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A Road Map For Tax Reform

Tax reforms happen, inevitably and not by accident. Once the tax provisions in the “Contract with America” have been addressed, Congress and the tax policy community will begin the long trek toward a new federal tax law. The changes they enact could well be the most profound since 1954 and affect every U.S. business and …

Tax reforms happen, inevitably and not by accident. Once the tax provisions in the “Contract with America” have been addressed, Congress and the tax policy community will begin the long trek toward a new federal tax law. The changes they enact could well be the most profound since 1954 and affect every U.S. business and citizen.

Some of the forces for change are simple. The tax code is written by human beings, who make mistakes. It is explained through regulations that may differ from the intent of Congress and may themselves contain any number of errors. Then these laws and regulations are interpreted by taxpayers, the Internal Revenue Service, and the courts. After a few years, the accumulated anomalies of the tax code inevitably compel review. Political forces and theories also change. A few years ago, broadening the base and lowering tax rates was “in,” and creating tax loopholes was “out.” This year, concern for the middle class is in, and bashing the rich is out. Meanwhile, the U.S. economy is evolving and integrating into the global economy. Whenever the tax code becomes inconsistent with the national or global economy, tax reform will not be far behind.

The tax code was last overhauled in the 1986 Tax Reform Act. This act was the culmination of an eight-year shift in tax policy, beginning with the Steigers Amendment in 1978, which lowered capital gains tax rates, and continuing through the 1981 Economic Recovery and Tax Act, which accelerated the movement toward lower tax rates. As in California, when the earth doesn’t tremble for a while, it’s about time for another policy earthquake called tax reform.

RECIPE FOR REFORM

Tax reform happens when individual taxpayers push for it. The recent election sent to Congress droves of new members in tending to cut taxes. President Clinton was elected, in part, because he promised a middle-class tax cut. President Bush pledged “no new taxes” and was sent packing when he broke that vow. It seems the American people believe they pay too much tax. And there’s plenty of data to illustrate why.

Every year, the Tax Foundation calculates “Tax Freedom Day,” which is the day the average taxpayer would be allowed to keep his or her income if all previous earnings went to pay federal, state, and local taxes beginning Jan. 1. In 1994, Tax Freedom Day fell on May 5, the latest it’s occurred since 1981 (see graphic on previous page).

For tax reform to become a priority, a majority of taxpayers must be convinced the proposed reforms will benefit them. Every proposal entails some risk, so reform either must offer a tax cut or appeal to a sense of national purpose to make the risk worthwhile. With the budget deficit titling out most tax cuts, acceptable reform proposals must suggest that American businesses will be more competitive, jobs will be more plentiful, and wages will rise. Tax reform must address the problems in our economy-such as the need to increase savings and investment-and eliminate tax-induced distortions in the way the economy allocates resources.

Businesses are especially wary when it comes to tax reform. Many larger businesses, in particular, prefer a clear and certain tax law to a reform designed to allow faster economic growth. However, the federal income tax is anything but clear and certain, so businesses are increasingly willing to entertain thoughts of change.

One measure of tax complexity is the cost of compliance. According to Tax Foundation research, that cost reached $123 billion in 1993 and could easily reach $130 billion in 1995 (see graphic). These figures are partly based on an estimated 3.3 billion hours a year spent nationally on tax paperwork.

Meanwhile, instability in the tax law creates its own set of costs in terms of confusion and compliance errors. In the 41 years since the Internal Revenue Act of 1954 was passed, we have seen 31 significant federal tax enactments, each triggering a rash of new regulations and litigation.

The sheer volume of the tax code is another testament to its complexity. The estimated number of words in the Internal Revenue Code has more than doubled since 1965 (see graphic).

TAX OPTIONS

Tax reform typically begins-and ends-with the federal income tax. Current tax reform proposals aim to replace the personal and corporate income taxes with an integrated consumed-income tax, which looks like a regular income tax but contains special provisions to eliminate the bias against saving and investment. The CIT would be collected in the same manner as the income tax, with taxpayers filling tax returns. Analytically, however the CIT is similar to the credit-invoice value added tax, which is common in Europe and resembles a sophisticated federal sales tax.

The CIT is basically a tax on what people take out of the economy through consumption, as compared to an income tax which imposes its burden on people’s contribution to the economy. The CIT and the income tax also differ in their treatment of international transactions. For example, the CIT is intended to allow the taxpayer to receive a rebate at the border corresponding to the tax incurred by domestic businesses of the exported goods or services. Similarly, the CIT would allow the U.S to impose a border tariff

On imported goods and services so that they bear the same rate of tax as domestically produced goods or services. Whether these “border tax adjustments” would be allowed under the rules of the general agreement on Tariffs and Trade had yet to be decided, however. Under the CIT, the U.S also would exclude foreign earnings of U.S taxpayers from domestic tax, this treatment, known as “territorality” would improve the international competitiveness of most U.S. businesses operating abroad.

Two CIT proposals have been advanced along these lines. Rep. Dick Armey, R-TX, majority leader in the House of Representatives, has introduced a flat tax proposal that taps into a deep vein of longstanding popular dissatisfaction with the current income tax system. Under the Armey plan, personal income is defined as wage, salary, and pension distributions-all savings are excluded. High personal allowances also would be permitted ($13,100 for individuals and $26,200 for married couples). Personal income less the personal exemptions then would be subject to a 20 percent tax rate, falling eventually to 17 percent if matched by corresponding spending reductions.

Businesses would pay at the same tax rate as individuals on the net of gross revenues over purchases of goods and services, capital equipment, structures, land, wages, and pension contributions. No deductions would be permitted for fringe benefits, interest, or payments to owners. The Armey plan, therefore, eliminates the double taxation of corporate income in a comprehensive effort to avoid the multiple taxation of savings and investment income.

Sens. Sam Nunn, D-GA, and Pete Domenici, R-NM, have developed an alternate plan, which they call the U.S.A. Tax System. Like the flat tax, their proposal would exempt all savings and would allow businesses to expense their capital purchases. However, the U.S.A. Tax System would not allow companies to deduct labor costs from taxable income and would have a significantly lower business tax rate.

In theory, either of these plans would make life easier for both businesses and individuals, largely because they simplify the definition of taxable income and eliminate most questions relating to the timing of income and expense. Even so, we cannot deny the complexities of the modern economy, including the treatment of financial services income and problems relating to estates, mergers, acquisitions, and reorganizations. Only the U.S.A. Tax System attempts to deal with these complexities in detail.

Both alternative tax systems assume the federal income tax on business income is antiquated and beyond repair. However, if and when tax reform reaches the barbershops and boardrooms of America, some businesses and citizen groups may question this assumption and conclude they would prefer to fix the current income tax rather than scrap it for a consumption-based system. As a result, some efforts will be made to develop a more modest tax reform proposal.

Most tax reform discussions thus far have ignored the president. Without significant and sustained presidential support, tax reform will never get out of the starting blocks. President Clinton and his Republican rivals for the White House eventually must hop on the tax reform bandwagon, because the alternative means defending the status quo. The high ground politically, of course, will be anything called a flat tax. Despite rumblings from the tax experts, the popularity and simplicity of the flat tax make it an ideal campaign plank.

GLOBAL IMPLICATIONS

National tax policies evolve according to political, social, economic, and international forces. For example, at the turn of the century, most Western countries adopted income taxes on individuals and businesses. But after World War II, most nations other than the U.S. adopted credit-invoice VATs, largely to replace existing consumption taxes, while integrating their personal and corporate income taxes to avoid double taxation of corporate income. Taxes quickly became social and economic policy tools as countries increased income tax rates, matched by proliferating deductions, exemptions, and credits.

The U.S. bucked the trend by enacting the 1981 Economic Recovery and Tax Act, which dramatically reduced tax rates, decreased taxes on business investment, and indexed key tax provisions for inflation. The 1986 tax act continued the trend toward lower tax rates and a broader tax base. Other countries complained about U.S. “competitive” tax cut policies, but reacted by lowering tax rates to protect the international competitiveness of their businesses.

The recent integration of the global economy has important implications for U.S. tax policy. Capital has moved relatively easily between countries and markets for years, but now labor is increasingly mobile, seeking higher after-tax returns wherever they can be found. Global integration means the markets for capital and labor will become increasingly tax intolerant, shifting away from countries with higher taxes or otherwise uncompetitive tax systems.

In the future, countries will be forced to engage in competitive tax cutting to attract capital and labor resources, much as various states have done to attract investment. Competitive pressure to cut taxes on labor and capital may propel countries to band together in a high tax rate cartel. Fortunately for taxpayers, cartel members eventually will cave in to the temptation to break ranks and slash taxes, leading to the group’s demise and reductions in tax burdens and complexity.

INEVITABLE EXTINCTION

Tax reform must have a theme that resonates with the voters and makes sense to most of the business community. The movement toward a consumed-income tax eventually may meet these criteria, or tax reform may go in another direction entirely. Whatever happens, reform in the late 1990s will not halt the evolution of the tax system. Ultimately, the growing tax intolerance of the capital and labor markets will ensure that high tax rates, outdated concepts, and costly tax systems  go the way of the dodo bird.


J.D. Foster is executive director and chief economist at The Tax Foundation in Washington, a nonprofit organization that monitors al, state, and local levels. He was formerly special assistant to the chairman, under Michael Boskin, of President Bush’s Council of Economic Advisers.

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