consumption tax alternatives: retail sales tax, flat tax and personal consumption tax. Justifications for tax reform range from the need to simplify the current system to raising revenues to modifying social policy. In the face of growing demands by politicians and taxpayers alike, the topic of tax reform has produced alternate federal income tax proposals. This essay compares income tax to consumption tax, and also reviews the retail sales tax, flat tax and personal consumption tax systems. The comparisons include discussion of differences between proposals, relative degree of effectiveness, as well as ease of implementation. Each of the major categories proposed accomplish tax reform with varying degrees of success, which must be considered along with their associated trade-offs. This essay examines some specifics of those approaches.
Reasons for Tax Reform
Growing support for tax reform comes from both politicians and taxpayers alike. Surveys conducted during the 2009 tax filing season showed that 42% of taxpayers felt that the tax systems should be completely overhauled, 40% stated that the tax system needs major changes, and only 2% thought that things were fine just as they are. In 2008, platforms of both major political parties mentioned the size of Internal Revenue tax code, calling for reform to ensure fairness and transparency and to promote economic growth. Both President George W. Bush in 2005 and President Barack Obama in 2009 established a task force and review panel to reform the tax code (AICPA, 2009, pp. 1-2).
The Joint Economic Committee of the U.S. Congress likewise advocates reform of the corporate tax system, in a report calling it a "patchwork of overly complex, inefficient and unfair provisions that impose large costs on corporate business" (Fichtner, 2005, p.1). The report describes how U.S. corporations, seeking to minimize the costs imposed by the detrimental provisions in the U.S. corporate tax system, have adopted strategies to reduce overall tax exposure and increase profits. The report further notes that many U.S. businesses conduct "costly and complex operations that have minimal economic content but rather seem designed solely to reduce tax exposure" (Fichtner, 2005, p.1).
One of the recurring concerns that motivates major federal tax reform is complexity of the current system. Compliance for both individual and business taxpayers is burdensome, both in terms of time and out-of-pocket costs. Complexity also increases administrative costs and impairs the efficiency of tax administration. Honest taxpayers make unintended errors due to tax law complexity, while dishonest taxpayers are more able to exploit the system. Complexity likewise makes it more difficult for the IRS to detect noncompliance (AICPA, 2009, p. 3).
Yale law professor Michael Graetz, in arguing for a value-added tax (VAT) consumption tax, points out that the IRS Form 1040 instruction booklet grew from 48 pages in 1976 to 122 pages in 2001; form 1040 for the year 2001 had 11 schedules and 20 additional worksheets. Graetz argues that the vast majority of American families should not have to file tax returns or deal with the IRS at all. To resolve issues of complexity, Graetz proposes that the current system be replaced by a VAT that would operate much like a national sales tax, but would be collected at all stages of production rather than just from retailers (Graetz, 2006).
Another problem created by the current system is the size of the legal tax gap, which is defined as the difference between taxes owed and taxes paid on time. The IRS estimates that in 2001 the legal tax gap was between $312 and $353 billion for all types of taxes; the estimated noncompliance rate was between 15% and 17%. Enforcement along with collection efforts reduced the uncollected amount to approximately $290 billion (AICPA, 2009, p. 4).
Equally problematic is the gap between reported pretax profits and effective tax rates that many corporations benefit from. According to Citizens for Tax Justice, a survey of 12 Fortune 500 companies having a 35% statutory tax rate showed that the firms enjoyed such substantial tax subsidies that effective tax rates ranged from 0.4% to 14.2%. Had these 12 companies paid the full 35% corporate tax rate, their income taxes over the three-year study period would have totaled $59.9 billion; instead they enjoyed so many tax subsidies that they paid $62.4 billion less than that. Altogether the 12 corporations paid an effective tax rate of negative 1.5% on $171 billion in profits. (Citizens for Tax Justice, 2011, pp. 1-3).
According to the Organization for Economic Co-operation and Development (OECD), household savings is a key domestic source of investment and discouraged by the current tax system. Household savings rates are lower for the U.S. than for other industrialized countries. OECD data for 2007 shows the U.S. lagging behind France, Germany, Japan and Canada (AICPA, 2009, pp. 5-6).
Another rationale frequently given in support of tax reform is that the current system impedes the international competitiveness of U.S. firms. The U.S. tax system differs from its trading partners' tax systems. For example, the U.S. has a worldwide tax system under which all income is taxed regardless of where it is derived, as opposed to a territorial system used by many countries, which only taxes income derived within a country's borders.
U.S. income taxes are not "border adjustable," whereas indirect taxes, such as value-added taxes (VATs), are imposed on imported goods and refunded for exported goods. All OECD countries, other than the U.S., rely on a VAT in addition to an income tax (AICPA, 2009, p. 6).
The foremost purpose of any tax system is raising sufficient revenue to fund government programs; the current system falls short of that goal. In January 2009, the Congressional Budget Office (CBO) estimated that the annual budget deficit would be $1.2 trillion, an amount that is two and a half times the prior year's deficit. The CBO concluded at that time that "under the current law the federal budget is on an unsustainable path" (AICPA, 2009, p. 8).
Another reason for reforming the tax system is the fact that the tax system is not neutral. Tax systems should interfere as little as possible with taxpayer decisions about whether or how to undertake a specific transaction or activity. And yet, the current U.S. tax system is frequently used to either encourage or discourage taxpayers from undertaking a particular activity. It happens in the U.S. that many economic, social, and environmental policies have been implemented through tax provisions. Congress does not often consider alternative approaches outside the tax system in its efforts to dispense benefits or encourage certain behaviors. Consideration should be given the fact that implementing policy goals by using preferential tax treatment comes at a cost that needs weighing against alternative means for reaching the same goal. Such considerations should be weighed on a wide variety of individual and corporate tax provisions; such analysis is rarely performed because of its difficulty vs. The comparative ease of adding preferences to the tax law (AICPA, 2009, p. 8).
Similarly, the current tax system has been criticized for growing increasingly less progressive. A progressive tax system is one in which everyone pays the same share of income in taxes. There has been a marked decline in top marginal individual income tax rates. In the early 1960s, the statutory individual income tax rate applied to the marginal dollar of the highest incomes was 91%. This marginal tax rate on the highest incomes declined to 28% by 1988, and then increased to 35% by 2003. Likewise, corporate profits as a fraction of gross domestic product have fallen by half, from 3.5 -- 4.0% in the early 1960s to less than 2% of GDP in the early 2000s. At the same time corporate profits as a share of GDP have not declined over the same period, suggesting that capital owners -- who are disproportionately of above-average incomes -- earn relatively more net of taxes today than in the 1960s (Piketty & Saez, 2007, pp. 1-4).
Objectives for Tax Reform
Tax policy objectives should include the following goals: simplicity, fairness, economic growth and efficiency, neutrality, transparency, minimizing noncompliance, cost effective collection, positive impact on government revenues, certainty, and payment convenience.
Tax laws should be simple enough to allow taxpayers to understand the rules that apply to their circumstances, and enable them to comply correctly and cost effectively. A simplified tax system reduces the number of errors, improves compliance, and increases respect for the system. While a truly simple tax system may not be possible, the level of complexity should at least be appropriate for the taxpayer or transaction involved (AICPA, 2009, p. 14).
Basic fairness requires that taxpayers in similar situations should be taxed similarly; however this simple premise is challenging to transform into operational definitions. The AICPA proposes seven dimensions of equity and fairness to be used to evaluate tax law proposals:
Over the long run, taxpayers should receive appropriate value for the taxes they pay.
Taxpayers should have a voice in the tax system and should be given due process, and treated with respect by tax…