Alternatives to the Current Federal Income Tax

¶ … 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 administrators.

Similarly situated taxpayers should be taxed similarly.

Taxes should be based on the ability to pay.

Taxes should not be unduly distorted when income or wealth levels fluctuate over time.

No group of taxpayers should be favored to the detriment of another without good cause.

All taxpayers should pay what they owe on a timely basis (AICPA, 2009, p. 14).

With respect to promoting economic growth and efficiency, the tax system should not impede or reduce an economy's productive capacity, and it should encourage the taxing jurisdiction's economic goals. In general, the tax system should not favor one industry or investment type at the expense of others (AICPA, 2009, p. 15).

Other tax policy objectives should include transparency, minimizing noncompliance, cost-effective collection, favorable as much as possible impact on government revenues, certainty, and payment convenience (AICPA, 2009, pp. 15-16).

Income vs. Consumption Taxes

The current debate over tax reform involves three general structural approaches: making significant changes to the current system, replacing the entire current tax system, or making significant changes to the current system and adding a new tax regime. In addition to debating the appropriate structural approach to reform, one must likewise consider the conceptual debate over income taxation vs. consumption taxation.

In general, income taxes are considered more progressive, while consumption taxes are considered simpler and more conducive to economic growth. Under a consumption tax, income that is saved is not taxed, and the tax burden on income from saving and investment is eliminated. Given that the wealthy are more able to save than the poor, who must, by necessity, consume a larger portion of their incomes to meet living costs, consumption taxes generally place a greater overall burden on low income households than do income taxes. Similarly, a single-rate income tax rate structure would also shift the tax burden to lower income households as compared to a progressive tax structure.

Economists believe that "border tax adjustments" associated with consumption taxes do not have a significant impact on international trade, but they do however maintain a level international playing field. Some degree of complexity is unique to the income tax, so switching to a pure consumption tax would eliminate this complexity, particularly when taxing businesses and income from savings and investment. Under a consumption tax, most income generated by personal saving would effectively be exempt from tax, eliminating the complicated rules that give preferential tax treatment to pensions, IRAs, tax-exempt bonds, annuities, and life insurance. (AICPA, 2009, pp. 22-23).

Consumption taxes will introduce new administrative and compliance issues that do not exist under the income tax. However, complex transition rules would be likely to be part of any shift to a consumption tax system to avoid penalizing taxpayers caught between the old income tax and any new consumption tax (AICPA, 2009, pp. 24-25).

If the income tax system is replaced by a consumption tax, state income tax administration and compliance burdens will increase in states that rely on federal tax statutes and guidance to determine adjusted gross income or the tax base for state income purposes, resulting in the need for states to create their own income tax rules. Moreover, if the federal government implements a consumption tax, the change could lead to a one time impact on price levels, depending on decisions that businesses make to cover the tax or absorb the cost. Imposing a consumption tax could lead to double taxation that would be viewed as unfair to many individuals who are using prior savings, already taxed as income, to consume, thereby subjecting those savings to a second consumption tax (AICPA, 2009, p. 26).

Retail Sales Tax

Most Americans encounter retail sales taxes every day. Forty-five states and numerous local jurisdictions levy sales taxes. These taxes are highly visible to taxpayers because they are shown separately from the purchase price on each taxable sales receipt (AICPA, 2009, p. 45).

To promote economic efficiency, a retail sales tax should tax all consumption equally to avoid distorting consumer choices and keep tax rates low. Only final sales by businesses to consumers should be subject to tax. In practice, however, states' retail sales taxes do not meet the ideal of taxing all consumption once. States often exempt many final goods and services, while levying tax on many intermediate goods. This practice results in under-taxation of some sectors and over-taxation of others (AICPA, 2009, p. 45).

In general, a sales tax is regressive, and therefore it follows that state governments, to reduce regressivity, exempt many goods and services, especially those considered to be necessities like food, clothing, and housing. Since purchases of necessities generally represent a larger fraction of income for the poor than for the wealthy, such exemptions enable greater tax relief for low income households. Other goods are exempt because they are considered "merit" goods that deserve public support, such as education and health care. Such exemptions generally increase tax authorities' administrative burdens and taxpayers' compliance burdens (AICPA, 2009, p. 46).

Even if all exemptions for consumer products were eliminated, the problem would still remain of separating taxable sales to consumers from nontaxable sales to businesses. State governments generally use one of two imperfect methods to segregate sales: they grant exemption certificates to business taxpayers or impose sales tax on some types of products regardless of the purchaser's status. As a result, retail sales taxes typically overtax final sales of some products and under-tax sales of others (AICPA, 2009, p. 46).

Evasion by business purchasers represents a challenge under a retail sales tax. Businesses, particularly closely held ones, can improperly claim exemption on items used for personal consumption. The problem of distinguishing business items from personal use items is not exclusively a retail sales tax problem, and is a significant concern under most tax systems. However, under income tax, businesses must be able to defend all deductions claimed, and even valid business deductions can be disallowed if improperly documented. Under retail sales tax there is a critical difference, in that evasion by retail sales tax purchasers would require auditing multiple taxpayers as opposed to auditing only the purchaser under other tax systems. Therefore the problem of evasion by business purchasers is not easily dismissed. Moreover, evasion by retail sellers is perhaps the most cited difficulty with a federal retail sales tax (AICPA, 2009, pp. 48-49).

The following points summarize highlights of recent retail sales tax proposals, Fair Tax Act of 2009 (H.R. 25) and a companion bill (S. 1025):

Repeal the income tax, employment tax, and estate and gift tax.

Impose a national sales tax on the use or consumption in eth U.S. Of taxable property or services.

Set the stated sales tax rate at 23% on the gross in 2011, which yields an effective rate of 30%, with adjustments to the rate in subsequent years.

Allow exemptions from the tax for property or services purchased for business, export, or investment purposes and for state government functions.

Allow a monthly sales tax rebate for families meeting certain size and income requirements.

Direct the Secretary of the Treasury to allocate sales tax revenues among (1) the general revenue, (2) the old-age and survivors insurance trust fund, (3) the disability insurance trust fund, (4) the hospital insurance trust fund, (5) the federal supplementary medical insurance fund (AICPA, 2009, pp. 49-50).

Arguments in favor of replacing the federal income tax with a generic retail sales tax include:

Familiarity to U.S. citizens of retail sales tax.

A retail sales tax does not have individual filing requirements.

A retail sales tax can be structured to be border adjustable.

Like other consumption taxes, a retail sales tax removes a bias against savings inherent in the income tax.

Arguments against replacing the federal income tax with a generic retail sales tax include:

The retail sales tax is viewed as regressive, however the regressive effect could be mitigated by exempting necessities like food, or by providing assistance to lower income households.

A federal retail sales tax would increase the compliance burden placed on retailers and businesses.

Replacing the current federal income tax system with a retail sales tax involves significant transition issues, and would also impair the ability of states to administer their own income tax systems.

Combined state, local, and federal sales tax rates would be extremely high if a federal rate were imposed in the 20 to 30% range, which raises questions about the ability to enforce the tax effectively (AICPA, 2009, pp. 50-51).

Flat Tax

A flat tax refers to a single-rate consumption tax collected from both individuals and businesses. The flat tax example that the AICPA examines, S. 1040 proposed in 2007, has 2 components. Individuals would be taxed on the value added by labor through a wage tax; all other value-added tax (VAT) would be collected from business using a subtraction method VAT but modified to allow a deduction for wages (AICPA, 2009, p. 76).