Skip Navigation

The Economic Effects of Comprehensive Tax Reform July 1997

Recent tax reform proposals introduced in the 104th Congress offer numerous versions of broader-based and lower-rate taxes (for greater detail on the proposals, see Tables 1 and 2).⁽¹⁾ Most proposals would replace both personal and corporate federal income taxes. Moreover, most of the proposals would switch from an income-based tax to a consumption-based tax. Some of them would tax all consumption at a single, uniform tax rate; others would continue to have a series of graduated tax rates. All of the proposals, however, would try to broaden the tax base by eliminating or curtailing many of the exclusions and deductions available under current law. A few proposals specify rules for handling the transition from the current system to a new one, but many do not. Some similar proposals have been introduced in the 105th Congress.
 

An Overview of the Alternatives

Most recent proposals for comprehensive tax reform would replace the current income tax with a tax on consumption. Some analysts and policymakers would use a retail sales tax (RST) or a value-added tax (VAT) to tax consumption. The RST and the VAT are examples of "indirect" taxes--namely, taxes that are levied on transactions instead of people. Because indirect taxes are not levied directly on people, they cannot be personalized so that the amount of tax depends on the circumstances and characteristics of the taxpayer.

Indirect taxes work well when they are levied at a single, uniform rate. Because they are collected only at the business level, one of their advantages is that individual taxpayers would no longer need to file returns or make payments to the Internal Revenue Service. Although that potentially makes indirect taxes much simpler to administer, some people see it as a disadvantage because the public would no longer be aware of exactly how much they pay in taxes each year. Nevertheless, most states and all of the major trading partners of the United States use indirect consumption taxes.

Other proposals would tax consumption through "direct" taxes on individuals. Those proposals do not require each family to keep track of and report all of its expenditures during the year. Rather, direct consumption taxes rely on the definition that consumption is equal to income less saving. Hence, a direct tax on consumption can be levied by taxing income but exempting saving. Some proposals exempt saving by allowing a deduction for income that is saved, whereas others achieve the same result by not taxing the return from saving. Because income is the starting point for measuring consumption, most direct consumption taxes look similar in form and operation to the current income tax. They can be personalized to reflect the individual economic circumstances of different families. Unfortunately, an example is lacking: at present, no direct consumption tax has ever been put into general practice.

National Retail Sales Tax

A retail sales tax is a tax on the sale of goods and services from businesses to households. Under an ideal retail sales tax, businesses would make tax payments only on sales to households. Businesses such as petroleum refineries and steel manufacturers engaged solely in producing and selling intermediate goods and services to other businesses would have no involvement in the tax system. Moreover, businesses that purchase from retailers (such as from a gas station) would not pay tax on those purchases or else would receive reimbursement for any taxes paid.

The retail sales tax is the most familiar form of consumption tax to U.S. consumers. Although no general retail sales tax exists at the federal level, 44 states and the District of Columbia levy one. Retail sales taxes are generally levied at a single rate, with a zero tax rate for certain items. Of course, sales tax rates could vary for different products, although that would reduce economic efficiency and increase administrative complexity.

Retail sales taxes are levied on sales to households, but distinguishing those sales from sales to other businesses is at times difficult. If sales to other businesses were taxed as well, retail sales taxes would cascade, causing some items to be taxed more than once. For example, a computer store may sell to both households and business purchasers, such as to the owner of a hardware store who wishes to use the computer to keep track of inventory. If the retail sales tax applied to all computer sales, then the tax would cascade on purchases from the hardware store: the tax on computers would increase the store's cost of doing business, which would be passed along in the price of hammers, rakes, and garden hoses.

Retail sales taxes can also cascade if used goods are taxed without making any adjustments for taxes paid at the time of original purchase. For example, a tax on the sale of a used motor vehicle by a dealer would tax that vehicle more than once if the original owner did not receive a partial tax rebate when he or she traded in the vehicle or sold it back to the dealer.

Most states try to prevent retail sales taxes from cascading by not taxing sales to registered business users, although by some estimates taxes on business purchases account for about two-fifths of current tax receipts from retail sales.⁽²⁾ But distinguishing business use from personal use poses another problem. For example, the hardware store owner might use the computer to conduct personal business, such as recordkeeping for a fantasy baseball league. The retail sales tax should properly apply only to the portion of the sales price that represents the personal use of the computer. Distinguishing between personal and business use is a familiar problem under the current income tax that would persist under a retail sales tax. Most states also eliminate the cascading taxes on resales of used motor vehicles by deducting trade-in allowances from the purchase price of new vehicles for tax purposes. The treatment of resales of other used goods varies.

Incidence. Businesses making retail sales to households would be responsible for remitting the tax to the government and thus in a literal sense would pay the tax. In an economic sense, however, households would pay the tax as part of the overall price they pay for goods and services. Although the tax would be quite visible, much as state and local sales taxes are now listed separately on sales receipts, households would nonetheless need to keep meticulous records if they wanted to know exactly how much tax they were paying over the course of a year.

Because lower-income households tend to spend more of their income than middle- and higher-income households, a retail sales tax tends to be regressive--that is, lower-income families pay a larger portion of their income in sales taxes than do higher-income families. Remedying the regressivity is difficult because such a tax is hard to personalize. Attempts to make retail sales taxes less regressive by not taxing certain expenditures, such as those on food or household utilities, are only partially successful. After all, identifying particular goods and services that lower-income families purchase disproportionately is a formidable task at best.

Hard-to-Tax Goods and Services. Unless a retail sales tax applied to all goods and services, households would probably change their spending patterns and buy more of those goods and services that were not taxed. Although such a result might be acceptable in some instances, producers of the taxed goods and services would be at a disadvantage.

Applying a retail sales tax to all goods and services is not a simple matter in all cases. Financial services are one example. Financial institutions often do not charge observable fees, or the fees do not necessarily reflect the true value of their services. Compensation to banking institutions, for example, may come in the form of the spread between the interest rate charged on loans and the interest rate paid to depositors so that banks are able to provide checking services with no explicit fees involved. Life insurance companies are compensated by returns from the investment of premiums, so the explicit premiums are far from a full reflection of the value of the insurance service.

To tax the value of financial services to consumers properly, financial institutions would have to determine the value of the services they provide to all of their customers, separate the portion of the value that went to businesses, and pay tax only on the amount provided to consumers. Even if financial services could be properly valued, allocating the value of services between consumers and businesses would be difficult.

Taxing government services is also hard because they are seldom financed by user fees that reflect their true cost. The same is true for the services that nonprofit organizations provide. Proper treatment under a retail sales tax would be to tax government and nonprofit provision of goods and services. Otherwise, those goods and services would be subsidized relative to private production, and there would be incentives to allocate more economic resources toward the government and nonprofit sectors. Such an outcome can be acceptable when governments and nonprofit organizations provide certain public goods, such as education or charitable services, that have spillover benefits to everyone. But it is a problem when the goods and services provided compete directly with those of for-profit firms.

In many cases, however, no identifiable transaction in providing government and nonprofit services exists, making taxation infeasible.⁽³⁾ Usually, the best that can be done is to have governments and nonprofit groups value resources at the same prices as the private sector by taxing sales from businesses to those entities.

Taxing Exports and Imports. Because retail sales taxes would be levied only on sales to U.S. households, exports would not be subject to the tax. Imports would be subject to the retail sales tax so as not to place domestically produced products at a disadvantage. Imports of intermediate goods and services purchased by businesses would not be taxed, however, to prevent the tax from cascading when the final product was sold to households.

Proposals. The National Retail Sales Act of 1996 (H.R. 3039), introduced by Congressmen Dan Schaefer, Billy Tauzin, and others, proposed a broad-based national retail sales tax of 15 percent. Under that proposal, all goods and services sold would be subject to the tax except those purchased for resale, for use in producing other goods and services, or to be exported from the United States. To lighten the tax burden on lower-income households, the proposal includes a family rebate equal to the lesser of the family's income from wages or the poverty level for a family of that size.

The tax would apply to explicitly and implicitly imposed charges of financial institutions. Governmental units would not be exempt from tax on the sale, purchase, or use of a taxable good or service. The proposal would apply a 15 percent excise tax to the wages of government employees, which would be collected from their employers. Without an additional adjustment, that provision would result in an extra tax on government-provided goods and services that were explicitly taxed at the time of sale to the public.

Nonprofit organizations would pay the sales tax on their purchases from businesses, except for purchases for resale or for use in producing other goods and services. The sales tax generally would not apply to dues, contributions, or other payments to qualified nonprofit organizations, except for goods and services that are commercially available or are not substantially related to the tax-exempt purpose of the organization.

Value-Added Tax

The value-added tax is essentially a sales tax on consumer purchases that businesses collect in stages. In general, businesses owe VAT on the difference between their sales and their purchases from other businesses. More than 50 countries, including all member countries of the Organization for Economic Cooperation and Development (OECD) except Australia and the United States, use a VAT.

Although most VATs rely on the credit method to calculate the amount of tax, a number of the current proposals for reform would use the subtraction method. Under a credit-method VAT, businesses pay tax on the total value of their sales but receive a credit for the VAT paid on their purchases of goods and services from other businesses. That type of VAT is generally preferred over a sales tax for two reasons: first, the rebate mechanism on business purchases prevents taxes from cascading, and second, the system of credits and invoices can reduce tax evasion. Unlike the credit-method VAT, a subtraction-method VAT does not require invoices that show how much VAT was paid on purchases and charged on sales. Instead, businesses simply subtract their purchases from their sales and pay tax on the difference. A subtraction-method VAT works well when all goods are taxed at the same rate. However, most countries using a VAT have zero or reduced rates on many goods, which makes using the subtraction method impractical.⁽⁴⁾

Incidence. The incidence of a VAT would be the same as a retail sales tax--households would ultimately pay the tax through higher prices for the goods and services they purchase. A VAT faces the same problem as a retail sales tax: lower-income households tend to spend a higher portion of their income and thus would pay a higher tax relative to their income than other families. Moreover, it is difficult to personalize or tailor a VAT according to the composition or economic circumstances of different households. Most countries using a VAT try to lessen the impact on lower-income households by taxing selected goods and services at a zero or reduced rate. Unfortunately, the zero-rating of necessities such as food, housing, and utilities only slightly reduces the VAT's regressivity.⁽⁵⁾

Hard-to-Tax Goods and Services. A VAT faces the same problems as a retail sales tax in trying to apply the tax to all goods and services. Once again, taking financial services as an example, the problem is not simply for financial institutions to place a value on those services, but also for them to allocate a portion of the value among their business customers so that each of those customers can take an explicit or implicit credit for the VAT charged on the financial services they use.

Because of that measurement problem, most European countries that use value-added taxes have chosen to remove financial services from the tax base. Purchases of financial services can either be zero rated, in which case the zero-rated institution pays no tax but receives a credit for taxes paid on intermediate inputs, or exempted, in which case the exempted institution neither pays a tax nor receives a credit for the taxes paid on intermediate inputs (goods and services purchased from other businesses).

Exemption is simpler because the exempt institution does not have to participate in the tax system at all: it pays no tax and receives no credits. But on the negative side, exemption causes taxes paid on intermediate goods to cascade because they are never offset by a credit. Under the subtraction-method VAT, the method generally proposed in recent comprehensive tax reform plans for the United States, exemption does not cause taxes to cascade. Any exemption for financial services would, however, encourage the consumption of those services over other goods and services, and in that respect the VAT would fall short of an ideal neutral consumption tax.

Arguably, financial services should not be taxed at all under a VAT. Critics maintain that purchasing financial services is not consumption; rather, it is merely a means to consumption (or an intermediate input rather than a final product). Such a view suggests that financial services should not be included in a consumption base because taxing such services would cause taxes to cascade, just as they would if other intermediate products were subject to tax.⁽⁶⁾

A VAT would tax some portion of the value of goods and services provided by governments and nonprofit institutions even if those institutions were not liable for tax on their sales to the public. Under a VAT, even if government entities were exempted (which means they did not have to register as businesses and collect the VAT), they would still pay tax on the value of their purchases from registered businesses. The same would be true for nonprofit organizations. They would pay no tax, however, on their own value added.

Taxing Exports and Imports. A VAT can be levied either on the basis of origin (goods and services are taxed where they are produced, so the United States taxes production in the United States) or on the basis of destination (goods and services are taxed wherever they are consumed, so the United States taxes consumption in the United States). Because a VAT is collected in stages as goods are produced, a border tax adjustment is generally required to tax exports and imports on the basis of their destination. A border tax adjustment refunds the VAT that has accumulated on the production of exports and imposes the VAT that would have accumulated on imports if they had been produced domestically. The choice between an origin- or destination-based tax should have little effect on the level of U.S. trade over the long run (see Chapter 3).

Proposals. Legislation introduced by former Congressman Sam Gibbons (H.R. 4050) proposed a value-added tax on businesses at a single rate of 20 percent. The tax would not only replace the current individual and corporate income tax but the Social Security payroll tax as well. The VAT would be calculated using the subtraction method and would impose border tax adjustments. As a way to achieve greater progressivity, the proposal includes a supplemental individual income tax that would apply only to individuals with high incomes. Low-income households would get a refundable credit to offset their VAT payments.

The proposal attempts to make the base of the VAT as broad as possible. The base would include not only virtually all sales by businesses to consumers, but also sales of nonprofit organizations, state and local governments, and the federal government. Very small businesses (those with gross receipts of less than $12,000 a year) would be exempt from the tax. The VAT would be levied on both rental and owner-occupied housing. For rental housing, the tax base would include rents. For owner-occupied housing, it would include new construction, renovations, and repairs.

Most businesses would use the subtraction method to calculate their VAT liability. To avoid the difficulties that are involved in determining the value of financial services under the subtraction method, the proposal would tax such services using an alternative method based on financial cash flow. Typically, banks and other financial institutions would be taxed on the "spread" between their gross income from loans and investments and their cost of borrowing funds. Although that calculation would capture the value of financial services in the tax base, it would cause the tax on financial services used by businesses to cascade.

A Bifurcated Value-Added Tax

A bifurcated VAT is similar to a subtraction-method VAT, except that businesses would also subtract wage payments from their sales when calculating their tax base. Wages would then be taxed directly at the personal level. Personal exemptions and a standard deduction would tailor the wage tax to family size. In effect, with the same tax rate on the business and wage portion of the tax, a bifurcated VAT is an ordinary VAT with an implicit refund that would depend on a family's size and wage earnings.

The flat tax proposed by economists Robert Hall and Alvin Rabushka is an example of this type of VAT. They describe the tax in the following way.

Here is the logic of our system stripped to basics: We want to tax consumption. The public does one of two things with its income--spends it or invests it. We can measure consumption as income minus investment. A really simple tax would just have each firm pay tax on the total amount of income generated by the firm less that firm's investment in plant and equipment. The value-added tax works just that way. But a value-added tax is unfair because it is not progressive. That's why we break the tax in two. The firm pays tax on all the income generated at the firm except the income paid to its workers. The workers pay tax on what they earn, and the tax they pay is progressive.⁽⁷⁾

Incidence. A bifurcated VAT has an advantage over an ordinary VAT in that the impact of the tax on lower-income households can be mitigated through the wage tax. Because the wage tax is an individual-level tax, it can be designed to vary according to the composition and economic conditions of different households. The flat tax proposed by Hall and Rabushka achieves some progressivity by providing a family allowance that increases with the number of dependents. However, the wage portion of the tax could certainly be levied at graduated rates, making the overall tax even more progressive. David Bradford has proposed another version of a bifurcated VAT, which he labels the X-Tax, that is much like the Hall and Rabushka proposal except that it would apply graduated rates to the wage tax.⁽⁸⁾

Hard-to-Tax Goods and Services. A bifurcated VAT solves some of the problems with an ordinary VAT by taxing wages at the individual level. Because wage payments account for a large portion of the value added attributable to governments and nonprofit organizations, a bifurcated VAT provides generally consistent treatment for those institutions and private businesses.

Taxing Exports and Imports. The General Agreement on Tariffs and Trade allows border tax adjustments on indirect taxes such as a VAT, but it does not permit them for direct taxes such as the individual income tax. Despite its similarity to an ordinary VAT, border tax adjustments are unlikely to be permissible for the wage portion of a bifurcated VAT.⁽⁹⁾ Under the Hall and Rabushka plan, traded goods and services would be taxed on an origin basis--no rebate would be given for exports and no tax levied on imports.

Proposals. House Majority Leader Richard Armey and Senator Richard Shelby proposed a version of the Hall and Rabushka flat tax--the Freedom and Fairness Restoration Act of 1995 (H.R. 2060 and S. 1050). The proposal would tax all businesses at a single rate of 20 percent initially and 17 percent in future years on the proceeds from sales, less purchases of inputs from other businesses, and less all salaries, wages, and pension contributions. Payments for fringe benefits other than pension contributions, state and local taxes, and payroll taxes would not be deductible from the business tax base.

State and local governments and nonprofit organizations would not be subject to the business tax, except on unrelated business activities. Thus, nonwage compensation for those organizations would escape taxation at both the business and personal levels were it not for a special tax on the value of employee compensation other than wages and retirement contributions for such organizations.

A personal-level tax at the same single rate as the business-level tax would apply to wages, salaries, pensions, and unemployment compensation above an exemption level that would vary by marital status and family size and would be indexed for inflation. The exempted amount would equal $31,400 for a family of four in 1996.

Senator Arlen Specter proposed a flat tax (S. 488) similar to H.R. 2060 and S. 1050. His proposal, however, would retain a limited level of itemized deductions for mortgage interest and charitable contributions up to specified limits. To offset that reduction in the tax base, the proposal would maintain a 20 percent tax rate indefinitely.

A Personal Cash Flow Tax

A personal cash flow tax is levied on income less net saving and is collected entirely from individuals. For the typical taxpayer, the personal cash flow tax would be similar to the current individual income tax except that all of the taxpayer's financial assets would be treated as if they were individual retirement accounts. Tax-deductible deposits to such individual retirement accounts could be made at any time in any amount, and taxable withdrawals could be made for any reason without penalty.

Borrowing would be treated as negative saving. Thus, the proceeds of any loan would be added to the tax base. At the same time, payment of interest and repayment of principal would be deductible.

Incidence. All taxes would be collected at the personal level. Thus, unlike the VAT, the burden of the personal cash flow tax could be personalized and made progressive; that is, the tax could allow for exemptions based on family size and economic circumstances. A single tax rate or graduated rates similar to current law would be available. As a result, a personal cash flow tax could be either more or less progressive than the current system.

Hard-to-Tax Goods and Services. The appropriate treatment of housing and durable goods presents problems for a tax on personal cash flow similar to those under the current income tax.⁽¹⁰⁾ If housing was treated as any other investment under the tax on cash flow, the price of a home would be deducted at the time of purchase, whereas returns from the investment in housing--the flow of housing services--would be taxable. Loans and withdrawals from saving to purchase the house would be added to the tax base, but repayment of loans (both principal and interest) would be deductible as those payments were made.

Because a tax on personal cash flow is unlikely to include the implicit returns from housing in the tax base, an alternative way to tax housing consumption would be to exclude it completely. The tax would not allow any deduction for housing purchases, and imputed returns would not be included in the base. Mortgage loans would not be added to the tax base, but payment of principal and interest would not be deductible. However, that treatment poses a nettlesome problem: although mortgage loans would not be added to the tax base, withdrawals from savings used to make a down payment would. Consequently, tax liability at the time a house was purchased would bulge, unless some provision was made to smooth out the increase in the tax base over a number of years.

Because all taxes are collected at the individual level, a tax on personal cash flow avoids the problems inherent in indirect taxes such as a retail sales tax or a VAT, including the problems of cascading and of taxing goods and services that governments and nonprofit organizations provide.

Proposals. Senator Pete Domenici and former Senator Sam Nunn proposed a tax on personal cash flow together with a business-level VAT in the Unlimited Savings Allowance (USA) Tax Act of 1995 (S. 722). In addition to replacing corporate and personal income taxes, the USA tax would give businesses and households a tax credit for the payroll taxes they pay. At the business level, a subtraction-method VAT would be applied to the difference between proceeds from sales and purchases of goods and services from other businesses, including capital input and land.

At the personal level, the tax base would be calculated as income less net saving and specified exemptions and deductions. Taxable income would include wages, salaries, pensions, most fringe benefits, alimony, child support, and income from assets, except for interest earned on municipal bonds. Net deductible saving would include the value of newly acquired savings assets, deposits to savings accounts, payments for life insurance policies, and contributions to pension plans or other retirement accounts. Sales of capital assets, proceeds from life insurance policies, distribution and withdrawals from retirement plans, and withdrawals from other savings accounts would reduce net deductible saving, and such saving would not include investment in land, art, collectibles, or vacation homes. A negative value for net saving would further add to a taxpayer's liability.

Borrowed funds would be taxable to the extent that they reduced an individual's deduction for net saving, although they could not reduce it below zero. Repayment of taxable borrowing--principal and interest--would be deductible. Certain types of borrowing would not be taxed, including all mortgages on principal residences, up to $25,000 of borrowing for purchases of consumer durable goods (such as automobiles and home furnishings), and up to $10,000 of additional borrowing for any purpose. Subsequently, with the exception of mortgage interest, repayment of principal and interest on nontaxable borrowing would not reduce tax liabilities.

The USA tax would retain deductions for mortgage interest and charitable contributions and would add a new deduction for postsecondary educational expenses. Unlike itemized deductions under the current income tax, taxpayers could take those deductions in addition to the standard deduction. Home buyers could deduct interest payments on their principal residence, even though mortgages on principal residences would not be included in taxable income. That treatment would create an incentive for taxpayers to borrow as much as possible on their home and would treat owner-occupied housing more favorably than other investments. Individuals could deduct contributions to charitable, religious, or educational institutions as defined under current law. Those deductions could not exceed half of an individual's taxable income in a given year. But taxpayers could carry forward unused deductions for up to five years and deduct them in future years. Families could deduct up to $2,000 for each family member (but no more than $8,000 per year) for postsecondary education and training each year. No deduction would be allowed for state and local taxes of any kind under the proposal.

Taxpayers could claim a standard deduction of $7,400 (in 1996 dollars) for married couples filing jointly, $5,400 for a single head of household, or $4,400 for a single filer, and an additional deduction of $2,550 for each family member. Those amounts would be indexed for inflation. The USA tax would retain a system of graduated rates, equal to 8 percent, 19 percent, and 40 percent once the tax was fully in place. Graduated rates would enable people to deduct saving when their tax rates were high to finance consumption later when their tax rates were low, thus subsidizing saving relative to a tax with uniform rates.

The proposal would create a system of rules during the transition period that would be designed to prevent individuals and businesses with assets that were taxed under the income tax from being taxed on those assets again under the USA tax system. It would do so by allowing tax-free recovery of the "tax basis" of assets purchased before the USA tax system became law. The tax basis is that portion of the value of an asset that has already been taxed.

A More Comprehensive Income Tax

Past efforts at comprehensive tax reform generally have retained an income-based system while attempting to broaden the tax base and lower tax rates. A good example is the Tax Reform Act of 1986 (TRA), which eliminated a number of deductions and exclusions in the income tax, including the two-earner deduction, the IRA deduction for high-income taxpayers, and the partial exclusion of long-term capital gains. It also restricted itemized deductions and limited the ability of taxpayers to offset their income from other sources with partnership and rental losses. On the corporate side, the TRA broadened the tax base by repealing the investment tax credit and limiting certain allowances for depreciation. The act reduced the maximum income tax rate from 50 percent to 28 percent, and the maximum corporate tax rate from 46 percent to 34 percent.⁽¹¹⁾

Deductions and exclusions in the tax code further certain policy objectives, such as increased home ownership and broader health insurance coverage. Arguably, some deductions provide adjustments for a taxpayer's ability to pay, for example, by allowing deductions for unusually large medical expenses.

Reducing deductions and exemptions treats taxpayers in similar economic circumstances more equally--a principle known as horizontal equity. For example, under current tax rules, employers' contributions for health insurance benefits are not treated as taxable income to the worker. A similar employee who must purchase his or her own insurance receives no deduction and is taxed on the full amount of income.

Itemized deductions under the current income tax not only treat taxpayers differently depending on whether they have deductible expenses but also differentiate on the basis of income. For example, homeowners who do not carry a mortgage are not able to claim the deduction for home mortgage interest. The deduction is available only to taxpayers with mortgage interest payments sufficiently large that, combined with other itemizable deductions, they exceed the standard deduction for that taxpayer. Even among taxpayers who take the deduction, the tax savings (which equals the amount deducted times the taxpayer's marginal tax rate) is larger for taxpayers with higher income.

Reducing deductions and exclusions not only improves horizontal equity but also, by increasing the size of the tax base, permits the same amount of revenue to be collected with lower tax rates. Lower tax rates reduce the incentives for taxpayers to engage in tax-motivated behavior, such as sheltering income or reducing real economic activity, and thereby increase the economic efficiency of the tax system.

An important component of a more comprehensive income tax is better integration between business and individual taxes. Under the current system, some income is taxed first at the business level as part of corporate earnings and then at the individual level when those earnings are distributed to shareholders. Most members of the Organization for Economic Cooperation and Development, all of which have income taxes in addition to broad-based consumption taxes, integrate the corporate- and individual-level tax to some degree.⁽¹²⁾

House Minority Leader Richard Gephardt proposed a broader-based and flatter version of the current income tax--the 10 Percent Tax Plan. That proposal would broaden the personal income tax base by eliminating the tax exclusion for state and local bond interest, employer-provided fringe benefits such as health insurance, and all current itemized deductions (except the mortgage interest deduction). It would tax employer-provided pension contributions when those contributions were made and eliminate the current tax deduction for IRA contributions. It would end the child care and elderly credits. The broader tax base would allow for reduced tax rates. The majority of taxpayers would face a 10 percent marginal tax rate, although higher-income households would face graduated rates ranging from 20 percent up to 34 percent. The proposal would eliminate or restrict a number of unspecified business tax preferences but would keep intact a separate, nonintegrated corporate income tax.
 

Common Elements of Recent Proposals for Comprehensive Tax Reform

The proposals just cited--a national retail sales tax, a value-added tax, a bifurcated VAT, a tax on personal cash flow, and a more comprehensive income-based tax--sound quite different. On the surface, they appear to take a variety of approaches to comprehensive tax reform. But in fact, many of their distinctions are not particularly significant from an economic standpoint. More important, the proposals actually have many common elements that may contribute to desirable economic changes.

A Tax on Consumption Rather Than Income

With the exception of a more comprehensive income tax, all of the proposals outlined above replace the current income-based system, which includes capital as well as labor income in the tax base, with a consumption-based system in which savings are deductible or the expected return from capital is exempt.

The basic distinction between income and consumption taxes is that an income tax generally will affect decisions about the timing of consumption, but a consumption tax will not (see Box 1).⁽¹³⁾ That "intertemporal neutrality" of a tax can be achieved either by initially deducting the amounts saved or invested and later taxing the withdrawals or proceeds ("immediate deduction") or by exempting the yield from such saving or investment in each period ("yield exemption").
 

Under certain assumptions, either type of tax would have a similar effect on the lifetime budget constraints and timing decisions of households. A savings deduction would be equivalent to a yield exemption if income was known with certainty, tax rates were stable, and capital markets were "perfect" in that the taxpayer had an unlimited ability to borrow or lend against future income at a single interest rate.⁽¹⁴⁾ However, because in any given year the yield-exemption base includes only wage income, not consumption, it is more accurately considered a wage tax rather than a consumption tax, at least from an annual perspective.

Shifting to a consumption base would obliterate the current tax incentive to consume now instead of later. Because the base of an income tax includes capital income, it encourages present consumption by reducing the net reward (the after-tax return) for postponing consumption. Thus, on the one hand, moving to a consumption base might encourage people to save more and would reduce the effects of taxes on the timing of consumption. On the other hand, a comprehensive consumption-based tax is not entirely free of influences on economic behavior. In particular, people can still avoid a consumption tax by reducing the number of hours worked and increasing their leisure time, which is untaxed under either a consumption or an income tax. Moreover, because savings are removed, a consumption base is generally smaller than an income base. Thus, a higher overall tax rate may be necessary, making the tax's net effects on the trade-off between leisure and consumption greater compared with those of an income tax.

In addition to removing the influence of taxes on the timing of consumption, another advantage of a consumption-based tax is that it avoids the problem of trying to measure capital income. In general, what makes capital income so difficult to measure properly is the mismatch in timing between actual income and observable cash flows. Measuring capital income is particularly complicated during periods of inflation because of the need to use information on market transactions made at different times. The Herculean task of coming up with perfect measures of all types of capital income leads to an income-tax system that unavoidably taxes some types of capital income more heavily than others.

More Uniform Tax Rates

Many recent reform proposals advocate moving to a single-rate, or flat, structure, with one tax rate applied to all income or consumption above an exemption level. One can contrast those single-rate systems with the current system in which marginal tax rates increase with income level.⁽¹⁵⁾ Most proposals would also apply the same tax rate to different types of income or consumption. Consequently, whatever income fell in the definition of the tax base would be taxed at the same rate.

Greater uniformity in tax rates would reduce incentives to change the timing or form of transactions. However, eliminating the graduation in marginal tax rates by income level, even if a certain amount of income is exempted from taxation, typically implies that the distribution of the tax burden among families with different incomes will change.

Except for the Gephardt 10 Percent Tax Plan, most proposals for fundamental tax reform would eliminate the distinction between corporate and noncorporate businesses by using a general business-level tax instead of a tax specific to corporations. Doing so would wipe out the present tax incentive to engage in noncorporate activities or purchase noncorporate products. In addition, the proposals attempt to coordinate business and personal taxes more effectively, both in terms of rate structures and what is included in the tax bases. As a result, the two levels of taxation put together would uniformly tax a single, comprehensive base. That so-called "integration" of the two levels of taxation would reduce the influence of taxes on the organizational and financial decisions of businesses.

A Broader Tax Base and Lower Tax Rates

Most of the proposals for fundamental tax reform would not merely switch to a consumption base: at the same time, they would increase the size of the tax base by eliminating many preferences that the current system grants to certain forms or uses of income. The flat tax, for example, would remove all types of itemized deductions while also expanding the definition of taxable income by including employer-paid fringe benefits. The USA tax would not totally eliminate deductions (for example, the deductions for mortgage interest and charitable contributions would remain), but it would still broaden the definition of gross income in a manner similar to the flat tax.

By including more economic transactions in the tax base, recent proposals for comprehensive tax reform (whether they are proposals for consumption-based taxes or not) could for the most part achieve lower overall tax rates while raising the same amount of revenue. Base broadening also implies a more similar treatment of different sources and uses of income. Both of those features suggest a tax system that would have less effect on people's economic behavior. Lower tax rates imply that individuals and firms would have less incentive to shift to activities that are more lightly taxed because the differences in tax rates would be reduced. Individuals and firms would also find it more difficult to substitute tax-exempt activities for taxable ones if nearly everything was brought into the tax base.

1. See also Joint Committee on Taxation, Impact on State and Local Governments and Tax-Exempt Organizations of Replacing the Federal Income Tax, JCS-4-96 (April 30, 1996), pp. 22-48; Joint Committee on Taxation, Impact on International Competitiveness of Replacing the Federal Income Tax, JCS-5-96 (July 17, 1996), pp. 66-91; and Henry J. Aaron and William G. Gale, eds., Economic Effects of Fundamental Tax Reform (Washington, D.C.: Brookings Institution, 1996), pp. 6-14.

2. Raymond Ring, "The Proportion of Consumers' and Producers' Goods in the General Sales Tax," National Tax Journal, vol. 42 (June 1989), pp. 167-179.

3. John L. Mikesell, "Sales Taxation of Nonprofit Organizations: Purchases and Sales," in William F. Fox, ed., Sales Taxation: Critical Issues in Policy and Administration (Westport, Conn.: Praeger Publishing, 1991), pp. 121-130.

4. For more detail on the mechanics of a value-added tax, see Congressional Budget Office, Effects of Adopting a Value-Added Tax (February 1992), pp. 5-19.

5. Ibid., pp. 31-47.

6. Harry Grubert and James Mackie, An Unnecessary Complication: Must Financial Services Be Taxed Under a Consumption Tax? (Department of the Treasury, Office of Tax Analysis, August 1996).

7. Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford, Calif.: Hoover Institution Press, 1995), p. 55.

8. David F. Bradford, "On the Incidence of Consumption Taxes," in Charls E. Walker and Mark A. Bloomfield, eds., The Consumption Tax: A Better Alternative? (Cambridge, Mass.: Ballinger, 1987), pp. 243-261.

9. Gary Clyde Hufbauer assisted by Carol Gabyzon, Fundamental Tax Reform and Border Tax Adjustments (Washington, D.C.: Institute for International Economics, 1996).

10. Henry J. Aaron and Harvey Galper, "The Cash-Flow Income Tax," in Aaron and Galper, Assessing Tax Reform (Washington, D.C.: Brookings Institution, 1985), pp. 66-107.

11. Although the Tax Reform Act reduced the top individual tax rate to 28 percent, it also contained provisions to recapture the benefits of personal exemption and the lower tax rates in the bottom bracket, resulting in an income tax rate of 33 percent over certain income ranges. For a discussion of suggestions for further steps toward comprehensive tax reform, see Joseph A. Pechman, "The Future of the Income Tax," American Economic Review, vol. 80, no. 1 (March 1990), pp. 1-20.

12. Department of the Treasury, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (January 1992).

13. If the consumption tax has a single tax rate, it will totally eliminate the effect of taxes on the timing of consumption. But with multiple tax rates, such as "graduated" tax rates that increase with the level of consumption, there will still be an intertemporal effect, in the sense that people can reduce their tax liability on consumption by shifting consumption to low-tax-rate periods. Even with the graduation in tax rates, however, a switch to a consumption-based tax is likely at least to reduce the intertemporal effect of taxes.

14. See Michael J. Graetz, "Implementing a Progressive Consumption Tax," Harvard Law Review, vol. 92, no. 8 (June 1979); and Edith Brashares and Laura T.J. Kalambokidis, "Assessing the Equivalence of Different Forms of a Consumption Tax," in National Tax Association/Tax Institute of America, Proceedings of the Eighty-Eighth Annual Conference on Taxation, 1995 (Columbus, Ohio: NTA-TIA, 1996), pp. 248-253.

15. The marginal tax rate is the rate applied to the next dollar of income.

---