Why Major Federal Tax Reform Is Being Discussed

1. The current U.S. tax system has imperfections, such as—

• Taxing of savings that represent previously taxed income.
• Double taxing corporate income.
• Encouraging corporate debt over corporate equity.
• Hindering capital formation (for example, preference for debt over equity, limits on capital losses, limited incentives for capital investments).
• Taxing the worldwide income of U.S. citizens and U.S. corporations while many other countries only tax income earned within their borders.
• Inflationary gains are taxed.
• Certain types of income are given preferential treatment, such as fringe benefits, tax-exempt bond interest, and capital gains; such preferences can lead to distorted decision-making.
• Lack of basic conformity with accounting principles, such as disregard for the matching principle .
• Sometimes, income must be reported by the recipient before the payor is allowed to deduct the related payment.
• Many married taxpayers are subject to higher tax rates as married taxpayers than if they each filed as single (the marriage penalty).
• Many dollars of taxes go uncollected every year (tax gap).
• Complexity.

2. The current U.S. tax system is too complex—

• The Wall Street Journal reported in 1995 that 7 of every 10 individual income tax returns for 1993 took the standard deduction (rather than itemizing) and that about 50% of all individual returns were prepared by a paid preparer. ["Tax Report," Wall Street Journal, June 21, 1995, page A1.]
• Some of the most complex provisions apply to those least able to afford professional tax preparation (for example, earned income tax credit, definition of a dependent).
• The instruction book accompanying Form 1040EZ is typically over 30 pages long.
• Continual changes to the tax law add to complexity.
• Even "simplification" provisions are sometimes complex. For example, Internal Revenue Code (IRC) �197 (allowing for 15-year amortization of certain intangibles, including goodwill) added in 1993 as a simplification provision, has raised many difficult issues.

• "We cannot lose sight of the fact that complexity is the result of our struggle for fairness."
  (former) IRS Commissioner Richardson

3. The current U.S. tax system is costly for taxpayers to comply with—

• Per Congressman Armey: "Americans spend 5.4 billion man-hours each year calculating their taxes - more man-hours than it takes to build every car, truck and van produced in the United States. The tax code puts a drag on our economy worth an estimated $232 billion a year in compliance costs, an amount equal to $900 for every man, woman, and child in the country." [Cong. Rec. July 19, 1995, E1461.]

4. The current U.S. tax system is frequently used to create incentives to either encourage a particular activity or discourage a particular activity (that is, it is not neutral)—

• The cost of preferential rules to the tax system is rarely weighed against alternatives for reaching the same goal, either when they are added, or in future years. For example, does the cost to the government of the preference which allows interest income on state and local bond interest to be exempt from tax cost the federal government more than the benefit derived by the state and local governments? Does anyone know? If the cost to the federal government is higher, a direct subsidy from the federal government to the state and local governments would be "cheaper" than having a tax preference for bond interest.
• Some preferences have evolved to lose sight of their underlying purpose. For example, a home mortgage deduction is allowed to encourage home ownership. However, the current tax rule allows for deduction of mortgage interest on two homes, rather than just one, and on debt up to $1.1 million dollars, far larger than the average home cost in the U.S.
• Some view preferences as "loopholes" that favor taxpayers who can afford to hire lobbyists. For example, Professors Hall and Rabushka state: "The federal income tax encourages lawyers and lobbyists to seek tax favors from Congress instead of earning an honest living." [Hall and Rabushka, The Flat Tax, second edition, page 3.] Such views tend to harm compliance rates and lead to lack of faith in the tax system.
• Preferences add complexity to the system.
• Some rules seem to be driven by revenue goals rather than what makes sense, what is simple, or what follows a particular philosophy for the income tax system. For example, the uniform capitalization rules (IRC �263A) require more types of costs to be included in inventory for tax purposes than for financial reporting purposes. This results in a lengthy set of regulations, numerous calculations and increased recordkeeping, which all just results in a difference in timing for when cost of goods sold affects gross income. Also, with more widespread use of inventory control techniques today, such as just-in-time manufacturing, turnover rates have increased making the invneotry tax rules less meaningful.

Commonly Listed Goals for Major Federal Tax Reform

Listed below are various goals that have been suggested as reasons to undertake major reform at the federal level in the U.S. Background information is also provided here to better understand why each of the goals has likely been offered as a reason for reform. The following goals are not listed in any particular order.

1. To simplify the current tax system.

A 1993 study by the Tax Foundation found that on average, a Fortune 500 company spends $2,110,000 annually to comply with income taxes. For small business, the federal income tax compliance cost for 1990 was 390% of the tax owed. ["The Income Tax Compliance Cost of Big Business," the Tax Foundation, Nov. 1993; "Accounting Costs, Another Tax," by Hall, Wall Street Journal, Dec. 9, 1993, page A18.]

At tax reform hearings before the House Ways & Means Committee in June 1995, the senior tax counsel for Mobil Corporation brought with him his 9 volume, 6,300 page, 76-pound federal tax return. He stated that Mobil spent $10 million, 57 man-years and workpapers consisting of about 146,000 documents to produce the return for which Mobil owed $2 billion in taxes. ["Hearings open on tax overhaul," San Jose Mercury News, June 7, 1995.]

2. To improve compliance to reduce the tax gap.

The tax gap is the difference between taxes that are owed and taxes that are voluntarily paid. Currently, the federal tax gap exceeds $110 billion per year. [The IRS estimates that the amount of taxes not voluntarily paid is about 17% of total federal income taxes each year (83% compliance rate). IRS enforcement efforts eventually raise the compliance rate to about 87% each tax year. GAO, Reducing The Tax Gap - Results of a GAO-Sponsored Symposium, GAO/GGD-95-157, June 1995, pages 2-3.]

3. To improve the ability of companies to compete globally.

The U.S. tax system has differences from those of trading partners: the U.S. has a worldwide tax system where all income is taxed no matter where it is earned (rather than a territorial system which only taxes income earned within the borders); U.S. income taxes are not border adjustable (for example, GATT (General Agreement on Tariffs and Trade) and the WTO (World Trade Organization) favor indirect taxes, such as a value-added tax, which can be imposed on imported goods and refunded for exports). The United States and Australia are the only OECD (Organization for Economic Cooperation and Development) countries without a value-added tax. [OECD, Consumption Tax Trends, 1995, pg. 11; hereinafter, Consumption Tax Trends.] However, Australia will start to use a goods and services tax (GST) in 2000.

4. To eliminate the IRS from every citizen's life.

House Ways & Means Chairman Bill Archer includes eliminating the IRS from the lives of individuals as one of his five key objectives for federal tax reform: "I mean completely and totally out of our individual lives." [Congressman Archer, "Goals of Fundamental Tax Reform," in Frontiers of Tax Reform, The Hoover Institute, 1996, page 4.]

Author Comment: As long as a tax exists, an administrative agency is required to collect the tax and be sure that the proper amount is collected. Thus, a tax agency, such as the IRS, cannot be completely eliminated.

5. To serve as part of a plan to shrink government.

If the public wants a smaller government, a simpler tax system would likely be needed in order to shrink the size of the IRS and Treasury Department. Also, if smaller government means that less revenue is needed, than perhaps the current system should be reviewed to determine what spending will be reduced and whether it ties into specific tax rules that could be eliminated. Such a review should also consider where complications and inefficiencies of our current tax system can be eliminated.

6. To serve as part of a plan to change government spending.

Government spending has changed greatly in the past 30 years such that today, entitlement spending and payment of interest on the federal debt dominate, relative to prior years.

Data source: "The Economic And Budget Outlook: Fiscal Years 1996-2000," CBO Director Robert Reischauer, 1/95, Tables E-4 and E-6.

Problems exist with Social Security and Medicare funding in that funds are not expected to be sufficient to meet the needs of the "baby boom" generation. In 1995, the Bipartisan Commission on Entitlement and Tax Reform reported that if no policy changes are made, spending on entitlements and interest on the debt will consume almost all federal revenue by the year 2010. By the year 2030, federal revenue will not be sufficient to pay for entitlement spending. [Final Report To The President from the Bipartisan Commission on Entitlement and Tax Reform, January 1995, pages 9 and 17. ] Medicare Part A is currently projected to be insolvent by the year 2003.

7. To enable individuals to better see how much money they are giving to the government.

Congressman Armey's first flat tax bill introduced in 1994, H.R. 4585, proposed to eliminate withholding and replace it with monthly payments to better enable citizens to see what they were spending on government. This proposal was eliminated from Armey's current flat tax proposal, H.R. 1040. However, this goal also underlies the proposal to replace the U.S. income tax system with a national retail sales tax. Proponents of a national retail sales tax suggest that it will be a more transparent system than the current wage withholding technique used for the individual income tax, and will enable individuals to better control how much they pay, by controlling how much they spend.

8. To improve savings.

The current U.S. tax system is viewed as not encouraging savings because it taxes earnings from savings. The U.S. savings rate is lower than that of Germany and Japan. OECD statistics show that between 1983 and 1992, Japan's national savings rate was over five times higher than the U.S. savings rate while Germany's rate was three times higher and than the U.S. and the European Union rate was over twice as much.

Net national savings in the U.S. as a percentage of GDP is low relative to other countries. For example, in 1989, the OECD reported that the net national savings as a percentage of GDP was as follows for these countries:

9. To improve capital formation.

The current system favors debt over equity because corporations can deduct interest payments, but cannot deduct dividend payments. Also, some view our current tax system as taxing capital gains at too high of a rate and not adjusting for inflationary gains (that is, the cost of a capital asset is not adjusted upward to reflect the effects of inflation, thus, when that asset is sold at a gain, some (or perhaps all) of that gain represents inflation, rather than a true increase in value). In addition, some view IRC �1202, added in 1993 to allow non-corporate shareholders a 50% exclusion for gains from small business stock held over five years, as too restrictive to be useful. Finally, some view the estate tax system as another hindrance to capital formation.

10. To reduce the tax burden for individuals.

The strong U.S. economy has led to a budget surplus (if the Social Security fund surplus is included) after a few decades of deficits. Many politicians would like to return some of this surplus back to individuals now. However, many would also like to wait until the Social Security system is strengthened.

Arguably, the American public will only give up favored deductions and tax credits if tax reform results in a lower tax liability for them now and in the future.

Author Comment: Before Congress engages in major tax reform, it should clearly indicate what the objectives are and rank the goals in order of importance so that proposals can be properly evaluated. Each of the current reform proposals does not meet each of the goals listed above.

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Copyright Annette Nellen 1999.