Experiment in Reforming the Tax System
Summary and Analysis of the Report of the President’s
Advisory Panel on Federal Tax Reform
Larry Witner, Kathleen Simons, Tim Krumwiede, Andrew Duxbury,
and Michael C. Plaia
2006 - In January 2005, President Bush appointed a nine-member
advisory Panel to make recommendations for reforming federal
tax laws. A review of the Panel’s interim work was
described in the October 2005 CPA Journal (“Federal
Tax Reform,” page 20).
Report of the President’s Advisory Panel on Federal
Tax Reform, titled “Simple, Fair, and Pro-Growth,”
was issued November 1, 2005.
report’s recommendations are described here as follows:
Taxation of Households (page 45);
Savings and Retirement Plans, Capital Income (Dividends,
Interest, Capital Gains) (page 49);
of Business (page 52);
of International Transactions (page 55); and
Epilogue (page 59).
prologue contains preliminary remarks, and it comments on
factors that may have influenced the Panel’s work
Panel and Its Charge
critics have claimed that the selection of the Panel’s
members and staff preordained the outcome. The authors leave
it to others to affirm or refute this allegation. The authors
believe that the members made a valiant effort, produced
results that will shape the upcoming debate, and deserve
the nation’s appreciation. The following factors,
rather than the composition of the Panel itself, may better
explain what influenced the Panel’s work.
President’s charge. In his charge to
the Panel, President Bush instructed it to make recommendations
that promote simplicity, fairness, and economic growth,
reducing costs of compliance;
recognizing the importance of home ownership and charity;
increasing saving and investment; and
strengthening U.S. competitiveness in the global marketplace.
addition, President Bush instructed the Panel to—
base at least one of its recommendations on the current
make recommendations that are “appropriately progressive”;
make recommendations that are revenue neutral (i.e., that
collect the same amount of taxes as current projections).
critics have claimed that this charge stacked the deck for
or against certain reform measures. This criticism has merit.
For example, there are legitimate arguments both for and
against the home mortgage interest deduction. By emphasizing
the importance of home ownership, the President weighed
in on one side of the debate and may have predetermined
the Panel’s final recommendation. The Panel did not
comment on the appropriateness of the President’s
charge and what effect, if any, it had on simplification
constraint: progressivity. The Panel imposed
on itself a constraint to keep the distribution of the tax
burden (i.e., level of progressivity) relatively the same
as under the current tax system. (While the tax burden may
be the same at the federal level under the Panel’s
proposals, it may increase at the state level; see “Taxation
of Households,” below.) The Panel reasoned that decisions
about progressivity are best left to elected officials.
There were no official minority reports to the Panel’s
recommendations, but at the conclusion of the Panel’s
work, Panel member Elizabeth Garrett expressed her personal
concerns about poverty, growing income inequality, and inadequate
I believe legislators should use this panel’s report
as a roadmap for reform, they should use the structure
we have provided to increase the progressivity of the
tax system and to raise sufficient revenue to responsibly
meet the country’s short- and long-term obligations.
(2005 TNT 211-24)
trumps other goals. The Panel recognized that
simplicity may be at odds with differing notions of fairness
and strategies for economic growth. For instance, it may
be fair to target tax benefits toward low-income taxpayers
and away from high-income taxpayers. It may be fair, but
it will not be simple if it involves phase-outs, caps, floors,
and the alternative minimum tax. The Panel decided to make
simplicity a priority. Thus, when simplicity conflicted
with other goals, more often than not simplicity won out.
of consensus on alternatives. The Panel worked
by consensus. Due to lack of agreement among the nine members
on the feasibility or desirability of alternatives to the
income tax system that were presented to them, they did
not recommend a consumed-income tax, a national retail sales
tax (NRST), or a value-added tax (VAT).
10 months of hearings and deliberations, the Panel formed
a consensus around two recommendations: the Simplified Income
Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT).
These plans are similar in their treatment of households
(individuals), but they differ in their treatment of capital
income (dividends, interest, and capital gains) and businesses.
Panel viewed the provisions of each plan as integral, inseparable
parts of the larger whole:
isolation, some of the recommended pieces may be controversial,
but, taken as a whole, they [the plans] accomplish the
panel’s objectives [simplicity, fairness, economic
growth]. Each plan is designed to be comprehensive and
should be viewed as an integrated package.
on the Tables and Text
several reasons, the reader may want to pay close attention
1 on page 45, (a new Form 1040 based on the Simplified
Income Tax Plan) and Form
2 on page 50, (a new Form 1040 based on the Growth and
Investment Tax Plan). They reveal the Panel’s efforts
to simplify the filing process, and the tables summarize,
in a familiar visual format, much of the verbiage contained
in the text.
authors have attempted to be objective in their analysis,
but despite their good intentions, some biases (liberal
or conservative) may slip through. Please excuse the authors
for this shortcoming, and feel free to correct or contradict
expressions “currently” and “current law”
are used to refer to tax law in effect in 2005. Citations
are kept to a minimum; the source material, unless otherwise
indicated, is the Panel’s 272-page report, which can
be downloaded from www.taxreformpanel.gov.
Report of the President’s Advisory Panel on Federal
Tax Reform recommends two options: the Simplified Income
Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT).
These plans are almost identical in their treatment of households
(i.e., individuals), so there is no need to distinguish
between the plans.
Alternative Minimum Tax (AMT)
there are two methods for individuals to calculate their
tax liability: the regular method and the AMT method. The
AMT is a separate and parallel tax system with its own definitions,
exclusions, deductions, credits, and tax rates. According
to the Panel, the AMT is “the most vivid example of
the wasteful complexity that has been built into our system
to limit the availability of some tax benefits.”
Panel noted that the AMT was passed in 1969 after it was
found that a few hundred wealthy families had not paid any
income taxes. The individual AMT’s function is “to
ensure that no taxpayer with substantial economic income
can avoid significant tax liability by using exclusions,
deductions, and credits. … [I]t is inherently unfair
for high-income individuals … to pay little or no
tax due to their ability to utilize various tax preferences”
(Senate Finance Committee Report, H.R. 3838, p. 518, U.S.
Government Printing Office, May 29, 1986).
AMT is not indexed for inflation, so, as time has passed
since it became law, more and more middle-income individuals
have become subject to the AMT. Unless something is done,
in 2006 21 million taxpayers will be affected, and in 2015
52 million taxpayers will be affected.
the sake of simplicity, and because the original intent
of the AMT—limited application—has been foiled,
the Panel recommends repealing the AMT. In the process,
however, the U.S. Treasury would lose $1.2 trillion in projected
tax revenues over the next 10 years. In this era of deficits,
hurricanes, wars, baby-boomer retirements, prescription
drug entitlements, inadequate healthcare, and so forth,
the United States cannot afford to lose $1.2 trillion. The
Panel was charged with making recommendations that were
revenue-neutral, but it could not address government spending
priorities or reductions that would potentially fund tax
cuts. In the author’s opinion, once the Panel decided
to repeal the AMT, that tax revenue had to be made up somewhere
else. This need for additional revenue partially explains
1) the Panel’s efforts to broaden the tax base, 2)
the Panel’s reduction of the home mortgage interest
deduction and elimination of the state and local tax deduction,
and 3) the Panel’s modest reduction in the tax rates,
all of which are discussed below, and discussed in the accompanying
article “Panel Discussion” on page 32.
Use of Credits
several reasons, the Panel favors increasing the use of
tax credits. To illustrate, the Panel uses the standard-deduction-versus-itemized-deduction
scenario of the current tax system. Currently, 35% of individuals
itemize deductions and 65% take the standard deduction.
Thus, with regard to certain tax benefits available only
to taxpayers that itemize, the 65% that take the standard
deduction are “losers.” For those who do itemize,
deductions are more beneficial to high-income individuals
than to low-income individuals. For example, consider a
hypothetical deductible expenditure of $1,000. Non-itemizers
cannot take advantage of it. For itemizers, those in the
35% tax bracket save $350 in taxes ($1,000 x 35%), but those
in the 15% tax bracket save only $150 in taxes ($1,000 x
on the other hand, do not play favorites. Reconsider the
hypothetical expenditure of $1,000, and assume it qualifies
as a credit, instead of as an itemized deduction. Regardless
of whether the taxpayer is an itemizer or a non-itemizer,
in the 35% bracket or the 15% bracket, a $1,000 credit saves
taxes of $1,000. For this reason, the Panel favors increasing
the use of credits, with its Family Credit, Work Credit,
and Home Credit. It did, however, still recommend using
deductions for charitable contributions, health insurance
contributions, and Social Security benefits.
New ’Family Credit’
in general, individuals may choose between itemizing deductions
and taking the standard deduction ($10,000 for married couples;
$5,000 for singles; $7,300 for heads of households). Certain
itemized deductions phase out as income rises. Individuals
can deduct a personal exemption ($3,200) for each member
of their household, which likewise phases out as income
rises. Individuals are also allowed a credit for child and
dependent care for expenses incurred to enable individuals
to work or seek employment, which phases out as income rises.
Panel recommends doing away with the choice of itemizing
deductions or taking the standard deduction. With no itemized
deductions as we now know them, there would be no deduction
for medical expenses and casualty losses.
Panel recommends using a Family Credit to replace the standard
deduction, the personal exemption, the credit for child
and dependent care, head of household filing status, and
the 10% tax bracket. The Family Credit would consist of
A $3,300 credit for a married couple, a $2,800 credit
for an unmarried person with a child, or a $1,650 credit
for an unmarried person;
A $1,150 credit for someone who is a dependent of another;
An additional $1,500 credit for each child; and
An additional $500 credit for each other dependent.
Family Credit would exempt most lower-income households
from income tax. According to the Panel, the amount of income
not subject to federal income tax under the Family Credit
would be similar to the amount not subject to tax under
New ‘Work Credit’
there is an earned income tax credit (EITC) designed to
encourage work by low-income individuals. The maximum credit
for a working family is $2,747 with one child and $4,536
with two or more children. This benefit phases out as income
exceeds certain levels. In addition, households are entitled
to a child tax credit of $1,000 for each child under age
17. In certain cases, the credit is refundable. This benefit
also phases out as income exceeds certain levels.
of these current provisions duplicate and overlap those
discussed in the section above. The eligibility rules and
the lengthy computations make it difficult for low-income
individuals to claim the EITC without the help of a tax
professional. More than 70% of EITC recipients use a paid
preparer. Nevertheless, the error rates for individuals
who claim the EITC and the refundable child tax credit are
substantial. The Panel reveals that the EITC overclaim rate
was 27% in 1999. At the same time, between 15% and 25% of
eligible individuals did not claim the EITC.
rules that vary by provision add complexity to the Tax Code.
For example, the maximum ages for children under the child
tax credit, the dependent exemption, and the EITC, are 16,
18, and 23, respectively. Numerous filing errors occur because
taxpayers are required to determine their eligibility for
each provision under different sets of rules.
Panel recommends replacing the EITC and the refundable child
tax credit with a Work Credit. The maximum Work Credit for
a working family would be $3,570 for one child and $5,800
for two or more children. The Panel recommends setting the
maximum age for children for both the Family Credit and
the Work Credit at 18 (20 for full-time students). According
to the Panel, the Work Credit provides about the same maximum
credit as the combined amount of the current-law EITC and
the refundable child tax credit.
As with the current credits and deductions
discussed above, many tax benefits phase out as income rises.
Phase-outs are a source of complexity because, among other
things, they phase out at different income levels, and they
require lengthy worksheets to compute. Phase-outs are essentially
backdoor tax increases (or stealth taxes) that enable lawmakers
to avoid raising other taxes. For the sake of simplicity,
with the exception of its Work Credit and Saver’s
Credit, the Panel recommends repealing all phase-outs.
in some circumstances, two people will pay less tax if they
file as two unmarried individuals rather than as a married
couple. This is called the “marriage penalty.”
Panel recommends reducing penalties for marriage by making
the tax brackets and other tax provisions for married couples
equal to twice the amount for unmarried individuals.
for a primary and secondary home, an individual can deduct
the interest on mortgages of up to $1 million for “acquisition
debt” and $100,000 for “home equity debt.”
Because the home mortgage interest deduction is available
only to itemizers, merely 54% of homeowners who pay mortgage
interest receive a tax benefit. Besides deducting mortgage
interest, homeowners can deduct state and local property
taxes, and when they sell, they can exclude a gain of up
to $500,000 ($250,000 if single).
to the Panel, taken together, these benefits provide a generous
tax subsidy for individuals to invest in housing. According
to statistics in the Panel’s report, the economy-wide
tax rate on housing investments is close to zero, whereas
the tax rate on business investments is about 22%. This
may result in too much investment in housing and too little
investment in business. According to the Panel:
the housing industry does produce jobs and may have other
positive effects on the overall economy, it is not clear
that it should enjoy such disproportionately favorable
treatment under the tax code.
to the Panel, the original intent of the home mortgage interest
deduction was to support the American dream of home ownership
for everyone. The Panel believes that current law, with
its arguably lavish provisions (multiple homes and million-dollar
mortgages) that provide tax benefits disproportionately
to high-income itemizers, may have strayed from the original
intent. The Panel compared the incidence of homeownership
to that in other countries. The Panel studied other countries
that do not allow a home mortgage interest deduction (Canada,
the United Kingdom, Australia), and found no correlation
to homeownership (69% of U.S. households).
Panel recommends replacing the home mortgage interest deduction
with a Home Credit equal to 15% of the mortgage interest
paid on acquisition debt. There would be no tax benefit
(deduction or credit) for interest paid on second homes
or home equity debt. Because it would be a credit, it would
be available to all homeowners, not just itemizers as under
the current system.
as not to encourage overinvestment in housing, the Panel
recommends limiting the amount of the Home Credit. The Panel
believes that interest eligible for the credit should be
limited to 130% of the average regional price of housing;
in today’s market, this ranges from $227,000 to $412,000.
According to comments made in the press by Connie Mack,
chair of the Panel, fewer than 5% of mortgages in the United
States exceed this proposed cap (“Panel Takes Aim
at Treasured Tax Deduction,” Associated Press, www.msnbc.msn.com/id/9927167).
homeowners would have five years before they have to use
the new credit. During this transition period, homeowners
could still take a home mortgage interest deduction, but
the size of the mortgage, the interest on which is deductible,
would gradually decline. At the end of five years, everyone
would use the Home Credit.
readers might expect, this recommendation is controversial,
especially for taxpayers in expensive real estate markets.
The National Association of Realtors claims that if this
recommendation becomes law, housing prices will fall by
15%. The Home Credit may not help homeowners in regions
of the country where housing prices have skyrocketed, such
as New York and California. Homeowners that itemize and
that are in a tax bracket higher than 15% will see their
tax benefits shrink. In response to these criticisms, the
Panel would probably point to the benefits for non-itemizers
and would ask itemizers to consider the package as a whole
and not to pass judgment based on isolated provisions.
current law, upon sale, homeowners can exclude from income
gain of up to $500,000 ($250,000 if single). The Panel recommends
that the exclusion should be increased to $600,000 ($300,000
if single), and that it should be indexed for inflation.
The Panel believes that the prerequisite for this benefit—the
period of personal use and ownership—should be increased
from two out of five years to three out of five years.
itemizers (35% of taxpayers) can deduct their charitable
contributions to the extent of, in general, 50% of their
adjusted gross income. Non-itemizers (65% of taxpayers)
do not receive a tax benefit for their donations to charity.
extend the tax benefit, the Panel recommends that all taxpayers,
whether or not they itemize, be allowed to deduct their
charitable contributions to the extent the contributions
exceed 1% of adjusted gross income. Under the recommendations,
then, a 50% cap is replaced with a 1% floor. In this case,
the Panel prefers a deduction over a credit, even though
a deduction provides greater benefits to high-income donors,
because the Panel believes this incremental incentive is
an important source of charitable donations. (For a lengthier
discussion of deductions versus credits, see the accompanying
article “The SET Tax,” on page 14.)
Panel wants a reporting requirement for charities. Specifically,
the Panel recommends that charities be required to report
large gifts ($600 or higher) directly to the IRS and to
the taxpayer. Although some commentators believe that this
could improve compliance, others wonder about the additional
current law, when an individual sells appreciated property
and gives the sales proceeds to charity, two things happen:
the taxpayer pays tax on the gain, and the (itemizing) taxpayer
deducts the cash contribution. The Panel recommends that
taxpayers be allowed to sell property without recognizing
gain and receive a full charitable deduction, provided the
entire sales proceeds are donated to charity within 60 days
of the sale. The sale would provide an objective measure
of the market value of the property, and it would reduce
the charity’s administrative costs and the burden
of selling the property. If property, rather than cash,
is contributed, issues arise about the contribution’s
value. The Panel recommends that the standards for appraisal
health insurance is the primary source of health insurance
for many Americans. Under current law, employees may exclude
from income all of the premiums paid on their behalf by
level the playing field between workers that have access
to employer-provided health insurance and those that do
not, the Panel recommends that all individuals be allowed
a deduction for health insurance premiums, regardless of
the source. Furthermore, the Panel recommends capping this
benefit at $5,000 for individuals and $11,500 for families,
which is equal to the national average expected to be spent
on premiums in 2006 (this cap would be indexed for inflation).
The cap would be the maximum amount that employers could
exclude from employee income, and similarly, it would be
the maximum amount that individuals who buy their own health
insurance could deduct from their income. The Panel estimates
that the new deduction will reduce the number of uninsured
Americans by one to two million people. This recommendation
is controversial, and it represents a significant change
from current practice.
and Local Taxation
itemizers can deduct state and local income and property
taxes. The Panel recommends repealing this deduction, using
the following logic:
deduction provides a federal tax subsidy for public services
provided by state and local governments. Taxpayers who
claim the state and local tax deduction pay for these
services with tax-free dollars. These services, which
are determined through the political process, represent
a substantial personal benefit to the state or local residents
who receive them …. The panel concluded that these
expenditures should be treated like any other nondeductible
personal expense, such as food or clothing, and that the
cost of those services should be borne by those who want
them—not by every taxpayer in the country.
recommendation has been controversial in states with higher
tax rates. For a fuller discussion of this provision, and
a general discussion of the impact of the Panel’s
proposed changes across states, please see the accompaying
article “Panel Discussion” on page 32.
current law, there are a number of duplicative and overlapping
tax benefits for higher-education costs, including the Hope
credit, the lifetime learning credit, the deduction of interest
on student loans, and the tuition deduction. The differing
definitions, allowable amounts, eligibility rules, and phase-outs
for these various provisions increase complexity and taxpayer
confusion. It is estimated that more than one-fourth of
eligible taxpayers fail to claim one of these benefits.
Panel recommends that tax preferences for education be simplified
by replacing the current hodgepodge of deductions and credits
through the new full Family Credit allowance of $1,500 for
families with full-time students age 20 and under. The Panel
also recommends that families be allowed to save tax-free
for future education expenses. (See the section below dealing
with savings and retirement plans.)
law allows employees to exclude the value of fringe benefits
received from employers. Besides the significant exclusion
for health insurance (discussed above), these fringe benefits
include educational assistance, childcare benefits, group
term life insurance, and long-term care insurance.
to the Panel, the favorable tax treatment of fringe benefits
results in an uneven distribution of the tax burden, because
workers that receive the same amount of total compensation
may pay different amounts of tax depending on the mix of
cash wages and fringe benefits. The Panel recommends putting
all taxpayers on a level playing field by eliminating tax-free
fringe benefits except for certain in-kind benefits provided
to all employees. For example, the Panel recommends that
meals at a company cafeteria remain untaxed, as under current
law, but only if provided to all employees.
there is a complicated three-tier structure whereby, based
on the amount of outside income, retirees either 1) exclude
all benefits, 2) include benefits based on a 50% test, or
3) include benefits based on an 85% test. There is a marriage
penalty, and because the numbers are not adjusted for inflation,
recipients are subject to “bracket creep” (i.e.,
taxes rise due to inflation).
Panel recommends replacing the three-tier system of taxing
Social Security income with a simple deduction. Married
couples with income of less than $44,000 ($22,000 if single)
would pay no tax on Social Security benefits. This recommendation
eliminates the marriage penalty and indexes brackets for
inflation. If retiree income exceeds these thresholds, Social
Security benefits are included in income to the extent of
the lesser of:
50% of the amount by which income exceeds the threshold,
of benefits received.
Assume a retired married couple has income of $50,000
($40,000 in outside income and $10,000 in Social Security
benefits), or $6,000 ($50,000 – $44,000) in excess
of the threshold. They would include $3,000 in income, because
this is the lesser of $3,000 (50% x $6,000) or $8,500 (85%
individual’s tax liability is calculated by multiplying
the tax base (i.e., taxable income) by the tax rate. For
derivation of the tax base, see Form 1 and Form 2. Currently,
there are six tax rates for individuals: 10%, 15%, 25%,
28%, 33%, and 35%. The Panel’s proposal would reduce
the number of tax rates to four in the case of the SIT,
and to three in the case of the GIT (see Exhibit
Tax Reform Act of 1986 was successful because it broadened
the tax base and reduced the rates. The Panel’s recommendations
broaden the base, but reduce the tax rates only moderately.
As mentioned in the Epilogue, below, if dynamic scoring
is used to calculate the effects of tax cuts on government
revenues, tax rates may be reduced further when Congress
eventually drafts legislation.
Impetus for Change
conducted by the Treasury Department that appear in the
Panel’s report indicate that, on average, most taxpayers
would not see a change in their tax burden under these proposals.
What, then, is the driving reason behind these reforms?
The Panel’s official answer is simplicity, fairness,
and economic growth. It also believes that “a simpler
and more transparent tax system would be less susceptible
to tax avoidance.” Finally, according to the Panel,
the new system would—
reduce time spent on filing returns and keeping records;
reduce out-of-pocket costs for paid preparers;
enable more taxpayers to prepare their own returns;
enable more taxpayers to understand how taxes are computed;
ensure that more taxpayers can correctly compute their
tax liability without overlooking anything; and
in taxpayers more confidence in the tax system and the
belief that other taxpayers have paid their fair share.
Witner, LLM, CPA, is an associate professor at
Bryant University, Smithfield, R.I.
and Retirement Plans, Capital Income (Dividends, Interest,
Kathleen Simons and Larry Witner
mentioned above, the Panel recommends two options: the Simplified
Income Tax Plan (SIT) and the Growth and Investment Tax
Plan (GIT). They are almost identical with regard to savings
and retirement plans. With regard to capital income (dividends,
interest, capital gains), the two differ significantly.
References below to the Panel’s recommendations will
apply to both SIT and GIT unless otherwise noted.
saving is crucial not only for families but also for the
economy. Families need to save for retirement, education,
healthcare, and housing. The economy relies on savings from
households because such savings flow into investment; investment
increases productivity. Increased productivity means increased
business profits and improved standards of living. The Panel’s
report reveals that, over the last three decades, the net
U.S. savings rate—household savings plus business
retained earnings plus government surplus/deficit—has
fallen from 9% of gross domestic income to 2% of gross domestic
there are tax incentives to promote savings for retirement,
education, and healthcare. Each of these follows a basic
strategy. First, a special savings vehicle for certain approved
purposes is created, where funds can be deposited. Second,
those dollars are permitted to grow tax-free until withdrawn.
Third, those funds are classified as taxable or nontaxable
when withdrawn. In the case of a traditional individual
retirement account (IRA), deposits are deductible and withdrawals
are taxable. But in the case of a Roth IRA, deposits are
not deductible, and qualified withdrawals are not taxable.
In the case of a health savings account, deposits are deductible
and withdrawals to pay healthcare expenses are not taxable,
but other withdrawals are. The Panel believes this lack
of uniformity is a source of complexity.
for Reform: Complexity, Confusion, Fairness
Panel believes the current tax system is too complex with
regard to savings and retirement plans. The numerous tax-favored
options have different eligibility rules, contribution limits,
and permissible withdrawals. In the area of saving for education,
there are numerous tax-favored options, each with its own
different set of rules. In the area of saving for healthcare,
there are medical savings accounts (MSA), health savings
accounts (HSA), and flexible spending arrangements (FSA),
each with its own set of rules. The Panel sees no reason
to have so many savings and retirement plans.
complexity of employer-sponsored retirement plans leads
to employee confusion, among other adverse consequences.
For example, the Panel notes, because of the elaborate rules
when changing jobs, it is not uncommon for a worker to have
multiple, modestly sized 401(k) accounts spread out among
past employers. Studies indicate that a sizable majority
of workers who receive a lump-sum distribution of $5,000
or less from their former employer do not roll it over into
another qualified plan or IRA. Rather, they pay tax and
penalties, and they spend the rest. Such results adversely
affect a worker’s ability to save for retirement.
90 million workers use some type of tax-favored retirement
plan at work. As the report relates, in part due to high
administrative costs, only about 53% of private employers,
and only about 25% of small employers, offer retirement
plans. The panel found this current situation unfair.
Panel did not recommend any changes to defined-benefit plans.
The panel recommends the following for defined-contribution
Replace the current hodgepodge with three new plans: Save
at Work, Save for Retirement, and Save for Family;
Reduce the administrative burden on employers, including
an AutoSave provision; and
Modify the Saver’s Credit for low-income taxpayers.
Panel recommends eliminating exclusions that allow some
individuals to save an unlimited amount tax-free through
annuities, life insurance, and deferred compensation. The
Panel recommends a more consistent treatment of savings
(capital income) outside of tax-favored accounts. According
to the Panel, these measures would encourage saving in a
manner that is fair, efficient, flexible, convenient, and
‘Save at Work’ Plans
employer-provided Save at Work retirement plan would combine
the following: 401(k), Simple 401(k), Thrift 403(b), governmental
457(b), SARSEP, and Simple IRA. The single plan would follow
the contribution limits and rules of existing 401(k) plans,
but the plan qualification rules would be much simpler.
to administer Save at Work plans would be reduced in three
ways. First, there would be a single set of administration
rules. Second, there would be an AutoSave provision, as
discussed below. And third, the discrimination-testing rules
would be simplified. Specifically, there would be a single
test to ensure that employee contributions were not tilted
in favor of highly compensated employees. In addition, there
would be a safe harbor for any plan designed to provide
consistent employer contributions to each plan participant,
regardless of compensation.
Save at Work plan contains features beneficial to small
businesses. Employers with 10 or fewer employees could set
up a Save at Work plan that resembles the current Simple
IRA. The accounts would be controlled by employees, the
employer would not have to file annual returns, and the
employer would not have the legal liability associated with
and GIT propose different Save at Work plans. Under SIT,
Save at Work contributions would be deductible, and withdrawals
would be taxable, like a traditional IRA. Under GIT, Save
at Work contributions would not be deductible, but withdrawals
would not be taxable, like a Roth IRA. Under GIT, existing
traditional IRAs could remain intact, or taxpayers could
pay taxes and transfer their funds.
The Panel wants workers to be pointed in the
direction of sound saving and investing decisions. Businesses
would be permitted, but not required, to include AutoSave
as part of their retirement plan. AutoSave would have four
Automatic enrollment in Save at Work, unless the employee
chooses not to participate;
The employee’s contribution percentage would increase
automatically over time, unless the employee chooses
Employee contributions would be invested automatically
in a balanced, diversified portfolio with low fees, unless
the employee chooses different investment alternatives;
When leaving a job, unless the employee chooses otherwise,
the account balance could be automatically retained in
the existing plan, transferred to a Save at Work account
with a new employer, or rolled over into a Save for Retirement
each of these features would be voluntary, the report argues
in favor of a default approach, because studies show that
employees tend to adopt default rules for enrollment, contributions,
and disbursements. The Panel recommends that liability protection
against investment losses be extended to employers who incorporate
AutoSave into their Save at Work plans. The Panel suggests
that less-stringent discrimination testing be used on retirement
plans that include AutoSave.
‘Save for Retirement’ Accounts
for Retirement accounts would supplement Save at Work plans
by allowing workers to save the lesser of $10,000 or their
earnings. Like Roth IRAs, contributions to the account would
not be deductible, earnings would accumulate tax-free, and
withdrawals would be taxable. Save for Retirement accounts
would replace traditional IRAs, Roth IRAs, deferred compensation
plans, and the tax-free inside build-up of cash surrender
value of annuities and life insurance.
current-law plans, there would be no income limitations.
Distributions (which would have no minimum amount) would
be restricted until after age 58, unless there is a disability
or death. Early distributions would be subject to tax plus
a 10% penalty. Under current law, early withdrawals are
permitted for education, first-time home purchase expenses,
and medical expenses. These exceptions would no longer be
necessary because Save for Family accounts, discussed below,
would include such provisions.
Roth IRAs could be converted to Save for Retirement accounts.
Traditional IRAs could also be converted upon paying the
tax. Under GIT, Save at Work accounts would be “after-tax,”
like a Roth IRA. Existing IRAs could be held outside the
Save for Retirement plan, but no new contributions could
be made to them.
‘Save for Family’ Accounts
taxpayer could contribute up to $10,000 to a Save for Family
account. Contributions to the account would not be deductible,
and earnings would accumulate tax-free. Save for Family
accounts would replace existing education and medical accounts,
such as HSAs, MSAs, and FSAs.
withdrawals from a Save for Family account could be used
for retirement, healthcare, education and training, or a
home down payment. Up to $1,000 could be withdrawn each
year for any reason, without penalty. Unqualified withdrawals
beyond that would be subject to tax plus a 10% penalty.
As with the Save for Retirement account, funds could be
withdrawn penalty-free by taxpayers 58 or older, and there
would be no minimum distribution rules.
saver’s credit. To encourage low-income
taxpayers to save, the Panel recommends a refundable saver’s
credit, which would replace an older, less inclusive version
that is scheduled to expire after 2006. The new refundable
saver’s credit equals 25% of the first $2,000 contributed
to a Save for Retirement or a Save for Family account. Thus,
the maximum refundable saver’s credit is $500 ($2,000
x 25%). The credit phases out as income exceeds $30,000
($15,000 for unmarried taxpayers).
Panel wants a more neutral treatment of financial income
earned outside of the plans above. Currently, there are
no limits on the tax benefits for increases in the cash
surrender value of annuities and life insurance, and certain
deferred compensation. The Panel wants to treat these arrangements
like other investments.
Panel recommends that, in general, the annual increase in
the cash surrender value (the inside build-up) of annuities
and life insurance be treated as current income, with two
exceptions: The inside build-up would not be subject to
current taxation 1) for life insurance that cannot be cashed
out, and 2) for annuities that provide regular, periodic
payouts of substantially equal amounts until the death of
Panel recommends eliminating the ability of some taxpayers
to save tax-free through deferred compensation plans. Specifically,
the Panel wants all amounts deferred under nonqualified
deferred compensation plans to be included in income to
the extent these amounts are not subject to a substantial
risk of forfeiture and were not previously included in income.
life insurance, and deferred compensation plans that are
now in existence would continue to be taxed under current
Save at Work plans, Save for Retirement accounts, and Save
for Family accounts, capital income (dividends, interest,
capital gains) accumulates tax-free. In general (except
Save at Work accounts under SIT), capital income is taxed
as ordinary income when funds are distributed from these
arrangements. What are the tax consequences for individuals
who generate dividends, interest, and capital gains outside
of these arrangements?
2 summarizes the treatment of capital income under current
law, SIT, and GIT. Under SIT, when stock in U.S. corporations
is sold, 75% of long-term capital gain is excluded from
income, and the other 25% is included in income and taxed
at ordinary income rates. Thus, under SIT, the tax rates
for the sale of stock held long term are 3.75% (25% x 15%),
6.25% (25% x 25%), 7.50% (25% x 30%), and 8.25% (25% x 33%).
corporate earnings are taxed twice: once when a corporation
earns profits, and again when profits are distributed as
dividends, and realized from the sale of stock. To reduce
the double tax on corporate earnings, SIT excludes from
income 100% of dividends received from U.S. corporations
that are paid out of domestic earnings, and 75% of long-term
capital gain from the sale of stock in U.S. corporations.
The Panel believes that this would increase investment in
corporate equity and promote economic growth.
SIT, long-term capital gains, other than those from the
sale of stock in U.S. corporations, would be taxed at ordinary
income rates (15%, 25%, 30%, 33%). This would raise the
tax rate on some capital gains for higher-income individuals,
but it would lower the tax rate for all investors in corporate
stock. According to the Panel, besides reducing the double
tax on corporate earnings, this treatment would simplify
the reporting of capital gains. In addition, it would eliminate
the need for a host of complex rules for recapturing tax
on the sale of assets by small businesses that take advantage
of the new simplified and expanded expensing rules described
below, in “Taxation of Business.”
as discussed below, GIT would move the tax system closer
to a consumption tax and would impose a reduced flat rate
tax, 15%, on capital income received by individuals.
authors wonder if Americans want to sacrifice a complex
system that allows them to invest in a retirement vehicle
with pre-tax dollars (traditional IRA) in favor of a simpler
one using after-tax dollars (Roth IRA). The Panel’s
reforms are based on the assumption that simplicity will
be a greater incentive than the ability to invest before-tax
dollars in a more complicated array of choices. A taxpayer
in the 30% bracket can currently put $1,000 into an IRA
and save $300 in taxes. Under GIT, the same taxpayer would
need to earn $1,429 in order to invest $1,000 ($1,429 x
70%) in a Save at Work account.
to the American Society of Pension Professionals and Actuaries
accounts would allow a couple owning a small business
to save $40,000 [$10,000 x 4] for retirement on a tax
preferred basis (compared to $10,000 under current law).
Many small business owners will forego adopting a workplace
retirement plan [e.g., Save at Work] if they can save
that much on their own on a tax preferred basis. [2005
employer-sponsored retirement plans disappear, evidence
indicates workers will save less. According to ASPPA:
retirement plans have been the most efficient and effective
way for workers to save. … [A]lmost 50% of American
households owning mutual funds held those funds through
employer-sponsored retirement plans. However, when deprived
of the discipline and structure of a workplace plan, the
vast majority of American workers simply do not save.
According to the Employee Benefit Research Institute,
low- to moderate-income workers are 20 times more likely
to save when they participate in a workplace retirement
plan. [2005 TNT 211-20]
are probably many factors that account for why Americans
do not save as much as they could or should. The authors
wonder if the reforms suggested by the Panel will change
Simons, DBA, CPA, is a professor, and Larry
Witner, LLM, CPA, is an associate professor, both
at Bryant University, Smithfield, R.I.
Tim Krumwiede and Larry Witner
Panel recommends two options: the Simplified Income Tax
Plan (SIT) and the Growth and Investment Tax Plan (GIT).
With regard to the taxation of business, the two options
have some similarities and many differences, which will
be discussed below. Unless otherwise indicated, to be consistent
with the Panel’s terminology here the term “corporation”
refers to regular, C corporations; S corporations are referred
to as such or as “pass-through entities.”
‘Cleaner‘ Tax Base
Panel strives for a “clean” tax base, one devoid
of special tax breaks (preferences) for certain industries
and business activities. According to the Panel, these special
tax preferences require complex rules and regulations for
taxpayers to determine eligibility and the IRS to enforce.
These preferences also have the effect of raising the tax
rates for all businesses.
generate a cleaner tax base, the Panel recommends eliminating
over 40 special provisions, including the research and experimentation
credit, the rehabilitation investment credit, and the deduction
for domestic production. A cleaner tax base would allow
the business tax rate to be reduced. Under SIT, the tax
rate on large businesses would be reduced from 35% to 31.5%—a
the Corporate AMT
many corporations are subject to two systems of taxation:
a regular tax and an alternative minimum tax (AMT). Like
the individual AMT, the corporate AMT is a second, parallel
tax system designed to ensure that all corporations pay
a certain share of tax.
SIT and GIT would repeal the corporate AMT. The Panel believes
it is too complex because it forces many corporations to
keep two different sets of books and to calculate their
tax liability under two different sets of rules.
SIT and GIT provide a clean tax base devoid of special breaks,
there is no need for a second, parallel AMT system.
to the Panel, eliminating numerous tax breaks and the corporate
AMT would simplify the tax system. A more level playing
field for all businesses would be created by eliminating
tax breaks that apply to only a limited number of companies.
Finally, removing tax considerations as much as possible
from investment and business decisions would result in allocating
resources more efficiently.
corporate earnings are taxed twice: once when a corporation
earns profits, and again when profits are distributed as
dividends or realized from the sale of stock. The Panel
believes this “double taxation” may discourage
investment in corporations.
may raise funds by issuing either debt or equity (stock).
Currently, corporations can deduct the interest paid on
their debt, but they cannot deduct the dividends paid on
their stock. This may encourage corporations to use debt
financing rather than equity financing. During economic
downturns, this increases the risk of bankruptcies. The
Panel worries that tax considerations, rather than economic
considerations, may unduly affect corporate decisions regarding
the retention and distribution of profits.
Panel claims there is a tax bias against the corporate form
of business organization. To illustrate this point, the
Panel cites the rapid rise in the number of pass-through
entities. For instance, between 1980 and the present, S
corporations have grown from 528,100 to 3,612,000, while
C corporations have hardly grown at all, from 2,115,000
to 2,190,000. The report reveals that total business net
income from pass-through entities recently exceeded total
business net income from C corporations.
Panel wants to remove the bias against investing in corporations
by providing a more neutral tax treatment among various
forms of business organization. In addition, the Panel wants
to level the playing field between debt and equity financing.
Taxation of Earnings
reduce the double tax on corporate earnings, SIT would exclude
from shareholder income: 1) 100% of dividends received from
U.S. corporations that are paid out of domestic earnings,
and 2) 75% of long-term capital gain from the sale of stock
in U.S. corporations.
individuals report on their individual tax returns their
share of earnings from sole proprietorships, partnerships
(including limited liability companies), and S corporations.
Although these three separate regimes are designed to provide
a single level of tax, there are enough differences among
them to unnecessarily complicate the choice of business
form as well as tax compliance. The Panel recommends more
uniformity among pass-through entities with regard to contributions,
allocations of income, distributions, and liquidations.
These changes would eliminate confusion and simplify the
choice of business entity.
Would Classify Businesses
SIT, business entities would be classified as small, medium,
or large on the basis of their gross receipts, as shown
3. The Panel suggests using, for purposes of classification,
the average of gross receipts over the prior three years.
businesses under SIT. Currently, there are
22 million small businesses, as defined by SIT, accounting
for 95% of all U.S. businesses. According to the Panel,
under current law, small businesses must use complex accounting
rules to keep their books and records. The Panel recommends
that small businesses be entitled to use a simplified cash
method of accounting. Under this method, taxable income
would equal cash receipts less cash payments (except for
purchases of buildings and land). In essence, small businesses
could use just their checking accounts to prepare their
primary feature of this system is that cash paid for most
assets would be deducted as paid, instead of being capitalized
and recovered through depreciation and amortization. Thus,
cash paid for inventory, tools, software, intangibles, and
equipment would be deducted as paid. The only exceptions
would be for the purchase of buildings (capitalized and
depreciated) and land (capitalized). (For a discussion of
depreciation, see “Depreciation under SIT,”
taxable income would be subject to individual tax rates
(15%, 25%, 30%, 33%), unless, as discussed below, the small
business chose to be treated as a corporation.
businesses under SIT. Under SIT, medium-sized
businesses could use the same simplified cash method of
accounting as small businesses, with two exceptions. First,
purchases of equipment would be capitalized and depreciated.
(For a discussion of depreciation, see “Depreciation
Under SIT,” below.) Second, medium-sized businesses
in inventory-intensive industries (e.g., manufacturing)
would use inventory methods.
improve recordkeeping and compliance, the Panel suggests
that small and medium-sized businesses use designated business
bank accounts to deposit all business receipts and make
all business payments. In these segregated bank accounts,
businesses could not commingle personal and business funds.
Banks maintaining the segregated accounts would provide
an annual summary of cash inflows and outflows both to the
businesses and to the IRS. Issuers of debit and credit cards
would report the purchases made by their cardholders to
the businesses and to the IRS.
business’ taxable income would pass through to owners
and be subject to individual tax rates (15%, 25%, 30%, 33%),
unless, as discussed below, the entity chose to be treated
as a corporation.
businesses under SIT. Under SIT, large businesses
would be taxed as corporations, and they would be subject
to an entity-level flat tax rate of 31.5%. In addition,
small and medium-sized businesses could choose to be taxed
as corporations, whereupon their shareholders would be eligible
for the dividends-received exclusion (100%) and the long-term
capital gains exclusion (75%).
partnerships, limited liability companies, and S corporations
are “large,” they are subject to the entity-level
flat tax rate of 31.5%. According
to the Panel, treating pass-through entities this way—
lessens opportunities for tax shelters and loopholes,
most of which have been facilitated by pass-through entities;
levels the playing field among various forms of business
SIT, regulated investment companies (RIC) and real estate
investment trusts (REIT) would continue to be taxed as under
current law, meaning they avoid the entity-level tax if
they distribute most of their earnings. Furthermore, the
report suggests that owners of RICs and REITs would benefit
from the new rules applicable to the dividends-received
exclusion (100%) and the long-term capital gains exclusion
SIT, large businesses would be denied the deduction for
state and local income and property taxes. According to
the Panel, because individuals and small businesses cannot
deduct these taxes, large businesses should not be able
to deduct them either. (See the discussion above, “Taxation
under SIT. Currently, businesses are required
to maintain detailed schedules and records related to the
cost and depreciation (cost recovery) of long-term assets.
For the most part, these records are maintained on an asset-by-asset
basis. Current law provides options in determining how much
of an expenditure should be immediately expensed and how
much should be capitalized and deducted over time. For instance,
IRC section 179 provides that a limited amount of capital
expenditures ($105,000 for 2005) can be expensed in lieu
of depreciation. According to the Panel, current law, by
requiring detailed records and numerous cost recovery options,
places a burden on taxpayers. SIT would alleviate some of
mentioned above, under SIT, small businesses would depreciate
buildings, and medium-sized and large businesses would depreciate
buildings as well as equipment. The current depreciation
system uses eight different asset class lives (3, 5, 7,
10, 15, 20, 27.5, and 39 years), different recovery methods
(accelerated, straight-line, and alternative depreciation
system), and three different conventions for the year an
asset is placed in service (mid-year, mid-month, and mid-quarter).
Panel recommends a simplified depreciation system that would
collapse the number of asset classes and cost recovery methods.
The Panel suggests four asset categories, as shown in Exhibit
Panel suggests that this simplified depreciation system
would provide about the same cost recovery deductions as
current law but would greatly simplify the depreciation
process, including eliminating much of the recordkeeping
accounting net income. Currently, financial
accounting rules dictate the preparation of income statements
and the calculation of net income, whereas the IRC dictates
the preparation of tax returns and the calculation of taxable
income. The Panel recommends for further study the idea
that large businesses be taxed on net income, thus avoiding
a separate calculation of taxable income.
Toward a Consumption Tax
to the Panel, GIT would move the U.S. tax system closer
to a consumption tax. Of all the Panel’s recommendations,
this fact is best illustrated by the taxation of business.
The key difference between an income tax and a consumption
tax is the relative burden placed on capital income (dividends,
interest, capital gains).
GIT, no business would include capital income in gross income
(with a special exception for financial services companies,
which would include interest income and deduct interest
expense). The Panel claims that GIT would be pro-growth;
by not taxing capital income, savings, investment, and productivity
would increase, growing the economy. GIT is not a pure consumption
tax, however, because individuals would still pay a flat
tax rate of 15% on all capital income.
taxes business cash flow. Under GIT, businesses
would pay tax on their “business cash flow,”
defined as follows:
(excluding capital income) – Purchases (of materials,
labor, and assets).
would exclude capital income (dividends, interest, capital
gains). Purchases would be deductible only if made from
businesses subject to U.S. taxation. Purchases from foreigners
not subject to U.S. taxation would not be deductible. (For
a further discussion, see “Comments,” below.)
focusing on cash flow, the Panel believes, complicated accounting
rules dealing with matching revenue and expense could be
avoided. The report suggests that the GIT tax on business
cash flow resembles a subtraction-method value-added tax
(VAT; discussed in “Federal Tax Reform,” The
CPA Journal, October 2005).
Panel recommends that sole proprietorships simply report
net cash flow on the income tax return of the owner, who
would pay tax at the graduated individual rates (15%, 25%,
30%, 33%). All other businesses would pay a flat tax rate
of 30%. Because this would equal the top rate for individuals,
the Panel believes it would reduce tax planning efforts
to shift income between businesses and individuals.
would resolve the issues of double taxation of corporate
earnings and tax bias against the corporate form in a curious
way. GIT would impose the same flat tax rate of 30% on all
business entities, regardless of their legal form. Under
GIT, then, there would be no pass-through entities (partnerships,
including limited liability companies, and S corporations).
According to the Panel, owners of pass-through entities
would compute their tax on a separate schedule, which would
be filed along with their individual return.
expenses capital expenditures. Under GIT,
all businesses would immediately deduct the cost of capital
expenditures, including those for equipment, building, and
land. Thus, there would be no need for complex rules for
the capitalization and cost recovery of long-term assets.
Panel justifies this recommendation on many grounds. First,
the current depreciation system is an imperfect mechanism
for measuring the actual decline in value of an asset. Second,
the current system fails to take inflation into account.
Third, eliminating complex rules for capitalization and
cost recovery would simplify the tax system and reduce compliance
costs. And fourth, the current system is inefficient, because
depreciation and other tax-related considerations may distort
investment decisions. The Panel states: “Moving from
depreciation allowances to expensing would lower the tax
burden on the returns to new investment and would level
the playing field across different types of business assets.”
on NOL carryforwards. The Panel recommends
that net operating losses (NOL) not be carried back. The
Panel recommends that NOLs be carried forward indefinitely
and not be sold or otherwise transferred from one entity
to another. GIT would allow interest on NOL carryforwards.
For example, assume an interest rate of 10% and an NOL of
$1 million in Year 1. In Year 2, as an offset against other
income, the business in question could claim a loss of $1.1
million [$1 million + ($1 million x 10%)]. If the loss offset
were not used in Year 2, it would be carried forward to
Year 3 and increased to $1.21 million [$1.1 million + ($1.1
million x 10%)].
versus equity financing. Under current law,
businesses that raise funds by issuing debt can deduct the
interest paid on that debt. On the other hand, businesses
that raise funds by issuing equity (stock) cannot deduct
the dividends paid on that stock. The Panel believes this
distorts financing decisions and disadvantages the corporate
Panel recommends eliminating the corporate deduction for
interest. Thus, under GIT, neither dividends paid nor interest
paid would be tax-deductible.
existing assets, the Panel suggests a transition period
to GIT. In the first year, assets placed in service prior
to GIT would be eligible for 80% of the depreciation. In
the second, third, and fourth years, the percentages would
be 60%, 40%, and 20%, respectively. The Panel suggests a
similar phase-out timetable for both interest deductions
and interest income. The Panel recognizes that transition
rules would be needed in other areas, such as the treatment
of NOL carryforwards, tax credits, and inventory holdings,
but did not provide specifics.
large businesses may believe that the current tax system,
with its research and experimentation credit, among other
things, may be better than the Panel’s recommendations.
Some predict a fierce battle over eliminating business’
ability to deduct interest payments. Opposition to fundamental
tax reform may come from the business community as well
as individuals (2005 TNT 209-2).
groups, including the National Retail Federation (NRF),
are weighing in on the Panel’s proposals. The NRF
has decried the “new import tax” (2005 TNT 211-17).
Under GIT, the business cash flow tax permits a deduction
for purchases of goods and materials only if the seller
is subject to U.S. taxation. According to the NRF, a majority
of consumer products (e.g., clothing, gas, toys) sold in
U.S. stores are made overseas. If the foreign suppliers
of these consumer goods are not subject to U.S. taxation,
the U.S. retailer cannot deduct the cost of imports. According
to NRF, this lack of deductibility would amount to a tax
on imports that would drive up the price of consumer goods
by nearly one-third. If proved correct, this could reduce
consumer spending and adversely affect the economy.
Krumwiede, PhD, CPA, is an associate professor,
and Larry Witner, LLM, CPA, is an associate
professor, both at Bryant University, Smithfield, R.I.
of International Transactions
Andrew Duxbury, Michael C. Plaia, and Larry Witner
regard to international taxation, currently, the United
States uses a worldwide system. Under the Simplified Income
Tax (SIT), the Panel recommends changing to a territorial
system. Under the Growth and Investment Tax Plan (GIT),
the Panel recommends changing to a destination-basis, border-adjusted
tax system. The expression “U.S. multinational corporation”
is used to refer to a U.S.-based entity that owns foreign
journalist summarized the problems with the current U.S.
international tax system as follows:
current worldwide or extraterritorial system] seeks to
tax U.S. taxpayers on their worldwide income on a current
basis, regardless of where the income is earned. Foreign-source
earnings of foreign subsidiaries are not taxed until those
profits are repatriated to U.S. parent companies in the
form of inbound dividends. Because repatriation is elective,
taxation is rendered elective, leading to a system in
which massive amounts of profits are held offshore for
as long as possible. According to the Panel, [this] creates
a disincentive to reinvest those funds domestically. (2005
to the Panel, the current system has other disadvantages,
such as making filing complex for businesses, putting U.S.
companies at a disadvantage against international competitors,
and embroiling the U.S. in controversies before the World
the United States does not tax the earnings of a non-U.S.
owned, non-U.S. entity (unless the non-U.S. entity does
business in the United States), it does tax the U.S. owner
when a controlled foreign corporation (CFC) pays a dividend
to the U.S. corporate owner. To avoid double taxation, U.S.
companies may offset this tax through a foreign tax credit
(FTC). (Note that this article and the examples in it will
ignore the fact that treaties between the U.S. and other
countries may alter tax consequences.)
1. A U.S. multinational corporation and a
Dutch multinational corporation each have subsidiaries in
the United Kingdom. Assume the U.K. tax rate is 20% and
the U.S. tax rate is 35%. The U.S. multinational corporation
is subject to a worldwide tax system, and the Dutch multinational
corporation is subject to a territorial tax system. Assume
the subsidiaries each earn $100 in the United Kingdom and
immediately send the profits home as a dividend. The U.S.
subsidiary and the Dutch subsidiary each pay $20 ($100 x
20%) of tax to the U.K., and a dividend of $80 ($100 –
$20) to the parent company.
regard to the dividend, the U.S. multinational corporation,
but not the Dutch multinational corporation, pays a repatriation
tax. Specifically, in its income, the U.S. multinational
corporation will include $100, consisting of $80 as dividend
income and $20 as a “section 78 gross-up.” The
U.S. multinational corporation is subject to a tax rate
of 35%, which will be offset by a foreign tax credit for
the $20 paid to the U.K. The U.S. multinational corporation,
then, pays tax of $35: $15 ($35 – $20) to the U.S.
and $20 to the United Kingdom. The Dutch multinational corporation,
however, pays tax of only $20.
1 reveals several things. In elemental terms, it differentiates
between a worldwide system and a territorial system. The
FTC rules are more complicated than the above example. There
are detailed regulations regarding source of income and
allocation and apportionment of expenses. These rules are
necessary to ensure that multinational corporations do not
offset tax on U.S. source income with FTCs. Essentially,
these sourcing rules divide a multinational company’s
taxable income between U.S. source and foreign source. Only
the tax on foreign source income (which is divided into
categories) may be offset by FTCs (of the same category).
important rule in the current tax system is Subpart F income,
which is divided into the following two basic categories:
Foreign personal holding company income (FPHCI) is income
from dividends, interest, rents, and royalties. This type
of passive income, or “mobile” income, when
earned by a CFC, is not eligible for U.S tax deferral
and is taxed to the U.S. shareholder in the year it is
earned by the CFC.
Foreign-based company sales income (FBCSI) is income earned
by a CFC on resale of property purchased and sold outside
of its country of incorporation when a related party is
involved in the product flow. (The foreign-based company
service income rules are similar, but less common.)
2. A U.S. multinational corporation manufactures
property in the United States. The U.S. multinational sells
the property to its CFC European distributor in the Netherlands,
which warehouses it. The CFC ultimately sells the property
to a third party in Italy. The income in question is FBSCI,
and as such, it is taxed to the U.S. multinational when
sold to the third party in Italy. The theory for currently
taxing net income on this type of transaction is that the
Dutch company adds no value to the transaction—a debatable
3. A U.S. multinational corporation manufactures
property in the United States. The U.S. multinational sells
the property to its Cayman Islands CFC. The Cayman Islands
CFC, without adding value to the property, sells it to a
third party in Italy.
2 and 3 are similar, except that the Netherlands tax rate
is 30.5%, and the Cayman Islands tax rate is zero. Therefore,
absent the Subpart F rules, the U.S. multinational would
have a tax incentive to earn profits through the Cayman
the Subpart F rules are potent, they do not extend to many
types of foreign source income earned by CFCs. Consequently,
U.S. parent coporations benefit when they shift income to,
or away from, their foreign subsidiaries that operate in
low-tax, or high-tax, jurisdictions.
4. A U.S. multinational corporation manufactures
an appliance for sale in the United States (35% tax rate)
and in a foreign jurisdiction (20% tax rate). Foreign sales
are made by a wholly owned foreign subsidiary. The appliance
costs $150 to manufacture, and sells for $250 abroad. If
the transfer price between the U.S. parent and the foreign
subsidiary is set low, much of the profit is shifted to
the low-tax foreign jurisdiction. For example, if the transfer
price is $150, there will be zero U.S. tax [($150 –
$150) x 35%] and tax of $20 [($250 – $150) x 20%]
in the foreign jurisdiction. But if the transfer price is
set high, at $250, there will be tax of $35 [($250 –
$150) x 35%] in the U.S. and tax of zero [($250 –
$250) x 20%] in the foreign jurisdiction. In this simplified
example, there is a significant tax savings ($15) to be
had if the profit is shifted to the foreign jurisdiction.
section 482 gives the IRS the authority to allocate gross
income, deductions, or credits between related parties to
correct any perceived distortion resulting from unrealistic
transfer pricing. In this area of tax law, there is much
ambiguity, complexity, and conflict between taxpayers and
companies outside of the United States are subject to a
value-added tax (VAT), levied at each stage of production
on the value added by each party. The value added is the
difference between sales and purchases of inputs. VAT is
collected by each entity at every stage of production. A
company calculates its VAT liability into its prices, so
it fully shifts the VAT liability to the buyer. There are
several ways to calculate the tax. Under a credit VAT, a
company calculates its VAT liability as follows: VAT on
sales (VAT rate x sales) – VAT on inputs.
companies are believed to have a competitive advantage over
U.S. companies because VAT is refunded on exports. Thus,
foreign goods appear cheaper by the time they reach retail
shelves in foreign markets. U.S. exporters, however, do
not receive the same preferential treatment, because U.S.
income taxes cannot be refunded on exports without violating
international trade rules. The following Examples 5, 6,
and 7, focus on VAT, and ignore income-tax-related concepts.
5. Consider a farmer, a miller, and a baker
involved in turning wheat into bread. The farmer grows wheat
and sells it to the miller, who grinds the wheat into flour
and sells it to the baker, who turns the flour into bread
and sells it to the public. The VAT rate is 10%. The farmer
sells the wheat to the miller for $1,100, consisting of
$1,000 for the wheat and $100 for VAT. The farmer forwards
$100 to the government. The miller sells the flour to the
baker for $3,300, consisting of $3,000 for the flour and
$300 for VAT. The miller forwards $200 ($300 VAT on sales
– $100 VAT on purchases) to the government.
6. Assume the same facts from Example 5, but
assume that the farmer and the miller are in different jurisdictions.
When the farmer sells to the miller, he is not charged VAT,
making the cost to the miller $1,000, not $1,100.
7. Assume the same facts from Examples 5 and
6 above, except the farmer is a U.S. farmer who sells wheat
to the miller for $1,100, consisting of $1,000 for the wheat
and $100 for U.S. income tax. The U.S. farmer does not receive
a $100 refund for income taxes paid. Thus, in Example 6
(foreign producer), the miller has a cost of $1,000, but
here, in Example 7 (domestic producer), the miller has a
cost of $1,100. The foreign exporter has an advantage over
the domestic exporter.
SIT, the Panel recommends replacing the current worldwide
taxation system with a territorial system. Under a territorial
system, a government taxes only the income earned within
its borders; thus, the foreign source income of U.S. companies
would be exempt from U.S. taxation. The Panel defines foreign
business income (FBI) as income earned in the active conduct
of a trade or business outside of the United States. This
income could be earned by either a CFC or a foreign branch
of a U.S. corporation.
much-criticized, complex Subpart F rules would be retained.
As mentioned previously, Subpart F taxes certain types of
passive (mobile) income earned by CFCs. As under the current
system, an FTC would be allowed to offset U.S. tax.
Panel’s recommendation contains new rules that disallow
expenses related to earning tax-exempt foreign income. These
expenses, including interest expense and general and administrative
expenses, would be allocated and apportioned using sourcing
rules similar to the current tax system. Research and experimental
expenses would be apportioned only to foreign mobile income
and U.S. income.
taxability of dividends to U.S. shareholders of multinational
corporations would change. Corporations would be required
to track their income between foreign exempt income and
U.S. taxable income. U.S. multinational corporations would
be required to disclose to shareholders the percentage relating
to FBI. Shareholders would be required to include that percentage
as taxable on their tax returns.
U.S. companies have established foreign holding companies
(e.g., in Bermuda) in order to escape U.S. tax. Under the
Panel’s recommendation, if a U.S. company met certain
control tests, the holding companies would be taxed as if
they were incorporated in the U.S.
the change to a territorial system would appear to represent
a major shift, the tax rules themselves would not change
dramatically. U.S. multinational corporations would still
need to track and report not only Subpart F income but also
the earnings and taxes of CFCs. In addition, because FTCs
would still be allowed to offset tax on “mobile”
income, FTC limitation calculations would still apply, as
would expense apportionment rules. Because these rules are
some of the more complicated rules in U.S. international
taxation, the Panel’s recommendation under SIT would
not significantly simplify our current international tax
Panel would broaden U.S. residency rules. Currently, corporations
are residents of the country in which they are organized,
where they file their articles of incorporation. The Panel’s
report reveals that this rule enables inversions, whereby
U.S. corporations can change their residency simply by incorporating
abroad. The American Jobs Creation Act of 2004 created certain
ownership tests. If, after changing residency, there is
a little (80% test) or a modest (60% test) change in ownership,
the inverted U.S. corporation would still be taxed, to differing
degrees, as a domestic corporation. The law does not prevent
newly organized entities from taking advantage of the rules.
Panel proposes a two-part residency test. An organization
would be considered to be a U.S. resident for tax purposes
if it were organized in the United States, or if its place
of primary management and control were in the United States.
The Panel believes this would curtail corporate inversions.
While the authors support the Panel’s goal to curtail
inversions, they question whether this two-part residency
test will have that effect. Creative U.S. companies may
be able to manipulate their place of primary management
and control to their tax advantage. The Panel leaves unanswered
questions relating to what rules would apply to the common
situation where U.S. companies own between 10% and 50% of
territorial system would put U.S. companies on a more equal
footing with their international competitors, most of which
operate under such a system. Although such a system would
remove a barrier to repatriation of earnings, the Panel’s
SIT recommendation would do little to simplify international
Destination-Basis, Border-Adjusted System
GIT, the Panel recommends changing from the worldwide system
to a destination-basis, border-adjusted system.
the destination-basis concept, tax would be imposed at the
point of purchase, not the point of production. As a result,
U.S citizens would pay the same price no matter the origin
(domestic or foreign) of the goods. According to the Panel,
a domestic exporter would still sell its goods in a foreign
country at the same price as without the tax. Goods sold
in the United States by a foreign producer would be subject
to the U.S. tax. As a result, the foreign importer would
compete in the U.S. on the same level as domestic sellers.
Under a border-adjusted system, there would be a refund
of tax on exports. The Panel believes that imposing a destination-basis
tax would not affect the country’s balance of trade.
8. Assume the same facts as Examples 5, 6,
and 7, where a farmer sold wheat to a miller. Under a border-adjusted
system, the U.S. farmer receives a $100 refund of domestically
imposed taxes, and the U.S. farmer’s price for wheat
on the international market would be $1,000, not $1,100.
Thus, whether the miller bought the wheat from a U.S. farmer
or a foreign farmer, the miller would pay the same price,
GIT, exports would be excluded from the tax base, and imports
would be included in the tax base. Purchases from abroad
(i.e., imports) would be taxed either by making them nondeductible
to the importing business or by imposing an import tax.
a destination-basis tax, transfer prices do not affect the
computation of tax liability. Border adjustments make the
tax base domestic consumption, which, at the business level,
equals domestic sales minus domestic purchases. As a result,
there would be no opportunity to use transfer prices to
minimize tax liability.
9. Assume the same facts as Example 4 above,
where the setting of a transfer price (between $150 and
$250) for an appliance determined how taxes were shifted
between jurisdictions. Under a destination-basis, border-adjusted
system, the tax base, at the business level, is equal to
domestic sales minus domestic purchases. If the U.S. multinational
has domestic sales of $1,000 and domestic purchases of $600,
it has profit of $400 and tax of $140 ($400 x 35%). Sales
in the foreign jurisdiction do not affect the multinational’s
U.S. tax liability. As a result, transfer pricing schemes
cannot affect U.S. tax liability.
to the Panel, under GIT—
the United States would be attractive to foreign investors
because capital expenditures (equipment, building, and
land) would be expensed;
there would be no tax incentive for U.S. companies to
move production overseas because tax liability would depend
entirely on U.S. sales; and
tax compliance and administration would be simplified
because there would be fewer complex cross-border tax-planning
GIT, all cash outlays for purchases of both tangible and
intangible goods from outside the United States would not
be deductible in computing a company’s taxable cash
flow. This is why transfer pricing becomes unimportant:
none of the purchase price would be deductible. Given the
proposed 30% tax rate on net business cash flow, this provision
would impose an effective 30% tax rate on all imports of
consumer goods, raw materials, and energy. Presumably, this
30% tax would be in addition to any duties already imposed
on these imports. This would amount to a substantial increase
in taxes that may adversely affect the U.S. economy. While
the idea may be good, the tax rate may be too high. Any
reduced tax rate for international transactions would have
to comport with economic studies, equity, government revenue
requirements, and World Trade Organization requirements.
GIT, the new system would be beneficial to net exporters
of technology and other intellectual property, because all
royalty income from licenses to use the licensed property
outside the U.S. would be tax-free. Presumably, the current
rules for sourcing income contained in IRC section 862 would
GIT proposal raises many questions. What would happen to
the CFC provisions of current law? Would the income-based
Subpart F provisions be retained or jettisoned? What would
happen to the FTC regime? How would this new tax be treated
under current tax treaties? Would our tax treaties have
to be renegotiated? How would earnings repatriated from
foreign subsidiaries be taxed, if at all? What would happen
to the U.S. withholding tax system under section 1441?
the Panel’s new international tax system really be
simpler—and, if so, at what price? A repeal of the
Subpart F regime would certainly be a simplification. But
some corporate attributes, such as earnings and profits,
might still have to be tracked, depending upon how repatriated
earnings are taxed. If the FTC system no longer existed,
the complex calculations of net foreign-source income and
the related determinations of which foreign taxes are creditable
would disappear, at least in the corporate context.
and when Congress takes up the Panel’s proposal, all
of these questions will be answered. But the deliberations
will bear close watching to make sure that the goal of tax
simplification is achieved.
Duxbury is a manager, international taxes, at Textron,
Inc., Providence, R.I., and an adjunct professor at Bryant
University, Smithfield, R.I. Michael C. Plaia
is a manager, international taxes, at Hasbro Corporation,
Pawtucket, R.I. Larry Witner, LLM, CPA,
is an associate professor at Bryant University, Smithfield,
R.I. The views expressed by the authors are their own and
not that of their employers.
Static Versus Dynamic
are two ways to “score” the effects of a tax
cut. To illustrate, assume the government cuts taxes by
$1,000. Under static scoring, the government loses revenue
of $1,000, and the analysis stops there. Under dynamic scoring,
however, the analysis continues, and secondary revenue effects
are considered. That is, if a tax cut promotes economic
growth, there is an increase in the tax base and thus in
government tax receipts. Some would argue that the estimated
cost of a tax cut should be offset by subsequent tax receipts.
If, in the example, the $1,000 tax cut promotes economic
growth that generates additional government tax receipts
of, say, $300, the cost of the tax cut would be $700 ($1,000
– $300), not $1,000. Some contend that subsequent
government tax receipts could more than offset the initial
tax cut, thus it would “pay for itself.”
Panel scored both plans using the traditional static method.
In a controversial move, the Panel recommended that Congress
use dynamic scoring in its work. The Panel states that if
it had used dynamic scoring, it could have reduced tax rates
even more. Proponents of further tax reductions are waiting
for the action to shift to Congress, where the dynamic scoring
of reform proposals will be possible.
Panel’s recommendations have received a mostly lukewarm
reaction from the public and the media because, for many
taxpayers, the recommendations are controversial. For some,
the recommendations do not go far enough, because they would
not tear out the old tax system by its roots and replace
it with something new. To
critics of the current system, the Panel’s recommendations
merely trim the branches. For some other critics, the recommendations
go too far and represent a shift of the tax burden from
wealth (upper class) to work (middle class).
for Major Tax Reform
to Panel member Bill Frenzel (2005 TNT 211-23), taxpayers
were more irritated with the Tax Code in 1986 than they
are now. As a result, tax-reform legislation may be that
much harder to sell. Major tax reform, like the 1986 Tax
Reform Act, may be a mid-term, rather than a short-term,
project. At present, Congress is preoccupied with hurricanes,
wars, and budget deficits. 2006 is an election year, and
politicians may be reluctant to tackle a controversial topic
such as major tax reform. Over the last 11 years, the Republican-controlled
Congress has not moved toward major tax reform, and there
is little indication it will move in that direction now.
To be successful, President Bush needs the support of moderate
Republicans and Democrats, and to get this support, tax
reform proposals probably cannot be too radical.
spite of the above, some kind of change is probably inevitable,
because of the near-term implications of the creeping AMT
and the sunset provisions enacted in recent tax legislation.
Each year, Congress has to tweak the AMT, with its non-indexed
brackets, so that it does not swallow up the middle class.
Certain recently enacted tax cut provisions expire in 2008
(dividends and long-term capital gains) and in 2010 (estate
tax repeal), so action will have to be taken before then.
Addressing the AMT and the expiring tax provisions will
provide an impetus for major tax legislation, and reform
proposals will likely influence the path of eventual legislation.
Panel’s recommendations will likely shape the debate
over tax reform in the years ahead, but its specific provisions
are not likely to become law soon.