals paying AMT had high incomes
(earned $200,000 or more). In most cases the AMT merely
increased the burden on people already paying tax, and did
so in a complex, arbitrary, and unpredictable way. It seems
highly questionable, from a tax policy point of view, to
subject tens of millions of taxpayers to the complications
of the AMT in order to collect tax from 14,000 people.
SET Tax is a better approach. The SET Tax eliminates the
AMT (both corporate and individual) and is a system available
to raise the same revenues from the same (or different)
taxpayers, in a transparent, relatively easy-to-understand
Designs the Code?
political leaders, after first divining the public’s
enthusiasm for, or at least tolerance of, competing tax
proposals, make the decisions about which policies will
be embedded into the Code. They sit in the captain’s
chair and determine in which direction we are to head as
they balance the views of various constituencies.
of its eclectic origin, the IRC reflects a balance among
many political forces. Macro political theories as well
as micro political interests influence the cycle of reforming
and recluttering the Code.
of macro theories. An example of a macro political
theory at work in the Code is the belief that the Code is
the most efficient means of effecting a social policy.14
This belief resulted in: (1) the earned income tax credit,
a Tax Code alternative to a bureaucratic delivery system
for welfare payments; (2) mortgage interest deductions to
foster home ownership en masse; (3) individual taxation
exclusion and deduction for health insurance instead of
direct government-sponsored medical care for workers; and
(4) IRAs and 401(k)s, a Code-based effort to induce greater
retirement savings [including employer contributions in
many corporate 401(k)s] and to minimize the need for government-sponsored
direct pensions through Social Security.
of micro interests. An example of a Code provision
resulting from micro political interests is the provision
passed in 1976 [currently Code section 162(h)] that provides
state legislators with liberalized rules for deducting their
travel away from home. Another example is the “above-the-line”
deduction of miscellaneous employment-related expenses incurred
by teachers. Still another is the Indian Employment Tax
Credit, originally enacted in 1993 and extended in 2004,
which gives employers a tax credit to stimulate economic
development on Indian reservations.
of industry-oriented code provisions. Between
these extremes are: (1) industry-wide incentives such as
the advantageous tax treatment given to commercial real
estate before the 1986 Tax Act, and the non–generally
accepted accounting methods still permitted to farmers;
(2) tax incentives to foster increased research and development;
and (3) special depletion methods to encourage oil and gas
The Color the Code Lacks Most
Graetz, in his 1997 book The Decline (and Fall?)
of the Income Tax, observes that between 1972 and 1979,
the public’s confidence in the income tax waned from
rating the income tax as the fairest in 1972 to the unfairest
in 1979.15 We maintain that the reason for this
particular attitudinal change is the opaqueness that the
Code adopted during that decade and, indeed, over the last
30 years generally. The present Code can be faulted on a
number of fronts, but the most serious—and the key
to restoring confidence in the tax system—is the Code’s
lack of transparency. As a characteristic of a tax system,
transparency can be viewed as follows:
should know that a tax exists and how and when it is imposed
upon them and others. Visibility enables individuals
and businesses to know the true cost of transactions.
It also enables them to see what their total tax liability
is and to which level of government it is being paid.
When a tax is not visible, it can be easily retained or
raised with little, if any, awareness among taxpayers
about how the tax affects them.16
we emphasize that transparency gives political leaders a
much better grasp on how a tax change will impact their
constituencies. It is frustrating for political leaders
to believe they are benefiting constituents—say, with
the addition of a child credit or marriage penalty relief
or lower tax rates—only to learn they have angered
constituents because the anticipated benefits had been neutered
by the alternative minimum tax or were inapplicable because
of phase-outs. Transparency benefits everyone, except those
wishing to hide a tax loophole from public scrutiny.
OF A GOOD INCOME TAX SYSTEM
to Know a Good Tax When You See It
some fashion or other, tax policy writers have a common
wellspring to gauge when a tax system is “good.”
They refer to Adam Smith’s monumental An Inquiry
into the Nature and Causes of the Wealth of Nations,
published in 1776, where Smith identifies the four maxims
for a good tax system, paraphrased as follows:
Everyone ought to support the government, through taxes
in proportion to their abilities.
payments ought to be certain and not arbitrary, with the
time of payment clear and plain.
Every tax ought to be levied at the time, or in the manner,
in which it is most likely to be convenient for the contributor
to pay it.
Every tax ought to be so contrived as both to take out
of and to keep out of the pockets of the people as little
as possible, over and above what it brings into the public
treasury of the state.
the years, these four basic concepts have been analyzed
on numerous occasions. An excellent, recent treatment was
performed by the American Institute of Certified Public
Accountants17, which parsed the four maxims into the following
10 “Guiding Principles”:
Equity and Fairness. Similarly situated taxpayers
should be taxed similarly.
Certainty. The tax rules should clearly specify
when the tax is to be paid, how it is to be paid, and
how the amount to be paid is to be determined.
Convenience of Payment. A tax should be due at
a time or in a manner that is most likely to be convenient
for the taxpayer.
Economy in Collection. The costs to collect a
tax should be kept to a minimum for both the government
Simplicity. The tax law should be simple so that
taxpayers understand the rules and can comply with them
correctly and in a cost-efficient manner.
Neutrality. The effect of the tax law on a taxpayer’s
decisions as to how to carry out a particular transaction
or whether to engage in a transaction should be kept to
Growth and Efficiency. The tax system should not
impede or reduce the productive capacity of the economy.
Transparency and Visibility. Taxpayers should
know that a tax exists and how and when it is imposed
upon them and others.
Minimum Tax Gap. A tax should be structured to
Appropriate Government Revenues. The tax system
should enable the government to determine how much tax
revenue will likely be collected and when.
and Wrong Ways to Achieve Progressivity
noted above, one of the “Guiding Principles”
for a good tax system is “Equity and Fairness.”
Economists talk about horizontal and vertical equity. Horizontal
equity is that similarly situated taxpayers should be treated
similarly. Vertical equity is that there should be appropriate
differentiations between persons on an income level and
those above and below.18
achieve vertical equity, our political leaders have, since
the Civil War income tax, designed progressivity into the
income tax. The most direct way to do this is with a progressive
tax rate structure. One problem that resulted from this
approach is that taxpayers began to arrange their dealings
to shift from higher tax-rate strata into lower ones. This
was done by converting income from a type that was taxed
at a higher rate (traditionally, dividends and interest)
into types that were taxed at a lower, more preferential
rate (capital gains or earned income), and from higher-income
taxpayers to lower-income taxpayers (from parents to children).
It was also done by deferring income from one year into
the next.19 To lessen the incentive to game the tax structure,
Congress, beginning with the Reagan administration, reduced
the degree of progressivity in the tax rate structure. Top
tax rates were reduced and the tax base was broadened, meaning
that rates were lowered but more income was subject to tax.
that same time, Congress has increasingly relied upon other
techniques to achieve progressivity, most notably caps and
phase-outs, which are used to limit tax benefits to higher-income
taxpayers. While caps are relatively straightforward, phase-outs
tend to greatly exacerbate the Code’s complexity and
reduce its transparency.
techniques to achieve progressivity tend to have disproportionate
impact on states with higher costs of living, generally
the blue states. The Tax Foundation makes the point with
the following example:
higher taxes may seem like a small price to pay for enjoying
higher incomes, but unfortunately many states’ higher
incomes are an illusion once cost of living is taken into
example, an income of $132,143 in San Francisco buys the
same living standard as $84,111 in Portland because of
Oregon’s sharply lower cost of living. However,
that San Francisco income would result in $22,812 in federal
taxes, while the Portland income would result in just
$10,748, illustrating how states with high per capita
incomes get the worst deal from Uncle Sam.
article makes the point that progressive rates impact a
higher percentage of taxpayers in high-income states. Caps
and phase-outs are techniques to raise progressivity outside
the tax rate structure.20
Principled Thoughts on Simplicity and Complexity
of taxes is a very complex phenomenon. The paradox in this
statement is the battle to be fought and won when redesigning
the Code. Simplification is a word that means different
things to different people. The differences are significant,
not subtle. Simplification takes on totally different meanings
based on each constituency’s perspective.
instance, simplification to most citizens really means,
“How do I pay less tax more conveniently?” The
SET Tax does not fall into this “less is more”
trap. Government must be financed. We have focused on the
“more conveniently” motivator while doing our
best to manage the “less tax” motivator. It
bears repeating: Every government needs to be financed.
the other hand, simplification to government administrators
in a “modern” society means, “How can
I collect more tax revenues at a lower cost with less effort?”
An optimized, fully functioning “self-assessment”
system is essential for the implementation of this philosophy.
current self-assessment system is neither optimized nor
fully functioning. This is primarily due to the design of
tax provisions enacted by Congress. There have been many
efforts to “simplify” the income tax process
and make these taxes more understandable, but no one has
successfully stood back and reexamined the “system”
to see if doing the same thing differently could produce
better results. Most efforts have focused on polishing and
cleaning up all the old tools, rather than looking for new
ones. For example, most changes since 1986 (which was the
last major overhaul of the tax system) have made the tax
system less efficient and, in the process, less simple.
Changes in the world economy have also made tax policy and
implementation methods that are embedded in the Code from
as far back as 1913 far less efficient in the 21st-century
economy. We must be mindful that our tax laws were enacted
at many different times for reasons that were valid for
those times but may have conflicted with the underlying
rationale of other changes. What is perceived as a “loophole”
in the 2000s oftentimes was believed to be a highly beneficial
provision in the 1940s.
the past, due to our political sensitivity to the needs
of defined segments of the taxpaying public, these concerns
have regularly introduced complexity to narrowly address
(and therefore define) certain groups of taxpayers. More
often than not, the complexity is a so-called “tax
trap” that causes the fully compliant taxpayers to
pay more tax than they otherwise would pay. These tax traps
(see: alternative minimum tax, phase-outs, Subpart F, etc.)
severely challenge the design and implementation of a self-assessment
system due to the tax administrators’ and general
public’s inability to fully understand and comply
with the complexity of the Code. The IRS is, and always
will be, underfunded for the task, and the public often
has little incentive to use resources to pay more taxes.
can lead to lower taxes through higher compliance rates.
Taxes collected are equal to taxes imposed, multiplied by
tax compliance rates. It follows that the higher the compliance
rate, the lower the tax rate required to produce the same
funding for government. Government estimates are that we
have the highest tax compliance rate in the industrialized
world: about 85%. This level of compliance may well be envied
by other countries, but for the U.S. it is still a suboptimal
performance. We can do better. If simplification increases
our compliance rate 10%, in a revenue-neutral system, all
compliant taxpayers could well be granted a 12% tax reduction
... and more discretionary time to pursue interests other
than tax compliance. Simple tax rules promote accurate,
honest self-assessment of tax.
to Impose Complexity
tolerate complexity when it involves minimal cost and effort;
in contrast, many endorse it when it leads to a reward.
In tax systems, the “reward” is an honestly
received reduction in taxes. Whenever possible, an efficient
tax system will introduce complexity to enable taxpayers
to save taxes. As long as the complexity is sufficiently
transparent for the government to administer, and the rules
are reasonable for honest taxpayers to implement, the resulting
tax system will provide the appropriate net tax to fund
the government. The drafters of the Revenue Act of 1913
understood this, in admittedly simpler times.
Code started with the precursor to the current bedrock of
the U.S. income tax, Code section 61. This short but simple
Code section defines what will be taxed: “gross income
means all income from whatever source derived.” The
Code then qualifies this broad statement with a theme that
follows in the rest of the current IRC: “except as
otherwise provided.” The exceptions lead to complexity—generally
fair and appropriate complexity—because they introduce
economic goals and social policy into the system.
root cause of inefficient complexity is those exceptions
to the exceptions. Congress typically designs them to narrow
the focus of the first-level exception, making penalties
for some out of rewards designed for others.
complexity. The AMT is a perfect example,
and is the quintessential example of needless complexity
that fosters noncompliance. The theory behind the AMT is
flawed from both simplification and efficiency perspectives.
It was designed as an additional system to tax people who
enjoyed too much benefit from the exceptions in the regular
tax system. By adding a completely new system, compliance
complexity and hard work lead to more tax. Any attempt to
enforce this on all but the most sophisticated (and fearful)
taxpayers is flawed and inefficient.
self-policing complexity. A more efficient,
self-policing complexity would require taxpayers to report
and identify to the IRS some targeted or all tax-deductible
payments paid to vendors as a condition of allowing the
payer a tax deduction. This would entail enhancing the current
Form 1099 reporting system, which generally simply provides
a $50-per-event penalty for failure to report certain payments
to independent contractors and other unincorporated service
providers, and would require modest fairness exceptions
(for the genuinely uninformed and less sophisticated) and
procedural protections (government receipts for the data,
to protect taxpayers from IRS errors). The reward for compliance
is the tax savings produced. Bonus: the recipient of the
payment has more encouragement to comply voluntarily with
the tax laws, and the government has more useful enforcement
donation of a qualified conservation interest in real property,
foreign-earned income/housing exclusions, and the requirement
to have a letter to further substantiate large charitable
contributions are all examples of relatively efficient complexity.
Most credits (e.g., welfare-to-work, child and dependent
care, adoption, low-income housing, community development
corporations, Liberty Zone, etc.) also provide rewards rather
than higher taxes for hard work, and are more easily tolerated,
administered, and monitored in a self-assessment system,
even though they are occasionally mind-numbingly complex.
will be shown later, these provisions are easily translated
to exemptions in the SET Tax.
as a Source of Complexity
in and of itself, adds complexity and is generally considered
anti-simplification. Any simplification will require substantive
changes to the way we are taxed, so any short-term complexity
must be considered the price we pay for long-term improvements
and simplification. The price must be worth the results.
of our system must be at a fair price. Simplification must
balance the taxpayers’ and our government’s
sense of simplification against transactional complexity
that is appropriate to the tax benefit granted and the policy
the same time, we cannot be afraid of rounding errors or
of insignificant groups or transactions. All too often,
tax provisions designed to tax a few people who receive
an unintended benefit introduce needless complexity that
is bad for the overall system. Former IRS commissioner Fred
Goldberg often promoted “rough justice” as a
needed compromise to attain the greater simplicity good.
Tolerance for rough yet fair justice is possible in an enlightened
need to be brave enough to start afresh and wise enough
not to change everything. It is simple: In designing the
Code, we should always be addressing who should pay less
tax, not who should pay more. The single, high tax rate
in the SET Tax approach sets the stage for this perspective.
Each section of the Code and each implementation of tax
policy embedded in the Code can be reevaluated and restructured
without changing the taxes we pay. Report the broadest of
tax bases, and all gross income. Then reduce it to be “fair”
and to exercise the political will of the people with legislated
reductions. Here’s an example:
taxes. Congress invented Subpart F in the
early 1960s to ensure that U.S. persons pay tax on their
worldwide income eventually. Prior to then, the law allowed
U.S. business owners to delay paying tax (indefinitely)
by leaving the earnings offshore. Tax must be paid on all
“income from whatever source derived,” but when?
When earned, or when received in the U.S.? Many perceived
that these offshore “pocketbooks” were no different
from bank accounts in foreign shell corporations, which
became subject to current tax in the 1930s when taxpayers
discovered this tax-free wealth-accumulation technique.
businesses pleaded that they needed to deploy capital offshore
so that they could build global businesses that would compete
efficiently with other global businesses. Congress designed
Subpart F to bring some foreign earnings into the current
tax system while respecting the needs of U.S. owners of
international businesses to compete globally.
Subpart F taxes some income, but requires the taxpayer to
expend enormous resources to compute how much more to pay.
Basically, a U.S. owner of a significant portion of a foreign
corporation may continue to defer tax on the owner’s
share of active business income abroad until the income
is returned to the U.S., but must pay tax currently on the
other income in the foreign corporate structure in the year
it is earned. Complex ancillary filing and reporting is
required to see if the owner owes more tax. Other than well-informed,
major multinational corporations, most taxpayers who own
stock in foreign corporations are surprised to learn of
this compliance requirement and potential tax responsibility.
(In fact, it is the same ignorance of special rules relating
to foreign investments that over the years has regularly
trapped unsuspecting taxpayers into cleverly marketed but
nevertheless fraudulent offshore tax shelters.)
efficient self-policing system would be to restate Subpart
F by taxing all foreign earnings of U.S. owners and making
reductions for earnings from a foreign trade or business,
for small shareholdings—i.e., owners of less than
5% or 10% of a foreign corporation—business needs,
and other relevant items. It should be easier for the public
to understand and accept disclosure (the key to policing
a self-assessment system), and taxpayers should work much
more willingly to reduce their taxes because they qualify
for a reduction of the income that is taxed.
Neutrality as Complexity Generator
neutrality rules need a commonsense fix to remove needless
complexity in the current system. The government uses the
cash basis of accounting, and measures results based on
the difference between cash received from taxes and cash
paid to fund government. Under the current revenue-scoring
rules, the change from any old tax to a new proposed tax
provision is measured by the change in the expected tax
collections over a fixed 10-year period. The fixed period
is referred to as a budget window. The combination of cash-basis
measurement of results and a fixed budget window inadvertently
creates false revenue neutrality in some cases—accountants
call them timing differences.
the current rules, in order to write legislation that follows
those revenue neutrality rules, all too often lawmakers
become “creative” and write legislation that
accelerates revenues by a day or so, or postpones a cost
for a few days or weeks, to accomplish their policy objective
at a minimum cost. Examples of financial gyrations designed
to provide questionable budget neutrality include:
estimated tax rules;
current estate tax law, including projected repeal and
most phase-ins and phase-outs.
techniques reduce the projected “cost” of many
tax law changes by minimizing the “cost” in
the budget from the revenue window.
provisions that accelerate revenue or defer expenses for
a week so that they fall into (or out of) a fiscal year
do not, in substance, affect the cost of government. When
accountants and lawyers manipulate the timing of income
and expenditures this way, it is called an abusive tax shelter;
when business does this, it is often scandalous and sometimes
criminal; but if the Congress does it, it is not criminal,
because the Congress sets the rules.
fiscal rules need to change. Some have suggested accrual
accounting, which would require government to match revenues
with expenses. While theoretically the right answer, in
current times this complexity may raise more new problems
than solutions to old problems.
way to fix the budget window is to ignore so-called “timing
differences” in the budget process that would reverse
in the next year. There is even a well-known tax principle
that revenue estimators could follow called “the recurring
item exception,” which allows a taxpayer to easily
deduct expenses in the current year that are paid year after
year and within a fixed period after the end of the year.
timing differences from budget scoring when they turn around
in a relatively short period would eliminate hundreds, perhaps
thousands, of needlessly embedded complex provisions in
the Tax Code. These provisions have been overwhelming in
the past 20 years under the reasonable budgetary restraints
but flawed rules of revenue neutrality. This would also
add greater transparency to budget estimates, highlighting
substantive changes and exposing what are now legitimate
TO ACCOMPLISH THESE GOALS
Is the Simple Exact Transparent Tax?
this background about what makes a tax a “good”
or a “bad” tax, and the crying need for transparency
and simplicity, we offer an approach that is the epitome
of these “good” tax traits, the Simple Exact
Transparent Tax, or SET Tax.
SET Tax is a greatly simplified income tax, devoid of unnecessary
complexity and alternative tax systems. Congress would select
a politically acceptable, economically appropriate single
tax rate to tax income, and then use only straightforward
exclusions of its choosing to accomplish additional public-policy
goals, such as:
encouraging economic behavior, such as saving for retirement,
manufacturing in the USA, discovering oil, and developing
alternate energy sources; and
accomplishing social policy goals, such as encouraging
home ownership, charitable giving, etc.
only tax credits permitted in this tax system might be refundable
credits Congress passes to deliver benefits to low-income
taxpayers, and possibly credits to coordinate the SET Tax
with economic and social realities, e.g., foreign tax credit,
although it is possible to do this with a calculated exclusion
other words, the SET Tax would tax all incomes over a generous
threshold established by our political leaders and after
other government-approved exclusions at an economically
appropriate and sociably acceptable single rate.
New Operating Principle
current system identifies taxpayers who should pay more
tax. Smart, careful drafters should be able to raise the
same tax revenues by starting with a general rule that measures
everyone’s annual, realized income in relatively simple,
easy to understand, easy to report terms.
income tax is calculated starting with this baseline of
income, less exceptions both for those who should not pay
tax and for public policy initiatives. Mathematically, then:
-- Congressionally defined exclusions) x Rate = Tax
essence, income subject to the tax rate would be reduced
by exemptions so designated by the Congress, including,
for example, mortgage interest, charitable donations, and
foreign holdings. A tax system should be designed so that
complexity increases with the sophistication of the transactions
entered into by the taxpayer. The complexity should, whenever
possible, lead to taxpayer rewards that can be readily monitored
by the IRS. As a principle, reducing taxes from a clearly
disclosed income baseline is more transparent, easier to
administer, more efficient to monitor, simpler for unsophisticated
taxpayers, and complex for those who can afford to deal
with complicated benefits. As an added bonus, when government
reduces taxes, the beneficiaries (taxpayers) are happy.
the SET Tax Would Work
SET Tax begins with a single tax rate. Generically, therefore,
it is a flat tax. Unlike the proposal referred to as the
flat tax, however, the SET Tax would continue to enable
Congress to use the tax laws to accomplish their multifaceted
policy initiatives. It does this with “base broadening,”
which is the term used for defining the income to be taxed.
proposals generally lower the tax rate and broaden some
segment or the entire tax base to generate sufficient funds
for our government and the programs it sponsors. Others
broaden the base, promising lower rates, only to add a supplementary
system (i.e., VAT or other taxes) to replace the old tax
that previously raised funds from now newly untaxed income.
It is the often invisible definitions of the tax base that
sit at the heart of tax complexity, along with the mechanics
of the income tax system. It is not the tax rates that add
SET Tax is straightforward. It starts with all
gross income, the broadest income tax base possible and
the easiest to teach and understand. Existing rules are
used to distinguish between income and loans, gifts, inheritances,
support, and so on, as well as to handle issues of when
income is “received” in complex situations.
The SET Tax then radically simplifies the tools used to
implement policy through the tax system, by using a mechanical
approach to arrive at taxable income. It does this by introducing
a single set of “exclusions” from gross income.
replace the current cluttered system of deductions, refundable
credits and nonrefundable credits, filing status determinations,
dependents, exemptions, so-called “nontaxable income,”
and the like to distribute the income tax burden among various
income groups. The exclusions are based on today’s
fundamentally sound tax-law concepts. For example, “exclusions”
in the SET Tax system could include all of today’s
deductions, exemptions, exclusions, credits (reengineered
into exclusions), and other reasons to reduce an individual’s
or a corporation’s gross income to determine his,
her, or its tax base.
following examples illustrate the simplicity of this process.
A simple lump-sum exclusion would eliminate the income tax
for people who can least afford it. The simple exclusions
would be easy to find and easy to understand. More complex
exclusions would require a little more work. The work (and
related required disclosure of complex behavior) makes the
SET Code easier to administer, and easier for the government
to find tax cheaters. Increasingly complicated exclusions
would apply as the sophistication of taxpayers, and their
income, increases. For example, the exclusion for charitable
giving would involve modest complexity. Exclusions for people
with income earned by certain businesses, foreign corporations
or partnerships, foreign or domestic trusts, or bank accounts
in foreign countries might become quite complex. The SET
Tax simply makes it easier for taxpayers to understand and
comply with the rules. In addition, the SET Tax Code could
be designed to tax all the people who are paying the “correct”
tax now the same amount, but each taxpayer would find their
tax burden easier to understand and easier to calculate.
of today’s cluttered, unsettling rules should produce
simplicity and transparency. Not only will the rules be
straightforward and easy to comply with, but taxpayers will
also know what exclusions can reduce their taxable income.
Most of the complicated parts of the Internal Revenue Code
would be retained merely as building blocks and protective
mechanisms to address the complex business and financial
transactions that are the hallmark of our ever-evolving
system of capitalism. Complexity, then, under the SET Tax,
only burdens people who engage in sophisticated or complex
financial activity. But even then, the complexity becomes
self-evident, easier to review and more efficient to monitor.
earners, normal investors in our capital markets (i.e.,
through marketable securities transactions and bank accounts),
and private business operators will find the SET Tax clear,
lacking needless calculations. The SET Tax eliminates the
alternative minimum tax, most, if not all, tax credits,
and complex filing-status decisions.
most important, the SET Tax principles apply equally to
income taxation of individuals and of businesses. If policymakers
want, they could seamlessly integrate corporate and individual
income taxation through identical SET Tax principles.
principle of the SET Tax would be that income taxes should
be borne by citizens and companies that are relatively prosperous.
Accordingly, only one rate is required, the SET Rate. In
the following examples, a 33 Qd % rate is used to make the
calculations easy to understand and to be clear that the
SET rate would need to be high enough to enable Congress
to include a high exclusion to eliminate lower-income individuals
and businesses from the burden of paying income tax. The
current maximum corporate and individual tax rate is 35%,
although complexity caused by progressive rates to recapture
a full 35% tax for the wealthiest taxpayers on incomes taxed
at lower rates causes some marginal income to be taxed at
rates up to 39%. Nevertheless, individual and corporate
incomes are arguably taxed in total at no more than a flat
35%. A single rate in the low- to mid-30% range should be
sufficient to produce at least the same, if not more, income
tax than is produced through the current tax.
SET Tax system will be a more efficient tax system and will
collect more of the tax that is due, setting off a “compliance
bonus.” Although our 85% tax compliance rate is the
envy of many of our trading partners, a 90% compliance rate
would raise significantly more tax revenue and permit Congress
to enact lower tax rates to compliant taxpayers, reduce
deficits, increase spending for worthy government programs,
or any combination of the three.
the SET Tax greatly reduces the complexity of measuring
our tax expenditures. Currently, the measurement of tax
expenditures is immensely complicated by the fact that benefited
taxpayers can be subject to dozens of different marginal
tax rates because of the interaction of the progressive
rate structure, limitations, and phase-outs.
relying on a single rate and simplifying the methods used
to deliver tax benefits, tax expenditures can be measured
annually, in a way that members of Congress can more easily
articulate and taxpayers can more easily understand. Hence,
there is transparency from the top down, and from the bottom
a SET Tax
leaders should retain the ability to use the Code for the
delivery of benefits they determine are needed for the common
good. They should rely, however, on an income tax that makes
valuation of those constituency benefits clear to all. The
Simple Exact Transparent Tax, the SET Tax, would accomplish
SET Tax has four components:
Single rate. We propose an income
tax set at a single, relatively high rate so everyone
can understand the maximum he or she would pay in the
absence of exclusions. We use 33 Qd % in our examples,
to make the illustration of the SET Tax easy to understand.
The actual rate is to be determined by our political leadership
after receiving input from economists, revenue estimators,
income is all income. Income would be measured
under existing principles, generally using the cash basis
for individuals and small businesses, while most larger
businesses (including corporations and partnerships) would
be required to use the accrual system to recognize gross
income. There would be no omission from realized gross
income, only deductions we call exclusions. Interest on
tax-exempt bonds, then, would be included in gross income
and granted an exclusion, provided Congress continues
to believe such interest should not be subject to federal
income tax.21 On the other hand, cash receipts that are
not income, like gifts or borrowings, would not be included
in gross income. Similarly, as under current law, various
tax-free business creations and reorganizations would
not create gross income to owners. Current law definitions
will be very helpful in this area, and retained.
Every taxpayer would have at least one exclusion;
all exclusions should be as simple as possible. Every
taxpayer should have a personal exclusion. This will draw
all income earners into the tax system, through an extremely
simple filing process. Exclusions beyond the basic exclusion
would be consistently and simply crafted, and could be
capped or subject to percentage limitations to accommodate
everybody may pay, BUT EVERYBODY FILES!
While we agree with building vertical equity into the
tax system through transparent approaches to transparency,
we do not believe it is wise to remove individuals completely
from tax reporting, even if they owe no tax. That approach
acclimates individuals to inaction in their interaction
with the tax system. It forces an individual to undertake
significant changes when he or she moves from being untaxed
into being taxed. In the process, it nurtures the underground
economy and tax-evasive behavior.
citizen should become accustomed to interacting with the
tax-filing system, either by filing a paper tax form or
through telephonic or electronic filing. Also, the income
tax system should be so designed that the tax forms and
instructions are exceedingly simple for lower-income taxpayers
to file without requiring assistance from an accountant.
These taxpayers should not be forced by an incomprehensible
tax system to seek professional assistance, especially to
receive the benefit of such items as the earned income tax
of the SET Tax
would be no need for an alternative tax system. Everyone
would generally know quickly how much the tax benefits they
receive are worth. Tax credits would be avoided as much
as possible. We anticipate that occasions may arise where
credits are necessary, such as if Congress wants to refund
taxes to nontaxpayers, similar to the earned income tax
credit, or perhaps in the context of foreign taxation.
will keep the tax system simple, compliant, predictable—in
other words, transparent. It integrates easily with the
current system, only is easier to administer. There are
no new concepts to learn, and many old tricks and traps
are relegated to the dustbin. A very significant SET Tax
benefit is that it lends itself to much simpler scoring.
Congress can better gauge the cost of tax-policy initiatives,
and taxpayers easily identify how much they receive in tax
“complexifying,” opaque drafting techniques
would disappear from the Code. There would no longer be
a need for:
phase-outs; the purpose served by phase-outs would be
addressed by limiting exclusions;
credits (except for refundable credits);
multiple filing statuses;
alternative tax systems;
transition rules; and
artificial constructs like “adjusted gross income,”
and “modified adjusted gross income.”
is important to emphasize that the SET Tax retains for the
Congress the flexibility to retain progressivity or reduce
it, and to engage in social engineering through the tax
system or not. The SET Tax enables the government to raise
the same money it does now and with the same income distribution,
if that is deemed by Congress to be advantageous.
an aside, the uncertain results of the flat tax (and, in
fact, other fundamental reform ideas, such as the value-added
and sales taxes, which would play havoc with the federal
system by unbalancing fiscal revenue sources relied on by
the states) lead many political leaders to conclude that
we need to introduce multiple tax systems to replace the
income tax. At first blush this may appear prudent; but
on reflection, it multiplies the uncertainties. The SET
Tax is a much surer solution, and keeps the country on familiar
political leadership would retain the flexibility to set
the rate and identify the amount and types of income to
tax. An example of how the tax might work explains the concept
best. The NYSSCPA is not endorsing any of the amounts included
in the following examples, nor the 33 Qd % rate mentioned
above. That determination must be made in the context of
the political process. As mentioned previously, the numbers
used and the tax rate are offered for illustrative purposes
exemption: progressivity. We would recommend
that Congress adopt a high personal exemption to achieve
progressivity. We use a $30,000 exemption here, but Congress
could conclude that it be much higher, perhaps as high as
the Social Security income ceiling. Alternatively, the personal
exemption could be lower, say at the official poverty level.
The SET Tax accommodates any range of government policy,
and clearly informs the people of the resolution of any
policies debated in this area.
purposes of this discussion, however, we assume Congress
sets the personal exemption at $30,000. Every income-earning
individual would know that the government was spending $10,000
on his or her behalf.22
more levels of progressivity are desired, subsequent layers
can be benefited with partial exclusions. For instance,
the first $20,000 of income could be 100% excludable and
the next $10,000 could be 50% excludable.
of a sort is also achieved by capping exclusions, as illustrated
in the examples that follow addressing mortgage interest
and state taxes.
the business context, an exemption mirroring the personal
exemption could be granted to all corporate taxpayers, or
to all small or new businesses, regardless of their choice
of business entity. The exemption could be capped or reduced
based on business size, using existing definitions of groups
and related parties to prevent entity abuse.
exclusion. If the political leadership determined
that society benefits if a person forgoes gainful employment
to raise a couple’s children, with appropriate disclosure,
an additional special exclusion (in addition to any other
standard exclusion) of, say, $15,000 could be permitted
on the income-earning partner’s return.23
Everyone would know that this would entail a $5,000 benefit.
interest exclusion. If our political leaders
determined to encourage home ownership, they could permit
an exclusion for mortgage interest up to a certain amount,
say $75,000 of interest, to approximately replace today’s
$1,100,000 total debt cap. This is an example of an exclusion
cap. Homeowners would know that they were receiving a benefit
of one-third of their mortgage interest, up to a total benefit
of $25,000. The amount of the exclusion could even vary
annually to take into consideration changing interest rates.
It would be up to our leaders to determine that fairness
and other policy goals warranted this level of complexity,
but each year every taxpayer would know how much of a benefit
was available, what he or she got, and, shortly after the
end of the next year, approximately what it cost the government
to provide the benefit. This is a difficult, controversial
calculation for many in today’s system.
taxes and charitable contributions. If the
political leadership wants to lessen the burden on taxpayers
from their contributions to support state government or
charities, similar approaches work simply and transparently.
Congress could permit an exclusion for all state and local
taxes up to a fixed dollar amount, say $9,000, or for contributions
up to $30,000. Again, everyone could understand that the
federal government was supporting these causes on a per-taxpayer
basis up to the extent of $3,000 and $10,000, respectively.
The concept of adjusted gross income and “above-the-line”
versus “below-the-line” deduction classifications
with varying benefits for items that are deducible is replaced
with a uniform measure of income before some exclusions
that may need to be means tested.
on capital income. Suppose our trading partners
taxed income from capital at only 15%. If our political
leaders decided that the U.S. should meet that societal
“offer” for capital, they could permit a 55% 24
exclusion of any income from capital (interest, dividends,
and capital gains). Everyone would know the amount the nation
would be investing in capital formation, the amount of capital
income times 55% times one-third. (This is an example of
a percentage exclusion.)
double tax. If our political leaders determine
that corporate income should not be taxed once at the corporate
level and again at the shareholder level, they could grant
a 100% exclusion (or lesser percentage) for dividends paid
An exemption for some (or all) of the annual
capital costs incurred in a business, similar to the current
section 179 deduction, could be easily added to the exemption
for all ordinary trade or business expenses. A percentage
depletion exclusion could simply mirror the current system
of depletion allowances supporting the extractive industries.
OF THE SET TAX WITH OTHER TAX-REFORM PROPOSALS
SET Tax and the Flat Tax
you could call it a flat tax, the SET Tax is not the
flat tax. For example, the current most widely recognized
flat tax—that is, the Hall-Rabushka proposal and its
progeny—is a single-rate wage tax that eliminates
deductions for mortgage interest, property taxes, state
and local income taxes, charitable contributions, tax exclusions
(such as those for scholarships, fellowships, and employee
awards), casualty losses, and additional deductions afforded
to the elderly and disabled.26 It does not tax investment
income, such as interest dividends and capital gains. The
heart of arguments by fans of the flat tax and supply-side
economists is that a tax system is better that has a broader
base and a single, lower tax rate.
primary arguments urged in favor of these base-broadening
approaches are economic, that these approaches reduce the
income tax’s drag on the economy, that entrepreneurial
initiative will be unleashed, that productivity will rise.
Typically, proponents urge that such a tax is simpler. However,
the result is not necessarily a more transparent tax.
the flat tax suffers from being rigid in design, and tries
to find the lowest tax rate and broadest tax base. The SET
Tax approach starts with a higher rate, and narrows the
base transparently. The flat tax removes from our political
leadership the ability to use the tax system to accomplish
targeted economic and social goals. The SET Tax approach
retains needed flexibility. The flat tax also requires a
significant leap of faith that it will in fact raise the
needed revenue to fund public services.
of the debate over the past 25 years relating to so-called
flat taxes has circled around lowering the maximum income
tax rate and substituting other mechanisms to replace the
lost revenues. These proposals have a lot of public appeal
because the prospect of lower tax rates is always popular,
but we remain concerned about the other mechanisms and their
lack of transparency. If the people want to use an income
tax to fund government, then all incomes should be considered,
and narrowed down to a tax base that everyone understands.
Because of the structure and history of our current income
tax system, by design and by default, some incomes are invisibly
sliced away from the tax base. Equally unfortunately, this
sometimes happens in an unpredictable, unintended fashion.
recognize that the Code’s complexity does not result
from multiple tax rates—that is, the progressive tax
rate structure. Complexity results from how the tax base
is defined. Nevertheless, progressive rate structures do
obscure the impact of tax provisions. They make estimation
of the fiscal impact problematic. A single-rate income tax
removes this revenue impact uncertainty. But the SET Tax
is not the flat tax.
flaw with the flat tax is that it fails to cope with nearly
a century of U.S. history in the making of tax law and the
evolution of the Internal Revenue Code. To adopt the flat
tax, one must buy it lock, stock, and barrel. Our political
leaders must be willing to surrender their flexibility to
adjust fiscal policy to the needs of the electorate as they
see them. Such a wholesale surrender of political decision-making
authority cannot be wise, regardless of whether one is a
red stater or a blue stater.
the most serious flaw, though, is that the flat tax has
the effect, perhaps even a goal, of removing many people
from the tax rolls. There is a psychological problem with
this. If an individual falls off the tax rolls, he or she
loses an important sense of involvement in the government.
Once lost, the allure of the underground economy can turn
a person into a noncomplier. The SET Tax proposes that everyone
with income should file something. For the vast majority,
the proverbial postcard return would suffice.
SET Tax and the Consumption Tax
deal of attention has been given to shifting from an income
tax approach to a consumption tax (otherwise known as an
expenditures tax), such as the Hall-Rabushka flat tax, a
national sales tax, or a value-added tax. The respective
benefits and detriments of the income tax and consumption
taxes have been debated for many years.27
the benefits of an income tax over a consumption tax include:
Many consider consumption taxes to have equity problems,
because they shift the incidence of taxation to those
with a higher ratio of consumption relative to income;
that is, there is a shift to lower-income and elderly
taxpayers, and large families.
Because consumption levies tend to tax different expenditures
at assorted rates, many believe they affect consumers’
purchasing decisions, misallocating economic resources.
For instance, in some consumption-tax proposals, buying
a house would not typically be seen as consumption, but
renting one would be. This could distort the housing market
in favor of purchasing homes, well beyond the current
distortion created by the deduction for interest and real
see the following benefits flowing from consumption taxes:
Income taxes have an adverse impact on savings and investment.
In certain international jurisdictions, indirect taxes,
including sales taxes and value-added taxes, can be refunded
for goods that are exported. This makes these taxes more
conducive to encouraging exports.
Consumption taxes focus on what one takes from, rather
than what one contributes to, the economy, which is a
Consumption taxes may do a better job of automatically
adjusting to inflation.
although consumption taxes are often touted as being simpler
than the income tax, they actually entail a great deal of
their own complexity. Both types of tax are prone to tax-evasion
the tax-reform debate at hand, proposals will surface that
reflect either blue-state or red-state philosophies. The
winning tax-reform approach must be flexible enough to reflect
either blue or red policy alternatives going forward, or
a modicum of both. The result could be a blend of each,
as arguably was the case with the landmark Tax Reform Act
of 1986. The NYSSCPA urges that, whatever the final hue,
any tax-reform legislation be crafted in such a way as to
be transparent. The red and blue influences must clearly
shine through. The SET Tax suggests a practical approach
to achieve transparency regardless of the tint of the outcome.
SET Tax and the Sales Tax (and VAT)
commentators have proposed that the income tax be replaced
with a national sales tax or a value-added tax. To replace
the income tax, estimates are that a national sales tax
rate would need to be as high as 23% or higher, depending
on the exemptions from the tax.29 In addition to the pros
and cons discussed above regarding consumption taxes generally,
both a national sales tax and a VAT have a serious additional
flaw: they impede the federalist balance between the national
and the state governments.
the states have relied on sales and use taxes, property
taxes, and, to a lesser degree, income taxes for their revenue.
Imposing so high a sales tax or VAT at the national level
would impact state revenues in ways that are difficult to
a public policy point of view, many have argued that a tax
system that is inherently regressive should not replace
an income tax, which is inherently progressive. Even the
staunchest VAT supporters recognize that the VAT, as a tax
on consumption, will tax a higher portion of the lower incomes
and a lower portion of the upper incomes of American households.
Europe has a VAT (we have sales tax), but it has not replaced
the income tax systems, it co-exists with them.
most distressing of all, the VAT is invisible, even if the
VAT amount is printed on the sales slip. Few, if any, take
notice of dozens, hundreds, or even thousands of transactions.
We think transparency is preferable.
of the Simple Exact Transparent Tax would focus political
debate entirely on what “tax expenditures” the
political leadership wants to make, and how much the expenditure
should be. Instead of locking Congress into what benefits
it wants to encourage—as do the flat tax and other
fundamental tax-reform approaches—the SET Tax provides
Congress and the President with a single, transparent delivery
vehicle for tax expenditures. It provides the American people
with a straightforward tool to measure their incomes and
the taxes they pay.
would have a better chance to understand how government
works and why it makes the fiscal decisions it does. This
benefits everyone, regardless of the color of his or her
the end, it is not a matter of whether a tax reform is red
or blue that matters, but whether it is transparent. The
SET Tax is transparent, not to mention simple, equitable,
and fair, certain, conveniently paid, efficient, and neutral.
It promotes economic growth (to the extent our political
leaders determine that is advisable) and results in a minimum
tax gap, and results in much easier assessment of fiscal
propriety. The SET Tax meets today’s economic need
for revenue neutrality. In short, it meets all the prerequisites
of a good tax system, while maintaining for political leadership
the flexibility necessary to govern and finance government
Per the calculator found at www.eh.net, based on consumer
price indices, the value of $600 in 1864 would be $6,986
in 2003 dollars; $10,000 would be $116,436.
B. Bittker and L. Lokken, Federal
Taxation of Income, Estates, and Gifts, vol. 1 (Warren
Gorham & Lamont, 1999), pp. 1–2 ff.
v. Farmers’ Loan & Trust Co., 157 U.S. 429,
158 US 601 (1895).
Per the eh.net calculator, $3,000 in 1913 would be the equivalent
of $55,478 in 2003; $4,000 would be $73,971; $20,000 would
be $369,855; $50,000 would be $924,639; and $500,000 would
“Internal Revenue Code” is shorthand for Title
26 of the United States Code.
We should note that for performance-based compensation to
exceed the cap, the performance goals must be approved by
outside directors, the compensation must be approved by
shareholder vote, and the performance goals must be certified.
The extra dollar adds “a fraction thereof.”
See the testimony of Federal Reserve Chairman Alan Greenspan
before the President’s Advisory Panel on Federal Tax
Reform, Washington, D.C., March 3, 2005.
“Mr. Bush’s Stealthy Tax Increase,”
The New York Times, March 13, 2005.
CBO Revenue and Tax Policy Brief No. 4, “The Alternative
Minimum Tax,” April 15, 2004; http://www.cbo.gov/showdoc.cfm?index=
B. Fooden and L. Shoenthal, “A Closer Look at the
Trusted Professional, April 1, 2005.
In addition to the references cited in this section, see
R. Harvey and J. Templaski, “The Individual AMT,”
National Law Journal (September 1997), pp. 453–73;
testimony of Thomas M. Sullivan, Chief Counsel for Advocacy,
U.S. Small Business Administration, to U.S. House of Representatives
Committee on Small Business, July 23, 2003, http://www.sba.gov/advo/laws/test03_0723.html;
“What tax cut? Meet the AMT,” CNNMoney,http://money.cnn.com/2004/02/
25/pf/taxes/amt_stories/; and Comments on Tax Simplification,
NYSSCPA Tax Simplification Task Force, May 27, 2003, http://www.nysscpa.org/commentletter/task_simplification.doc.
The Alternative Minimum Tax For Individuals: A Growing Burden
(Joint Economic Committee Study, May 2001), http://www.house.gov/jec/tax/amt.htm.
M. Friedman, Capitalism
and Freedom (1962).
The Decline (and Fall?) of the Income Tax (W.W. Norton
& Company, 1997).
Tax Policy Concept Statement Number 1, Guiding Principles
of Good Tax Policy: A Framework for Evaluating Tax Proposals
Bittker and Lokken, para. 3.1.4.
Bittker and Lokken, para 2.2.
“Unequal Burdens: Some States Feasting at the Expense
of Others?,” Tax
Watch (Tax Foundation, Winter 2005).
There are those who think this would require a Constitutional
By the way, there would be no need for joint reporting by
married couples, no marriage penalty; all that complexity
results from progressive rates.
In the alternative, Congress could permit couples, married
or otherwise, to use combined reporting to simplify filing,
and a caregiver deduction could be allowed there.
(33 Qd – 15%) ? 33 Qd = 55%
We understand there are some compelling reasons to choose
a credit approach to address the corporate double tax issue,
if Congress and the President were to decide to do so. Nevertheless,
we urge use of a deduction approach if the SET Tax is adopted,
and suggest that corporate and individual tax integration
can be accomplished several ways through a whole or partial
R. Hall and A. Rabushka,
Low Tax, Simple Tax, Flat Tax (1983). See also M. Sullivan,
Flat Taxes and Consumption Taxes: A Guide to the Debate
(AICPA, 1995) for a concise discussion of the flat tax.
B. Bittker and L. Lokken, para. 3.7.
S. Karlinsky and H. Burton, “America’s Inexorable
Move to a Consumption-Based Tax System, or Why Warren Buffett
Is Winning the Class Tax War,” Tax
Notes Today, November 2, 2004.
See the Fair Tax Act, S. 25, introduced by Senator Chambliss
on January 24, 2005.