Comparing consumption tax 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).

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).

Under the proposed S. 1040, individuals would pay a wage tax at a flat rate of 17%, after an initial tax rate of 19% for the first two years after implementation. The wage base would include pension benefits but exclude income earned abroad and employer-paid fringe benefits. Life insurance proceeds and capital income would not be taxed. Large standard deductions and additional large deductions for dependents would remove tens of millions of taxpayers from the tax rolls but not necessarily from filing obligations (AICPA, 2009, p. 76). Every itemized deduction and tax credit allowed under current law would be repealed, including deductions for mortgage interest, state and local taxes, charitable contributions, and the earned income tax credit. For many taxpayers, filing under the S. 1040 proposal would be significantly simpler than under current law (AICPA, 2009, p. 76-78).

The business flat tax would be imposed on all corporate and non-corporate businesses, including flow-through entities such as sole proprietorships or LLCs, partnerships and S corporations not subject to an entity level tax. The tax base, or gross active income, takes gross business receipts and deducts only material inputs, wages and compensation paid, including pension contributions but excluding other fringe benefits, and investment in capital (AICPA, 2009, p. 79).

Arguments supporting replacing the federal income tax with a flat tax include:

Simplicity and possible ease of compliance burdens for many taxpayers.

Administrative system familiarity to taxpayers.

Elimination of bias against capital formation.

Reduced recordkeeping burden for individuals and businesses.

Eliminates the marriage penalty.

Less obvious conflict with the states than other consumption taxes (AICPA, 2009, p. 83).

Arguments against replacing the federal income tax with a flat tax include:

Substantially more regressive than the current income tax.

Appears similar to current income tax for individuals, causing taxpayers to expect the same deductions and credits.

Because a flat tax is in essence a wage tax on individuals, it may be perceived as inequitable by those having little or no investment income.

Transition rules would be complex.

A flat tax would significantly rearrange business incentives and disincentives (AICPA, 2009, p. 83).

Personal Consumption Tax

While retail taxes and VATs are consumption taxes collected by or from businesses, they are ultimately imposed on individuals. A personal consumption tax, on eth other hand, is imposed directly on and collected from individuals. Under a personal consumption tax, individuals would file annual returns but would be allowed an unlimited deduction for net annual additions to saving. Additions to savings for the tax year must be reduced by dissavings in the form of additional borrowing (AICPA, 2009, p. 85).

The primary difficulty with a personal consumption tax is finding a workable method to calculate the deduction for net annual additions to saving. Another significant transition issue is whether to and how to differentiate between new saving and old saving (AICPA, 2009, p. 86).

Arguments that support replacing the federal income tax with a personal income tax include:

A personal consumption tax can have a progressive rate structure, as well as permit the exemption of low income households from taxation because it requires an annual filing, as under current law.

Net new savings are exempt from tax, encouraging greater savings

A personal consumption tax is flexible enough to permit adjustments based on individual circumstances, such as deductions for mortgage interest and charitable donations.

A personal consumption tax is less likely to lead to a one-time price level increase (AICPA, 2009, p. 90).

Arguments against replacing the federal income tax with a personal consumption tax include:

Complexity for individuals, especially the calculation of net new savings.

Personal consumption taxes are not used internationally so there is little real life experience to rely on.

A personal consumption tax system does not improve compliance and would increase the federal government's administrative burden.

There would be significant transition issues, and once its complexities were better understood, it might be perceived as inequitable (AICPA, 2009, pp. 90-91).

Conclusion

The need to reform the current federal tax system is clear; what is not so clear is which of the competing proposals achieves the best outcome all around.