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No.

536 February 24, 2005


Routing

Options for Tax Reform


by Chris Edwards

Executive Summary

President Bush has established an advisory high cost of government.


panel to study federal tax reform options. The This study examines reform options including
panel is headed by former senators Connie Mack a flat tax, a national retail sales tax, and a savings-
of Florida and John Breaux of Louisiana. exempt tax in reference to those goals. It also pro-
Congressional leaders, including House Speaker poses a new option: a “dual-rate income tax.” This
Dennis Hastert and Majority Leader Tom Delay, revenue-neutral option would convert the individ-
have also pledged their support for reform. ual income tax to a two-rate system that elimi-
Enacting a major tax reform bill will be a chal- nates most deductions and credits and allows
lenge, but the president has been remarkably nearly all families to pay tax at a low 15 percent
successful with his tax agenda so far. Income tax rate. A 27 percent rate would kick in for earnings
rates have been reduced, dividend and capital above $90,000 (single) and $180,000 (married).
gains taxes have been cut, and the tax rules on To promote growth, the maximum individual
retirement savings vehicles have been liberalized. rate on dividends, interest, and capital gains
However, the tax system remains terribly com- would be 15 percent. The corporate tax rate would
plex and inefficient. The number of pages of feder- be dropped to 15 percent and interest made non-
al tax rules has increased 48 percent in the past deductible. These changes would equalize and cut
decade. The complex alternative minimum tax will the combined top income and payroll tax rates on
hit about 35 million households by the end of the wages, dividends, interest, and small business
decade if not repealed. The high-rate U.S. corpo- income to just under 30 percent, compared with
rate income tax is under growing pressure as glob- between 35 and 45 percent under current law.
al investment capital has become more mobile. The dual-rate tax plan would retain the stan-
This study looks at possible changes to dard deduction, an expanded personal exemp-
address those problems. It identifies three goals tion, and the earned income tax credit. The plan
for tax reform: simplification, efficiency, and would create a simpler and more efficient tax
limited government. The latter goal focuses on code within the structure of today’s system and
tax code features such as visibility and equal may be just the type of tax plan that the presi-
treatment that cultivate an understanding of the dent’s advisory panel is looking for.

_____________________________________________________________________________________________________
Chris Edwards is director of tax policy studies at the Cato Institute.
The Bush Introduction with further tax reforms because reforms are
administration easier to enact when accompanied by tax
The Bush administration and the Repub- cuts. Congress needs to make spending cuts a
and the lican Congress have been remarkably success- high priority in order to create room in the
Republican ful at passing tax cut legislation. In the past budget for tax reform. In another report, I
four years, they have enacted four substantial have proposed more than 100 budget cuts to
Congress have tax bills.1 Table 1 summarizes the progress bring the deficit down to zero over five years.3
been remarkably those bills have made toward the three tax That said, the president has indicated that
successful at reform goals examined in this study: simplifi- he wants to pursue tax reform on a revenue-
cation, efficiency, and limited government. neutral basis—neither increasing nor reduc-
passing tax cut There has been progress toward making the ing overall federal revenues. The Tax Reform
legislation. tax code more efficient with cuts to individual Act of 1986 illustrated that it is possible to
tax rates, reduced taxes on dividends and cap- make major changes to the tax code on a rev-
ital gains, and liberalization of savings instru- enue-neutral basis, although numerous of
ments such as individual retirement accounts the revenue raisers in that bill were economi-
(IRAs). However, there has been no progress cally damaging.4 Note that the use of
toward making the tax code simpler or mak- “dynamic scoring” of tax changes could help
ing the burden more equal and visible to help grease the skids of reform. Dynamic scoring
limit the government’s growth. would take into account the real-world eco-
Another problem with recent tax cuts is nomic benefits of adopting a more efficient
that they have not been matched by federal tax system. Congress could enact a pro-effi-
spending cuts. Federal outlays jumped 31 ciency tax reform that might reduce federal
percent between fiscal 2001 and 2005 as the revenue on a static basis but would be rev-
administration and Congress went on a enue-neutral on a dynamic basis as the posi-
spending spree.2 High spending has created tive effects of reform boosted the economy.
large and persistent deficits. The deficits may The following sections discuss the three
impede the ability of Congress to move ahead main goals of tax reform, as illustrated in

Table 1
Recent Progress toward Tax Reform Goals

Tax Reform Goal Progress? Notes

1. Simplification No The number of pages of federal tax rules is up 48 percent


in the past decade. Congress continues to add special
interest tax breaks to the code. Simplification has been
studied by the Treasury and the Joint Committee on
Taxation, but no action has been taken.
2. Efficiency Yes Individual tax rates have been cut. Top dividend and capital
gains rates have been reduced to 15 percent. Savings
vehicles such as IRAs have been liberalized. Business
capital expensing was enacted temporarily. However, all
reforms will expire unless Congress acts to make them
permanent.
3. Limited government No The corporate income tax and half of the 15.3 percent
payroll tax create large hidden burdens on individuals. The
tax code is as intrusive as ever and treats Americans very
unequally.

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Figure 1
Goals of Tax Reform

Simplification Efficiency

• Reduced time and expense for admin- • Lower marginal tax rates
istration, planning, and enforcement • Reduced taxation of saving and invest-
• Better economic decisionmaking ment
• Fewer taxpayer and government • Equal treatment of industries, assets,
errors and investments
• Less tax avoidance and evasion • Greater growth and higher incomes

Limited Government

• Greater tax visibility so that people can


measure the cost of government
• Fewer and slower-growing tax bases to bet-
ter control the overall tax burden
• Equal treatment of citizens and an end to
social engineering in the tax code
• Maximization of privacy and civil liberties

Figure 1. I then discuss some preliminary and returns that are more cluttered with spe-
reforms to clear the decks for broader cial credits and deductions.
changes. Last, the paper examines four alter- The complexity of today’s tax system cre-
nate tax proposals: a flat tax, a sales tax, a sav- ates five main problems. First, it imposes Many of the best
ings-exempt tax, and a “dual-rate income high administrative and compliance costs.
tax.” The latter proposal would create a sim- Americans spend 6.5 billion hours annually
and brightest are
pler and more efficient income tax—a good filling out tax forms, keeping records, and drawn into the
model for the type of reform that the admin- learning tax rules.6 Many of the best and nation’s “tax
istration and its tax advisory panel may be brightest are drawn into the nation’s “tax
considering. industry,” which helps individuals and busi- industry.”
nesses reduce their taxes and comply with the
complicated law. The cost of complying with
Simplification federal income taxes is roughly $200 billion
annually.7
According to CCH, a tax law publisher, Second, tax complexity impedes efficient
federal tax rules spanned 60,044 pages in decisionmaking by individuals and business-
2004—48 percent more pages than a decade es. For example, the growing number of tax
ago.5 Taxpayers have to contend with a rising rules on pensions, savings vehicles, and
number of tax forms, longer tax instructions, investment earnings confuses family finan-

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The IRS has cial planning. For businesses, the complex interest, or capital gains.11 As a consequence,
suffered a string and ever-changing income tax injects uncer- half a billion IRS Form 1099s that track
tainty into decisions such as investment financial income would no longer be needed,
of losses in court spending. and information about Americans’ personal
cases that charged Third, tax complexity causes taxpayers saving would become none of the govern-
and the Internal Revenue Service to make fre- ment’s business.
corporations with quent and costly errors. Special tax provi- A fifth problem caused by tax complexity
creating illegal sions that are enacted for social policy rea- is that it leads to greater noncompliance with
tax shelters. sons, such as the earned income tax credit the tax system. Today, many taxpayers end up
(EITC) and the alternative minimum tax paying the wrong tax amount because they
(AMT), often become nightmares of com- are confused about what income is taxable
plexity. Consider that almost one-third of and what tax breaks are allowed. Complexity
EITC payments—about $9 billion annually— also fosters aggressive tax planning. Since
are erroneous.8 Or consider what the IRS complex tax rules are subject to multiple
National Taxpayer Advocate recently said interpretations, they spur taxpayers to take
about the AMT: risks in the hope that their tax-cutting strate-
gies are not caught by the IRS. The connec-
[M]ost taxpayers subject to the AMT tion between income tax complexity and
don’t know it before they prepare their aggressive tax planning was driven home by
taxes. As a result, many taxpayers dis- the Enron scandal.12 The congressional
cover too late that they underpaid their report that untangled Enron’s tax shelters
tax and are therefore subject to a penal- was 2,700 pages long.13 It makes no sense
ty for failure to pay sufficient estimat- that the code is so complicated that such a
ed tax. Indeed, taxpayers often must huge effort is needed just to evaluate one
complete a 12-line worksheet, read company’s tax situation.
eight pages of instructions, and com- Despite the impression left by Enron, it is
plete a 55-line form simply to deter- a popular misconception that the problem
mine whether AMT applies.9 with the corporate income tax is simply
wrongdoing on the part of business execu-
Fourth, tax complexity promotes invasion tives. Instead, the complexity of the income
of personal privacy by the government. The tax makes it very ambiguous whether or not
government must hunt for volumes of data any particular corporate tax reduction strate-
to enforce the current system because gy is illegal.14 David Weisbach of the
Congress has larded the code with breaks University of Chicago Law School notes that
that need special documentation. The IRS the government’s “attacks on shelters often
needs your mortgage records for the mort- rely on vague standards” based on incoherent
gage interest deduction, your education doctrines.15
records for education tax breaks, and so on. Indeed, the Washington Post recently report-
Because the base of the current tax system is ed that the IRS has suffered a string of losses
income defined broadly, savings and capital in court cases that charged corporations with
gains are taxed. That results in the IRS gain- creating illegal tax shelters.16 In one recent
ing access to bank account and investment case, a U.S. District Court ruled in favor of
data, property transaction records, and myri- Black and Decker, which saved $57 million in
ad other financial data.10 taxes by creating a fancy transaction to offset
Privacy would be greatly increased under a a capital gain that it had in 1998.17 Black and
simpler consumption-based tax system that Decker won the case, but its shareholders,
had no special breaks. For example, the Hall- workers, and the U.S. economy are losers
Rabushka flat tax would generally tax just because of the wasteful efforts that are put
wages at the individual level, not dividends, into the cat-and-mouse struggle with the

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IRS. Ultimately, the corporate tax should be tions in the tax code. Those distortions create
repealed or radically reformed so that com- economic costs, or “deadweight losses.” For
panies and the government do not have to example, the income tax puts corporate equi-
expend their energies on efforts that add ty at a disadvantage compared with debt. As a
nothing to the nation’s output.18 result, the tax code induces corporations to
Another misconception is that any carry excessive debt, which may cause added
replacement tax system would become just as bankruptcies and reduced output.
complicated as the current one because The magnitude of deadweight losses is
politicians enjoy enacting special breaks. directly related to marginal tax rates. In fact,
However, excessive complexity is intrinsic to as marginal rates rise, deadweight losses rise
the income tax, which attempts to measure more than proportionally.20 That is why a
unavoidably complicated items such as capi- flatter tax structure with lower rates would
tal gains and depreciation.19 By contrast, con- be much more efficient than today’s graduat-
sumption taxes and wage taxes have more ed, or “progressive,” tax structure. Some peo-
transparent and coherent tax bases and do ple favor graduated tax structures in order to
not require all the ad hoc rules that the redistribute income, but that policy comes at
income tax does. The federal payroll tax that a high economic cost.21
funds Social Security has remained a simple, Looking at the individual income tax, the
Some people
flat-rate system for decades. largest reductions in deadweight losses favor graduated
It is true that politicians will always be would come from cutting the highest rates. tax structures
tempted to carve out narrow tax breaks for People with high incomes often have unique
favored groups, but the bigger source of com- talents as entrepreneurs, executives, or sur- in order to
plexity is the income base of the current sys- geons, for example. If a skilled surgeon redistribute
tem. A goal of tax reform is to find a cleaner decides to work less because tax rates are
and more consistent base that would be increased, the real losers are the potential
income, but that
more resistant to political tampering over the patients who suffer from the withdrawal of policy comes at a
long run. her skills from the market. high economic
Also, there is a high concentration of
small businesses in the top income tax brack- cost.
Efficiency ets.22 About three-quarters of the top 1 per-
cent of federal taxpayers report some small
Although U.S. economic output would be business income.23 A series of studies by
higher if federal spending and revenues were economists Robert Carroll, Douglas Holtz-
reduced, it is also true that, at any particular Eakin, Mark Rider, and Harvey Rosen found
level of revenue, output would be higher if that marginal tax rate changes have a sub-
the tax system were more efficient. An effi- stantial effect on small business hiring,
cient tax system is one that minimizes distor- investment, and growth.24 For example, the
tions that affect working, saving, investing, authors found that a five percentage point
and entrepreneurship. The current income reduction in marginal tax rates would cause a
tax system is very inefficient because it alters 10 percent increase in capital expenditures. A
wage, price, and profit signals and diverts recent study by economists William Gentry
resources into low productivity uses. This and Glenn Hubbard found that higher mar-
section looks at some of the distortionary ginal tax rates and greater tax progressivity
features of the current tax system that should discourage entrepreneurship.25
be high-priority targets for reform. Another factor to consider is that the
largest behavioral effects of tax changes come
Marginal Tax Rates in the highest tax brackets.26 If tax rates are
A key goal of tax reform is to cut marginal increased, the tax base will shrink as people
tax rates because high rates exacerbate distor- increase their tax avoidance and reduce their

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earnings, perhaps by working less overtime expand and modernize their factories,
or retiring early. Those in the top brackets machinery, and other assets. When business-
have the most flexibility in adjusting their es increase their capital investment, U.S. pro-
taxable income, and their actions create sub- ductivity rises. Rising productivity in turn
stantial impacts on the economy.27 Larger translates into higher wages for American
behavioral changes create larger deadweight workers.
losses. Unfortunately, the current tax code
How large are deadweight losses from stands in the way of the growth process by
high taxes? The Congressional Budget Office discouraging saving and investment. Under
says that “typical estimates of the economic the income tax, current consumption is not
cost of a dollar of tax revenue range from 20 taxed, but the returns to saving are. That
cents to 60 cents over and above the revenue encourages people to spend their earnings
raised.”28 One estimate by economists Dale now rather than to save for their long-term
Jorgenson and Kun-Young Yun found that financial security. Similarly, businesses are
the marginal deadweight loss of the individ- discouraged from making long-term invest-
ual income tax is 35 cents on the dollar.29 ments because they are not allowed to imme-
That means that a new $100 million govern- diately deduct, or expense, the cost of their
ment program financed by income taxes capital purchases.
would cost the private sector $135 million. Those distortions would be eliminated
Jorgenson and Yun conclude that “there under a consumption-based tax, which
appear to be large potential welfare gains that would remove a layer of tax from saving and
could be exploited through tax reform aimed investment. Jorgenson and Yun have found
at lowering marginal tax rates.”30 that “the potential welfare gain from replac-
The existence of deadweight losses means ing the current income taxes with consump-
that the government essentially uses a “leaky tion-based individual taxes is potentially very
bucket” whenever it takes action. Michael large.”32 Their economic modeling indicates
Boskin, former chairman of the Council of that the gain would be in the range of $2.6
Economic Advisers, explains: “The cost to the trillion to $4.3 trillion. For comparison, total
economy of each additional tax dollar is U.S. output is about $12 trillion.
about $1.40 to $1.50. Now that tax dollar . . . For businesses, the tax code can be con-
is put into a bucket. Some of it leaks out in verted to a consumption base by substituting
overhead, waste, and so on. In a well-man- capital expensing for depreciation. Under
aged program, the government may spend 80 expensing, businesses would immediately
The existence of or 90 cents of that dollar on achieving its deduct the full purchase price of equipment,
goals. Inefficient programs would be much structures, and other investments.33 The
deadweight losses lower, $.30 or $.40 on the dollar.”31 effect would be to reduce the cost of capital
means that the Boskin’s leaky bucket should be fixed in and spur greater capital accumulation. (The
government two ways. First, the government should be cost of capital is the required rate of return
downsized and inefficient programs repealed that businesses need in order to go ahead
essentially uses a in order to stop the leaks on the spending with new investments.) The tax laws of 2002
“leaky bucket” side of the budget. Second, marginal tax rates and 2003 provided partial expensing on a
should be reduced to make sure that needed temporary basis.34 An alternative way to
whenever it takes government revenue is raised with the least remove the tax bias against investment
action. damage to the economy. would be to eliminate taxes imposed on busi-
nesses altogether, as proposed under some
Saving and Investment tax reform options.
Saving is one of the root sources of eco- For individuals, the tax code can be con-
nomic growth because it provides businesses verted to a consumption base by either
with the investment funds they need to exempting all new saving from taxation or

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exempting the returns to saving from tax. The ciency. In a 1985 Cato Journal article he wrote: The income tax
tax code already contains many pro-savings exclusion for
elements, but the rules are far too complex. The main argument for tax reform, I
The code has different rules for dividends, believe, is to achieve greater efficiency interest on state
interest, capital gains, 401(k)s, Keoghs, in the way the tax code works. When and local
SIMPLEs, SEPs, IRAs, pension plans, annu- Congress gets into the business of fig-
ities, and tax-exempt bonds. Saving options uring out $370 billion of tax breaks a
government
involve different rules for tax rates, eligibility, year, the House Ways and Means bonds favors
contributions, distributions, withdrawals, Committee and the Senate Finance sexy projects
penalties, and rollovers.35 Committee really are put in the busi-
The rules on traditional employer pen- ness of trying, at least partially, to plan favored by
sions are so complex that many firms have the American economy. . . . I confess politicians over
dropped pensions altogether.36 Also, many that I am not qualified to act as a cen- unglamorous
companies have large shortfalls in their pen- tral planner and I do not know any-
sion plans, and the federal agency that is sup- body on either committee who is.39 private projects
posed to insure pensions, the Pension that are the real
Benefit Guaranty Corporation, is in severe Unfortunately, central planning in the
financial distress.37 Tax reform would end income tax code continues unabated 20 years
backbone of the
this mess by eliminating the need for tradi- later. Special breaks in the tax code have risen economy.
tional pensions and the PBGC. Under a con- in value from Gephardt’s $370 billion to
sumption-based system, retirement saving more than $700 billion.40 The tax code is rid-
would become individually based, freeing dled with incentives and disincentives that
Americans from risky employer schemes. have disparate impacts on individuals, invest-
Under the Hall-Rabushka flat tax, individu- ments, and industries. The tax code alters
als would save as much as they wanted from market price and profit signals, redirecting
their after-tax earnings, and all accumula- resources into less productive uses. Examples
tions and withdrawals would be free from include the tax preference for owner-occu-
taxes and government rules.38 pied homes and the ad hoc tax rules for
Short of a full consumption-based plan depreciation, which favor some industries
such as Hall-Rabushka, Congress could sim- over others.
plify and encourage saving substantially. One Another example of “central planning” is
promising route is the Bush administration’s the income tax exclusion for interest on state
proposed “lifetime savings accounts,” which and local government bonds. That break
are like supercharged Roth IRAs. LSAs would gives a financing advantage to government-
allow all individuals to make large after-tax sponsored projects over private projects. The
contributions to savings. All withdrawals Washington Post recently reported that at least
from saving would be free from taxes and 38 major league sports venues have been
penalties. The flexibility of withdrawals built since 1990 using tax-exempt bond
would make LSAs very liquid, encouraging financing.41 The tax break favors sexy proj-
families to build large nest eggs. With larger ects favored by politicians over unglamorous
pools of savings, Americans could better pay private projects that are the real backbone of
for their own retirement and enjoy greater the economy, such as oil refineries and
economic security free from the government. machine tool factories. A related subsidy for
state and local governments is Qualified
Ending Central Planning Zone Academy Bonds, which fund state and
A leader on tax policy in the 1980s, former local school buildings through complex tax
congressman Richard Gephardt (D-MO), credits.42
said that he favored closing special interest While many tax distortions stem from
tax breaks in order to improve economic effi- such deliberate central planning, others arise

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from fundamental structural problems with based taxes create neutrality with simple
the income tax. A good example is how the rules. The flat tax would substitute business
tax code applies a single layer of tax to non- expensing for depreciation, which would
corporate business profits and two layers to equalize marginal effective tax rates on
corporate profits. Economist Jane Gravelle investment across industries and assets. Such
estimates that the marginal effective tax rate a system would both simplify business tax
on corporate investments is about 32 per- accounting and remove distortions that
cent, compared to the rate on noncorporate affect investment decisions.
investment of about 18 percent.43 The conse- Finally, if tax rates were cut under tax
quence is that many firms that could operate reform, the damage of any remaining “cen-
more efficiently in corporate form are tral planning” provisions in the code would
induced by the tax law to operate as partner- be reduced. For example, the tax preference
ships and other forms. for owner-occupied homes would be less dis-
Another fundamental distortion in the tortive under a 15 percent tax rate than
income tax is the depreciation system, which under the current top tax rate of 35 percent.48
creates different effective tax rates on differ- As a side benefit, the Washington game of
ent types of investment. Depreciation is dis- lobbying for tax loopholes would be starved
Under a torted by inflation and the ad hoc rules that as rates fell and the value of narrow breaks
revenue-neutral govern the time period over which invest- was reduced.
reform, ment costs are deducted. The result is that
some assets and industries are favored over More Efficiency Means Higher Incomes
switching to a flat others. For example, investment in equip- The replacement of the income tax with a
consumption- ment is generally favored over investment in simple consumption-based system would
structures. That works in favor of the mining cause resources to flow from lower-valued to
based system industry, which invests heavily in equipment, higher-valued uses and the capital intensity
might increase but works against the petroleum industry, of the economy to increase. In the short term
U.S. incomes by which invests more in structures.44 there would be some economic dislocations,
Economists think that such distortions but in the long term the American economy
up to 10 percent cause large economic losses.45 would be larger and incomes higher.
in the long run. The Tax Reform Act of 1986 moved Numerous economic models have simu-
toward equalizing marginal tax rates on lated consumption-based tax reform, each
investments, but it pushed up effective rates based on various assumptions and parame-
on many types of assets, particularly equip- ters. The results have varied quite widely, but
ment. For example, before TRA86 the mar- it appears that under a revenue-neutral
ginal tax rate on corporate investment in reform, switching to a flat consumption-
electric transmission equipment was 21 per- based system might increase U.S. incomes by
cent and the rate on communications equip- up to 10 percent in the long run:49
ment was 4 percent.46 After TRA86, those tax
rates jumped to 36 percent and 22 percent, • Boston University’s Laurence Kotlikoff
respectively. A 2002 study by Treasury econo- found that replacing the income tax
mist James Mackie found that there are still with a retail sales tax would increase per
substantial differences in effective tax rates capita income by about 7 percent in the
across industries and types of assets.47 long run. Even higher gains would be
Although an income tax could, in theory, possible if the progressivity of the tax
get rid of some of the distortions, it would be system were reduced.50
much easier to do so by adopting a con- • Alan Auerbach of the University of
sumption-based tax. With the income tax, California at Berkeley found that long-
creating more neutrality often requires more run gross domestic product per capita
complex rules. By contrast, consumption- would be 9.7 percent higher under a

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national sales tax and 8.4 percent higher ment tax cuts, they understate the economic
under the Hall-Rabushka flat tax.51 benefits and overstate the government rev-
• In an American Economic Review study, enue loss.56
David Altig and others (including Tax reform would also create nonmone-
Kotlikoff and Auerbach) found that tary benefits for Americans. For example,
replacing the income tax with a flat con- eliminating today’s complex tax rules on per-
sumption-based tax would raise long- sonal savings would make financial planning
run incomes by 9 percent and that much easier and more flexible. Also, a sim-
replacing the income tax with a progres- pler tax code would give Americans satisfac-
sive consumption tax would raise tion in having a government that treated
incomes by 5 percent.52 everyone more equally. Those sorts of bene-
• Former chairman of the Council of Eco- fits of reform are tough to put dollar values
nomic Advisers Michael Boskin thinks on but would be substantial nevertheless.
that the long-term gain to GDP from a
consumption-based tax reform would be
about 10 percent.53 Limited Government
• A 1997 Joint Committee on Taxation
report summarized results from nine Scholars of the public choice school argue
different models that simulated a flat that “democracy contains an inherent bias
rate consumption-based tax. The results toward inefficiently large government.”57 That
ranged widely, with different models bias stems from public officials acting in self-
finding that long-run GDP would be interested ways that are contrary to the broad
from 1.7 to 16.9 percent greater. The public interest. For example, logrolling be-
model average was 5.8 percent.54 tween members of Congress results in the pas-
• Dale Jorgenson and Kun-Young Yun sage of expensive provisions that do not have
found that a Hall-Rabushka flat tax wide support among the public. Large
would create welfare gains of $2.1 tril- omnibus spending bills typically include
lion and a sales tax that included low- many items that would not gain legislative
income relief would create gains of $3.3 support under a more visible stand-alone vote.
trillion.55 Legislators have a bias toward dishing out gov-
ernment largesse to visible and important
Those would be large gains, but such constituencies, while hiding the resulting
models do not account for all the benefits of costs from current taxpayers in the form of
tax reform. For one thing, tax reform would deficits. Economic models
reduce the roughly $200 billion in annual To steer democracy toward a more effi-
compliance costs of the tax system. With a ciently sized government, legislators need to
usually do not
simpler system, corporate executives and be restrained by rules to deter shortsighted include the full
small business people would waste less time and self-interested policy actions. For exam- benefits of
on tax planning and spend more time focus- ple, 49 of the 50 states have statutory or con-
ing on creating growth in the economy. stitutional requirements for balanced bud- technology
Also, economic models usually do not gets to ensure that legislators do not evade advances that
include the full benefits of technology the tough fiscal tradeoffs that they are elect-
advances that occur from rising capital invest- ed to make. Also, most state governors have
occur from rising
ment. Tax cuts can generate rising investment line-item veto power with which to eliminate capital
in business machinery. But new machines do narrow special interest spending. investment.
not just replace similar old machines; they The federal government is notably lacking
embody new technologies that increase pro- in such fiscal constraints, as the current spec-
ductivity and spur growth. When economic tacle of high spending and big deficits makes
models do not include that benefit of invest- clear. A Congressional Research Service report

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A certain tax noted: “State constitutions are much more the long term if it promotes excessive govern-
structure may detailed about the budget process than the ment growth.
U.S. Constitution. It is not unusual for state Consider the broadness of tax bases.
promote constitutions to . . . prohibit legislation in Orthodox public finance theory concludes
economic appropriations bills, specify the style and for- that broad tax bases are more efficient than
mat of appropriations bills, direct that appro- narrow ones because under a broad base
efficiency in the priations bills shall embrace nothing but resources would flow to their most efficient
short run, but it appropriations, and require a single subject uses, not to tax-favored uses. That is correct
may affect the for each bill.”58 A number of states impose as far as it goes, but Buchanan and Brennan
controls on the overall annual growth rate of point out the benefit of narrow bases: “To
economy revenues or spending. the extent that activities which yield value to
negatively in the To fix the undisciplined federal budget taxpayers remain outside the allowable
long term if it process, new controls are needed, akin to the reaches of the fiscal authority, the appetites
tougher controls that many states have.59 To of Leviathan are checked. People may resort
promotes control spending, a cap that tightly limits to nontaxable options, and in the knowledge
excessive annual growth in overall outlays is a good that they will do so, government necessarily
option.60 To control taxes, a constitutional curbs its revenue extraction.”64 Thus, a nar-
government amendment to require a supermajority vote rower tax base will limit the government’s
growth. to enact tax increases should be considered. total tax take, which increases economic effi-
Aside from such formal budget rules, the ciency.
structure of the tax system can play an Other tax system attributes that can check
important role in controlling the size of gov- the appetite of Leviathan include visibility
ernment. Different tax structures lead to dif- and equal treatment. The following sections
ferent fiscal outcomes. For example, the discuss tax code design and limited govern-
introduction of withholding for the federal ment.
income tax in 1943 made paying taxes less
painful, thus helping fuel government Visibility
growth in subsequent decades.61 Another fea- Consumers in the marketplace like to see
ture that fuels government growth is “brack- prices clearly displayed before making a pur-
et creep” under the graduated income tax, chase. People weigh the benefits of buying
which bestows ever higher revenues on the products against the costs to their pocket-
government without the need for unpopular book. There is no reason why the federal gov-
votes in Congress.62 ernment should not be as open and transpar-
Economists James Buchanan and Geoff- ent about its costs as grocery stores or gas
rey Brennan explored the importance of tax stations are. It is important that citizens in a
structures to the size of the government in democracy understand the costs of govern-
their 1980 book The Power to Tax: Analytical ment. Indeed, public understanding is more
Foundations of a Fiscal Constitution.63 The important than ever because most of the con-
authors challenged the “benevolent despot stitutional constraints that used to restrict
model of public finance,” which assumes government growth have been discarded.
that the level of taxes is already decided and Unfortunately, the federal tax system does
that the role of experts and policymakers is not allow an easy way for citizens to gauge
simply to find the most efficient way to raise and control the cost of government. The
it. If, instead, government is viewed as a rev- income tax has many different rates, deduc-
enue-maximizing Leviathan, finding the tions, and credits, making it difficult for peo-
most efficient tax system becomes more ple to perceive what share of their earnings is
complicated. A certain tax structure may pro- being taxed. Also, citizens face unlegislated
mote economic efficiency in the short run, tax increases as a result of economic growth
but it may affect the economy negatively in under a graduated income tax system.

10
Another way that the federal government the public’s view include import duties; unem-
conceals the size of the tax load is by spreading ployment insurance taxes; and excise taxes on
the burden across numerous tax bases. A cen- gasoline, alcohol, and tobacco.
tury ago, the federal government had just two All in all, 37 percent of federal taxes are
main tax sources, alcohol excises and customs hidden, as shown in Figure 2.66 As a conse-
duties, and the government remained small.65 quence, voters perceive the “price” of govern-
In the 20th century, three powerful revenue ment to be artificially low, causing the
engines were added—the individual income “demand” for government services to be too
tax, the corporate income tax, and the payroll high. Public choice economists call this prob-
tax—and federal spending expanded dramati- lem “fiscal illusion,” a strategy used by legis-
cally. lators to make the government appear to be
The federal revenue engine is made more less of a burden than it actually is.
powerful by the fact that a big share of the tax A goal of tax reform should be to end fis-
burden is hidden from the general public’s cal illusion and make the tax burden trans-
view. The biggest hidden tax is the employer parent. A good first step would be for
half of the 15.3 percent payroll tax that funds Congress to reconsider the Right-to-Know
Social Security and Medicare. That $372 bil- National Payroll Act, which was passed by
lion tax is not reported on worker paystubs, yet the House in 2000 but not signed into law.67
The federal
economists agree that the burden ultimately The proposal would require employers to dis- revenue engine is
falls on workers in the form of reduced wages. close the entire payroll tax paid for each made more
The second largest hidden tax is the $230 worker on annual income tax W-2 forms
billion corporate income tax. That tax is ulti- mailed to employees. Another idea is to powerful by the
mately passed through to individuals in the encourage employers to voluntarily provide fact that a big
form of higher prices, lower wages, or reduced fuller information about payroll taxes on
investment returns. Like the payroll tax, busi- worker paystubs.68
share of the tax
nesses collect it, but individuals bear the bur- H. L. Mencken said, “Democracy is the the- burden is hidden
den. Other federal taxes that are hidden from ory that the common people know what they from the general
Figure 2 public’s view.
Hidden and Visible Federal Taxes, FY05 ($ billions)

37% Hidden Taxes


Payroll: $372b
Corporate income: Visible Taxes
$230b Individual
Other: $140b income: $874b
Payroll: $372b
Other: $32b
63%

Source: Author’s calculations based on Budget of the U.S. Government, FY2005. “Other” hidden taxes include
customs duties; unemployment insurance taxes; and excise taxes on alcohol, fuel, and tobacco. “Other” visible
taxes include estate and gift taxes and various smaller levies.

11
want, and deserve to get it good and hard.”69 trative reasons for it—in order to limit the gov-
The people do not hesitate to demand govern- ernment’s revenue-raising power.
ment spending when they want it, but that Brennan and Buchanan say that taxpayers
needs to be balanced with a tax system under should “deliberately . . . build certain ‘loop-
which the people feel the full cost of the holes’ or ‘escape routes’ in the tax structure.
spending “good and hard.” These provide the protection or guarantee
against undue fiscal exploitation.”73 Thus, a
Tax Bases 20 percent tax on half of consumption may
Choosing the right tax base for federal tax be preferable to a 10 percent tax on all con-
reform has important implications for limit- sumption because the latter system may
ed government. For one thing, revenues from morph over time into a 20 percent tax on all
some types of taxes tend to grow more slow- consumption.
ly than revenues from others. For example, Nobel laureate Gary Becker and fellow
sales tax revenues tend to grown more slowly economist Casey Mulligan built on Buchanan
than income tax revenues over time. From and Brennan’s observations in a 1998 paper.74
1973 to 2003, state sales tax revenue grew at After examining a sample of countries over
an annual average rate of 7.1 percent while time, they conclude that those with “‘more
state income revenue grew at 8.3 percent.70 efficient’ tax systems—systems which rely on
That occurred partly because income tax broad-based taxes with fairly flat rate struc-
rates tend to be more graduated that sales tax tures—are associated with larger govern-
rates, but it is also a tax base issue. Sales taxes ments.”75 The authors also conclude that “an
tend to exclude newer, fast-growing indus- efficient tax system may not minimize the
tries, such as service industries, from the tax total deadweight costs of government activi-
base. Services have increased from 45 percent ties” if increased tax collection efficiency is
of personal consumption expenditures in outweighed by the inefficiency of the govern-
1970 to 59 percent today, thus effectively nar- ment consuming more resources.76
rowing the sales tax base.71 Consider the single largest exclusion from
Economists note that excluding some the current income tax base, employer contri-
activities from the tax base distorts resource butions for health insurance, which are
allocation. But from a limited-government deductible to employers and exempt from tax
perspective, narrower and slower-growing tax for employees. This exemption has increas-
bases are advantageous. Consider the federal ingly narrowed the income tax base over
corporate income tax. The government’s time. In 1983 the exclusion created a federal
Excluding some “yield” from the tax—measured as a share of revenue loss equal to about 6 percent of indi-
GDP—has been falling over time as the tax vidual income tax receipts.77 But because
activities from the base has narrowed. The corporate tax is health care costs have grown quickly, the
tax base distorts grossly inefficient and should be reformed or exclusion now creates a federal revenue loss
resource repealed, but at least it has not provided fuel equal to 12 percent of income tax receipts. If
for expanded government.72 health costs continue to rise faster than U.S.
allocation. But Under any major tax reform, the tradeoff incomes, the exclusion will act to further
from a limited- between tax base broadness and limited gov- reduce growth in federal tax receipts.
ernment needs to be considered. Some con- That is good news from a limited-govern-
government sumption tax proposals have very broad tax ment perspective, but it is also true that the
perspective, bases. Although that would be economically current tax treatment of health care creates
narrower and neutral, it would not be “neutral” from a polit- serious distortions. In particular, the exclusion
ical economy perspective if it resulted in larger itself is an important reason why health care
slower-growing government. Under tax reform, some portion spending has risen so rapidly in recent
tax bases are of a consumption base should be exempted— decades. (Another reason is that employer
advantageous. if there are reasonable economic or adminis- health contributions are exempt from the pay-

12
roll tax).78 The exclusion has also caused the the tax base might make economic sense Narrowing the
U.S. health care system to gravitate toward under a consumption-based system. In a 2000 tax base may
employer-based insurance coverage and away study, Treasury economists Harry Grubert
from individual coverage and control. and James Mackie make a good argument that make sense under
Tax reform should address those distor- the main purpose of investment businesses, consumption-
tions. Individual health care coverage should insurance, and related industries is to help
receive tax treatment similar to that afforded Americans save.84 The value added by those
based tax reform
employer-based coverage. Recently enacted industries represents the transactions costs of if it confers a
health savings accounts have helped to move saving, not consumption spending. Thus, they simplification
the health care system modestly toward more argue that excluding financial services from
individual control. A further reform step was taxation would be consistent with the goal of advantage and
suggested by former White House economist creating a pro-saving or consumption-based there is a good
Glenn Hubbard and coauthors writing in the tax system. economic
Wall Street Journal.79 They argued that anyone Another advantage of exempting financial
with at least catastrophic insurance coverage services is that it would be a tricky industry justification
should be allowed to deduct personal health to tax under any consumption-based system. for it.
care expenses under the income tax. That State retail sales taxes and European value-
would increase health industry efficiency by added taxes (VATs) typically exclude financial
promoting individual insurance coverage services. To tax the industry, special rules
and out-of-pocket spending. Other analysts would be needed, which would increase the
have proposed an individual tax credit for tax system’s complexity.85 That is also true
personal health care expenses.80 for other services industries, and it is one rea-
Another reform option would be to limit son why state sales taxes apply to only about
the current exclusion for employer-provided half of the full personal consumption base.86
coverage to a fixed dollar amount, while pro- In sum, narrowing the tax base may make
viding limited tax benefits for individual cov- sense under consumption-based tax reform
erage.81 Some tax reform proposals, such as if it confers a simplification advantage and
the Hall-Rabushka flat tax, would simply there is a good economic justification for it.
eliminate the preferential treatment of health A final consideration regarding the tax
care in the tax code. base and tax reform is how many different
Interestingly, a number of consumption- tax bases federal revenue should be raised
based tax reform plans would exempt educa- from. From an efficiency standpoint, econo-
tion spending from taxation on the basis that mists might favor a greater number of bases.
education is an “investment.”82 Although Two 10 percent taxes on different bases
most education spending probably does have might be less distortionary than one 20 per-
a long-term payoff, much health care spend- cent tax because deadweight losses rise more
ing does as well. If medical treatment increas- than proportionally as tax rates rise. On the
es a worker’s long-term productivity, perhaps other hand, more tax bases would create larg-
it should be considered investment spending er compliance costs than fewer bases.
as well. When a construction worker under- More important, a greater number of tax
goes back surgery, his medical costs are an bases would make it more difficult for citizens
investment in his productivity. Both health to control the government’s total tax take.
care and education spending contain ele- After European countries imposed VATs in
ments of both consumption and investment; addition to existing income taxes during the
thus, it seems that the proper tax treatment is 1960s and 1970s, their government budgets
a judgment call.83 ballooned. In 1970 tax revenue as a share of
Another sector that requires a careful look GDP averaged 30 percent in Europe and 28
under consumption-based tax reform is finan- percent in the United States.87 By 2000, the
cial services. Excluding financial services from European average had soared to 42 percent as

13
VAT rates rose, while the U.S. tax share had tax, the average tax rate (tax paid divided by
risen only modestly to 30 percent. adjusted gross income) for those earning
To summarize, tax reforms should create over $200,000 was 26 percent in 2002.90 By
a simpler and more efficient system, but the comparison, the average tax rate on house-
public should be on guard that reform does holds earning between $50,000 and $100,000
not make it easier for the government to raise was 11 percent. Those figures indicate that
money. New sources of revenue should not the income tax is overly graduated and cre-
be added unless other sources of revenue are ates a high degree of inequality.
eliminated. The tax system should be made A goal of tax reform should be to move
more transparent so that citizens are more the system toward proportional tax burdens.
aware of the government’s full costs. A focus With proportional burdens, all taxpayers
on those limited-government aspects of tax would pay an equal share of their income (or
reform is especially important because the consumption) to the government. Greater
coming entitlement crisis will create a tempt- equality in the tax burden would have two
ing excuse for some policymakers to call for key benefits. First, it would improve econom-
higher federal revenues.88 ic efficiency because, as noted, the dead-
weight losses of the tax system rise more than
Vertical “equity” Equal Treatment of Individuals proportionally as tax rates rise. Raising taxes
is often used to Equality under the law is a core American on someone in the 35 percent rate bracket
imply the exact principle that should help guide federal tax creates more economic damage than raising
reforms. Public finance experts refer to “hori- taxes on someone in the 15 percent bracket.
opposite of equal zontal equity” as the idea that individuals with A second benefit of a more proportional
treatment. similar income or consumption levels should tax system would be to reduce the demand
pay similar amounts of tax. Unfortunately, for government. Under today’s highly gradu-
individuals are treated very unequally under ated system, many people are not aware of
the income tax as a result of the code’s many the burden created by the federal govern-
exemptions, deductions, and credits. For ment. Indeed, 64 million of 151 million U.S.
example, homeowners and renters with simi- households (42 percent) did not pay a dime
lar incomes can pay substantially different in federal income taxes in 2004.91 The “price”
amounts of tax because of the mortgage inter- of government is zero for those folks, so they
est deduction. Another disparity is between likely demand too much of it. As Michael
the many workers who receive tax-free health Boskin lamented: “We now have a much
insurance through their employers and work- higher ratio of people who are net income
ers who do not have employer coverage and recipients to people who are taxpayers than
have to pay for health care with after-tax dol- in any previous time in history.”92
lars.89 Similarly, there is unequal access to sav- Since the 1980s, Congress has taken mil-
ings vehicles in the tax code. Some workers lions of Americans off the income tax rolls.
have access to 401(k) plans through their Expansion of the standard deduction, the
employers, but many do not. Reforms should personal exemption, the EITC, the child tax
create a tax system that provides equal oppor- credit, and the creation of the 10 percent tax
tunities to all. bracket helped zero out tax liability for many
In addition to horizontal equity, some families. No one wants to increase taxes on
public finance specialists call for “vertical lower-income families, so the best way to cre-
equity” in the tax code. However, this concept ate more tax equality would be to cut federal
has no clear meaning. Indeed, vertical “equi- spending and ratchet down taxes on the 58
ty” is often used to imply the exact opposite percent of households who do pay income
of equal treatment—that people with higher taxes. That way, the nonpayers could retain
incomes should pay a larger share of their their tax freedom, but other Americans
income in taxes. Under the federal income would be treated more fairly.

14
Greater equality under a more uniform AMT is a complex Band-Aid to make up for
and proportional tax system would create the failure of Congress to impose an equal
“solidarity” among taxpayers.93 Under the and neutral regular income tax.
current tax system, with its multiple rates, The solution is to repeal the AMT and end
deductions, and credits, politicians can use a narrow tax breaks in the regular tax code.
“divide-and-conquer” strategy to confuse the Replacing the income tax with a simple and
public about who is affected by proposed neutral consumption-based system would
cuts or increases. By contrast, if the tax sys- achieve consistent tax treatment for families
tem had a single statutory rate (above a basic and businesses, and there would be no need
exempt amount), a proposed increase would for a special add-on tax.
generate widespread opposition, unless peo-
ple thought that politicians would spend the Repeal the Estate Tax
added funding wisely. The 2001 tax law repealed the federal
estate tax, but only for the single year of
2010. After 2010, the “death tax” returns in
Clearing the Decks for full force with a top tax rate of 55 percent.
Reform The estate tax raises only about 1 percent of
federal revenues but imposes a substantial
Repeal the Alternative Minimum Tax cost on the economy. The chairman of the
The individual alternative minimum tax Council on Economic Advisers, Greg
(AMT) is a complex income tax that operates Mankiw, noted at a November 2003 Treasury
alongside the ordinary income tax and conference that as a tax on savings, the death
requires many taxpayers to calculate their tax suppresses growth and reduces the wages
taxes two different ways. The corporate AMT of average workers. He concluded that “the
is also burdensome and adds uncertainty to repeal of the estate tax would stimulate
business decisionmaking. There is broad growth and raise incomes for everyone.”97
agreement that the ill-conceived alternative The estate tax is probably the most ineffi-
taxes should be repealed because they serve cient tax in America. It has created a huge
no economic purpose. and wasteful estate planning industry to help
AMT repeal has been recommended by wealthy Americans avoid the tax if they hire
the Joint Committee on Taxation.94 The IRS enough lawyers and accountants. Studies
National Taxpayer Advocate has also sup- indicate that for every dollar raised by the tax,
ported repeal, noting that the AMT is “so roughly one dollar is lost to avoidance, com-
complicated that many taxpayers are not pliance, and enforcement costs. In addition, Greater equality
aware that they may be subject to it” and that the tax may not actually raise any money for
it is “too complicated for most taxpayers to the government, on net, as noted by Mankiw
under a more
calculate without paid professional help.”95 at the Treasury conference. The reason is that uniform and
There are many problems with the AMT. the impact of the estate tax suppresses other proportional
For one thing, it is not indexed for inflation. federal tax collections, thus offsetting estate
That is one reason why current projections tax receipts. Mankiw concluded that “estate tax system
show that 35 million taxpayers will be subject tax repeal . . . could actually increase total fed- would create
to the AMT by 2010 under current law.96 eral revenue.”98 Congress should complete
The broader issue with the AMT is that the job it started in the 2001 tax law and per-
“solidarity”
the government does not need two separate manently repeal the death tax. among taxpayers.
income tax systems. The AMT was installed
to prevent individuals from taking too many Modernize the Tax Policy Process
special tax breaks under the regular income When Congress considers raising or cut-
tax. Who put those special breaks into the tax ting taxes, the Joint Committee on Taxation
code? Congress did, of course. Thus, the is charged with estimating the expected

15
A recent study by changes to federal tax revenues. Those esti- they found that a traditional one-year analy-
Gregory Mankiw mates are very important to policy debates, sis showed that just 35 percent of taxpayers
but they can be flawed or incomplete. One benefit from the new 25, 28, 33, and 35 per-
and Matthew problem is that JCT estimates have tradition- cent tax rates. But over 10 years, 61 percent of
Weinzierl showed ally been “static,” meaning that they do not taxpayers benefit from the lower rates. In
take into account the effects of tax changes sum, new analysis tools can provide useful
that the dynamic on the macroeconomy. If marginal tax rates information regarding the effects of pro-
effects of capital are cut, for example, the economy will grow posed tax changes. Congress and the admin-
income tax cuts faster and generate a partly offsetting istration should incorporate those new tools
increase in federal revenues. into their regular policy processes.
can be large. Such macroeconomic feedbacks can be
captured in “dynamic” estimates of tax poli-
cy changes. A recent study by Gregory Four Options for Tax
Mankiw and Matthew Weinzierl showed that Reform
the dynamic effects of capital income tax
cuts can be large.99 In a neoclassical growth Most of the tax reform proposals of recent
model, using what the authors say are empir- years have had similar economic struc-
ically plausible assumptions, they find that tures.102 The flat tax, sales tax, and other pro-
the government would recoup 50 percent of posals would all replace the income tax with
the revenues lost from a cut to capital income a low-rate consumption-based system that
taxes over the long term. The authors find would exempt savings, or the return from
that such dynamic feedback effects of cuts to savings, from taxation. But reform plans
capital income taxes are stronger than the have differed on key design features, such as
effects of cuts to labor taxes. the point of collection and the visibility of
In recent years, the JCT and the Congres- taxation.
sional Budget Office have begun to modernize Table 2 shows the basic structure of four
their tax-estimating apparatus, and some tax reform options: a Hall-Rabushka flat tax,
recent analyses have included macroeconomic a national retail sales tax, a savings-exempt
modeling results.100 Those efforts should con- tax, and a dual-rate income tax. The first
tinue, and economic modeling should be made three options would repeal the individual
a routine part of the tax policy process. One and corporate income taxes, and the fourth
benefit would be to help members of Congress would reform the income tax system. The tax
understand that tax changes are not just about rates given for the first three options are the
gaining or losing revenues for the government, proposed rates. There has been debate about
that tax changes can create substantial impacts whether or not the tax rates for these propos-
on the economy. als are revenue neutral, as discussed below.
Other aspects of the tax policy process For the dual-rate tax, I have designed the
should also be modernized. One problem structure to be roughly revenue neutral on a
area has been an overreliance on “distribu- static basis. From a dynamic perspective, all
tional” tables, which show tax liability for four plans would increase the economy’s effi-
people at different income levels. Traditional ciency and likely create positive revenue feed-
distribution tables capture taxpayers at a sin- backs for the government. Thus we could
gle point in time and do not reveal the reduce tax rates over time and still retain rev-
dynamism in most individuals’ tax situa- enue neutrality.
tions. Using a new data set, Treasury econo- Tables 3 to 5 summarize the simplifica-
mists recently looked at the effect of the Bush tion, efficiency, and limited-government
income tax cuts over a long time frame and implications of each tax option. Those impli-
found that there is substantial movement of cations are discussed in the following sec-
people between tax brackets.101 For example, tions for each reform option.

16
Table 2
Structure of Tax Reform Plans
Options 1 to 3 would replace the individual and corporate income taxes. Tax rates are as proposed.
Option 4 would reform the income tax. Tax rates are roughly revenue neutral.

Tax Plan Individuals Businesses

1. Hall-Rabushka • 19% tax on wages and salaries • 19% cash-flow tax on all businesses
Flat Tax • Dividends, interest, and capital • Capital expensing
gains not taxed • Wages are deductible, but interest
• Large personal allowances: and dividends are not
$9,500 singles, $16,500 married, • Territorial treatment of foreign
$4,500 per dependent investment
• All other deductions and credits • Cash-flow accounting that excludes
eliminated financial flows from tax base

2. Retail Sales Tax • Tax not collected from individuals • Sales tax collected from 10 million
• Most sales tax plans would mail retailers. Alternatively, a VAT would
rebate checks to all U.S. households be collected from 25 million businesses.
• To replace income taxes, a 17% (tax-
exclusive) rate would be needed on
55% of GDP
• The FairTax would have a 30% rate
on a broader tax base to replace income
and payroll taxes

3. Savings-Exempt • Flat rate tax of about 22% on • No business tax


Tax individual income that is not saved,
per IRET plan
• Large basic family allowances
• All saving is deducted, but all saving
withdrawals are taxed
• Nearly all other deductions and
credits are ended

4. Dual-Rate • Income tax rates of 15% and 27%. • 15% tax on corporations
Income Tax Higher rate begins at $90,000 (single) • Wages are deductible, but interest
and $180,000 (married) and dividends are not
• Dividends, interest, and capital gains • Further optional reforms include
taxed at 15% maximum capital expensing and territorial
• Standard deduction per current law. treatment for international investments
Personal exemption increased from
$3,200 to $4,500
• Earned income tax credit retained
• Savings vehicles, such as IRAs,
retained
• All other deductions and credits
eliminated

17
Table 3
Simplification Comparison

Tax Plan Benefits Concerns

1.Hall-Rabushka • Ends personal taxes on dividends, • Some business tax items, such as
Flat Tax interest, and capital gains and ends transfer pricing, would continue to
need for special savings vehicles such create complexity
as IRAs • Taxation of financial institutions
• Ends complex business rules for would need special rules
depreciation, inventory, capital gains,
and mergers and acquisitions
• Simplifies tax rules on foreign
investment

2.Retail Sales Tax • Ends all personal taxation • Rebate mechanism would add
• Individuals could save and invest tax- complexity
free without any complex rules • Compliance costs on 10 million retail
• Businesses could invest, hire, and businesses may be large
reorganize without complex and • Taxing some industries, such as
distortionary rules financial services, would require
special rules
• Susceptible to creation of multiple
rates and exemptions

3.Savings-Exempt • All business taxes are repealed • Calculations related to personal


Tax • Neutral individual tax that ends financial income and net saving might
narrow breaks be complex
• No capital gains taxation • Individual tax would be susceptible to
reintroduction of special tax breaks

4.Dual-Rate • Individual income tax is simplified • Tax system is simplified, but it would
Income Tax by repealing most deductions and retain a broad income base making it
credits and taxing nearly all income susceptible to the reintroduction of
at 15% special tax breaks
• For corporations, the lower tax rate
and neutral debt/equity treatment
would reduce tax sheltering

1. Hall-Rabushka Flat Tax Armey and 1996 presidential candidate Steve


Forbes. More recently, Rep. Michael Burgess
The flat tax Benefits (R-TX) and Sen. Arlen Specter (R-PA) have
In 1981 Robert Hall and Alvin Rabushka introduced Hall-Rabushka-style plans in
adopts essentially of the Hoover Institution introduced their Congress. Princeton University economist
Roth IRA “flat tax” proposal.103 Since then, numerous David Bradford has proposed an “X-Tax,”
treatment for versions of the Hall-Rabushka plan have which has a structure similar to that of the
been proposed, including the flat tax propos- Hall-Rabushka plan but would have two tax
personal saving. als of former house majority leader Dick rates instead of one.

18
Under the Hall-Rabushka plan, wages in same simple tax return and pay a flat 19 per- The flat tax
excess of a large personal exemption would cent on a net cash-flow base.104 Taxable cash uniformly
be taxed at a flat 19 percent. Individuals flow would equal revenues from the sale of
would not be taxed on interest, dividends, or goods and services, less deductions for wages, removes a layer
capital gains because capital income would materials, equipment, buildings, and other of taxation from
be taxed at the business level. The flat tax purchases.105
adopts essentially Roth IRA treatment for The flat tax is not just a simple version of
saving and
personal saving—wages would be taxed when the current income tax. It is a consumption- investment.
earned, but after-tax earnings that were saved based tax system because it uniformly
would accumulate tax-free. The exception is removes a layer of taxation from saving and
pension benefits, which would be subject to investment. For individuals, it does not tax
the individual tax because contributions the return to savings. For businesses, it allows
were from pretax income. an immediate deduction, or expensing, of the
Large and small businesses would file the full value of new capital investment.

Table 4
Economic Efficiency Comparison

Tax Plan Benefits Concerns

1.Hall-Rabushka • Ends tax bias against saving and • Retains a tax on businesses, although
Flat Tax investment and cuts top marginal tax one that is much less distortionary
rates • Not “border adjustable” as are some
• Equalizes marginal tax rates across other tax options, which might affect
different industries, assets, and invest- U.S. business competitiveness
ments
• All businesses taxed under the same
system

2.Retail Sales Tax • Ends tax bias against saving and invest- • Susceptible to the creation of
ment and cuts top marginal tax rates exemptions and multiple tax rates
• Ends most business tax distortions, • Rebate mechanism would reduce
although retail businesses would have to efficiency
collect the sales tax • Evasion may be a serious problem
with a high rate

3.Savings-Exempt • Ends tax bias against saving and invest- • Individual tax susceptible to reintro-
Tax ment and cuts top marginal tax rates duction of special tax breaks
• Ends all business tax distortions
4.Dual-Rate • Cuts the top marginal tax rate on wages, • Does not reduce taxes on saving and
Income Tax dividends, interest, and small business investment as much as a consumption-
profits based system
• Equalizes treatment of debt and equity • Retains an income tax on businesses
• Eliminates many income tax distortions • Susceptible to reintroduction of
by reducing rates and ending most special tax breaks
deductions and credits

19
Table 5
Limited Government Comparison

Tax Plan Benefits Concerns

1.Hall-Rabushka • No need for government to probe • A large business tax remains hidden
Flat Tax family finances because taxation of from the general public
financial income is ended • Individual wage tax could be
• All individuals and businesses treated expanded into an income tax
neutrally and equally • The three major federal tax bases are
retained

2.Retail Sales • Individual tax filing eliminated • Politicians could manipulate the
Tax • Tax burden fully visible to individuals system to create multiple rates and
• If the sales tax had a high rate of 15% exemptions
or more, it would be difficult to raise it • Rebate checks would create depen-
any further dence on government for a monthly
• The number of major federal tax bases handout
reduced from three to one under the • Americans may end up with both an
FairTax income tax and a sales tax unless
Sixteenth Amendment repealed

3.Savings-Exempt • Full tax burden visible to individuals • Taxation of personal savings and
Tax because businesses do not collect taxes withdrawals requires giving additional
• The number of major federal tax bases financial data to the government
reduced from three to two • Substantial individual tax compliance
burden

4.Dual-Rate • Income tax would be more neutral and • Basic income tax structure remains in
Income Tax horizontally equitable than the current place. Rates and complexity might
system increase over time
• Simple structure of individual tax • Retains a hidden tax on corporations
would increase tax code transparency • All three major federal tax bases are
retained

A flat tax would be much simpler and including accounting for inventories and
For multinational more efficient than the income tax, as I have capital investment. The flat tax would use
discussed in detail elsewhere.106 Ending per- simple cash accounting in place of accrual
businesses, sonal taxes on dividends, interest, and capital accounting, which is used under the income
the flat tax is gains would remove large paperwork and tax. Accrual accounting requires that firms
financial-planning difficulties that families match revenues and expenses each year to
“territorial,” thus face under the current tax code. The flat tax measure net income and to “capitalize”
taxing only would eliminate half a billion IRS Form expenses that create future benefits. Under
business activities 1099s, which are used to report personal the flat tax, businesses would include
financial income.107 receipts when cash is received and deduct the
within the United For businesses, the flat tax would simplify full costs of materials and equipment when
States. the most complex parts of the tax code, purchased. Aside from simplification, such

20
capital “expensing” would eliminate distor- transfer pricing, that would require extra The flat tax
tions on marginal investment decisions.108 policing.113 Nonetheless, the low rate of the system would
For multinational businesses, the flat tax flat tax would be a large cut from today’s cor-
is “territorial,” thus taxing only business porate rate of 35 percent. That would reduce retain a business-
activities within the United States. That incentives for companies to engage in all level tax, thus
would eliminate most U.S. tax rules on inter- sorts of tax-sheltering activities.
national investment and make the United Another concern is that the flat tax system
perpetuating a
States an excellent place to locate the head- would retain a business-level tax, thus per- hidden tax
quarters of global corporations. All in all, the petuating a hidden tax burden on individu- burden on
flat tax’s combination of capital expensing, als. Hall and Rabushka were well aware that
territoriality, and a low tax rate would give “people pay taxes, not businesses,” but they individuals.
the United States a superior business tax sys- decided that taxing capital income at the
tem and give U.S. firms a competitive edge in business level would be simpler than at the
world markets. individual level.114 They called their business
tax “a giant, comprehensive withholding tax
Concerns on all types of income other than wages,
A first point of contention regarding the salaries, and pensions. It is carefully designed
flat tax has been whether the proposed tax rate to tax every bit of income outside of wages
of 19 percent (17 percent under the Armey ver- but to tax it only once.”115 That design is effi-
sion) would be revenue neutral or not.109 A cient, but it is a weakness from a limited-gov-
1996 Treasury study argued that the revenue- ernment perspective.
neutral Armey tax rate would be 21 percent.110 A final concern raised by some tax reform-
But federal income tax revenues have been cut ers is that the flat tax is not “border
in recent years—from 10.7 percent of GDP in adjustable.” Border adjustable taxes would
FY96 to 9.1 percent in FY05.111 Thus, a some- exempt exports from U.S. taxes, while impos-
what lower flat tax rate of about 18 percent ing taxes on imports. Some analysts argue
would be revenue neutral today. that border adjustability would make U.S.
The tax rate under the flat tax could be businesses more competitive in global mar-
lower if the system did not include such large kets. Retail sales taxes and European VATs
basic exemptions. Under the version of are examples of border adjustable taxes.116 By
Armey’s plan introduced in the 107th contrast, the flat tax and the current corpo-
Congress, a married couple with two children rate income tax are not border adjustable.
would not pay any tax on earnings of less than Some supporters of tax reform are deter-
$35,200. That would create a problem from a mined that any major reform plan be border
limited-government perspective because it adjustable.117 Former Ways and Means
would take millions of families off the tax Committee chairman Bill Archer supported a
rolls. In particular, Armey figured that his plan sales tax reform instead of the flat tax partly
would reduce the number of taxpayers by 10 because of this issue.118 The Simplified USA
million; thus 10 million more people would Tax of Ways and Means member Phil English
view government spending as “free,” and they (R-PA) would replace the corporate income
would demand more of it.112 tax with a 12 percent border adjustable tax.119
Some concerns about the flat tax regard Under the plan, businesses would be taxed on
the business part of the system. The Hall- domestic sales less purchases. Capital invest-
Rabushka business tax would be much sim- ment would be expensed. Wages and interest
pler than the corporate income tax, but there would be nondeductible.
are administrative issues that would need to Border adjustable plans have appeal, given
be ironed out. For example, experts have recent concerns about the U.S. manufacturing
pointed to areas where the flat tax would be industry and the outsourcing of jobs.
vulnerable to business tax sheltering, such as However, economists generally argue that bor-

21
der adjustability would not make much differ- differential industry impacts of tax reform.
ence to U.S. business competitiveness. They For example, it is likely that net exports of cap-
argue that foreign exchange markets would ital-intensive goods would increase under a
eventually push up the value of the dollar after consumption-based tax even if the long-run
a border adjustable tax was imposed, offset- trade balance were unchanged.124 One definite
ting any initial exporting advantage. The CBO advantage of a border adjustable tax would be
said that border adjustability might seem “to elimination of today’s complex transfer pric-
favor the location of production domestically ing rules on multinational corporations.
and encourage exports while discouraging There is general agreement that the
imports, but that argument is without United States needs a tax code that is less
merit.”120 Public finance economist Gilbert burdensome on businesses in the increasing-
Metcalf said that it is a “fallacy” that a border ly competitive global economy. The U.S. cor-
adjustable tax would improve the trade bal- porate tax rate is substantially higher than
ance.121 that of nearly all of our trading partners.125
Still, the extent to which an exchange rate Replacing the income tax with a consump-
offset would occur is subject to uncertainty. tion-based system with lower tax rates—
Current market exchange rates reflect whether or not border adjustable—would
There is general numerous factors, and it might take years to increase the capital intensity of U.S. produc-
agreement that reach any new equilibrium after the federal tion and make the United States an excellent
the United States tax system is changed.122 Note also that tax location for international investment.
reform would affect other factors that influ- Ultimately, border adjustability may need
needs a tax code ence trade flows, such as the level of domes- to be part of any major business tax reform
that is less tic saving and investment decisions by multi- package to garner enough legislative sup-
national corporations. port. Political time frames are short, and
burdensome on Former chairman of the National Eco- stimulating net exports in the short run with
businesses in the nomic Council, Larry Lindsey, summarized a border adjustable tax is attractive to many
increasingly his view regarding the lack of border adjusta- legislators, even if it wouldn’t make a differ-
bility of the current tax system: ence to the trade balance in the long run.
competitive
global economy. Economists believe that this disadvan- 2. Retail Sales Tax
tages American production less than it
might seem because the differential Benefits
taxation will be reflected in the ex- In the 1990s Reps. Dan Schaefer (R-CO)
change rate. But in a world in which and Billy Tauzin (R-LA) gained support for
many of our trading partners in Asia their plan to replace the individual and cor-
and Latin America fix their exchange porate income taxes with a 15 percent
rates with the dollar, this adjustment is national retail sales tax.126 More recently, the
much slower, and less transparent, than “FairTax” proposal championed by Rep. John
it should be. Moreover, if exchange Linder (R-GA) has garnered more than 50
rates are determined by capital flows cosponsors in the House. The FairTax would
over the intermediate term, rather than replace the individual and corporate income
by trade, it might take a long time for taxes and the federal payroll tax with a 23
the burden of taxes on domestic pro- percent retail sales tax.127 House Speaker
ducers to be offset in the foreign Dennis Hastert has said that he favors replac-
exchange market.123 ing the income tax with a sales tax or a value-
added tax, and Majority Leader Tom Delay
Other economists have pointed out that, has said that he favors a sales tax but is open
even as the exchange rate adjusted under a to other tax reform options.
new border adjustable tax, there would still be The proposed tax rates of these plans are

22
calculated on a “tax inclusive” basis. That not be hidden by being collected in bits and
allows for an apples-to-apples comparison pieces over the course of a year as the taxpay-
with income tax rates, which are also er goes shopping, as either sales or value-
expressed on a tax inclusive basis. By contrast, added taxes.”130 Although taxes reported on
state sales tax rates are usually expressed on a paystubs, such as the income tax, allow peo-
“tax exclusive” basis, which is simply the per- ple to see the share of their earnings being
centage mark-up on a product. For example, a taxed, sales taxes have the advantage of pro-
5 percent (tax exclusive) sales tax on a $100 viding more frequent reminders of the gov-
item yields a tax of $5. This rate is the same as ernment’s burden if they are noticed at the
a 4.8 percent rate measured on a tax inclusive checkout counter.
basis, calculated as 5/(100 + 5). The Schaefer- A frequently discussed alternative to a
Tauzin plan has a tax exclusive rate of 18 per- sales tax is a “credit-invoice” value-added tax.
cent, and the FairTax plan has a tax exclusive Sales taxes and this form of VAT are similar
rate of 30 percent. Thus, a consumer purchas- in many ways. Both taxes treat savings and
ing a $1,000 computer after the FairTax was investment favorably, both would end distor-
enacted would pay $300 in tax. tions on business investment, and both
Replacing income taxes with a national would have lower compliance costs than the
sales tax has potentially large benefits. There is income tax.
no doubt that a workable flat retail sales tax The difference between VATs and sales
would strongly promote economic growth by taxes is administrative: VATs are collected at
ending the income tax bias against saving, each stage of production, while sales taxes are
eliminating distortions on business invest- collected only at final purchase. Under a
ment, and reducing top marginal tax rates. credit-invoice VAT, businesses receive a credit
A national sales tax would also be much for taxes paid on their purchases so that by
simpler than the income tax. It is true that the time a product is sold at retail its full
Congress would likely manipulate a sales tax value added has been taxed once, but not
over time to include numerous different rates more than once. That is the same result as a
and exemptions.128 However, that would be a retail sales tax.
minor problem compared with the complexi- If a VAT is considered as a replacement for
ties of the current system, which has hun- the income tax, it would be crucial that the
dreds of deductions, exemptions, and credits implementing legislation require that the VAT
and different effective tax rates on every be explicitly listed on sales receipts, as are retail
industry. Even with numerous exemptions, sales taxes. That would make the burden of
real-world state sales taxes have compliance the VAT fully visible to the general public. In There is no
costs that are perhaps only one-fifth as high Europe, VATs are hidden in the price of goods
as income tax compliance costs, when mea- and services, making those taxes “money
doubt that a
sured as a share of revenue collected.129 machines” for governments. European politi- workable flat
Finally, a big advantage of replacing income cians have been able to steadily increase VAT retail sales tax
taxes with a retail sales tax would be that the rates to an average rate of about 20 percent
full federal tax burden would be visible to indi- today.131 would strongly
viduals. The FairTax plan would repeal the two However, Canada has had a different VAT promote
largest hidden taxes, the corporate income tax experience.132 It adopted a “goods and ser-
and the employer payroll tax. Citizens would vices tax” in 1991, which has a structure sim-
economic growth
see the full cost of government every time they ilar to that of European VATs. The difference by ending the
were at a retail checkout counter. is that the Canadian GST is legally required income tax bias
Some analysts argue that people would to be listed on retail sales receipts. That
have a hard time figuring out their total taxes requirement has been crucial in averting any against saving.
paid under a sales tax. Economist Steve increase in the GST’s 7 percent rate. I am told
Entin, for example, says that “taxes should that Canadian taxpayers hate the GST

23
Adding a major because they see it every time they go shop- retain versions of the corporate and individ-
new federal ping, and they have shot down occasional ual income taxes and impose a new 15 per-
proposals by the government to raise the rate. cent VAT on top.136 Although the plan,
revenue source Since the introduction of the GST, total fed- designed by Prof. Michael Graetz, is sup-
would be a eral tax revenues in Canada have actually fall- posed to be revenue neutral, it would give the
en modestly as a share of GDP.133 In 2000 government a new tax base while retaining
disaster for Australia adopted a 10 percent GST that is the most inefficient parts of the current tax
limited legally required to be listed on all retail sales code, namely the corporate income tax and
government in receipts.134 the individual income tax on people with
The Canadian experience suggests that a high incomes. This plan deserves a quick bur-
the United States, visible, or explicitly listed, VAT is a reform ial because it has few advantages and opens
akin to adding option to consider if income taxes are com- the door to rapidly rising taxes in the future.
the income tax in pletely repealed. However, as with the national A number of fiscal experts support creating
sales tax, the Sixteenth Amendment would a new federal consumption tax in order to pay
1913 and creating have to be repealed first to ensure that for the rising costs of entitlement programs.
income tax Americans did not end up with both the Boston University’s Laurence Kotlikoff has a
income tax and a VAT, as did the Canadians plan that would create a 10 percent national
withholding in and Australians. retail sales tax to help finance Social Security
1943. With that proviso, and if made visible, a reform.137 University of Michigan tax law pro-
VAT would have some advantages over a sales fessor Reuven Avi-Yonah also wants to create a
tax. First, VATs are thought to be more easily new federal revenue source. He recently argued
enforceable than sales taxes for two reasons: in Tax Notes that the “revenue-raising potential
the collection burden is spread across more [of the income tax] is inherently limited . . . to
businesses, and the tax creates a ready audit fund the social safety net, the government
trail for administrators. Easy enforceability needs another tax instrument that can pro-
would be an important advantage if the rate duce high levels of revenue.”138 He concludes:
of a proposed consumption tax were high (as
under the FairTax). To finance the retirement and health
Second, VATs avoid “cascading,” a form of needs of the baby boom generation, not
double taxation that occurs under sales taxes to speak about other urgent needs like
when intermediate goods and services are extending health insurance to all
taxed. Mechanisms can be put in place to Americans, we face a budgetary gap of
avoid that problem, but about 40 percent of $70 trillion. There is simply no way to
current state sales tax revenue comes from raise that kind of revenue with the exist-
double-taxed intermediate products.135 Al- ing income tax . . . we need to adopt a
though recent national sales tax proposals are VAT in addition to the existing income
designed to eliminate cascading, politicians tax.139
tend not to mind cascading because it is a
form of hidden taxation. VATs more easily The dilemma for tax reformers who
avoid cascading by giving businesses credits believe in limited government is that advo-
against taxes paid on inputs. cates who believe in big government, such as
Avi-Yonah, might steer Congress toward
Concerns adopting a new consumption tax as an add-
For supporters of limited government, a on rather than a replacement system. Adding
key concern regarding sales taxes and VATs is a major new federal revenue source would be
that they are often supported as add-ons a disaster for limited government in the
rather than replacements for existing federal United States, akin to adding the income tax
taxes. For example, one option examined by a in 1913 and creating income tax withholding
2002 Bush administration study would in 1943. European governments have swelled

24
in size since they began adopting their hid- cates that there are both political and techni-
den VATs in the 1960s on top of their income cal limitations on how broad a base could be
tax systems. Imposing a federal sales tax or under a national sales tax.
VAT without complete and permanent repeal Because the FairTax plan would eliminate
of the income tax should be avoided at all both the income tax and the federal payroll
costs. If Congress moves to replace the tax, it needs a very broad base and high rate in
income tax with a national retail sales tax or order to be revenue neutral. I have argued that
VAT, it should be paired with repeal of the narrower tax bases have the advantage of mak-
Sixteenth Amendment to the Constitution ing revenue harder for the government to
to ensure that the income tax does not reap- raise. But if the FairTax base were narrower, its
pear in the future.140 rate would be higher than 30 percent, which
Aside from concerns about limited gov- some analysts argue already understates the
ernment, there are concerns about the required revenue-neutral rate.146 Note that a
administrative feasibility of a sales tax that federal sales tax would be layered on top of
has a high enough rate and broad enough existing state and local sales taxes, which have
base to replace current federal revenues. The combined rates up to 11 percent.147
FairTax would tax an extremely broad base Some economists have argued that non-
covering all consumption in the United compliance would be a serious problem with a
Imposing a
States. The base would account for 84 per- high-rate sales tax and that a rate above about federal sales tax
cent of GDP according to the designers of the 10 percent “cannot be effectively adminis- or VAT without
FairTax.141 By contrast, the average state sales tered.”148 Economist Robert Hall recently tes-
tax base covers about 36 percent of GDP, tified to Congress that “sales taxes are notori- complete and
with a range from about 26 percent in New ously leaky and cannot sustain tax rates much permanent repeal
Jersey to 71 percent in New Mexico.142 In above 10 percent.”149 The problem arises
Europe, VATs typically tax only about 41 per- because sales taxes would be collected from
of the income tax
cent of GDP.143 about 10 million businesses selling at retail, should be
The FairTax would tax many items that whereas the current federal tax burden is avoided at all
currently bear no state sales taxes, including spread across about 130 million households
many services, and other items that face little and 25 million businesses. Collecting $1.8 tril- costs.
sales or income tax.144 For example, the lion per year in federal revenue under the
FairTax would impose taxation on health FairTax from that smaller number of taxpay-
care goods and services. (The Hall-Rabushka ers creates a concentrated pressure point for
flat tax would also tax some items that are evasion.
not currently taxed, such as employer contri- Nonetheless, it is far too pessimistic to say
butions for health insurance.) Although that that a sales tax above 10 percent could not
would be a step toward creating a more neu- work. There appears to be little proof of that
tral tax system, it would be difficult political- claim—critics who take that view seem to sim-
ly to impose sales taxes on such items as hos- ply cite similar opinions from other critics.150
pital bills and prescription drugs. A leading It is simply unknown how high a feasible sales
sales tax champion of the 1990s, former tax rate could be. I suspect that a 15 to 20 per-
Ways and Means Committee chairman Bill cent sales tax could be made to work, but no
Archer, would have exempted the health care doubt with tougher enforcement than today’s
sector from the sales tax base.145 low-rate state sales taxes.151 Supporters of a
It is true that many state sales taxes have sales tax point out that, with fewer taxpayers
bases that are too narrow as a result of unjus- under a sales tax system, the government
tified exemptions. Economists generally sup- would be able to focus more intense enforce-
port broader sales tax bases than currently ment pressure on them to reduce evasion.152
exist in the states. However, the narrowness Of course, tax evasion is a substantial prob-
of real-world sales tax and VAT bases indi- lem under the current tax system. Govern-

25
ment studies have found that the “tax gap” of Such rebates may create a fraud problem.
tax owed but not paid under the individual The current EITC program, which mails
income tax is about 20 percent of tax checks to 22 million households, faces a large
receipts.153 That estimate includes only fraud and error problem on the order of 25
unpaid taxes on legal income, not unpaid percent.158 The FairTax would mail larger
taxes on income from illegal activities, such as checks to six times as many households.
drug dealing. Some economists argue that a However, the FairTax rebate would be much
national sales tax would be able to get at some simpler than the EITC, which varies on the
types of economic activity that the current sys- basis of income and other factors.
tem misses. Thus, a sales tax might create Another concern with rebates is that they
some new tax evasion problems but might would get Americans hooked on receiving
solve others.154 money from Washington each month, akin to
Note that the current tax system imposes a welfare check. Politicians would be tempted to
high marginal rates on many people who dish out ever larger rebates to favored groups—
have good opportunities to evade taxes.155 conservatives would push to give larger rebates
For example, self-employed contractors, nan- to married couples, liberals would push to give
nies, exotic dancers, taxi drivers, and others larger rebates to single mothers, and so on.
who receive cash for services have a strong Finally, a design problem with the FairTax
incentive to evade, given that they face a 15 is repeal of the federal payroll tax. The payroll
percent payroll tax plus an income tax with tax is the simplest and most pro-saving fed-
rates of 10 to 35 percent. The latest in a long eral tax.159 It is true that the payroll tax is a
parade of high-profile nanny tax evaders was partly hidden tax, but that problem can be
former New York police commissioner fixed as discussed above. By including payroll
Bernard Kerik. tax repeal, the FairTax needs to raise 67 per-
The point is that there is substantial evasion cent more revenue than a sales tax that just
under the current high-rate tax system, but no replaces the income tax. The needed high rate
one says that it “cannot be administered.” and very broad base open the FairTax up to
When the federal income tax was introduced in the concerns discussed.
1913 with a top rate of 7 percent, people would An alternative to the FairTax would be to
have thought that rates above, perhaps, 30 per- replace the individual and corporate income
cent would be impossible to enforce. Yet the taxes with a lower-rate and narrower-base
government did enforce top marginal income sales tax. A narrower base would limit a sales
tax rates of 70 percent and above from 1936 tax’s revenue-raising potential, and it would
A sales tax with a through 1981.156 It was a very inefficient tax anticipate that policymakers would want to
system, but it did operate. exempt some activities from the tax base. A
17 percent tax If feasible, the replacement of the income sales tax with a 17 percent tax exclusive rate
exclusive rate and tax with a sales tax would generally be favor- and a base of 55 percent of GDP would raise
a base of 55 able from a limited-government perspective. $1.15 trillion in FY05.160 That would be
But one concern regards proposed rebate sys- enough to replace revenues from the individ-
percent of GDP tems under the various sales tax plans, which ual and corporate income taxes and leave
would raise are designed to relieve taxes on low-income room for a narrowly tailored low-income
families. Under the FairTax, the government credit like the EITC, but delivered through
enough to replace would mail checks to all U.S. households the payroll tax system.161
revenues from the each month to offset the burden of sales
individual and taxes on consumption up to the poverty line. 3. Savings-Exempt Tax
In 2003 the official poverty level for a family
corporate income of four was $18,660; thus FairTax rebates per Benefits
taxes. family would have been about $467 per A savings-exempt tax would replace the
month, or $5,600 annually.157 individual and corporate income taxes with a

26
comprehensive tax on individuals that Another key advantage of a savings- The dual-rate tax
allowed a full deduction for net saving dur- exempt tax that eliminated business taxation would provide an
ing a year. Under such a system, there would would be to make the federal tax burden
be no need for a business-level tax because highly visible. IRET argues that the two pur- incremental step
capital income would be handled at the indi- poses of the tax system are to raise revenue toward a flat
vidual level. The tax base of a savings-exempt with minimal economic damage and to allow
tax would be economically similar to the base citizens to accurately “price” the govern-
consumption-
of a sales tax and the Hall-Rabushka flat tax, ment.165 The IRET plan does that by creating based system.
and it would have the same pro-growth a highly visible and pro-savings flat tax col-
advantages. A savings-exempt tax has also lected from individuals.
been called a “saving-deferred tax,” a “con-
sumed-income tax,” and a “personal con- Concerns
sumption tax.” The key disadvantage of a savings-exempt
A tax of this type is the Inflow-Outflow tax tax system would be reduced personal finan-
designed by the Institute for Research on the cial privacy and increased individual tax com-
Economics of Taxation.162 The IRET plan plexity related to personal saving and with-
would have a flat rate above a basic personal drawals. The creation of a deduction for net
allowance, and it would get rid of virtually all of saving would require that the government
today’s deductions, credits, and other narrow track Americans’ personal finances in detail.166
breaks.163 Another prominent savings-exempt Aside from the new savings deduction, the
tax plan was the individual part of the “USA” IRET plan is a fairly simple tax structure with
tax proposed by former senator Sam Nunn (D- a flat rate and few deductions. Some aspects
GA) and Sen. Pete Domenici (R-NM).164 of personal finances would be simplified; for
However, that plan would have retained a busi- example, capital gains taxation would be
ness-level tax, unlike the IRET plan. eliminated. The elimination of all business
Under a savings-exempt tax, individual tax taxation would be a massive simplification.
returns would be similar to today’s income However, a savings-exempt tax system would
tax returns. Income from various sources retain the general form of the individual
would be tallied and deductions taken. But a income tax and thus would be an inviting
savings-exempt tax return would include an target for politicians to reintroduce social
extra schedule that detailed an individual’s engineering tax breaks into the code.
additions to savings and withdrawals from
savings, such as assets held in bank accounts 4. Dual-Rate Income Tax
and mutual funds. If savings during a year
exceeded withdrawals, the taxpayer would Benefits
receive a deduction. If withdrawals exceeded This option would reform individual and
savings, the net withdrawal would be added corporate income taxes by cutting marginal
to taxable income. Complex capital gains cal- tax rates, creating neutrality between differ-
culations would be eliminated. ent income sources, and ending narrow tax
The key advantage of the IRET design is breaks. The dual-rate tax would provide an
that there would be no need for a tax on busi- incremental step toward a flat consumption-
nesses. Business payouts of dividends and based system.167 The dual-rate tax is a good
interest would be taxed at the individual level model for the president’s advisory panel if it
if not saved. The IRET plan would eliminate wants to propose reforms within the general
the direct taxation of both corporations and bounds of the current tax structure.
small businesses. That would massively sim- Under this plan, the individual income tax
plify the tax code and remove all tax distor- would be turned into a two-rate tax that
tions from capital investment and other busi- eliminated most deductions and credits.
ness decisions. Individuals would be taxed at a low 15 per-

27
Figure 3
Marginal Income Tax Rate, Single Taxpayer

35%

30%
Current law
Marginal Tax Rate 25%

20%

15%
Proposed dual-rate tax
10%

5%
0 20 40 60 80 100 120 140 160
Taxable Income ($000s)

Source: Author’s calculations.


Note: Figure excludes the EITC. Taxpayer assumed to take the standard deduction.

Under the cent rate on income up to about $90,000 wages between about $38,000 and $90,000
(singles) and $180,000 (married) and 27 per- face a payroll tax rate of 15.3 percent and
dual-rate tax, the cent on earnings above those thresholds.168 marginal income tax rates of 25 or 28 percent
vast majority of Currently, there are six income tax rates rang- under current law.
families—roughly ing from 10 to 35 percent. While marginal tax rates would fall under
Under the dual-rate tax, the vast majority the dual-rate system, nearly all credits and
95 percent— of families—roughly 95 percent—would face a deductions would be eliminated, such as the
would face a low low 15 percent marginal income tax rate. mortgage interest deduction.170 By dropping
Under current law for 2005, singles with tax- marginal rates and ending special breaks, the
15 percent able income above $29,700 and couples with dual-rate tax would create a high degree of
marginal income taxable income above $59,400 are in the 25 horizontal equity.
tax rate. percent and higher tax brackets. The dual-rate The dual-rate tax plan would retain the
tax would cut the marginal rate for most of current law standard deduction, which is
those taxpayers to 15 percent (see Figure 3). $5,000 for singles and $10,000 for married
The 27 percent rate would kick in at the couples in 2005. The plan would also include
wage threshold at which the 12.4 percent an increased personal exemption, which
payroll tax that funds Social Security cuts would partly offset the elimination of the
out. The effect would be to create a consis- child tax credit. The exemption would be
tent marginal tax rate of about 29 percent on increased from $3,200 under current law in
earnings of all middle- and higher-income 2005 to $4,500. The plan would also retain the
households, taking into account both the EITC, which reduces taxes for low-income
payroll and the income tax. That would be a workers.
big cut in the marginal rate for many middle- The dual-rate tax would also retain pro-
income families, who currently face a mar- savings features of the current tax code,
ginal rate of about 38 to 41 percent (see including 401(k)s, IRAs, and Health Savings
Figure 4).169 For example, single earners with Accounts. Indeed, further steps to simplify

28
Figure 4
Marginal Tax Rate on Wages, Single Taxpayer, Combined Income and Payroll Tax Rate

45%
Current law
40%
Marginal Tax Rate

35%

30%

25%
Proposed dual-rate tax
20%

15%
0 20 40 60 80 100 120 140 160
Taxable Income ($000s)

Source: Author’s calculations.


Note: Figure excludes the EITC. Taxpayer assumed to take the standard deduction. Calculations include the
effect of half of the payroll tax being deductible against the corporate tax.

and liberalize personal savings could be and corporate income taxes.


incorporated into the plan.171 The dual-rate tax plan borrows from the
A key goal of the dual-rate system is to “dual income tax” systems that have been
reduce and equalize tax rates on income from implemented in a number of Nordic coun-
savings. The maximum tax rate on dividends, tries. Those systems feature a low flat rate on
interest, and capital gains would be set at the individual capital income (such as interest,
lower personal rate of 15 percent. (Interest is dividends, and capital gains) and higher,
currently taxed up to the maximum individ- graduated rates on labor income. Denmark,
The top
ual rate of 35 percent.) To match that change, Finland, Norway, and Sweden implemented combined
the corporate tax rate would be cut to 15 per- dual income taxes a decade ago, and the marginal rates on
cent and net interest deductions (interest Netherlands and Austria have more recently
receipts less interest deductions) excluded enacted similar reforms.175 Capital income is wages, dividends,
from the tax base.172 The result would be that taxed at a lower flat rate in order to reduce interest, and
interest and dividends would be taxed at both economic distortions and to respond to ris-
the corporate level and the individual level at ing global capital mobility. If countries do
small business
15 percent, for a net combined rate of 28 per- not cut tax rates on capital income, tax com- profits would be
cent.173 petition will cause capital to flow abroad. For just under 30
Table 6 and Figure 5 show that the top example, the Netherlands dropped its tax
combined marginal rates on wages, divi- rate on dividends and capital gains to 25 per- percent in the
dends, interest, and small business profits cent from 52 percent in 2001 in order to dual-rate plan,
would be just under 30 percent in the dual- reduce tax evasion. Many citizens had compared to 35
rate plan, compared to 35 to 45 percent opened bank accounts in Switzerland and
under the current tax system.174 Wages would elsewhere to avoid the Dutch tax.176 to 45 percent
be taxed under the individual income tax and Ending special breaks under the current under the current
the existing payroll tax. Interest and divi- tax system in favor of lower rates would cre-
dends would be taxed under the individual ate a simpler and more efficient tax system.
tax system.

29
Figure 5
Top Marginal Tax Rates
50%
44.8% Current Law
45%
40.6% Dual-Rate Tax
40%
35.0% 35.0%
35%
27.8% 27.8% 29.7%
30% 27.0%
25%

20%

15%

10%
Dividends Interest Wages Small Business
Profits

Source: Author’s calculations.


Note: Includes individual income tax, corporate income tax, and the payroll tax. See Table 6 for details.

Table 6
Top Marginal Tax Rates

Current Law Dual-Rate Tax

1. Corporate income tax


Dividends 35% 15%
Interest 0% 15%
Wages 0% 0%

2. Individual income tax


Dividends 15% 15%
Interest 35% 15%
Capital gains 15% 15%
Wages 35% 27%
Small business profits 35% 27%

3. Federal payroll tax


Wages below $90,000 15.3% 15.3%
Wages above $90,000 2.9% 2.9%

Combined tax rates


Dividends 44.8% 27.8%
Interest 35.0% 27.8%
Wages 40.6% 29.7%
Small business profits 35.0% 27.0%

Source: Author’s calculations.


Note: Combined tax rates for wages include the effect of the employer half of the payroll tax being deductible
against the corporate tax.

30
Consider the advantage of eliminating the fits for employer-provided coverage were limit- The itemized
itemized deduction for state and local ed or ended, tax reform could instead provide deduction for
income and property taxes. The deduction individuals with a tax deduction or tax credit
encourages state and local governments to for individual insurance purchased. As noted, state and local
raise taxes because higher taxes are offset by Glenn Hubbard and others have argued that income and
the federal deduction. The deduction mutes individuals should be able to deduct insurance
beneficial tax competition between jurisdic- premiums and out-of-pocket expenses in
property taxes
tions. Also, before the recent change that order to move the health system back toward encourages state
allows a federal deduction for state sales individual control.181 and local
taxes, states were encouraged to favor income Another corporate base broadener would
taxes over more pro-saving sales taxes. be to eliminate the deduction for state and governments to
Eliminating the deductibility of state and local income, sales, and property taxes. That raise taxes.
local taxes was discussed before the Tax would create the benefit of increasing tax
Reform Act of 1986. President Ronald Reagan competition between the states. Without the
noted in June 1985: “Perhaps if the high-tax federal deduction, businesses would be more
states didn’t have this federal crutch to prop sensitive to state taxes in their location deci-
up their big spending, they might have to cut sions, thus providing a useful constraint on
taxes to stay competitive.”177 Indeed, a study at state and local fiscal policy.
the time by Harvard’s Martin Feldstein and The combination of these corporate tax
Gilbert Metcalf found that federal deductibili- changes (net interest, the health care deduc-
ty led to modestly higher state spending.178 tion, and state and local taxes) would expand
The dual-rate tax system would eliminate this the corporate tax base by about 70 percent
pro-spending distortion. and offset more than half of the revenue loss
The changes to the individual income tax from the rate cut.182 To get the corporate rate
under the proposed dual-rate system are esti- all the way down to 15 percent and retain rev-
mated to be roughly revenue neutral on a sta- enue neutrality, corporate subsidies on the
tic basis. Calculations were based on my spending side of the federal budget could be
analysis of IRS tax return data for 2002 and a cut. Also note that cutting the corporate tax
preliminary estimate by the Tax Foundation rate would create macroeconomic feedback
for 2004 using their individual tax microsim- effects that would offset a large share of the
ulation model.179 revenue loss.183
The proposed changes to the corporate The proposed corporate tax changes bor-
income tax under the dual-rate plan are sug- row from both the Hall-Rabushka flat tax
gested incremental reforms, rather than a and the “comprehensive business income
detailed proposal. To get the corporate rate tax” proposed in a 1992 Treasury study.184
down to 15 percent, a variety of tax base Both proposals would equalize the treatment
broadeners and federal spending cuts would of interest and dividends by excluding inter-
be needed. The first step would be to end the est from the business tax base. Also, the flat
deduction for net interest in order to create tax would broaden the tax base by ending the
neutrality between corporate debt and equity. deduction for employer-paid health benefits.
The second step would be to end or limit The flat tax would also end the business
the deduction for employer-paid health insur- deduction for federal payroll taxes. The dual-
ance benefits. As discussed above, employer- rate tax retains deductibility of federal pay-
paid benefits for health insurance are current- roll taxes but ends the deduction of state and
ly tax-free, creating distortions in the delivery local taxes to encourage interstate tax com-
of health care in the United States. An alterna- petition.
tive to limiting the employer deduction would Like the dual-rate tax, the flat tax base for
be to limit the individual exclusion for corporations would be larger than the corpo-
employer-provided benefits.180 If the tax bene- rate income tax base, allowing the tax rate to

31
be cut substantially.185 Analyses have found Reform Act of 1986, which broadened the
that the Hall-Rabushka flat tax would be rev- base and lowered rates, offers a mixed lesson
enue neutral for corporations at about 19 on this point. On the one hand, the low tax
percent.186 rates of 1986 did not last long. (Rates went
Under the dual-rate system, the corporate up in 1990 and 1993.) On the other hand,
tax could be moved all the way to a Hall- recent tax bills have reversed the 1986 act by
Rabushka cash-flow business tax with four narrowing the tax base, often in beneficial
further steps. First, depreciation would be ways such as liberalizing IRAs.
replaced by capital expensing. Second, accrual On visibility, the dual-rate system would
accounting would be replaced by cash retain a large hidden tax in the form of the 15
accounting. Third, the “worldwide” tax system percent corporate tax. On the other hand, the
would be replaced by a “territorial” system individual tax would have a simple structure,
that taxes firms on their domestic profits only. which would allow individuals to more clear-
Territorial taxes are used by most industrial ly understand what share of income they
countries today because they are simpler and paid in taxes. Although this option is the
they allow firms to better compete in foreign least radical of the four presented in this
markets.187 Fourth, the tax would be extended paper, it would be a bold reform stoke, giving
A 15 percent from corporations to all types of businesses. the United States a far simpler and more effi-
corporate tax that To summarize, the dual-rate tax plan cient tax code.
was territorial would move incrementally toward a lower-
rate pro-saving system. The plan would cut
and included top marginal tax rates on working, saving, Conclusion
expensing would and small businesses. It would create greater
tax equality between families, while also pro- This report has provided four models of tax
spur growth and viding low-income tax relief. For corpora- reform for policymakers to consider. The most
give the United tions, various base broadeners and subsidy dramatic reform would be to rip out the
States one of the cuts would be used to reduce the tax rate income tax and replace it with a retail sales tax.
sharply. A 15 percent corporate tax that was A 17 percent sales tax with a base that covered
best business tax territorial and included expensing would 55 percent of GDP could replace the individual
climates in world. spur growth and give the United States one and corporate income taxes on a revenue-neu-
of the best business tax climates in world. tral basis in 2005. If feasible, a sales tax would
be much simpler and more efficient than the
Concerns income tax. A national sales tax would also
The dual-rate tax system would retain the make the tax burden visible—people would feel
basic structure of the income tax, thus for- the burden of government “good and hard”
feiting some of the efficiency benefits of a every time they went shopping.
consumption-based system. Also, complex Another leading alternative to the income
income tax features such as capital gains tax- tax is the Hall-Rabushka flat tax. The flat tax
ation would be retained. Nonetheless, the has been studied for 20 years, and while not
reduced tax rates, the equal treatment of yet adopted it has provided an excellent para-
interest and dividends, and the elimination digm to guide incremental reforms. Recent
of deductions and credits would create gains tax rate cuts, reductions to dividend and cap-
in simplicity and growth. ital gains taxes, creation of Roth IRAs, and
From a limited-government perspective, partial expensing of business investment
the main concern regarding this option is have all moved toward the flat tax ideal.
that the individual and corporate tax bases The proposed dual-rate income tax would
would be broader. A broader tax base would represent a further jump toward the flat tax.
tend to raise increased revenue over time if Marginal tax rates would be cut and most
tax rates were moved upward again. The Tax deductions and credits eliminated to simpli-

32
fy the code and increase horizontal equity. 1. The Economic Growth and Tax Relief
Reconciliation Act of 2001, the Job Creation and
The vast majority of families would pay a Worker Assistance Act of 2002, the Jobs and
simple, flat 15 percent tax. The combined top Growth Tax Relief Reconciliation Act of 2003,
federal tax rates on wages, dividends, interest, and the American Jobs Creation Act of 2004.
and small business income would be cut and
2. Congressional Budget Office (CBO), “The
equalized. For corporations, the low 15 per- Budget and Economic Outlook,” September
cent rate would spur investment and make 2004, www.cbo.gov.
U.S. businesses more competitive in the glob-
al economy. This option provides a good 3. Chris Edwards, “Downsizing the Federal
Government,” Cato Institute Policy Analysis no.
model for the president’s advisory panel if it 515, June 2, 2004.
does not want to move all the way to a con-
sumption-based system. 4. In particular, the 1986 tax act increased taxes
The president’s call for tax reform creates on savings and investment in a number of ways,
such as by scaling back individual retirement
both risks and opportunities for taxpayers accounts.
and the economy. The risk stems from com-
mentators who view major tax changes as an 5. This is the page count for the CCH “Standard
opportunity to increase revenues in order to Federal Tax Reporter,” which includes the tax
code, tax regulations, and related IRS rulings. See
fund entitlement programs and reduce the www.cch.com/wbot2004.
budget deficit. Recently, there have been calls
to raise income and payroll taxes, and calls to 6. Office of Management and Budget, “Informa-
create an add-on sales tax or VAT. Those calls tion Collection Budget of the U.S. Government,”
FY2004, p. 17, www.whitehouse.gov/omb/inforeg
should be rejected—under no circumstances /infocoll.html.
should a tax reform bill be considered if it
raises taxes. There is no need for higher taxes 7. Income tax compliance costs have been various-
when there are hundreds of inefficient feder- ly estimated at between 10 and 20 percent of rev-
enues collected. Such estimates typically apply a
al programs that could be eliminated to save per hour wage rate to the estimated number of
money.188 hours that Americans spend on tax compliance
The fact that the economy needs pro-saving activities. See discussion in Chris Edwards, “Tax
and pro-growth policies more than ever pro- Complexity Factbook,” Joint Economic Commit-
tee, April 2000.
vides the opportunity for tax reform. The finan-
cial strains that will be caused by the retirement 8. General Accounting Office (GAO), “Federal
of the baby-boom generation will be easier to Budget: Opportunities for Oversight and Im-
handle if U.S. economic performance is maxi- proved Use of Taxpayer Funds,” GAO-03-922T,
June 18, 2003, p. 13.
mized. Tax reforms can help to increase person-
al saving, allowing people to be better prepared 9. Internal Revenue Service (IRS), National
for their future health care and retirement Taxpayer Advocate, “Annual Report to Congress,”
needs. And tax reforms can increase investment December 31, 2004, p. 3, www.irs.gov/pub/irs-utl
/ntafy2004annualreport.pdf.
and productivity, enabling U.S. businesses to
better tackle rising competition in global mar- 10. For example, the IRS recently gained access to
kets. Tax reform involves some risks, but if it is data on Visa cards issued by foreign banks. See
tailored to maximize savings, investment, and “Washington in Brief,” Washington Post, March 29,
2002, p. A11.
growth, all families will enjoy greater financial
security and rising incomes. 11. However, pension benefits would be taxed
under the flat tax because pension contributions
are from pre-tax income. This form of saving
would decline in importance under a flat tax.
Notes
Stephen Entin, David Burton, Dan Mastromarco, 12. For a detailed discussion, see Chris Edwards,
and Ryan Ellis provided helpful comments. Of “Replacing the Scandal-Plagued Corporate
course, all errors are those of the author. Income Tax with a Cash-Flow Tax,” Cato Institute

33
Policy Analysis no. 484, August 14, 2003. ships, partnerships, farms, and S corporations.

13. Joint Committee on Taxation, “Report of 24. See the following National Bureau of
Investigation of Enron Corporation and Related Economic Research (NBER) papers by Robert
Entities Regarding Federal Tax and Compensation Carroll, Douglas Holtz-Eakin, Mark Rider, and
Issues, and Policy Recommendations,” vol. 1, Harvey Rosen: “Entrepreneurs, Income Taxes, and
Report, JCS-3-03, February 2003. Investment,” NBER Working Paper 6374, January
1998; “Income Taxes and Entrepreneurs’ Use of
14. David Weisbach of the University of Chicago Labor,” NBER Working Paper 6578, May 2000;
Law School notes: “The typical corporate tax shel- and “Personal Income Taxes and the Growth of
ter case is more difficult. It will almost always be Small Firms,” NBER Working Paper 7980, October
ambiguous whether the transaction should be 2000. All papers available at www.nber.org.
treated as a permissible tax reduction or not.”
David Weisbach, “Corporate Tax Avoidance,” 25. William M. Gentry and R. Glenn Hubbard,
National Tax Association Proceedings of the 69th “Success Taxes, Entrepreneurial Entry, and Innova-
Annual Conference 2003 (Washington: National tion,” NBER Working Paper no. 10551, June 2004.
Tax Association, 2004), p. 9.
26. For some empirical estimates, see Emmanuel
15. Ibid., p. 13. Saez and Jonathan Gruber, “The Elasticity of
Taxable Income: Evidence and Implications,”
16. Albert B. Crenshaw, “All Tax Shelters Are Not NBER Working Paper no. 7512, January 2000. Saez
Illegal, Another Court Tells IRS,” Washington Post, and Gruber found that the elasticity of taxable
November 4, 2004. income for those earning less than $100,000 was
only as third as large as for those earning more
17. Albert B. Crenshaw, “Black & Decker Wins IRS than $100,000. For a comprehensive survey of the
Tax Shelter Case,” Washington Post, October 22, 2004. literature, see Seth Giertz, “Recent Literature on
Taxable-Income Elasticities,” Technical Paper
18. For a discussion, see Edwards, “Replacing the Series 2004–16, CBO, December 2004.
Scandal-Plagued Corporate Income Tax with a
Cash-Flow Tax.” 27. The magnitude of economic benefits from tax
rate cuts can be estimated by looking at the
19. For a discussion about why consumption- increase in the size of the tax base. In particular, the
based taxes are simpler than income taxes, see change in compensated taxable income determines
Chris Edwards, “Simplifying Federal Taxes: The the magnitude of the change in deadweight losses.
Advantages of Consumption-Based Taxation,” See Martin Feldstein, “Tax Avoidance and the
Cato Institute Policy Analysis no. 416, October Deadweight Loss of the Income Tax,” NBER
17, 2001. Working Paper 5055, March 1995.
20. Michael Boskin, “A Framework for the Tax 28. CBO, “Budget Options,” February 2001, p. 381.
Reform Debate,” in Frontiers of Tax Reform, ed.
Michael Boskin (Stanford: Hoover Institution, 29. Jorgenson and Yun, pp. 289, 302.
1996), p. 14.
30. Ibid., p. 304.
21. After modeling various tax reforms, economists
Dale Jorgenson and Kun-Young Yun conclude that 31. Boskin, “A Framework for the Tax Reform
“one of our most important findings is that redis- Debate,” p. 14.
tribution through tax policy is very costly in terms
of efficiency.” Dale Jorgenson and Kun-Young Yun, 32. Jorgenson and Yun, p. 280.
Lifting the Burden: Tax Reform, the Cost of Capital, and
U.S. Economic Growth (Cambridge, MA: MIT Press, 33. Expensing exempts the “normal” risk-free rate
2001), p. 321. of return from taxation. But “above-normal”
returns would continue to be taxed under a sys-
22. For a summary of the literature, see Chris tem with expensing, such as the flat tax. Above-
Edwards, “Economic Benefits of Personal Income normal returns stem from monopoly power,
Tax Rate Reductions,” Joint Economic Committee, unexpected windfalls, and other factors. Because
April 2001. it is thought that above-normal returns account
for most of business profits, a tax system with
23. Scott Hodge and Scott Moody, “Wealthy expensing would continue to tax most business
Americans and Business Activity,” Special Report profits. See Glenn Hubbard, Testimony before
no. 131, Tax Foundation, August 2004. Small busi- the House Ways and Means Committee, Hearing
ness income includes income from sole proprietor- on “The Impact on Individuals and Families of

34
Replacing the Federal Income Tax,” April 15, 43. Jane Gravelle, “Historical Effective Marginal
1997. See also Daniel Shaviro, “Replacing the Tax Rates on Capital Income,” Congressional
Income Tax with a Progressive Consumption Research Service, Report no. RS21706, January
Tax,” Tax Notes, April 5, 2004, p. 91. 12, 2004. These rates are for 2003 and include the
effects of temporary capital expensing and the tax
34. The Job Creation and Worker Assistance Act rate cuts that are set to expire later in the decade.
of 2002 allowed businesses to expense 30 percent
of qualified capital equipment. The Jobs and 44. CBO, “The Economic Effects of Comprehen-
Growth Tax Relief Reconciliation Act of 2003 sive Tax Reform,” July 1997, p. 39.
expanded expensing to 50 percent, but this
reform expired at the end of 2004. 45. Jorgenson and Yun, p. 317.

35. Eugene Steuerle of the Urban Institute has a 46. Jane Gravelle, The Economic Effects of Taxing Capital
useful summary table showing the complexity of Income (Cambridge, MA: MIT Press, 1994), p. 55.
the current retirement and pension rules. See
Eugene Steuerle, Testimony before the House 47. James B. Mackie, “Unfinished Business of the
Ways and Means Committee, Subcommittee on 1986 Tax Reform Act: An Effective Tax Rate
Oversight, Hearing on “Impact of Complexity of Analysis of Current Issues in the Taxation of
the Tax Code on Individual Taxpayers and Small Capital Income,” National Tax Journal 60, no. 2
Businesses,” May, 25, 1999. (June 2002): 293.

36. On pension complexity, the Joint Committee 48. Regarding owner-occupied housing, the tax
on Taxation notes that “the federal laws and reg- preference results from the combination of the
ulations governing employer-provided retirement mortgage interest deduction and the exemption
benefits are recognized as among the most com- from taxable income of imputed rent on homes.
plex sets of rules applicable to any area of the tax
law.” See Joint Committee on Taxation, Study on 49. Note that these simulations are mainly from
the Overall State of the Federal Tax System, vol. 2, JCS- the mid-1990s, thus before the recent federal tax
3-01 (Washington: Government Printing Office, cuts.
April 2001), p. 149.
50. Laurence Kotlikoff, “The Economic Impact of
37 Albert Crenshaw, “Pension Providers May Pay Replacing Federal Income Taxes with a Sales Tax,”
More for Insurance,” Washington Post, January 11, Cato Institute Policy Analysis no. 193, April 15,
2005, p. A1. 1993.

38. Note that under the flat tax businesses would 51. Alan Auerbach, “Tax Reform, Capital Allocation,
still deduct pension plan contributions, and ben- Efficiency, and Growth,” in Economic Effects of
efits would be taxable to individuals. But in the Fundamental Tax Reform, ed. Henry Aaron and
long run employer-based pensions would be William Gale (Washington: Brookings Institution
deemphasized because the tax hurdles to other Press, 1996), p. 58. These are the closed economy, no
savings would be eliminated. adjustment cost, simulations.

39. Richard Gephardt, “The Economics and 52. David Altig et al., “Simulating Fundamental
Politics of Tax Reform,” Cato Journal 5, no. 2 (Fall Tax Reform in the United States,” American
1985): 458. Economic Review 91, no. 3 (June 2001): 574.

40. As measured by official “tax expenditures.” 53. Boskin, “A Framework for the Tax Reform
See Budget of the U.S. Government, FY2005, Analytical Debate,” p. 24.
Perspectives, p. 294. Official measures of tax expen-
ditures have numerous shortcomings, as dis- 54. Joint Committee on Taxation, “Tax Modeling
cussed in the budget. Project and 1997 Symposium Papers,” JCS-21-97,
November 20, 1997, p. 21. Two of the models did
41. Peter Whoriskey, “Stadiums Are Built on Federal not produce long-run results. Also, both the “low”
Tax Break,” Washington Post, July 29, 2003, p. A1. and “high” of the Fullerton-Rogers model runs
are including in my average.
42. Dennis Zimmerman and Elizabeth Pinkston,
“Tax-Credit Bonds: Are There Advantages to This 55. Jorgenson and Yun, p. 334.
New Financial Instrument that Compensate for
Introducing Additional Complexity?” in National 56. For a discussion of capital taxation and
Tax Association Proceedings of the 96th Annual dynamic revenue scoring, see Gregory Mankiw
Conference, p. 426. and Matthew Weinzierl, “Dynamic Scoring: A

35
Back-of-the-Envelope Guide,” NBER Working www.bartleby.com/73/423.html.
Paper no. w11000, December 2004. Mankiw and
Weinzierl figure that if the technology benefits 70. U.S. Bureau of Economic Analysis, National
from capital investment are indeed large, a cut to Income and Product Accounts, Table 3.3, www.
capital taxes would only cost the government bea.doc.gov/bea/dn/nipaweb/index.asp. This is
about 26 percent of the traditionally estimated only a rough comparison because it does not
revenue loss. adjust for the effect of legislated tax changes dur-
ing the period.
57. Randall Holcombe, “Tax Policy from a Public
Choice Perspective,” National Tax Journal 51, no. 2 71. Council of Economic Advisers, Economic Report
(June 1998): p. 366. of the President 2004 (Washington: Government
Printing Office, February 2003), p. 284.
58. Louis Fisher, “Line Item Veto Act of 1996:
Lessons from the States,” Congressional Research 72. Federal corporate tax revenues have fallen
Service, December 26, 1996. from an average of 3.8 percent of GDP in the
1960s to 1.5 percent in 2004.
59. The House Republican Study Committee has
proposed changes to the budget process in the 73. Brennan and Buchanan, p. 199.
“Family Budget Protection Act” that would
reduce the current bias toward overspending. 74. Gary Becker and Casey Mulligan, “Deadweight
Costs and the Size of Government,” NBER
60. For state experiences with budget limitations, Working Paper no. 6789, November 1998.
see Michael New, “Proposition 13 and State
Budget Limitations: Past Successes and Future 75. Ibid., Abstract.
Options,” Cato Institute Briefing Paper no. 83,
June 19, 2003. 76. Ibid., p. 1.

61. For a discussion, see Amity Shlaes, The Greedy 77. Budget of the U.S. Government, FY1984, Special
Hand (New York: Harcourt, 1999), pp. 3–8. Analyses (Washington: Government Printing
Office, 1983), p. G-32
62. The income tax is partly indexed for inflation
today, but real growth continues to push taxpay- 78. For background, see Jonathan Gruber and
ers into higher tax brackets over time. James Poterba, “Reform and Employer-Provided
Health Insurance,” in Economic Effects of Fundamen-
63. Geoffrey Brennan and James M. Buchanan, tal Tax Reform, p. 125.
The Power to Tax: Analytical Foundations of a Fiscal
Constitution (Cambridge: Cambridge University 79. John Cogan, Glenn Hubbard, and Daniel
Press, 1980). Also available online at www.econ- Kessler, “Brilliant Deduction,” Wall Street Journal,
lib.org/library/buchanan/buchCv9c12.html. December 8, 2004.

64. Ibid., chap. 3, p. 48. 80. Grace-Marie Turner, “Health Care: Avoiding
the Achilles Heel of Tax Reform,” Institute for
65. In 1900 alcohol excises accounted for 35 per- Policy Innovation, Policy Report no. 167, February
cent of federal revenues and customs duties 2002.
accounted for 45 percent. See Chris Edwards,
“The U.S. Economy at the Beginning and End of 81. For a discussion, see Robert B. Helms, “Tax
the 20th Century,” Joint Economic Committee, Reform and Health Insurance,” American Enter-
December 1999, p. 26. prise Institute, February 2005. See also the joint
statement of a group of conservative and libertar-
66. For a detailed discussion of this issue, see ian scholars at www.galen.org/vision.asp.
Bryan Riley, Eric Schlecht, and John Berthoud,
“Hidden Taxes: How Much Do You Really Pay?” 82. For example, the FairTax would tax health care
Institute for Policy Innovation, July 2001. but exempt spending on education and training.

67. The legislation was H. R. 1264 sponsored by 83. A share of higher education spending and
Rep. Pete Hoekstra (R-MI). numerous health care products and procedures
probably do not affect long-term productivity
68. See the Mackinac Center for Public Policy proj- and may be considered consumption.
ect on the Right-to-Know Payroll Form at www.
mackinac.org. 84. Harry Grubert and James Mackie, “Must
Financial Services Be Taxed under a Consumption
69. H. L. Mencken, A Little Book in C Major, 1916, Tax,” National Tax Journal 53, no. 1 (March 2000): 23.

36
85. See Peter Merrill and Chris Edwards, “Cash- 100. For background, see David Burton,
Flow Taxation of Financial Services,” National Tax “Reforming the Federal Tax Policy Process,” Cato
Journal 49, no. 3 (September 1996). Institute Policy Analysis no. 463, December 17,
2002.
86. William Fox, “Should the Hawaii General
Excise Tax Look Like Other States’ Sales Taxes?” 101. Julie-Anne Cronin et al. Office of Tax
Report prepared for the State of Hawaii Tax Analysis, U.S. Treasury, “Treasury’s New Panel
Review Commission, October 15, 2002, p. 12. Fox Model for Tax Analysis,” National Tax Association
calculates tax bases as share of personal income. I Proceedings of the 69th Annual Conference, p. 379.
have converted his figures to a share of personal
consumption expenditures. 102. For a good survey, see Martin Sullivan, “Flat
Taxes and Consumption Taxes: A Guide to the
87. Organization for Economic Cooperation and Debate,” American Institute of Certified Public
Development, Revenue Statistics 1965–2001 (Paris: Accountants, December 1995.
OECD, 2002).
103. Robert Hall and Alvin Rabushka, The Flat
88. For background on the entitlement spending Tax, 2d ed. (Palo Alto: Hoover Institution Press,
crisis, see Chris Edwards and Tad DeHaven, “War 1995).
between the Generations: Federal Spending on
the Elderly Expected to Explode,” Cato Institute 104. The Hall-Rabushka tax is an “R-based” (R for
Policy Analysis no. 488, September 16, 2003. real) cash-flow tax under which financial flows
such as interest, dividends, and capital gains are
89. See discussion in Cogan, Hubbard, and Kessler. disregarded. By contrast, an R+F cash-flow tax
would include real and financial flows in measur-
90. IRS, “Individual Income Tax Returns: Prelim- ing the tax base.
inary Data, 2002,” SOI Bulletin, Winter 2003–2004,
p. 6. 105. Business expenses that would not be
deductible under the flat tax include interest, div-
91. Joint Committee on Taxation, “Estimates of idends, nonpension fringe benefits, the employ-
Federal Tax Expenditures for Fiscal Years 2005– er’s share of payroll taxes, and bad debts.
2009,” JCS-1-05, January 12, 2005, p. 41.
106. Edwards, “Simplifying Federal Taxes.”
92. Boskin, “A Framework for the Tax Reform
Debate,” p. 13. 107. This includes 1099INT, 1099DIV, 1099B, and
1098 forms. See GAO, “Potential Impact of
93. For a discussion on this issue, see Edward Alternative Taxes on Taxpayers and Administra-
Crane et al., “Rewriting the Code: A Roundtable tors,” GAO/GGD-98-37, January 1998, p. 37.
on Tax Reform,” Reason Online, July 1995, www.
reason.com/9507/tax.html. 108. Mervyn King, “The Cash Flow Corporate
Income Tax,” NBER Working Paper no. 1993,
94. Joint Committee on Taxation, Study on the August 1986, pp. 14–21.
Overall State of the Federal Tax System, vol. 1, JCS-3-
01 (Washington: Government Printing Office, 109. Dick Armey designed his 17 percent flat tax
April 2001), p. 10. to create an overall tax cut, while Hall and
Rabushka designed their 19 percent plan to be
95. IRS, National Taxpayer Advocate, “Annual revenue neutral.
Report to Congress,” December 31, 2004, p. 3,
www.irs.gov/pub/irs-utl/ntafy2004annualreport. 110. U.S. Treasury, “New Armey-Shelby Flat Tax
pdf. Would Still Lose Money, Treasury Finds,” Tax
Notes, January 22, 1996, p. 451.
96. Joint Committee on Taxation, “Budget Effects
of The Conference Agreement for H. R. 2, the Jobs 111. CBO, “The Budget and Economic Outlook:
and Growth Tax Relief Reconciliation Act of 2003,” Fiscal Years 2006 to 2015,” January 2005, p. 3.
JCT-55-03, May 22, 2003.
112. Dick Armey, “The Impact on Individuals and
97. Gregory Mankiw, comments at “Roundtable Families of Replacing the Federal Income Tax,”
on Jobs, Growth, and Abolition of the Death Testimony before the House Ways and Means
Tax,” U.S. Treasury, November 6, 2003. Committee, April 17, 1997.

98. Ibid. 113. Transfer pricing is the shifting of profits


from high-tax to low-tax countries using the
99. Mankiw and Weinzierl. prices of products and intangibles that are traded

37
between corporations and their subsidiaries. estate tax and most federal excise taxes.
Another point of trouble for the flat tax would be
separating financial and nonfinancial transac- 127. The FairTax (H. R. 25 in the 108th Congress)
tions. would also replace the estate tax. For background,
see www.fairtax.org.
114. Robert Hall and Alvin Rabuska, “The Flat
Tax: A Simple, Progressive Consumption Tax,” in 128. European VATs, for example, typically have
Frontiers of Tax Reform, p. 33. multiple rates and exemptions. See Alexandre
Mathis, “VAT Indicators,” European Commission,
115. Ibid., p. 33. Working Paper no. 2, April 2004.

116. Current international trade rules allow 129. See Joel Slemrod, “Which Is the Simplest Tax
exports to be exempt and imports to be taxed System of Them All?” in Economic Effects of
under “indirect” taxes, such as sales taxes and Fundamental Tax Reform, p. 369. Slemrod notes
credit-invoice VATs, but not “direct” taxes, such as that studies of state income tax compliance put
the corporate income tax. the cost at between 2.4 and 4.8 percent of rev-
enues. Income tax cost estimates range from
117. For example, see Ernest Christian, “The Slemrod’s 10 percent of revenues to about 20 per-
International Components of Tax Reform,” cent of revenues. Slemrod, however, notes that
Institute for Policy Innovation, Policy Report no. low-rate state sales taxes are not directly compara-
166, February 2002. ble to federal taxes.

118. Bill Archer, “Goals of Fundamental Tax 130. Steve Entin, “The Inflow Outflow Tax: A
Reform,” in Frontiers of Tax Reform p. 8. Saving-Deferred Neutral Tax System,” Institute
for Research on the Economics of Taxation,
119. The bill was H. R. 269 in the 108th Congress. www.iret.org, undated, p. 4.
See Rep. Phil English webpage, www.house.gov/
english/pdf/SUSATbrfg.pdf. 131. This is the average of the “standard rate” of
VAT. See Mathis.
120. CBO, “The Economic Effects of Comprehen-
sive Tax Reform,” July 1997, p. 28. 132. Based on discussions with Jason Clemens,
Fraser Institute; David Perry, Canadian Tax
121. Gilbert Metcalf, “The Role of a Value-Added Foundation; and others.
Tax in Fundamental Tax Reform,” in Frontiers of
Tax Reform, p. 97. 133. Revenues fell from 36.4 percent in 1991 to
35.2 percent in 2001, according to Organization
122. See discussion in James Hines, “Fundamental for Economic Cooperation and Development,
Tax Reform in an International Setting,” in Revenue Statistics 1965–2001.
Economic Effects of Fundamental Tax Reform, p. 479.
Hines notes that exchange rates can differ from 134. E-mail communications with Chris Evans,
purchasing power parities for years, but not differ director, Atax, University of New South Wales,
in the long term; thus export benefits of border and Peter Saunders, social research director,
adjustments are eventually nullified. Centre for Independent Studies, New South
Wales. Retail prices in Australia are normally
123. Lawrence Lindsey, “Simplify, Simplify, quoted on a tax-inclusive basis, but sales receipts
Simplify,” Wall Street Journal, September 16, 2004. separately list the amount of GST in the price.
124. U.S. International Trade Commission, 135. Raymond Ring, “Consumers’ Share and
“Implications for U.S. Trade and Competitiveness Producers’ Share of the General Sales Tax,”
of a Broad-Based Consumption Tax,” Publication National Tax Journal 52, no. 1 (March 1999): 79.
3110, June 1998, p. 33. On cascading, see also John Mikesell, “The
American Retail Sales Tax: Considerations on
125. Chris Edwards, “Corporate Tax Reform: Bush, Their [sic] Structure, Operations, and Potential as
Kerry, and Congress Fall Short,” Cato Institute Tax a Foundation for a Federal Sales Tax,” National
& Budget Bulletin no. 21, September 2004, Tax Journal 50, no. 1 (March 1997): 149.
www.cato.org/pubs/tbb/index.html.
136. The study took the form of a memo to
126. For background on this plan, see Arthur Treasury Secretary Paul O’Neill from Assistant
Hall, “Analysis and Summary of the National Secretary (Tax Policy) Pam Olson, “Tax Reform
Retail Sales Act of 1996,” Tax Foundation, March Materials,” November 7, 2002. Available at
1996. The plan would also have eliminated the http://thepriceofloyalty.ronsuskind.com/the-

38
bushfiles/archives/000093.html. 147. Federation of Tax Administrators, “Compari-
son of State and Local Retail Sales Taxes,” January
137. Laurence Kotlikoff, “How to Fix Taxes and 2004, www.taxadmin.org/fta/rate/.
Social Security,” Washington Post, November 7,
2004, p. B7. Kotlikoff says that the sales tax rate 148. Sullivan, “The Rise and Fall of the National
could be reduced over time as a new Social Sales Tax,” p. 919. For an alternative view, see Dan
Security system based on private accounts was Mastromarco, “The FairTax and Tax Compliance:
phased in. An Analytical Perspective,” Tax Notes, April 20,
1998
138. Reuven Avi-Yonah, “Risk, Rents, and
Regressivity: Why the United States Needs Both 149. Robert Hall, “Guidelines for Tax Reform,”
an Income Tax and a VAT,” Tax Notes, December Testimony to the House Budget Committee,
20, 2004, p. 1653. October 6, 2004, www.house.gov/budget/hear
ings.htm.
139. Ibid., p. 1666.
150. For example, Bruce Bartlett cites the OECD
140. The FairTax designers support repeal of the saying: “Governments have gone on record as say-
Sixteenth Amendment. ing a [sales tax] of more than 10 percent to 12 per-
cent is too fragile to tax evasive possibilities.”
141. David Burton and Dan Mastromarco, Economist Bill Gale recently argued: “Govern-
“Response to William Gale,” March 16, 1998, p. 3, ments have gone on record noting that at rates of
www.fairtax.org. This figure can be roughly calcu- more than 12 percent, sales taxes are too easy to
lated by adding personal consumption expendi- evade.” Bruce Bartlett, “Consequences of Replacing
tures to government consumption and dividing Federal Taxes with a Sales Tax,” Joint Economic
by GDP. This share of GDP is prior to rebates for Committee, August 1995, p. 8. William Gale,
low-income households. “Federal Revenue Options,” Testimony to the
House Budget Committee, October 6, 2004, p. 4.
142. Fox, p. 12. Fox calculates tax bases as share of
personal income. I have roughly converted his fig- 151. One scholarly analysis of possible evasion
ures into shares of GDP. under a national sales tax concluded that it is
hard to say whether it would be better or worse
143. Cited in William Gale, “The Required Tax than under the income tax. See Matthew Murray,
Rate in a National Retail Sales Tax,” Brookings “Would Tax Evasion and Tax Avoidance
Institution, May 1999, p. 15. Undermine a National Retail Sales Tax?” National
Tax Journal 50, no. 1 (March 1997): 167.
144. For the coverage of state sales tax bases, see
Paul Menchik, “Consumption Patterns, Demo- 152. Burton and Mastromarco, “Response to
graphic Change and Sales Tax Revenue: Is Yet William Gale,” p. 24.
Another Fiscal Shock on the Horizon?” National
Tax Association Proceedings of the 96th Annual 153. GAO, “Taxpayer Compliance: Analyzing the
Conference, p. 367. Nature of the Income Tax Gap,”GAO/T-GGD-97-
35, January 9, 1997, p. 8. The figure is based on
145. Archer, p. 8. the $95 billion tax gap for individuals in 1992
divided by individual income taxes of $476 billion
146. Some studies have calculated that the revenue- that year.
neutral rate for a FairTax would be higher than 30
percent. See Gale, “The Required Tax Rate in a 154. For a discussion of these issues, see David
National Retail Sales Tax.” And see Joint Committee Burton and Dan Mastromarco, “Response to Ken
on Taxation, “Budget Neutral Rate for H.R. 2525,” Kies’ Letter to Chairman Archer,” Americans for
Memorandum to John Buckley, April 2000. Memo Fair Taxation, February 4, 1998, www.fairtax.org.
replicated in Martin Sullivan, “The Rise and Fall of
the National Sales Tax,” Tax Notes, November 15, 155. Burton and Mastromarco, “Response to
2004. However, the designers of the FairTax have William Gale,” p. 7.
challenged these estimates. See David Burton and
Dan Mastromarco, response to Ken Kies’s letter to 156. Tax Foundation, Facts and Figures on
Chairman Archer, February 4, 1998, which critiques Government Finance, 36th ed. (Washington: Tax
an earlier JCT estimate. Joint Committee on Foundation, 2003), Table C29.
Taxation, “The Impact on Individuals and Families
of Replacing the Federal Income Tax,” JCT-8-97, 157. U.S. Bureau of the Census, “Poverty Thresh-
April 14, 1997. See also Burton and Mastromarco, olds 2003,” www.census.gov/hhes/poverty/thresh
“Response to William Gale.” ld/thresh03.html.

39
158. GAO, “Federal Budget: Opportunities for equalized treatment of debt and equity, business
Oversight and Improved Use of Taxpayer Funds,” capital expensing, expanded personal savings
p. 13. opportunities, and creation of a more interna-
tionally competitive U.S. corporate tax. See
159. Taxes on wages are economically similar to Christian, “De-Radicalizing Tax Reform.”
taxes on consumption. See discussion in Joint
Committee on Taxation, “Impact on Individuals 168. More precisely, the plan’s tax rates would be
and Families of Replacing the Federal Income applied to taxable income, which would be
Tax,” p. 93. adjusted gross income (as under current law) less
the standard deduction and an expanded person-
160. Author’s calculations based on CBO, “The al exemption. In 2005 the standard deduction is
Budget and Economic Outlook: An Update,” $5,000 for single and $10,000 for married filers,
September 2004, p. 4. Various analyses have found and the expanded personal exemption would be
that a VAT base of about 55 percent of GDP is a $4,500. Thus, the 27 percent bracket would begin
fairly realistic base. For example, see CBO, “Effects at about $80,000 of taxable income for singles
of Adopting a Value-Added Tax,” February 1992, and about $160,000 of taxable income for mar-
Table 8, p. 22. The “broad” base calculated by CBO ried couples. (Dividends, interest, and capital
at 55 percent of GDP would exclude parts of food, gains would taxed at a maximum of 15 percent.)
housing, health care, religious, and financial ser-
vices consumption from the tax base. 169. Calculations include the effect of the
employer-paid payroll tax being deductible
161. A payroll credit combined with a sales tax is against the corporate income tax.
discussed in Gilbert Metcalf, “The National Sales
Tax: Who Bears the Burden?” Cato Institute 170. For a full list of “tax expenditures” in the
Policy Analysis no. 289, December 8, 1997. I am code, see Budget of the U.S. Government FY2005,
assuming a credit as costly as the refundable por- Analytic Perspectives, p. 285. Note, however, that
tion of the EITC at about $34 billion. official lists of tax expenditures have certain tech-
nical shortcomings.
162. Entin. An original model of this design was a
proposal by economist David Bradford. See David 171. The administration has proposed adding life-
Bradford, Blueprints for Basic Tax Reform, 2d ed. time savings accounts and simplifying the rules on
(Arlington, VA: Tax Analysts, 1984). current retirement plans. For a description, see U.S.
Treasury, “General Explanation of the Administra-
163. The IRET plan would retain a deduction for tion’s FY2005 Revenue Proposals,” February 2004,
education expenses, with the justification that www.treas.gov/offices/tax-policy/library/blue
education is an investment not consumption. bk04.pdf.

164. Under the “Unlimited Savings Allowance” 172. Looking at IRS data for all nonfinancial C cor-
(USA) tax plan of Nunn and Domenici, the cor- porations for 2000 and 2001, the interest deduc-
porate income tax would be replaced by an 11 per- tion is typically about $60 billion larger than inter-
cent broad-based business tax. See Ernest est income. Special rules would be required for the
Christian, “De-Radicalizing Tax Reform,” Tax financial services industry. For corporate data, see
Notes, April 13, 1998, p. 243. IRS, Statistics of Income Division, Corporate Income
Tax Returns 2001 (Washington: Government
165. Entin. Printing Office, undated), Table 12.
166. For a discussion of administrative issues 173. Calculated as 15 + (1 — 0.15)*15.
under such a tax, see GAO, “Potential Impact of
Alternative Taxes on Taxpayers and Administra- 174. For this proposal, I have assumed that the
tors,” GAO/GGD-98-37, January 1998, p. 174. For corporate income tax would be paid by C corpo-
another view, see Slemrod, p. 377. Slemrod thinks rations, as under current law. Small businesses
that such a tax would be unenforceable at the stan- would continue to pay tax under the individual
dard of privacy that Americans would expect from system. However, in the long run the tax code
the government. See also Charles McClure and should be reformed to equalize the tax treatment
George Zodrow, “A Hybrid Approach to Direct of all businesses.
Consumption Taxation,” in Frontiers of Tax Reform,
p. 78. 175. Alessandro Bavila, “Moving Away from Global
Taxation: Dual Income Tax and Other Forms of
167. Tax expert Ernest Christian’s incremental Taxation,” European Taxation (Amsterdam: Inter-
steps toward reform are called the “five easy national Bureau of Fiscal Documentation, June
pieces,” which include reduced marginal tax rates, 2001). See also Paul van den Noord and

40
Christopher Heady, “Surveillance of Tax Policies: A For corporate data, see IRS, Statistics of Income
Synthesis of Findings in Economic Surveys,” Division, Table 12.
OECD Working Paper 303, July 17, 2001.
183. Business subsidies, or “corporate welfare,” on
176. Hubert Hamaekers, “Taxation Trends in the spending side of the federal budget total about
Europe,” Asia-Pacific Tax Bulletin (International $90 billion annually. See Chris Edwards and Tad
Bureau of Fiscal Documentation), February 2003, DeHaven, “Corporate Welfare Update,” Cato
p. 48. Institute Tax & Budget Bulletin no. 7, May 2002.

177. Ronald Reagan, Remarks during a White 184. U.S. Department of the Treasury, Integration
House Briefing on Tax Reform, June 7, 1985, www. of the Individual and Corporate Tax Systems
reagan.utexas.edu/resource/speeches/1985/ (Washington: Government Printing Office,
60785b.htm. January 1992).

178. Martin Feldstein and Gilbert Metcalf, “The 185. An analysis by Price Waterhouse (now
Effect of Federal Tax Deductibility on State and PricewaterhouseCoopers) for nonfinancial C cor-
Local Taxes and Spending,” NBER Working porations for 1992 shows that the flat tax base
Paper no. 1791, January 1986. would have been 62 percent larger than the
income tax base. Price Waterhouse, “Tax Liability
179. The Tax Foundation’s Individual Tax of Nonfinancial Corporations under the USA and
Simulation Model is based on the IRS, Statistics Flat Taxes: An Industry Analysis,” June 29, 1992.
of Income, public use data file.
186. For example, a PricewaterhouseCoopers
180. See Helms. analysis looking at the years 1998 through 1992
found that a flat tax with a rate of about 19 per-
181. Cogan, Hubbard, and Kessler. cent would be revenue neutral for all U.S. nonfi-
nancial corporations. See Peter Merrill et al.,
182. Based on my calculations of aggregate IRS “Corporate Tax Liability under the USA and Flat
data for all nonfinancial C corporations in 2000 Taxes,” Tax Notes, August 7, 1995.
and 2001. The exclusion of interest income and
deductions would expand the corporate tax base 187. For a discussion of international tax systems
by about 10 percent; ending the health insurance used in other countries, see Peter Merrill,
deduction would expand the base by about 30 PricewaterhouseCoopers, Testimony before the
percent; and ending deductions for state and House Budget Committee on the “Competitiveness
local taxes would expand the base by about 30 of the U.S. Tax Code,” July 22, 2004.
percent. Special rules would be needed for the
financial services industry under such a tax plan. 188. Edwards, “Downsizing the Federal Government.”

41
OTHER STUDIES IN THE POLICY ANALYSIS SERIES

535. Robin Hood in Reverse: The Case against Economic Development


Takings by Ilya Somin (February 22, 2005)

534. Peer-to-Peer Networking and Digital Rights Management: How Market


Tools Can Solve Copyright Problems by Michael A. Einhorn and Bill
Rosenblatt (February 17, 2005)

533. Who Killed Telecom? Why the Official Story Is Wrong by Lawrence
Gasman (February 7, 2005)

532. Health Care in a Free Society: Rebutting the Myths of National Health
Insurance by John C. Goodman (January 27, 2005)

531. Making College More Expensive: The Unintended Consequences of


Federal Tuition Aid by Gary Wolfram (January 25, 2005)

530. Rethinking Electricity Restructuring by Peter Van Doren and Jerry Taylor
(November 30, 2004)

529. Implementing Welfare Reform: A State Report Card by Jenifer Zeigler


(October 19, 2004)

528. Fannie Mae, Freddie Mac, and Housing Finance: Why True Privatization
Is Good Public Policy by Lawrence J. White (October 7, 2004)

527. Health Care Regulation: A $169 Billion Hidden Tax by Christopher J.


Conover (October 4, 2004)

526. Iraq’s Odious Debts by Patricia Adams (September 28, 2004)

525. When Ignorance Isn’t Bliss: How Political Ignorance Threatens


Democracy by Ilya Somin (September 22, 2004)

524. Three Myths about Voter Turnout in the United States by John Samples
(September 14, 2004)

523. How to Reduce the Cost of Federal Pension Insurance by Richard A.


Ippolito (August 24, 2004)

522. Budget Reforms to Solve New York City’s High-Tax Crisis by Raymond J.
Keating (August 17, 2004)

521. Drug Reimportation: The Free Market Solution by Roger Pilon (August 4,
2004)

520. Understanding Privacy—And the Real Threats to It by Jim Harper (August


4, 2004)

519. Nuclear Deterrence, Preventive War, and Counterproliferation by Jeffrey


Record (July 8, 2004)
518. A Lesson in Waste: Where Does All the Federal Education Money Go?
by Neal McCluskey (July 7, 2004)

517. Deficits, Interest Rates, and Taxes: Myths and Realities by Alan Reynolds
(June 29, 2004)

516. European Union Defense Policy: An American Perspective by Leslie S.


Lebl (June 24, 2004)

515. Downsizing the Federal Government by Chris Edwards (June 2, 2004)

514. Can Tort Reform and Federalism Coexist? by Michael I. Krauss and Robert
A. Levy (April 14, 2004)

513. South Africa’s War against Malaria: Lessons for the Developing World
by Richard Tren and Roger Bate (March 25, 2004)

512. The Syria Accountability Act: Taking the Wrong Road to Damascus by
Claude Salhani (March 18, 2004)

511. Education and Indoctrination in the Muslim World: Is There a Problem?


What Can We Do about It? by Andrew Coulson (March 11, 2004)

510. Restoring the U.S. House of Representatives: A Skeptical Look at Current


Proposals by Ronald Keith Gaddie (February 17, 2004)

509. Mrs. Clinton Has Entered the Race: The 2004 Democratic Presidential
Candidates’ Proposals to Reform Health Insurance by Michael F. Cannon
(February 5, 2004)

508. Compulsory Licensing vs. the Three “Golden Oldies”: Property Rights,
Contracts, and Markets by Robert P. Merges (January 15, 2004)

507. “Net Neutrality”: Digital Discrimination or Regulatory Gamesmanship


in Cyberspace? by Adam D. Thierer (January 12, 2004)

506. Cleaning Up New York States’s Budget Mess by Raymond J. Keating


(January 7, 2004)

505. Can Iraq Be Democratic? by Patrick Basham (January 5, 2004)

504. The High Costs of Federal Energy Efficiency Standards for Residential
Appliances by Ronald J. Sutherland (December 23, 2003)

503. Deployed in the U.S.A.: The Creeping Militarization of the Home Front
by Gene Healy (December 17, 2003)

502. Iraq: The Wrong War by Charles V. Peña (December 15, 2003)

501. Back Door to Prohibition: The New War on Social Drinking by Radley
Balko (December 5, 2003)

500. The Failures of Taxpayer Financing of Presidential Campaigns by John


Samples (November 25, 2003)

499. Mini-Nukes and Preemptive Policy: A Dangerous Combination by


Charles V. Peña (November 19, 2003)

498. Public and Private Rule Making in Securities Markets by Paul G. Mahoney
(November 13, 2003)

497. The Quality of Corporate Financial Statements and Their Auditors


before and after Enron by George J. Benston (November 6, 2003)

496. Bush’s National Security Strategy Is a Misnomer by Charles V. Peña


(October 30, 2003)

495. The Struggle for School Choice Policy after Zelman: Regulations vs. the
Free Market by H. Lillian Omand (October 29, 2003)

494. The Internet Tax Solution: Tax Competition, Not Tax Collusion by Adam
D. Thierer and Veronique de Rugy (October 23, 2003)

493. Keeping the Poor Poor: The Dark Side of the Living Wage by Carl F.
Horowitz (October 21, 2003)

492. Our History of Educational Freedom: What It Should Mean for Families
Today by Marie Gryphon and Emily A. Meyer (October 8, 2003)

491. Threats to Financial Privacy and Tax Competition by Richard W. Rahn


and Veronique de Rugy (October 2, 2003)

490. Defining Democracy Down: Explaining the Campaign to Repeal Term


Limits by Patrick Basham (September 24, 2003)

489. EU Enlargement: Costs, Benefits, and Strategies for Central and Eastern
European Countries by Marian L. Tupy (September 18, 2003)

488. War between the Generations: Federal Spending on the Elderly Set to
Explode by Chris Edwards and Tad DeHaven (September 16, 2003)

487. The Balanced Budget Veto: A New Mechanism to Limit Federal Spending
by Anthony W. Hawks (September 4, 2003)

486. What Does a Voucher Buy? A Closer Look at the Cost of Private Schools
by David F. Salisbury (August 28, 2003)

485. Mending the U.S.–European Rift over the Middle East by Leon T. Hadar
August 20, 2003)

484. Replacing the Scandal-Plagued Corporate Income Tax with a Cash-Flow


Tax by Chris Edwards (August 14, 2003)