Full Text: GAO Report on Impact of Alternative Tax Systems (Part 1 of 2)

UNITED STATES GENERAL ACCOUNTING OFFICE

REPORT TO THE CHAIRMEN AND RANKING MINORITY MEMBERS,

January 1998

GAO/GGD-98-37

General Government Division

B-265785

January 14, 1995

The Honorable William V. Roth, Jr.

The Honorable Daniel Patrick Moynihan

The Honorable Bill Archer

The Honorable Charles B. Rangel

[1] In the past few years, many proposals have been put forward to comprehensively reform the federal income tax system. Proponents of tax reform believe that replacing the current income tax system would improve the performance of the economy and make the tax system fairer. Proponents of several proposals also believe that reform would make administration of the tax law easier and less costly for the government and make compliance with the law easier for taxpayers.

[2] To help Congress evaluate how tax reform would affect tax administration and the burdens taxpayers face in complying with the tax law, we studied, at our own initiative, the basic design features of several kinds of tax systems. /1/ The generic systems we studied are a national retail sales tax (RST), two types of value-added taxes (VAT), a flat tax, a personal consumption tax, and several versions of broad-based income taxes. Various forms of these alternative tax systems have been included in specific legislative proposals in the current and past sessions of Congress or have been prominent in tax reform discussions generally.

[3] In this report, we describe (1) the major differences in design among the alternatives we studied and (2) how the alternatives, by incorporating different design features, may affect the taxpayers' burden of complying with the tax laws and the government's responsibilities for administering those laws. The basic design features we considered in contemplating alternative systems are the tax base (what is taxed); the types of taxpayers (whether individuals, businesses, or both are legally subject to tax); tax preferences (tax system provisions, including exemptions, deductions, credits, and multiple rates, directed at various economic and social goals); and the tax rate(s). We considered taxpayers' compliance burden to include the time, effort, and cost of filing the required returns and maintaining necessary records. We defined tax administration as including the government processing taxpayer returns, assessing compliance with tax laws, collecting taxes owed, and providing taxpayer assistance.

[4] This report is intended to be a reference document for readers with different interests and needs. The letter summarizes (1) how the basic design features are included in the current income tax system and could be incorporated into alternative tax systems and (2) what the resulting impacts on compliance burden and administration could be. For readers who want more details on particular alternative tax systems, the relevant appendixes contain more in-depth treatment.

BACKGROUND

[5] Tax systems can have multiple goals. For example, in addition to the common goal of raising revenue for the government, goals can also include redistributing income, stabilizing the economy, and achieving various other social and economic objectives through the use of preferences. Generally speaking, the greater the number of goals, the more complex is the tax system.

Criteria and Trade-Offs Relating to the Design of a Tax System

[6] Tax systems are commonly judged and compared according to four criteria: equity, economic efficiency, simplicity, and administrability. A tax system is generally considered better than alternatives that raise the same amount of revenue if it is more equitable, more economically efficient, simpler for taxpayers to comply with, and easier and less costly to administer. /2/ In this report, we focus on simplicity and administrability and do not analyze equity and efficiency. In deliberating on any changes to the current tax system, Congress would need to consider each of the four criteria.

[7] Designing a tax system that is superior on each of the four criteria is difficult because the criteria frequently conflict with one another and trade-offs must be made. For example, a tax system that provides credits to low-income individuals may be judged by some to be more equitable than a system without this feature. However, if including credits makes it necessary for more individuals to calculate their income and file tax returns, the tax system could become more complex for both taxpayers and tax administrators.

The Current System

[8] The federal tax system raised about $1.4 trillion in fiscal year 1995 through individual and corporate income taxes, payroll taxes, various excise taxes on certain goods and services, and estate and gift taxes. Income taxes accounted for 62 percent of total federal tax revenue.

[9] The current income tax system includes an individual tax and a business tax. Wages, interest and dividend income, capital gains, and some types of business income, including that of sole proprietorships and partnerships, are taxed under the individual income tax. Individual income is taxed at graduated rates. Income earned by certain corporations is subject to a separate business income tax, also at different rates.

[10] The current system provides exemptions and different tax rates on savings and investment through a variety of special provisions, such as the preferential treatment of pensions, individual retirement accounts, life insurance, annuities, state and municipal bonds, and capital gains. The result is a hybrid income- consumption system of taxation that exempts some types of saving and investment from tax but taxes others. /3/

[11] The current system includes numerous other tax preferences. Examples include the earned income credit; specific deductions for home mortgage interest, charitable contributions, and state and local taxes; and exclusions of employer contributions for health insurance.

[12] Requirements for filing returns and performing other tax- related functions vary. All individuals with gross income above certain thresholds based on personal allowances and a standard deduction must file returns. Businesses have certain responsibilities beyond filing returns, including withholding and remitting employee income and payroll taxes, such as Social Security, Medicare, and unemployment taxes. Further, many businesses must send information returns to the Internal Revenue Service (IRS) and to individuals detailing income paid as wages, interest, and dividends.

[13] For more detailed descriptions of the federal income tax system, as well as its complexity and burdens for both taxpayers and tax administration, see appendix II.

Kinds of Alternative Tax Systems We Studied

[14] In the last several years, proposals for making fundamental changes to the tax system have been discussed by policymakers and tax experts in government, academia, and the private sector. An overview of tax reform design issues appears in appendix III. The alternative tax systems we studied are briefly described below and are further detailed in appendixes IV through VIII.

o A NATIONAL RST would generally be collected by businesses

o VATs, now widely used internationally, are business-level

o THE FLAT TAX discussed in this report would have both business

o A PERSONAL CONSUMPTION TAX would look much like the current

o INCOME TAX REFORM OPTIONS that would replace the current

RESULTS IN BRIEF

[15] The alternative tax systems we studied differ in their potential impacts on taxpayer compliance burden and tax administration. The different potential impacts of the tax systems can largely be explained by four basic design features: (1) the basis for taxation (income or consumption); (2) the type of taxpayer (individuals, businesses, or both); (3) preferential tax treatment (e.g., exemptions, special deductions, and credits) for certain individuals, businesses, or goods and services; and (4) the rate structure for individuals (single or multiple rates). Table 1 compares the design features of the tax systems we studied and shows:

     o Many of the alternatives, namely, a national RST, VAT, flat

     o Two consumption tax alternatives -- the national RST and the

     o Regardless of the base or the type of taxpayer, preferences

     o Finally, under income or consumption tax systems that include

TABLE 1: MAJOR DESIGN FEATURES OF ALTERNATIVE TAX SYSTEMS AND THE

                                            x

                          [Table continued]

_________________________________________________________________

National RST              x           N/A   N/A        N/A

                         FOOTNOTES TO TABLE

     /a/  Other than a tax rate of zero.

     /b/ Appendix VIII discusses options for taxing business

                      END OF FOOTNOTES TO TABLE

Source: GAO analysis of the designs of alternative and current tax

[16] The differences in the four basic design features of the tax systems we studied explain in large part the differing potential impacts of the tax systems on taxpayer compliance burden and tax administration. For example, consumption-based taxes, such as the national RST, VAT, flat tax, and personal consumption tax, would eliminate many of the issues of defining and recognizing income that complicate income tax systems and, in this respect, reduce taxpayer compliance burden and tax administration activities. This is because under an income tax, taxpayers would be required to establish depreciation costs for different types of assets, account for income earned but not necessarily received, and keep records on the value of assets over time. Conversely, under a consumption tax, taxpayers could generally rely on records of sales, of purchases, or of funds actually received to calculate their tax liability. Simplifying the determination of tax liability for taxpayers could simplify assessing compliance and providing taxpayer assistance for tax administrators.

[17] While different from income tax systems, the consumption- based systems could also differ from each other in their potential impact on taxpayer compliance burden and tax administration. For example, the personal consumption tax, requiring individuals to report their borrowing and saving, could be more burdensome for both taxpayers and administrators than other consumption-based systems. Another example involves a VAT and a national RST. Because all sales, not just retail sales, are included in a VAT, more recordkeeping and taxpayers could be required under a VAT than under a national RST. However, some experts believe that the additional records could make compliance assessment simpler for tax administrators.

[18] Tax systems that would tax only businesses, rather than individuals and businesses, could reduce taxpayer compliance burden and the costs of tax administration by greatly reducing the number of taxpayers required to file returns. With a VAT, a national RST, or a business-level income tax, only businesses would be responsible for determining tax liability, filing returns, and remitting taxes. Individuals' compliance burdens could be eliminated. Tax administrators could focus on many fewer taxpaying entities, thus reducing the numbers of returns processed, actions taken to collect taxes owed, and taxpayer questions needing answers. In addition, businesses would no longer be required to withhold individual tax and file many types of information returns.

[19] Tax systems that combine a business tax with a relatively simple individual tax, such as the flat tax or some versions of a reformed income tax, could add limited burden relative to a business- only tax. A simple individual tax, if administered largely through withholding and document matching, would have little need for the filing of individual tax returns. Tax systems requiring individuals to report more information about their personal finances, such as a personal consumption tax or a more complicated individual income tax, could add more burden than a business tax combined with a simple individual tax because more individuals could have to file tax returns and the returns would be more complicated. More tax returns and more complicated returns would make returns processing, assessing taxpayer compliance, and answering taxpayer questions more difficult for tax administrators.

[20] The alternative tax systems in table 1 could all incorporate tax preferences. But, incorporating tax preferences -- exemptions, special deductions, credits, or multiple rates on goods and services aimed at various economic and social goals -- would generally add complexity. Tax preferences generally increase taxpayer compliance burden by complicating the determination of tax liability, adding recordkeeping requirements, and creating incentives to engage in tax planning. Similarly, tax administration would be made more complicated because tax administrators would need more information and time to verify the accuracy of tax returns and collect taxes owed. Tax administrators would also face more questions from taxpayers.

[21] Tax systems with multiple tax rates for individuals, which could include income taxes and a personal consumption tax, do not need to add burden to taxpayers' calculation of tax liability compared to single-rate systems. Multiple rates for individuals add little to the burden of computing tax liability because the use of tax tables minimizes this burden. Rate schedules for multiple rate systems could include a zero rate or provide one implicitly through a standard deduction or personal exemptions. A zero rate or its equivalent would limit the number of taxpayers having to file returns and reduce the processing volume for tax administrators. However, tax systems with multiple rates could encourage tax planning, which would increase burden for taxpayers and make tax administration more complex.

[22] In addition to impacts due to the four basic design features, the transition to an alternative tax system could affect taxpayer compliance burden and tax administration. The extent of the impact would depend on the type of transition allowed. For example, if a consumption tax system were adopted, a transition might allow for the gradual phaseout of depreciation. In the event of such a transition, taxpayers and tax administrators could be required to keep and check records for both the old and the new systems, complicating the determination and verification of tax liability during the transition period.

MAJOR DESIGN DIFFERENCES AMONG ALTERNATIVE TAX SYSTEMS

[23] Table 1 lists four basic design features of the tax systems we studied: (1) the basis for taxation (income or consumption); (2) whether individuals, businesses, or both would be subject to tax; (3) whether tax preferences could exist for certain individuals, businesses, or goods and services; and (4) the rate structure for individuals (single or multiple rates).

An Income or Consumption Tax Base

[24] One major difference in the design of alternative tax systems is whether the tax base is income or consumption. An income tax system generally does not allow deductions for savings and requires that earnings on savings be measured and taxed as they are earned. Also, it generally requires that businesses depreciate their purchases of assets, that is, deduct the cost of assets over time rather than at the time they are purchased.

[25] Consumption-based tax systems differ from income-based tax systems in that they generally exempt from tax income from savings and investment. The national RST, VAT, flat tax, and personal consumption tax would achieve this exemption in different ways. Under a national RST, businesses would generally not pay tax on goods and services they buy. Under the VAT and the flat tax, businesses could immediately deduct purchases of goods and services, including purchases of plant and equipment, that they made from other businesses. Under a personal consumption tax, funds that are saved or invested would be deducted by individuals.

Type of Taxpayer

[26] Another major design difference among alternative tax systems is who would be subject to tax. Consumption and income taxes could be levied on individuals, businesses, or both. By levying tax directly on individuals, a tax system can make distinctions among individuals or households to account for varying individual circumstances by, for example, allowing deductions and multiple rates. Alternatively, a tax system could focus only on businesses and thus require fewer taxpayers.

[27] The alternative consumption tax systems we considered differ from one another according to who would be taxed.

o The national RST and the VAT generally would only tax

o The flat tax would collect much of the tax base from

o The personal consumption tax would continue to tax

[28] Similar to the national RST, VAT, or flat tax, an income tax could be designed to collect taxes from businesses rather than from individuals. Such an income tax could, for example, disallow business deductions for wages and free individuals from filing returns. It would collect tax on all or part of individuals' incomes where the incomes were generated and before they were paid. Other income tax options would, like the current income tax system and the personal consumption tax system, tax most types of income at the individual level. /5/

Preferential Treatment

[29] Each of the various alternatives could include tax preferences, although the types of preferences provided would differ among alternatives. These preferences could include special deductions, exemptions, and/or credits, as well as various tax rates on different types of income or goods and services.

[30] The types of taxpayers in a tax system would influence the type of preferences that could be allowed. Alternatives that tax individuals directly could include preferences designed to target specific groups of individuals. It would be more difficult for a tax system, such as a national RST or a VAT, that applied only to businesses to provide preferences for groups of individuals because businesses can apply different tax rates to goods and services but cannot distinguish among individuals. Preferences under business- level taxes could also include exemptions of specific types of businesses or activities.

Tax Rates

[31] The fourth design difference is the rate structure for individual-level income or consumption tax systems. The alternatives that we considered that include an individual-level tax -- the flat tax, the personal consumption tax, and several income tax options -- could tax different individuals at different rates. All these options could include what is, in effect, a zero tax rate by providing a standard deduction or personal allowances. For example, under the flat tax, individuals with wage income under the personal allowance amount would not owe any individual tax; wage income above the deduction or allowance amounts would be taxed at a single rate. Individual-level taxes in general could apply a single tax rate or multiple rates.

IMPLICATIONS OF THE ALTERNATIVE TAX SYSTEMS FOR TAXPAYER COMPLIANCE

[32] Because of differences in the four basic design features, the tax systems we studied would have different impacts on taxpayers' and tax administrators' responsibilities, and thus on taxpayers; compliance burden and the costs of tax administration. This section describes basic types of taxpayer and administration responsibilities and the potential effects of the alternative tax systems on each of them.

Taxpayers' and Tax Administrators' Basic Responsibilities

[33] The taxpayer compliance burden created by any tax system will depend on how many taxpayers have tax-related responsibilities, such as filing tax returns, and on what difficulties these taxpayers face carrying them out. Similarly, tax administration is affected both by the number of taxpayers and by the difficulty of carrying out administrative responsibilities related to each taxpayer. Table 2 shows the basic taxpayer and tax administration responsibilities we identified. /6/

 TABLE 2: BASIC RESPONSIBILITIES OF TAXPAYERS AND TAX ADMINISTRATORS

_____________________________________________________________________

File tax returns              Process filed returns and maintain

Determine correct tax         Devise programs, such as examination

Remit taxes owed              Collect taxes owed but not remitted

Get assistance, if            Assist taxpayers by answering specific

Source: GAO analysis of taxpayer and tax administrator responsibilities under tax systems in general.

[34] In many respects, tax systems that are relatively easy for taxpayers to comply with will also be relatively easy to administer, and alternatives that are relatively burdensome for taxpayers will also be more difficult to administer. For instance, the more taxpayers that have to file returns, the more returns the administrators must process and accounts they must maintain. Likewise, a system's complexity resulting from exemptions, deductions, and other preferences could affect taxpayers and administrators similarly by increasing their respective burdens.

[35] However, in some instances, burden could be shifted from government administrators to taxpayers or from taxpayers to government administrators. For example, U.S. businesses currently perform some duties to help ensure compliance, such as withholding and providing information returns, that tax administrators could do through other means.

POTENTIAL EFFECTS OF ALTERNATIVE TAX SYSTEMS ON TAXPAYERS' AND

[36] The overall costs to taxpayers and tax administrators of carrying out their basic responsibilities under the tax systems we studied are difficult to quantify. Even for the current income tax system, while IRS' administration costs are known, only very rough estimates exist for taxpayer compliance burden. This is because of the difficulty in separating accounting and recordkeeping costs for tax purposes from those that are incurred for other purposes and because taxpayers may not measure such costs. Estimates of taxpayer compliance burden for the current income tax vary widely, but all are many times larger than IRS' fiscal year 1998 budget of $7.8 billion.

[37] In a qualitative sense, changing from the current income tax system to an alternative system would potentially affect each of the basic responsibilities that taxpayers and tax administrators have. The following discussion of possible impacts on each area of responsibility precedes a table summarizing them and relating them to different tax systems.

Return Filing and Processing

[38] The tax systems we studied could differ significantly from each other in the number of returns filed by taxpayers and processed by administrators. Business-level tax systems generally have fewer filers than individual-level tax systems or systems that combine a business and individual tax. Business-level tax systems also generally require less information reporting.

[39] The current income tax system is relatively complex in the sense that some income is taxed at the individual level, some at the business level, and some at both levels. In 1995, taxpayers filed and IRS processed about 116 million individual tax returns, of which about 18 million reported income from a sole proprietorship. Another 6 million returns were filed by partnerships and corporations. Employers, investment institutions, and others sent IRS about 1.1 billion information returns, including withholding documents for wages and information on investment earnings.

[40] The alternative tax systems that would only tax businesses, such as the national RST or the VAT, would eliminate individual tax filing requirements. In addition, businesses would not be required to file information returns related to individuals. The total number of returns filed under these options would depend on how many businesses were subject to tax and on how frequently returns were required. For instance, while only businesses would be required to file tax returns under a national RST or a VAT, they could be required to file quarterly or monthly. Under a VAT, small businesses could be exempted, and under a national RST, wholesalers would not have to file tax returns.

[41] The alternatives that include a business tax and a relatively simple individual tax would likely require return filing by businesses and by some individuals. However, the number of individual returns filed and processed under these alternatives could be significantly less than under the current income tax system. Under a flat tax or one reformed income tax option, a "return-free" filing system could be feasible because wages and salaries would be the only type of income subject to tax for many individuals. These employees would not have to file returns if employers withheld tax on wages during the year and made any necessary adjustments in withholding at the end of the year so that the amount of tax withheld equaled tax liability. If these alternatives also featured large standard deductions or personal allowances, the need for individual returns would be further reduced.

[42] Under the personal consumption tax or certain reformed income tax options we studied, large numbers of individual tax returns and information returns could still be required. The individual tax under these systems would be relatively complex in the sense that many types of funds or income would be taxable for individuals. Withholding correct amounts of tax would be more difficult for employers and other businesses because final tax liability would depend on the total amount of income or funds individuals receive from many sources. Unless withholding was extended to other types of taxable funds, individuals would likely be required to account for all types of taxable funds on their tax returns, and employers and businesses could be required to provide information returns to both individuals and tax administrators. Under a personal consumption tax, additional information returns related to borrowing and saving could be required, resulting in increased burden for the businesses required to file the returns and for tax administrators.

Determining Correct Tax Amounts and Assessing Compliance

[43] Because of differences in the four design features we discussed earlier, the tax systems we studied would differ in the burden experienced by taxpayers in determining their tax liability and in the costs to tax administrators of assessing compliance.

[44] In terms of the first design feature, the basis for taxation, consumption-based taxes, such as the national RST, VAT, flat tax, and personal consumption tax, could make determining tax liabilities by taxpayers and, correspondingly, tax administrators' assessment of taxpayers' compliance simpler in some respects than income-based taxes. This is because many difficulties of defining and recognizing income would be eliminated. To measure income from saving and investment as it is earned, taxpayers have to estimate costs for depreciation, account for income earned but not necessarily received as cash, and keep records on the value of assets over time. Also, taxpayers could have to decide if expenses are deductible or must be capitalized. Similarly, tax administrators must be able to verify the income measurements required under an income tax. In contrast, consumption tax liability can generally be accurately calculated by taxpayers and verified by tax administrators by using records of sales, purchases, and funds actually received.

[45] Whether an income or consumption tax system includes an individual tax and how complex that tax is would also affect the ease or difficulty of determining taxes and assessing compliance. Under the flat tax and one income tax option we considered, many individuals would face relatively few recordkeeping responsibilities and determining tax liability would be relatively simple, especially if taxes on wages were withheld by businesses. Tax administrators could largely administer these individual taxes by checking that proper amounts were withheld or by matching individual tax returns with information returns. Based on experience with the current income tax system, compliance would likely be high and few audits of individuals might be necessary. In contrast, under alternatives with more complex individual-level taxes, recordkeeping and tax determination burdens would likely be higher. For example, under some individual income tax options, individuals would have to keep records or receive information reports for many types of income. Under a personal consumption tax, individuals could be responsible for keeping records on borrowing and saving and including these amounts in their tax calculations. More extensive document matching and auditing would probably be needed to ensure a high level of compliance.

[46] Even though a national RST and a VAT tax the same base- consumption -- and the same type of taxpayer -- businesses -- they could still affect assessing tax compliance differently. For a national RST and a subtraction VAT, administrators would have to rely on businesses' own records to verify that the proper tax had been paid. However, with a credit VAT, there would be a certain amount of checking available through records of other businesses; this is thought by some tax specialists to improve compliance. Also, based on state and international experience, many experts believe that including sales of all types in the tax base and allowing businesses to deduct or receive a tax credit for purchases from other businesses, as under a VAT or flat tax, would have some compliance advantages over a national RST. While including sales of all types in the tax base would require more recordkeeping and more taxpayers, it could better ensure that business purchases would not be overtaxed, taxes of sales to households would be reported, and a paper trail would be created so that compliance could be better assessed.

[47] Preferences -- that is, exemptions, deductions, credits, and multiple rates on goods and services -- could be part of any of the alternative tax systems we considered and could often complicate, but sometimes simplify, how tax liability is determined and verified. Preferences could force taxpayers to determine and tax administrators to verify whether an income or consumption item is taxable, nontaxable, deductible, or taxable at a different rate. The burdens associated with extensive use of preferences could include (1) more recordkeeping than otherwise, as was the case for the estimated 33 million individuals who reduced their tax liability by itemizing tax deductions for tax year 1993; (2) more time for determining and reporting tax liability; and (3) more tax planning by taxpayers. These burdens would require more audit time from tax administrators. On the other hand, in some instances, preferences given through exemptions could simplify taxpayers' burden. For example, if, as is commonly done with a VAT, large numbers of small businesses were exempted, they would not have to file returns or remit tax, thus easing their compliance burden. However, tax administrators would have to verify compliance by determining that only eligible taxpayers took the exemption.

[48] The fact that some tax systems -- the current income tax, versions of a reformed income tax, and the personal consumption tax -- have or could have multiple rates on individuals imposes little additional burden on taxpayers or tax administrators except to the extent that multiple rates encourage tax planning. Graduated rates alone have little effect on the actual tax calculation burden of taxpayers who can determine their tax liability through a tax table. Tax administrators still must verify that proper rates have been applied. However, multiple tax rates could encourage taxpayers to devote resources to tax planning in order to avoid high marginal rates.

Tax Remittance and Collection

[49] The issues related to this third area of taxpayer and tax administration responsibilities we discuss -- tax remittances and collections -- may not differ greatly among the tax systems we considered except that widely different numbers of taxpayers would be responsible for remitting the taxes. If individuals, including the 18 million individuals owning sole proprietorships, no longer had to file tax returns as individuals but only in their capacity as business owners, nonbusiness collection issues related to them would disappear. Similarly, if a simpler tax reduced the problems tax administrators found during examinations, or if changes in withholding or other information reporting reduced the number of mismatches requiring follow-up, tax administrators would be less likely to assess additional taxes they would then have to collect.

[50] In its responsibility for collecting unpaid taxes from taxpayers who filed but did not pay the required tax or who did not file required returns, in fiscal year 1995, IRS' collection function disposed of millions of taxpayer delinquencies. Business delinquencies most commonly involved employment taxes.

[51] An issue of concern to administrators in the current tax system involves businesses, particularly small ones, getting into financial difficulty and using collected taxes as working capital rather than remitting them to the administrators. This problem could continue under many of the alternatives we considered, including a national RST or a VAT, and it could be more pervasive if the amounts of taxes to be collected and remitted by businesses were higher than under the current income tax system or state sales tax systems. The amounts could be higher because specific businesses would be processing federal taxes on their sales in addition to their payrolls and could face a greater temptation to retain some of the money for their own use. More frequent remitting and filing could reduce noncompliance but increase the burden on businesses.

Taxpayer Questions and Assistance

[52] Although the universe of taxpayers who must file returns could change under the various alternatives, those who would still need to file would likely have questions that still needed to be answered. Even if a "return-free" tax system were adopted, questions about individuals' involvement with the system would still arise. However, the probable reduction in the number of taxpayers, particularly individuals, under some of the alternatives and the removal of certain complex provisions, such as defining and recognizing income and providing deductions, would likely reduce the overall level of assistance needed.

[53] On the other hand, the more complications introduced under any alternative tax system, such [as] those introduced with many preferences, the greater would be the need for tax administrator assistance in those areas. Greater assistance would also be needed for certain alternatives' distinctive complicating features, such as the personal consumption tax' reliance on borrowing and savings information. The more radical the departure from the current income tax system, the more likely that assistance or education would be needed in the short term.

[54] Table 3 provides primarily qualitative information about alternative tax systems in the four areas of taxpayer and tax administrator responsibilities we have just discussed. More detailed tables for each tax system are shown in appendixes IV through VIII.

   TABLE 3: POTENTIAL IMPLICATIONS OF ALTERNATIVE TAX SYSTEMS FOR

_____________________________________________________________________

           TAXPAYER AND TAX ADMINISTRATOR RESPONSIBILITIES

TAX SYSTEM ALTERNATIVE

     Current system

RETURN FILING AND PROCESSING

     In 1995, 116 million individual tax returns, including 18

DETERMINING CORRECT TAX AMOUNTS AND ASSESSING COMPLIANCE

     Need to define and recognize income; wide range of exemptions,

TAX REMITTANCE AND COLLECTION

     Collections needed from millions of nonfilers and filers without

TAXPAYER QUESTIONS AND ASSISTANCE

     Almost 111 million calls answered by IRS in fiscal year 1995.

_____________________________________________________________________

TAX SYSTEM ALTERNATIVE

     Reformed income tax alternatives

RETURN FILING AND PROCESSING

     For individual tax, number of filers contingent on amounts of

DETERMINING CORRECT TAX AMOUNTS AND ASSESSING COMPLIANCE

     Complexity owing to measuring capital income; continuing need to

TAX REMITTANCE AND COLLECTION

     For individual tax, most tax remitted by businesses through

TAXPAYER QUESTIONS AND ASSISTANCE

     Most current questions still relevant, unless individual-level

TAX SYSTEM ALTERNATIVE

     National RST

RETURN FILING AND PROCESSING

     Businesses, including at least 10 million retailers and service

DETERMINING CORRECT TAX AMOUNTS AND ASSESSING COMPLIANCE

     No need to define and recognize income; difficulties arising

TAX REMITTANCE AND COLLECTION

     Nonbusiness collection issues eliminated; delinquent amounts a

TAXPAYER QUESTIONS AND ASSISTANCE

     Fewer questions than under the current system because of

TAX SYSTEM ALTERNATIVE

     VAT

RETURN FILING AND PROCESSING

     About 24 million businesses (corporations, partnerships, and

DETERMINING CORRECT TAX AMOUNTS AND ASSESSING COMPLIANCE

     No need to define and recognize income; fraud potential related

TAX REMITTANCE AND COLLECTION

     Nonbusiness collection issues eliminated; tax payment spread

TAXPAYER QUESTIONS AND ASSISTANCE

     Fewer questions than under the current system because of

TAX SYSTEM ALTERNATIVE

     Flat tax

RETURN FILING AND PROCESSING

     Both individuals and businesses responsible for filing, though

DETERMINING CORRECT TAX AMOUNTS AND ASSESSING COMPLIANCE

     Compliance aided by no need to define and recognize income, by

TAX REMITTANCE AND COLLECTION

     Fewer delinquency problems for individuals likely if withholding

TAXPAYER QUESTIONS AND ASSISTANCE

     Taxpayer assistance on many complex issues unneeded owing to

TAX SYSTEM ALTERNATIVE

     Personal consumption tax

RETURN FILING AND PROCESSING

     Large number of individual filers likely; business filings or

DETERMINING CORRECT TAX AMOUNTS AND ASSESSING COMPLIANCE

     Many issues of defining and recognizing income eliminated;

TAX REMITTANCE AND COLLECTION

     Withholding possibly not closely matching tax liability, with

TAXPAYER QUESTIONS AND ASSISTANCE

     Questions on filing requirements, filing status, account

TRANSITION TO A NEW TAX SYSTEM

[55] A wide range of options exist for moving from the current income tax system to an alternative tax system, and the way that any transition is formulated could have significant effects for economic efficiency, equity, taxpayer compliance burden, and tax administration. Many transition issues involve how income and deductions related to saving done before the transition to the new system should be treated. Consumption taxes, while designed to encourage new saving, could tax existing saving when it is used for consumption; in general, existing saving would not be subject to tax again under the current income tax system. Special rules designed to exempt existing saving from tax could burden individuals with additional recordkeeping, filing, and tax determination requirements and create additional tax compliance issues for tax administrators. Another transition issue involves whether tax credits and other tax benefits already earned under the current tax should be made available under a new system. For example, what would happen to depreciation expenses for existing investments that businesses would have been able to deduct if the current tax were retained? Depending on how these and other compliance issues are addressed, taxpayer compliance burden and tax administration responsibilities could be greater in the transition period than when a new system is fully phased in. We discuss transition broadly in appendix III and on an alternative-by-alternative basis in appendixes IV through VIII.

OTHER ISSUES

[56] Other issues, many of which are hard to handle even now, could also have significant implications for both taxpayers and tax administrators under most, if not all, of the alternative tax systems we discuss. Some of these issues are (1) the extent to which employee benefits, such as employer-provided health insurance, should be included in the tax base; (2) how to deal with the special complexity and difficulty of taxing financial services; (3) how housing would be taxed; (4) whether governments and nonprofit organizations should be taxpayers and filers; and (5) how international activities would be taxed.

[57] Another important issue would be the relationship between federal tax filing and reporting requirements and those of states and localities, especially in those jurisdictions that currently piggyback on the federal income tax system. Changing the federal system could effectively force states to change or even abandon their own income tax systems because they depend on the federal tax infrastructure. For example, states depend on IRS' information reporting program and use income reported on federal tax returns as a starting point on state returns.

[58] These issues are discussed broadly in appendix III or in separate sections in the appendixes for the various tax system alternatives.

SCOPE AND METHODOLOGY

[59] To accomplish our objectives related to the different alternatives, we (1) studied relevant literature, (2) reviewed our previous reports covering taxpayer compliance burden and tax administration issues throughout the 1980s and 1990s, (3) held discussions with tax specialists inside and outside IRS, and (4) examined data related to current tax systems. The bibliography at the end of this report lists our major references on alternative tax systems. We did our work in Washington, D.C., between August 1995 and November 1997 in accordance with generally accepted government auditing standards. Our objectives, scope, and methodology are further discussed in appendix I.

[60] The alternatives included in this study were chosen because they represented different approaches that have emerged in public discussions about tax reform. They do not include all possible ways of changing the current income tax system. The report focuses on the implications for compliance burden and administration of replacing the current income tax system, although some advocates for changing the tax system have proposed replacing other taxes as well. The report does not analyze implications for the economy, such as effects on saving, work incentives, and economic growth, or for the distribution of the tax burden among different types of individuals.

AGENCY COMMENTS AND OUR EVALUATION

[61] We provided a draft of this report to the Secretary of the Treasury and the Acting Commissioner of Internal Revenue for comment. IRS deferred to Treasury, and responsible Treasury officials, including the Director of the Office of Tax Analysis, provided comments in a July 31, 1997, meeting. The Treasury officials had no major problems with the draft but suggested various points that we should emphasize, make parallel, or clarify. We have incorporated their comments as appropriate.

[62] We will send copies of this report to the Secretary of the Treasury, the Commissioner of Internal Revenue, other interested committees, and other interested parties on request.

[63] This work was done under the direction of Mark J. Gillen, Assistant Director for Tax Policy and Administration Issues; other major contributors are listed in appendix IX. If you have any questions, please call either one of us on (202) 512-9110.

Lynda D. Willis

James R. White

FOOTNOTES

/1/ For information on how comprehensive tax reform could affect the economy, see Congressional Budget Office, The Economic Effects of Comprehensive Tax Reform, July 1997.

/2/ Equity refers to value judgments about how to tax taxpayers with either similar or differing abilities to pay tax; thus, different people have different views of what constitutes a fair tax system. A tax is economically efficient if, in the absence of market failures or other distortions, it does not alter or distort incentives, such as incentives to save, work, and consume. See, also, Joint Committee on Taxation, Description and Analysis of Proposals to Replace the Federal Income Tax (JCS-18-95), June 5, 1995, pp. 58-59.

/3/ A consumption tax is designed to tax only income that is used for consumption, effectively exempting from tax income that is saved or invested.

/4/ Regardless of whether a tax is levied on individuals or businesses, individuals will ultimately bear the economic burden of any tax. For example, while an RST is levied on, or collected by, businesses, individuals are commonly thought to bear the economic burden of the tax through higher prices. Because this report focuses on compliance burden rather than on economic burden, we use the term TAXPAYER to refer to the individual or other entity on whom the tax is levied rather than to whoever bears the economic burden of the tax.

/5/ The various income tax options are described in appendix IV.

/6/ In this report, we do not focus on tax administrators' activities, such as monitoring private pension plans, that do not fall under one of the four basic responsibilities we describe. Similarly, we do not address whether new government spending programs that could require separate administration would replace certain activities now encouraged through the tax system.

END OF FOOTNOTES

                              CONTENTS

LETTER

APPENDIX I OBJECTIVES, SCOPE, AND METHODOLOGY

APPENDIX II CURRENT INCOME TAX

APPENDIX III OVERVIEW OF ALTERNATIVE TAX SYSTEMS AND DESIGN ISSUES

APPENDIX IV INCOME TAX REFORM OPTIONS

APPENDIX V NATIONAL RETAILS SALES TAX

APPENDIX VI CREDIT AND SUBSTRACTION VALUE-ADDED TAXES

APPENDIX VII FLAT TAX

APPENDIX VIII PERSONAL CONSUMPTION TAX

APPENDIX IX MAJOR CONTRIBUTORS TO THIS REPORT

BIBLIOGRAPHY OF SOURCES ON ALTERNATIVE TAX SYSTEMS

TABLES

FIGURE

ABBREVIATIONS

AMT    Alternative minimum tax

APPENDIX I

OBJECTIVES, SCOPE, AND METHODOLOGY

[64] Our work had two objectives. The first was to describe major differences in attributes among alternative tax systems. Our second objective was to describe how the alternatives, by incorporating these differences, may affect taxpayers' burden of complying with the tax laws and the government's responsibilities for tax administration. Taxpayers' compliance burden includes their filing the required returns, maintaining the necessary records to support the information reflected on those returns, and accurately calculating their tax liabilities in the face of whatever complexity the tax code presents. Tax administration responsibilities include processing taxpayer returns and maintaining accurate taxpayer accounts, verifying the accuracy of return information, collecting the proper amount of taxes owed and considered delinquent, and providing taxpayers with needed information or assistance. We selected the major alternatives we studied based on the ideas that have emerged in public discussions about tax reform.

[65] To accomplish our first objective -- describing the major differences in attributes among alternative tax systems -- we studied the literature related to the current income and sales tax systems and to various alternative tax systems that have been developed over the years. This literature included our own reports on income and consumption taxes and reports of other government organizations, journal articles, academic and research papers, and other materials related to the various alternatives. A bibliography of sources we used discussing alternative tax systems appears at the end of this report. We also attended tax conferences to enhance our understanding of these tax system alternatives and how they related to specific proposals that have emerged. In the report, we limited ourselves to discussing the basic features of each alternative system, knowing that any implementing details would have to evolve through the political process.

[66] In accomplishing the first part of our second objective -- describing how alternative systems might affect taxpayer compliance responsibilities -- we considered what categories of taxpayers might still have to file returns under the various systems. We also researched the literature for information that would enable us to analyze items, such as the amount of taxpayer recordkeeping and calculations that would be required in preparing tax returns, the type of information that would be included in the returns, and filing frequency. Finally, we pinpointed references in our previous reports to taxpayer compliance burden issues and assessed how these issues would be affected under new systems.

[67] We did similar work in accomplishing the last part of our second objective -- describing the alternative systems' potential impacts on tax administration. In reviewing the relevant literature, we specifically examined our previous reports covering various aspects of the tax systems and IRS. We also discussed specific administrative functions with tax specialists inside and outside IRS, reviewed data on IRS' recent administrative experiences from published sources and from within IRS, and studied summaries of state sales tax experiences. In analyzing the alternatives, we addressed (1) the administrative functions of returns processing, document matching and examination, collections, and taxpayer services; and (2) issues pertaining to transition, state tax administration, and international tax administration.

[68] In addition, to help accomplish the second objective, we interviewed officials of, and reviewed documents from, three state tax administrations and two state tax associations. The three states were New York, Florida, and New Mexico. We selected these three states based on suggestions from the Federation of Tax Administrators of states that were knowledgeable about issues we were examining. Because of the existence of actual sales tax systems in the various states and credit-invoice value-added taxes (VAT) in different countries, the collective experience with these taxes was more specific than the experience with other alternatives we were studying.

[69] Our intention in doing this study was to stress compliance and administration issues associated with the alternative systems using knowledge that we had accumulated throughout the 1950s and the 1990s. Our intention was not to examine other implications of the alternatives, such as their effect on the economy or on the distribution of the tax burden. Nor did we rank them against each other, assess the relative severity of the various implications, or weigh the administrative arguments and counterarguments regarding particular ideas.

[70] In identifying issues in as broad an arena as the potential impact of alternative tax systems on taxpayers and the potential implications for tax administration, we touched on some topics only briefly or not at all. For example, we did not do an in- depth analysis of the relationship of alternative systems to IRS sweeping Tax Systems Modernization plans. This IRS effort, inextricably linked with streamlining whatever IRS-administered tax system might exist, regardless of whether it modified or replaced the current income tax, involves years of work and billions of dollars. However, basic tax administration functions, such as returns processing, document matching and examination, collections, and taxpayer services, would still be in place under a new system. We did not try to estimate the resources or costs involved in administering any of the systems, regardless of how the modernization effort proceeded.

[71] Similarly, our study did not focus on the relationship of individual alternatives to the particular problems of taxpayer compliance and tax system administration for specific types of entities. For example, this report does not concentrate on the special considerations that would apply under different alternatives regarding the financial services industry and nonprofit organizations. It does, however, describe how financial and nonprofit services might present administrative difficulties under a consumption tax.

[72] In focusing on the effects on the agency primarily responsible for tax administration, we did not analyze the impacts on other agencies. For instance, we did not examine how the U.S. Customs Service's taxation of imports and tracking of exports would be affected. Nor did we evaluate the role of the Federal Reserve System in receiving payments under a new tax system.

[73] We requested comments on a draft of this report from the Secretary of the Treasury and the Acting Commissioner of Internal Revenue. IRS deferred to Treasury, and we met with Treasury officials on July 31, 1997, to discuss the report. Treasury's comments are characterized near the end of the letter of this report and incorporated into the letter and appendixes as appropriate.

[74] We did our work in Washington, D.C., between August 1995 and November 1997 in accordance with generally accepted government auditing standards.

* * * * *

APPENDIX II

CURRENT INCOME TAX

BACKGROUND

[75] In fiscal year 1995, IRS' revenues totaled about $1.4 trillion from a variety of sources. /1/ As shown in figure II.1, about half came from the individual income tax, more than three- quarters of which had been withheld by employers. About a third more arrived through employment taxes, with the largest component by far being Social Security and Medicare taxes under the Federal Insurance Contributions Act (FICA). Another 13 percent of IRS' total revenues resulted from the corporate income tax. /2/

FIGURE II.1: SOURCES OF IRS GROSS REVENUE, FISCAL YEAR 1995

Individual Income Tax

[76] As shown in table II.1, depending on its amount, individuals' income is taxed at five different rates, ranging from 15 to 39.6 percent, with most taxpaying individuals falling into the 15- percent tax bracket. Individuals in certain circumstances are not liable for any income tax at all and may even be eligible for the earned income credit, which can pay them money. The credit is available to low-income working people with children and, beginning in tax year 1994, to certain people without children.

TABLE II.1: ESTIMATED NUMBER OF TAX YEAR 1993 INDIVIDUAL TAX RETURNS

_____________________________________________________________________

Tax rate category                   Number of returns (in millions)

15 percent                                             65.6

                        FOOTNOTES TO TABLE II

     /a/ This form contained certain investment income reported by

     /b/ The number in this row does not equal the sum of the other

                          END OF FOOTNOTES

Source: IRS, Individual Income Tax Returns 1993.

[77] Individuals figure their income tax by going through a series of steps. First, they compute their taxable income by determining their filing status (e.g., single versus married); the exemptions to which they are entitled; their total income; adjustments to income; and deductions from income, either a standard deduction based on filing status or deductions itemized to their specific circumstances. They then use their taxable income to compute their tax liability, which may be adjusted by, among other items, tax credits and other taxes such as the alternative minimum tax (AMT).

Corporate Income Tax

[78] Corporations determine their income tax in the same basic way as individuals do: they subtract various deductions from their income to reach taxable income, and they compute their final tax, considering AMT if needed. The corporate AMT is intended to ensure that taxpayers with substantial economic income or with positive financial statement income in a given year remit tax for that year. Deductions subtracted from income in computing regular taxable income include the cost of goods sold, wages, interest, contributions to employee benefit programs, and depreciation of assets, such as equipment whose full value cannot be deducted immediately. Depreciation spreads the cost of such assets over time to reflect their benefits in the periods the businesses use them. Depending on their taxable income, corporations remit regular tax (as opposed to AMT) using four rates, ranging from 15 to 35 percent.

Relationship to State and Foreign Income Taxes

[79] For reasons of simplicity and compliance, state income tax systems greatly depend on the federal system. According to the Federation of Tax Administrators, 37 states (including the District of Columbia) with an individual income tax use either the individual's federal tax liability, taxable income, or adjusted gross income as a starting point for the individual's state income tax computation. Forty-two of the 47 jurisdictions with a corporate income tax start their calculations with the corporations' federal taxable income. In addition, as the Multistate Tax Commission has pointed out, states rely on federal information reporting and withholding rules for their own administrative purposes and depend extensively on federal audits of taxpayers. /3/

[80] Both U.S. individuals and corporations are subject to U.S. income tax on their worldwide taxable income. If they remit foreign income taxes on foreign-source income, they may, in a complicated calculation, generally take foreign tax credits against U.S. income tax imposed on that income. The United States has a network of about 50 bilateral tax treaties that cover how nations interact on the income tax.

IMPACT ON TAXPAYERS' COMPLIANCE BURDEN

[81] As taxpayers strive to comply with federal, state, and local tax requirements, they spend time, incur costs, and experience frustration. We refer to this time, cost, and frustration as taxpayer compliance burden. Table II.2 summarizes key aspects of the burden, which can vary from little to great from taxpayer to taxpayer, that taxpayers experience under the current income tax.

 TABLE II.2: SUMMARY OF SOME KEY ASPECTS OF THE COMPLIANCE BURDEN OF

_____________________________________________________________________

Burden                    Characteristics of the burden

Burden on individual taxpayers

  Return filing         116 million returns filed in 1995

Burden on business taxpayers

  Return filing         24 million returns filed in 1995

Documents Filed

[82] One indicator of this burden is that every year taxpayers and others file millions of documents with IRS, with some filing one and others filing many. For example, in 1995, individuals filed 116 million personal income tax returns, with most of them including salaries, wages, or pensions. /4/ These individuals included 18 million schedules for sole proprietorships. Because corporations and partnerships filed another 6 million income tax or income returns, the total number of business returns filed was 24 million. In addition, employers submitted 29 million employment tax returns. Finally, as table II.3 shows, employers, financial institutions, and others filed 1.1 billion information and withholding documents, which ease the burden recipients would bear if they had to generate the information on their own. Documents, such as wage and various other income statements, are important for compliance purposes but not very burdensome for recipients to retain, although employers must generate them. Although almost all information returns were filed with IRS in nonpaper format through magnetic tape filing, electronic filing, or diskette filing, most business income and employment tax returns and most individual tax returns were not filed electronically.

   TABLE II.3: INFORMATION AND WITHHOLDING DOCUMENTS FILED IN 1995

_____________________________________________________________________

W-2: Wage and Tax Statements                                      205

Source: IRS, Calendar Year Projections of Information and Withholding

[83] Although in recent years over 100 million individuals filed income tax returns annually, as table II.4 shows, most of them did not report many common income, adjustment, deduction, and credit items every year. For instance, for tax year 1993, most of the 114.6 million individuals who filed did not claim such items as capital gains or losses, rental income, itemized deductions, the earned income credit, or the foreign tax credit, minimizing their compliance burden. And, although almost 33 million individuals itemized their deductions and included themselves in the millions of taxpayers filing supplemental forms and schedules, relatively few of those itemized, for instance, miscellaneous deductions that generally involve much taxpayer time and recordkeeping whether claimed or not. Over a lifetime, of course, circumstances could allow taxpayers to include many items on their returns that do not show up every year.

  TABLE II.4: ESTIMATE OF INDIVIDUALS REPORTING DIFFERENT ITEMS ON

_____________________________________________________________________

[84] Another indicator of the tax system's impact on taxpayers is how often they must file returns and remit taxes -- the greater the frequency, the more the burden. Generally, individuals must file annually, even though their wages and salaries may be withheld throughout the year. Individuals, including sole proprietors, however, did file 36 million estimated tax returns in 1995, and they paid estimated taxes as many as four times during the year. Businesses generally file income tax returns annually and often remit estimated tax four times a year. They also withhold income, Social Security, and Medicare taxes from their employees periodically, file quarterly employment tax returns, and transfer the funds withheld to a financial institution monthly, semiweekly, or even more often depending on the amount of tax.

Records Kept

[85] Another burden of complying is that individuals and businesses must keep records supporting their tax returns. For instance, individuals should keep receipts, canceled checks or other proof of payment, and documentation to support any deductions or credits claimed. Similarly, for small businesses, IRS requires that records be kept to support the income, expenses, and credits reported. IRS believes, though, that generally these are the same records needed for businesses to monitor themselves and prepare financial statements. Nevertheless, the corporate tax return does have a schedule on which the taxpayer reconciles the income or loss shown on its books with that shown on its tax return. The schedule includes such items as depreciation and contribution carryovers.

[86] Individuals and businesses can use various methods of accounting, although many businesses are precluded from using the cash method for tax purposes. Instead, they use the accrual method, designed to match income and expenses in the correct year. The accrual method is required when income-producing inventory is involved.

[87] Keeping the right documentation has been a problem for some taxpayers. We found this, for example, when we reviewed 185 Tax Court petitions dealing with "ordinary and necessary" business expenses related to a taxpayer's trade or business. For sole proprietors, small and medium-sized corporations, and individuals claiming employee business expenses, the most frequent source of disagreement with IRS in those petitions was the adequacy of documentation for a given expense deduction. These disputes were especially frequent where the documentation requirements were the most rigorous -- for entertainment, travel, meals, and automobile expenses. /5/

[88] In another example, we found that the test that taxpayers used to claim other people as dependents on their tax returns was too complex and burdensome for them to voluntarily comply with. The test required taxpayers to maintain detailed records and make complex calculations. According to our estimates, 43 percent of taxpayers that IRS found had not met the dependent support test did not have adequate records to show whether they provided the necessary support. /6/

Level of Simplicity or Complexity

[89] The forms that taxpayers need to file vary with the circumstances, as does the use of paid preparers. In 1994, we reported that IRS publishes about 400 tax forms and accompanying instructions each year. More detailed guidance is provided in about 100 publications. /7/ Still, as reflected in table II.4, most individuals file relatively basic forms, such as the estimated 71 percent of about 115 million individual filers for tax year 1993 (almost 81 million) that took the standard deduction as opposed to itemizing deductions and needing a separate schedule.

[90] As shown in table II.5, for tax year 1993, 48 million of 115 million individuals (42 percent) filed the Form 1040EZ or the Form 1040A instead of the standard Form 1040. As table II.5 further shows, although these individuals filed income tax returns designed to be easier than the standard return, they still sometimes paid preparers to complete them. In all, about half of all individual tax returns had a paid preparer's signature on them. Some of the taxpayers who filed the simpler forms and claimed the earned income credit may have paid a preparer simply as a way to file their returns electronically and get their credit early.

    TABLE II.5: INDIVIDUAL TAX RETURNS SHOWING A PAID PREPARER'S

_____________________________________________________________________

1040EZ                         20.4              1.5               7%

                       FOOTNOTE TO TABLE II.5

     /a/ These numbers are estimates based on samples.

                           END OF FOOTNOTE

Source: IRS, SOI Bulletin (Winter 1995-1996).

[91] The complexity of the tax code, itself, is a major reason why federal tax compliance is burdensome. It stems from areas such as depreciation requirements, which all 17 businesses we interviewed for testimony told us caused them to keep some detailed records solely for tax purposes; uniform capitalization rules and the AMT requiring time-consuming calculations; and inventory, foreign income, and capital gains calculations. /8/ In 1994 testimony, IRS noted that the code had grown from 504 pages in 1939 to over 2,700 pages, and this did not include implementing regulations. A guiding principle we have stated regarding tax rules and compliance is "the simpler . . . the better." /9/

[92] Much of the complexity of the tax code stems from the difficulties faced in defining income and determining when to recognize it on the tax return. For instance, the complexity surrounding calculations and records needed for determining capital income is great, creating accompanying compliance and administrative costs. To determine capital income, taxpayers must separate capital gains from ordinary income, determine depreciation, and decide if expenses are deductible or must be capitalized. Complexity is also created by the tension between the ideal economic definition of income -- changes from one year to the next in asset value -- and the need to recognize income only when it is actually realized -- in a market transaction, such as a sale of stock. For instance, the tax law has provisions to keep taxpayers from borrowing money to buy assets, deducting the interest, and not paying current tax on the assets' appreciation. This contributes to different kinds of interest expense being treated differently for tax purposes. /10/

Interaction of Taxpayers and Tax Administrators

[93] A final aspect of the current system's (and any system's) burden on taxpayers is the amount and nature of interaction the public has with tax administrators. As we allude to later, taxpayers annually experience millions Of IRS notices; more than a million examinations; when delinquent, hundreds of thousands of tax liens placed against their assets; and millions of unanswered telephone calls. Neither we nor IRS know the level of any alleged IRS "abuse" of taxpayers through the public's interactions with IRS employees. When we studied the issue in 1996, IRS, while improving certain controls, had not yet established a capability to capture management information that is needed to ensure that abuse is identified and addressed. /11/

Estimates of Compliance Costs for Existing Taxes

[94] As described in appendix III, compliance cost studies in general have been limited by different factors. These factors include the difficulty in differentiating between recordkeeping for tax purposes from recordkeeping that would have been done anyway and the difficulty in generalizing to all taxpayers from surveys with low response rates.

[95] Because of the importance of the issue of compliance costs and their possible magnitude, various efforts have been made to measure compliance costs. These included several academic studies of compliance costs for U.S. income taxes, a study of paperwork burden of U.S. taxes done for IRS, and recent estimates based on the IRS- sponsored burden study.

Studies of Compliance Costs of U.S. Taxes

[96] Several compliance cost studies have been done by Joel Slemrod of the University of Michigan and co-authors. /12/ Two studies were done on compliance costs for the individual income tax, and one study was done on compliance costs for large corporations, all using mailed questionnaires. The studies of the individual income tax surveyed Minnesota residents; the more recent of the two studies found that on average taxpayers spent about 27 hours on federal and state income tax matters and spent about $66 on tax assistance and other expenses. The study also obtained information on the wages of the respondents to place a value on the time spent on taxes.

[97] The consulting firm Arthur D. Little studied paperwork burden for IRS in 1984. /13/ The Little study used questionnaires to gather information on how much time individuals and businesses spent in 1983 to meet tax filing requirements. Individual costs were also measured through a diary study, in which taxpayers were asked to contemporaneously record costs as they occurred rather than recall costs. For businesses, burden categories included recordkeeping, getting advice and learning about filing requirements, obtaining materials, finding and using tax preparation services, preparing the tax return, and filing the tax return. For individuals, burden categories included recordkeeping; learning about the tax law; preparing the tax return; and copying, assembling, and sending the return to IRS. Little obtained a 65-percent response rate from the individual questionnaire and a 37-percent response rate to the business questionnaire.

[98] The purpose of the Little study was to gather data and develop a methodology that IRS could use to estimate the average number of hours taxpayers spend to complete particular tax forms. To do this, Little used a statistical analysis to find variables, such as the number of lines on a tax form and associated worksheets and the number of attachments required, that could predict the level of burden found in the questionnaires. /14/ While several models were evaluated, the models ultimately chosen were those that could be easily updated by IRS rather than those that best predicted the survey results. The study noted that "in a few instances significant accuracy was sacrificed by selecting a simplified model" over a more complicated and accurate model. As a result, IRS estimates of recordkeeping burden for a business tax form are only dependent on the number of lines on the form and associated worksheets, and the estimated time for preparing a form is dependent on the number of lines on the form and worksheets, the number of references in the instructions to the Internal Revenue Code and accompanying regulations, and the number of attachments that are requested. One researcher has called these models "transparently implausible" and also pointed out that the model estimates of burden for corporations and partnerships in 1983 were five times higher than the results found in the survey for the same year. /15/

Recent Estimates of Compliance Costs of Current Tax System

[99] Two authors have used the paperwork burden hours estimates from the IRS models to estimate income tax compliance costs in terms of both hours and dollars. To convert hours of burden into an estimate of the dollar value of these hours, the authors generally multiplied the hours estimate by an amount representing the time value of each hour. The estimates therefore rely on the underlying IRS methodology and are sensitive to the hourly dollar amount used. In theory, the dollar value chosen should represent the opportunity cost of spending an hour on tax matters; for individuals, for example, this could be an additional hour of wages, the value of an hour spent in a leisure activity, or the hourly amount that an individual would be willing to pay to not have to calculate taxes.

[100] Arthur Hall of the Tax Foundation, citing IRS and Office of Management and Budget historical data, recently estimated that taxpayers would spend about 5.3 billion hours complying with federal tax laws in 1996. Hall then applied an hourly rate of $42.40 to this hours estimate to obtain an estimate of $224.7 billion of compliance costs for the entire federal tax system. /16/ Based on his calculations, he asserted that at least 70 percent of this cost was due to the income tax. Applying this 70 percent to the total burden would make income tax compliance costs $157 billion for 1996. Hall estimated that business compliance costs would be $105 billion, leaving individual compliance costs at about $52 billion.

[101] In his book and in testimony before the Ways and Means Committee, James Payne also made estimates of compliance burden resulting from the tax system. In his 1993 book, Payne estimated that federal compliance costs in 1985 amounted to $159.42 billion. /17/ This estimate was made by multiplying the Little model estimates of 5.4 billion taxpayer burden hours for 1985 by an hourly value of $28.31 (an average of IRS and Arthur Andersen labor costs) and adding an estimate for tax preparer costs. In 1995 testimony, Payne estimated that taxpayer burden in terms of hours for 1995 was 10.2 billion hours. /18/ The increase in the estimate reflected, in part, increases in the number of taxpayers and an increase in total burden of 3.7 percent in each year from 1985 through 1995, based on findings in Blumenthal and Slemrod (1992) that individual burden had increased by 26 percent from 1982 to 1989.

[102] Recently, Slemrod offered what he described as "back-of- the-envelope" estimates of the compliance costs of the income tax, based on his views on the strengths and weaknesses of the existing evidence. /19/ Adjusting the results from the 1989 Blumenthal and Slemrod survey of individual taxpayers and using $15 for the per hour cost, Slemrod estimated that the cost of the individual income tax was probably around $50 billion. He also estimated that businesses (partnerships and corporations) spend about 800 million hours complying with taxes, a figure in line with the results of the Little survey rather than derived from the IRS model estimates. Valuing business hours at $25 per hour, Slemrod estimated the cost of compliance for these businesses at about $20 billion.

IMPACT ON TAX ADMINISTRATORS

[103] Table II.6 summarizes some of the key impacts of the current income tax system on tax administrators.

           TABLE II.6: SUMMARY OF SOME KEY IMPACTS OF THE

_____________________________________________________________________

Item           Characteristics of the Current Income Tax

Number of      Hundreds of millions of returns and other materials

Refund         92 million refunds issued in fiscal year 1995

Examination    Tax returns matched with information returns; fiscal

Compliance     Compliance problems related to income definition,

Collections    Millions of taxpayer delinquent investigations and

Individuals'   Millions of taxpayer inquiries fielded, covering a

                       FOOTNOTE TO TABLE II.6

     /a/ Transfer prices are prices companies charge related parties

                           END OF FOOTNOTE

Source: GAO analysis of available information about the current

[104] Table II.7 shows IRS' fiscal year 1996 actual budget along functional lines to help put the discussion that follows into perspective.

               TABLE II.7: SUMMARY OF IRS' FISCAL YEAR

_____________________________________________________________________

Returns        20,460       19%          $781             11%

Note 2: The budget for IRS' appeals function is included in the

Source: IRS fiscal year 1998 budget estimates, Feb. 6, 1997.

Processing of Returns

[105] When IRS annually receives the hundreds of millions of returns, remittances, and other materials from taxpayers and others, the first thing it must do is process them. Returns processing includes (1) receiving, sorting, and establishing controls over the materials; (2) editing, perfecting, and coding them for transcription onto computer tape; (3) transcribing, verifying, and correcting tax document information; (4) maintaining accounting records for assessments, collections, receivables, refunds, and other transactions affecting taxpayer accounts; and (5) preparing correspondence to taxpayers. IRS' fiscal year 1996 budget for returns processing was almost $800 million for more than 20,000 full-time equivalent positions.

[106] IRS' returns processing workload is primarily affected by the number of returns filed and the work needed to prepare those returns for posting to taxpayer accounts. For instance, according to IRS data, it takes significantly fewer keystrokes to enter data into the computer from a paper Form 1040EZ and Form 1040A than from an average Form 1040. Although generally more and more tax returns are being filed electronically and processed by computer, thus minimizing the human effort needed to prepare them for posting, the vast majority of returns are still filed on paper and processed manually by IRS. Consequently, a significant part of IRS' returns processing effort involves error correction because returns filed on paper and processed manually are more prone to errors by both preparers of the returns and the IRS staff processing them.

[107] Statistics on the number of notices sent and refunds given to taxpayers illustrate the level of IRS activity involved in processing returns. For instance, as we noted in a 1994 report, IRS sent more than 60 million notices to taxpayers in 1993 concerning the status of their tax accounts. /20/ (Recently, IRS announced a dramatic reduction in the number of notices to be sent.) Similarly, in fiscal year 1995, IRS issued 92 million refunds to taxpayers.

Matching and Examination Programs

[108] A taxpayer's most likely enforcement contact with IRS is receiving word about a computer match of income reported on his or her return with information returns provided to IRS by third parties. These third parties include employers and payers of interest and dividends. Discrepancies between the amounts reported on the tax return and the information return indicate potential underreporter cases. When a tax return is not filed for income that is reported on an information return, IRS is to establish a nonfiler case. IRS' fiscal year 1996 budget for document matching was $73 million and about 2,100 full-time equivalent positions.

[109] As another part of its enforcement efforts, IRS' examination function, funded in fiscal year 1996 at almost $1.6 billion and about 27,000 fun-time equivalents, administers a nationwide audit program to see if taxpayers correctly determined their tax liabilities. One of the ways IRS selects returns to audit is by using a system that scores each return's audit potential. After learning the results of an audit, taxpayers may agree with the findings, appeal them through IRS' appeals function, or take IRS to court. As shown in table II.8, in fiscal year 1995, IRS had many different kinds of examinations, with an overall examination coverage rate of 1.36 percent. Although many more examinations were done of individuals than of corporations, corporate examinations took much longer.

       TABLE II.8: IRS' FISCAL YEAR 1995 EXAMINATION COVERAGE

____________________________________________________________________

Individual                 114,683             1,919           1.67%

Employment                  29,298                54            0.18

Source: IRS, 1995 Data Book.

[110] Although IRS does not generally track noncompliance by subject matter through its examination program, it does know quite a bit about taxpayer noncompliance. Its knowledge comes from its random, though dated, detailed audits of tax returns through its Taxpayer Compliance Measurement Program and from other sources. As we testified using 1988 IRS estimates of tax year 1992 compliance, individuals voluntarily paid 83 percent of the income taxes they owed, and corporations remitted 81 percent. /21/ In addition, as shown in table II.9, according to IRS estimates, compliance was not uniform across groups of taxpayers. IRS data show that compliance was highest for individuals where there was tax withholding, a little lower where there was information reporting to IRS, and much lower where there was neither. The complexity of tax rules was another factor influencing the level of compliance, with a more complicated tax code allowing more opportunities for disagreement over the "fine points" of the law.

            TABLE II.9: PERCENTAGE OF EARNINGS CATEGORIES

_____________________________________________________________________

                                        Is infor-

Wage earners          97 percent of         Yes               Yes

Interest recipients   90 percent of         Yes                No

Dividend recipients   87 percent of         Yes                No

Self-employed (sole   36 percent of         No                 No

Informal suppliers    11 percent of         No                 No

Source: GAO/T-GGD-95-176.

[111] Variations in compliance patterns also existed in the corporate sector. Small corporations, whose compliance level for 2.3 million firms was 61 percent for tax year 1987 (down from 81 percent for a smaller number of tax year 1980 firms), tended to mirror the compliance patterns of sole proprietors. Underreported income was the biggest compliance problem and enough documentation was often a difficulty. Large corporations, in contrast, tended to have issues associated with the ambiguity and complexity of the tax code. Table II.10 shows, as of late 1995, the largest open examination issues in the examination program covering various tax years for the nation's largest corporations.

                TABLE II.10: LARGEST OPEN EXAMINATION

____________________________________________________________________

Dollars in billions

                                 Proposed IRS adjustments to income

Transfer pricing                                       $7.2

Availability of the installment

Deductibility of trade or business expenses             3.4

Deductibility of capital expenditures                   3.4

Depreciation                                            1.9

Source: IRS.

[112] In 1988, IRS estimated a "tax gap" of as much as $127 billion between tax year 1992 income taxes owed on income from legal sources and income taxes voluntarily remitted. This gap did not include taxes that go uncollected from illegal activities, such as drug dealing and prostitution. Thus, the gap reflected part of the underground economy -- the legal transactions that occurred without being reported to the tax agency -- but not the other part -- the illegal transactions. As shown in table II.11, IRS attributed about three-fourths of the tax gap to individuals and about one-fourth to corporations.

     TABLE II.11: 1988 GROSS TAX GAP ESTIMATE FOR TAX YEAR 1992

____________________________________________________________________

Dollars in millions

Individual tax gap                   $93,994                  73.9%

[113] In 1996, IRS presented new estimates of the individual income tax gap, this time using compliance data for tax years 1985 and 1988, as opposed to 1982. The gap consisted of a nonfiling gap, or tax liability owed by those not filing required returns voluntarily and in a timely manner; an underreporting gap, or liability not voluntarily reported by filers; and an underpayment gap, or liability reported but not paid voluntarily and in a timely manner.

[114] As shown in table II.12, the largest dollar components of the underreporting part of the individual tax gap (covering underreported income and overstated deductions and credits) were ranges related to nonfarm proprietor income and informal supplier income. The items with the highest reporting noncompliance, as shown by the ranges of net misreporting percentages, were informal supplier income, tax credits (reflecting overreporting of the earned income credit), nonfarm proprietor income, farm income, and income from the sale of business property.

              TABLE II.12: 1996 RANGES OF ESTIMATES OF

_____________________________________________________________________

Dollars in billions

                                                     Net misreporting

Nonfiling gap                     $13.5     $13.8    N/A          N/A

                          FOOTNOTE TO TABLE

     /a/ net misreporting percentage is the ratio of the net amount

                           END OF FOOTNOTE

Source: Federal Tax Compliance Research: Individual Income Tax Gap

[115] According to a 1993 IRS report on the EMPLOYMENT tax gap, noncompliance with employment taxes was relatively low except in the self-employment area. For self-employment taxes estimated for tax year 1987, the tax liability not paid voluntarily was more than half the "true" tax liability. This estimated ratio of unpaid liability to true liability was projected to remain relatively stable for tax years 1984 through 1997.

[116] Although for FICA taxes the equivalent 1987 estimated ratio of unremitted liability to true liability was only about 4 percent, almost all of the underreported wage and salary part of the FICA tax gap was attributable to misclassification of employees. In June 1996, we testified that from fiscal year 1988 through fiscal year 1995, IRS' almost 13,000 Employment Tax Examination Program audits resulted in reclassifying 527,000 workers from independent contractors to employees. /22/ Common-law rules for classifying workers as employees or independent contractors were unclear and subject to conflicting interpretations. IRS' strategy is to reduce independent contractor noncompliance by requiring businesses to treat misclassified independent contractors as employees subject to withholding taxes. Efforts to improve the misclassification situation were continuing during our review.

[117] Just because IRS proposes adjustments does not mean taxpayers will agree. In 1993, we reported on the most prevalent issues appealed by taxpayers. As of September 30, 1992, out of about 12,000 disputed relatively large issues that IRS stated were predominately corporate, almost a quarter involved trade or business deductions, gross income, or depreciation. /23/ Similarly, of all the cases contained in Tax Analysts' Index to U.S. Tax Court Petitions and Complaints Filed in the Court of Federal Claims and the 94 U.S. District Courts During 1993, about a third of the pages of listings involved just two Internal Revenue Code sections -- those dealing with gross income and trade or business expense deductions. When we analyzed appealed trade or business deductions in a separate report, we found that large corporate taxpayers disagreed with IRS most frequently over the issue of capital expenditures, more specifically over whether large expenses were immediately deductible. /24/ IRS was unable to provide us with a breakdown by subject matter of all 219,000 cases closed by its Chief Counsel in fiscal year 1994.

Collection Activities

[118] With a fiscal year 1996 budget of almost 18,000 full-time equivalent positions and about $850 million, IRS' collection function is responsible for collecting taxes from taxpayers who did not file required returns or those who filed returns but did not remit the required tax. Its first step is to notify taxpayers in writing and ask them either to remit outstanding taxes or to file unfiled returns. If taxpayers do not respond at the notification stage, IRS generally refers the cases to its automated call sites, where IRS employees may telephone taxpayers to ask for remittance. At that time, balance-due accounts are referred to as taxpayer delinquent accounts (TDA), and nonfiler cases are called taxpayer delinquency investigations (TDI). If telephone calls are not successful, IRS revenue officers must try to collect higher priority cases through personal visits to taxpayers and other collection enforcement actions. The cases may be resolved in many ways, ranging from taxpayers' voluntarily making full remittances to IRS' taking actions involving hens, levies, or seizures. As an example of the volume of activity that is involved, in fiscal year 1995, IRS issued about 800,000 notices of tax liens, sent out 2.7 million notices of levies, and made 11,000 seizures.

[119] IRS is involved with millions of TDA and TDI cases, although not all of them eventually need the attention of IRS collection officials. In fiscal year 1995, IRS disposed of 4.2 million TDAs and 1.7 million TDIs. About two-thirds of the accounts were for individuals, and about three-quarters of the business accounts related to employment tax returns. The business returns most commonly resulting in investigations were also employment tax returns. According to an IRS official, businesses holding employment taxes are tempted to keep them to overcome cash shortfalls.

[120] Our high-risk series 1995 report on IRS' accounts receivable illustrates how the problems in different IRS functions affect each other and therefore how a change in problem levels can affect a tax administrator's other operations. /25/ We pointed out that if returns processing did not properly account for a taxpayer's remittance, collection personnel may have to try resolving an invalid account receivable. /26/ Similarly, if an IRS compliance effort overstated a taxpayer's liability, it would make additional work for collection personnel with no guarantee of revenue generation.

[121] Concerning IRS' accounts receivable, we reported that individual taxpayers with primarily nonwage income owed about three- quarters of IRS' September 30, 1993, tax debt owed by individual taxpayers of $79.2 billion. Half of the total debt was owed by taxpayers whose primary source of income was from self-employment (27 percent) or from interest and dividends (23 percent). /27/

Taxpayer Services

[122] With a fiscal year 1996 taxpayer services budget of about 8,000 full-time equivalents and $500 million, IRS did various things to try to help taxpayers comply with tax laws. In fiscal year 1995, for example, it answered the telephone in almost 111 million instances to provide various forms of assistance. For instance, although IRS received many more calls than it was able to answer, IRS personnel staffing its toll-free system did respond to almost 38 million procedural, account, and tax law calls. Of these contacts, IRS disposed of over 29 million account calls concerning tax bills and notices, and it handled almost 8 million calls on tax law matters, which included technical tax information related to specific laws and regulations. IRS estimated that 8 different categories each covered almost 10 percent of the tax law calls, with each call being counted only once. These categories were (1) filing information; (2) dependents, exemptions, and filing status; (3) individual income; (4) individual business income and deductions; (5) capital gains and losses; (6) pensions and deferred compensation; (7) individual deductions and adjustments; and (8) tax computation, credits, and payments. Thus, not only did the tax law calls fall into a number of similarly sized categories, but also each category comprised only a very small percentage of the 38 million toll-free calls answered.

[123] Tele-tax is another form of IRS telephone assistance, one through which taxpayers can receive recorded tax information on the status of their refunds and on many tax law issues. In fiscal year 1995, IRS counted about 61 million "hits," or tape menus accessed by callers, about double the year before. According to an IRS official, 80 to 90 percent of these hits involved questions about refunds. Refunds were especially problematic in 1995 when IRS enhanced its efforts to ensure the appropriateness of refund claims, resulting in millions of refunds being delayed and much adverse reaction. For the hits that did not involve refunds, IRS supplied us with lists of topics accessed by taxpayers for the years ended in June 1994 and June 1995. Other than general subjects, topics receiving more than 75,000 calls and thus ranking in the top 15 of the 1995 list were (1) electronic filing; (2) dependents; (3) medical and dental expenses; (4) earned income credit; (5) menu of filing requirements, filing status, and exemptions; (6) filing status; (7) which form 1040, 1040A, or 1040EZ; (8) business entertainment expense; (9) moving expenses; (10) child and dependent care credit; and (11) collection issues.

[124] In fiscal year 1995, IRS also provided over 4.2 million people with taxpayer education programs. It reached over 80 percent of them through the Volunteer Income Tax Assistance and Tax Counseling for the Elderly Programs and the rest of them through a community outreach program, small business workshops, and tax practitioner institutes.

FOOTNOTES TO APPENDIX II

/1/ This amount is before considering refunds of $106 billion and associated interest.

/2/ Based on IRS estimates projected from samples, about 2 percent of the 2.1 million income year 1993 returns of active corporations (not including S corporations, real estate investment trusts, and regulated investment companies) accounted for about 96 percent of the income tax after credits due from those corporations for that year.

/3/ According to its executive director, the Multistate Tax Commission is an interstate compact agency created to preserve federalism and promote fairness in state and local taxation of businesses.

/4/ The potential universe of individual filers is larger than the 116 million filers in 1995. For instance, for tax year 1992, IRS identified almost 60 million potential individual nonfilers, mostly by matching data on information returns, such as wage statements from employers, with data on filed income tax returns. However, IRS took no enforcement action on most of them, primarily because it later determined that the individuals had no legal filing requirement. For instance, the individual might not have had enough gross income to have to file.

/5/ See Tax Administration: Recurring Issues in Tax Disputes Over Business Expense Deductions (GAO/GGD-95-232, Sept. 26, 1995).

/6/ See Tax Administration: Erroneous Dependent and Filing Status Claims (GAO/GGD-93-60, Mar. 19, 1993). We were 95-percent confident that the true percentage of these taxpayers with inadequate records was between 33 percent and 52 percent.

/7/ See Tax Administration: IRS Efforts to Improve Forms and Publications (GAO/GGD-95-34, Dec. 7, 1994).

/8/ See Tax System Burden: Tax Compliance Burden Faced by Business Taxpayers (GAO/T-GGD-95-42, Dec. 9, 1994).

/9/ See Taxpayer Compliance: Reducing the Income Tax Gap (GAO/T- GGD-95-176, June 6, 1995).

/10/ Henry J. Aaron and Harvey Galper, Assessing Tax Reform (Washington, D.C.: The Brookings Institution, 1985), pp. 22-24.

/11/ See Tax Administration: IRS Is Improving Its Controls for Ensuring That Taxpayers Are Treated Properly (GAO/GGD-96-176, Aug. 30, 1996).

/12/ See Joel Slemrod and Nikki Sorum, "The Compliance Cost of the U.S. Individual Income Tax System," National Tax Journal, Vol. XXXVII, No. 4 (Dec. 1984), pp. 461-74; Marsha Blumenthal and Joel Slemrod, "The Compliance Cost of the U.S. Individual Income Tax System: A Second Look After Tax Reform," National Tax Journal, Vol. XLV, No. 2 (June 1992), pp. 185-202; and Joel Slemrod and Marsha Blumenthal, "The Income Tax Compliance Cost of Big Business," Public Finance Quarterly, Vol. 24, No. 4 (Oct. 1996), pp. 411-38. Also see Joel Slemrod, "Which Is the Simplest Tax System of Them All?" in Henry J. Aaron and William G. Gale, Ed.S., Economic Effects of Fundamental Tax Reform (Washington D.C.: Brookings Institution Press, 1996) for a summary of the strengths and limitations of this work.

/13/ The methodology of the Little study is reviewed in Slemrod (1996).

/14/ Little adjusted the individual questionnaire results to reflect the generally lower cost estimates found in the diary study.

/15/ Slemrod (1996), pp. 383-84.

/16/ See Arthur P. Hall, "Compliance Costs of Alternative Tax Systems," Tax Notes, Vol. 71, No. 8 (May 20, 1996), pp. 1081-89.

/17/ James L. Payne, Costly Returns: The Burdens of the U.S. Tax System, (San Francisco: Institute for Contemporary Studies, 1993).

/18/ Statement of James L. Payne prepared for the House Ways and Means Committee Hearings on Replacing the Federal Income Tax, June 6, 7, and 8, 1995.

/19/ "See Slemrod (1996).

/20/ See Tax Administration: IRS Notices Can Be Improved (GAO/GGD-95-6, Dec. 7, 1994).

/21/ See GAO/T-GGD-95-176. In 1996, IRS also reported that the tax year 1992 noncompliance estimate as a percentage of the "true" tax liability for individuals was about 83 percent.

/22/ See Tax Administration: Issues in Classifying Workers as Employees or Independent Contractors (GAO/T-GGD-96-130, June 20, 1996).

/23/ See Tax Administration: Recurring Tax Issues Tracked by IRS' Office of Appeals (GAO/GGD-93-101, May 4, 1993).

/24/ See GAO/GGD-95-232.

/25/ See High-Risk Series: Internal Revenue Service Receivables (GAO/HR-95-6, Feb. 1995).

/26/ According to a recent report, Tax Administration: Alternative Filing Systems (GAO/GGD-97-6, Oct. 16, 1996), when IRS investigated 1.8 million potential 1991 underreporter cases in certain categories, about half resulted in no change to the taxpayers' tax liabilities.

/27/ See Tax Administration: Tax Compliance of Nonwage Earners (GAO/GGD-96-165, Aug. 28,1996).

END OF FOOTNOTES TO APPENDIX II

* * * * *

APPENDIX III

OVERVIEW OF ALTERNATIVE TAX SYSTEMS AND DESIGN ISSUES

[125] In recent years, several proposals for fundamental tax reform have been put forward. These proposals would significantly change tax rates, the tax base, and the level of tax (whether taxes are collected from individuals, businesses, or both). Some of the proposals would replace the federal income tax with some type of consumption tax levied only on businesses. Consumption taxes levied only on businesses include retail sales taxes (RST) and value-added taxes (VAT). The flat tax would also change the tax base to consumption but include both a relatively simple individual tax along with a business tax. A personal consumption tax, a consumption tax levied primarily on individuals, has also been proposed. Similar changes in the level at which taxes are collected could be made while retaining an income tax base.

[126] If Congress were to decide to fundamentally reform the tax system, it would have to make choices on several basic issues, all of which have ramifications for tax compliance and administration. First, should the tax base be income or consumption or, as under the current system, contain elements of both? Second, should taxes be levied on businesses, individuals, or both? Third, should the preferential tax treatment now given certain goods and services and types of income be maintained or eliminated, thereby affecting not only the economic and social purposes for which they were established but also the ease of tax compliance and administration? Fourth, if consumption is chosen as the appropriate base for taxation, what issues arise in making the transition to a new tax base, and how should certain types of consumption that are difficult to tax be treated? Fifth, how should a new system be designed to balance other goals for the tax system with the goals of minimizing administration costs and taxpayers' costs of compliance?

[127] This appendix provides some information to clarify these issues. To summarize, the fundamental difference between income and consumption taxes lies in the treatment of saving and investment. A broad-based income tax would tax all income, regardless of how it is used and regardless of its source. In particular, a broad-based income tax would tax income regardless of whether it is used for consumption or for saving and investment and would tax all income earned from saving and investment. In contrast, consumption taxes are designed to tax only income used for consumption, exempting from tax income used for saving and investment. Under certain conditions, this is equivalent to exempting income earned from saving and investment. As a result, different consumption taxes can in effect exempt saving and investment in different ways, so taxes that appear to be different may actually tax the same base -- consumption.

[128] Either income or consumption taxes could be levied on individuals, businesses, or both. The choice of level of tax (or collection point) alone does not determine the base of a tax or who will bear its economic burden. The choice does affect how equitable and how complicated a tax may be because it determines whether a tax can treat different individuals differently. A tax levied on individuals, whether income- or consumption-based, can tax different individuals at different rates or allow for adjustments such as standard deductions or exemptions for dependent children. Such provisions may make a tax system more equitable but may also make it more complicated. A tax levied solely on businesses (corporations, partnerships, and sole proprietorships) may be simpler to administer and less costly for taxpayers to comply with because the number of tax return filers may be substantially reduced and because only businesses would be burdened with tax-related recordkeeping and accounting tasks. Businesses may keep some of the same records for nontax purposes and are likely to be more efficient at recordkeeping and accounting than individuals. However, taxes levied solely on businesses are generally less able to make distinctions between individuals for reasons of equity.

[129] The current income tax is actually a hybrid tax because it exempts or lightly taxes some types of saving and investment from tax but fully taxes other forms. The current tax also grants preferential treatment to some types of consumption, such as employer-provided health insurance. A reformed tax system could treat saving and investment more uniformly, either by taxing all saving and investment (income tax) or by exempting all saving and investment (consumption tax). A reformed tax system could also eliminate the current tax code preferences for certain items of consumption, or it could maintain them.

[130] Any tax reform that replaces the current income tax with a consumption tax would have to address transition issues. In particular, the decision on whether to tax existing wealth could raise issues of fairness and administrability, as well as revenue. Moving to a consumption tax would also raise issues involving the taxation of some types of goods and services that could be difficult to tax from an administrative viewpoint. In particular, decisions would have to be made on whether to tax and how to tax financial services, housing, fringe benefits, and goods and services produced by governments and nonprofit organizations. Some of these items are also difficult to tax under an income tax.

[131] While some information is readily available on administration costs, policymakers have little quantitative evidence on compliance costs available to help them design new tax systems. Compliance costs are costs that individuals and businesses incur, in terms of both time and money directly spent, because of the requirements of the tax system. Compliance and administrative costs are interrelated because some of the tasks that need to be done to collect taxes can be done by the public sector or by the private sector. As a result, costs can be shifted from one sector to another. The distribution of compliance costs among different businesses and individuals is also important for understanding the full effects of a tax system. A major difficulty in measuring compliance costs is disentangling accounting and recordkeeping costs due to taxes from the costs that would have been incurred in the absence of the tax system. As a result, the reliability of the results of most compliance cost studies that have been done to date is limited.

DIFFERENCES BETWEEN INCOME AND CONSUMPTION TAXES

[132] The fundamental difference between income and consumption taxes lies in their treatment of saving and investment. /1/ Income can be used for either consumption or saving and investment, so if income used for saving and investment can be exempted from tax, the result will be a tax only on consumption. As described below, the exemption of saving and investment can be done in different ways, so consumption taxes can be structured differently and yet still have the same overall tax base. In contrast, income taxes do impose a tax on income used for saving and investment. The current tax system is considered to be a hybrid between a pure income tax and a pure consumption tax because it effectively exempts some types of saving and investment from tax but taxes other forms of saving and investment.

Tax Treatment of Saving and Investment

[133] Consumption taxes exempt income used for saving and investment in one of two ways. First, tax could be levied only on income used to buy consumption goods and services. This could be done by either taxing the sale of goods and services to consumers or by allowing individuals to deduct the amount that they saved from their income. Under either method, the income that an individual saved or invested would not be taxed until it was used to buy goods and services for consumption.

[134] A second way to in effect exempt saving and investment from tax would be to exempt income earned by saving and investment. Over time, not taxing the earnings from savings can be economically equivalent to not taxing the amount saved originally. As shown below, under certain conditions, these two methods are equivalent in that what individuals earn through saving, the rate of return to saving and investing, is the same under these seemingly different taxes. /2/

[135] In contrast to consumption taxes, a broad-based income tax would levy tax on income from all sources and tax income regardless of whether it is used for consumption or saving. In particular, all income earned from saving and investment would be taxed, and income used for saving and investment would not be deductible.

[136] A simple example focusing on the treatment of saving under alternative taxes is shown in table III.1. The example compares an income tax to two forms of consumption taxes and also illustrates the equivalence between a consumption tax that exempts saving and a tax that exempts the income earned by saving. The three cases all assume that $100 of wage income is earned in the first year, all after-tax income is saved the first year and used for consumption in the second year, the interest rate is 10 percent, and the tax rate is 20 percent.

                TABLE III.1: TAX TREATMENT OF SAVING

_____________________________________________________________________

                                            Consumption

First year

Second year

  Tax                                  1.6            0            22

Present value of taxes              $21.45          $20           $20

[137] The first column shows how a person would be taxed under an income tax. In the first year, the individual pays $20 in tax and saves the balance ($80). In the second year, the individual earns $8 in income from saving, and pays $1.60 in tax on this income, leaving $86.40 available for consumption. Because the earnings from saving were subject to income tax, the after-tax rate of return on the individual's saving is 8 percent ($6.40 of $80) instead of the 10- percent rate ($8 of $80) that would be earned without the income tax.

[138] The second column shows how the same individual would be taxed under a consumption tax that does not tax the earnings from saving. In the first year, the individual would be taxed on all income ($100), so as in the income tax case, $20 would be paid in tax and $80 would be available for saving. Once saved, the $80 would earn a 10-percent rate of return ($8), as in the income tax case, but the earnings from saving would not be taxed. Thus, in the second year, the individual has $80 in saving and $8 in earnings on saving available for consumption, for a total of $88. In comparison to the income tax, which reduced the after-tax return to saving, the rate of return on saving is not changed by the consumption tax, so incentives to consume today or save for the future are not affected by the tax.

[139] The third column shows how the individual would be taxed if a deduction from income for saving were allowed and all income was taxable when used for consumption. In the first year, the individual owes no tax because all income is saved. The $100 saved earns a 10- percent rate of return, so in the second year $110 would be available for consumption before tax. The individual would owe $22 in tax (20 percent of $110), leaving $88 for consumption after tax, the same amount as under the first consumption tax. /3/

[140] While the two consumption taxes differ in the timing of the tax payment, as shown under this simple scenario, they would be equivalent in terms of the present value of the taxes owed. Under the first consumption tax, the individual owes $20 in tax the first year and none in the second; under the alternative consumption tax, the individual owes no tax in the first year and $22 in the second. In this case, having no tax liability in the first year would enable the person to save an additional $20 and therefore earn an additional $2, just enough to pay the additional tax in the second year. Therefore, under the consumption tax in column 2, the individual effectively prepays the consumption tax in the first year by paying $20; the individual has paid an amount that if saved, would earn just enough to pay the tax owed when the income was actually used for consumption.

INCOME AND CONSUMPTION TAXES CAN BE LEVIED ON INDIVIDUALS OR

[141] Both income and consumption taxes can be levied on individuals or businesses. Whether collected from individuals or businesses, ultimately, individuals will bear the economic burden of any tax. /4/ The choice of whether to collect a tax at the business level or the individual level depends on whether it is thought to be desirable to levy different taxes on different individuals. A business-level tax, whether levied on income or consumption, can be collected "at source" -- that is, where it is generated -- so there can be many fewer tax filers and returns to administer. Business- level taxes cannot, however, directly tax different individuals at different tax rates. Individual-level taxes can allow for distinctions between different individuals; for example, standard deductions and/or graduated rates can be used to tax individuals with low income (or consumption) at a lower rate than individuals with greater income (consumption). Other individual characteristics can also be taken into account. For example, adjustments can be made for family size, and additional deductions could be allowed for individuals who have very large medical expenditures. However, individual-level taxes require more tax returns, impose higher costs to comply with the tax laws, and would generally require a larger tax administration system.

[142] Table III.2 shows alternative income and consumption taxes that are levied on businesses only, individuals only, or both. The current tax, while including a separate corporate income tax, could be considered primarily an individual tax because most types of income are taxed under the individual tax. As mentioned earlier, the current tax is somewhere in between a pure income and pure consumption tax because under the current tax some forms of income from saving are taxed, while others, particularly income from saving for retirement, are not taxed. We describe each of the alternative taxes in the next two sections.

                 TABLE III.2: ALTERNATIVE INCOME AND

Level of tax/features         Consumption type         Income type

Business level                National RST             Income VAT

  Tax collected at source     Consumption VAT

  No filing by individuals      Credit method

  No way to vary tax rates or   Subtraction method

Mixed business/individual     Flat tax                 Comprehensive

  Simplified individul

  Standard deductions or

Individual level              Personal consumption     Integrated

  Business must allocate

  Tax rates can vary

Alternative Types of Consumption Taxes

[143] The second column of table III.2 shows two business-level consumption taxes (a national RST and a VAT), a mixed business/individual-level consumption tax (a flat tax), and an individual-level consumption tax (a personal consumption tax). Table III.3 shows an overview of the major components of the alternative consumption taxes and details the major differences between them. While the taxes differ because they tax consumption at different levels, they ultimately all tax the same base.

                            TABLE III.3:

BUSINESS LEVEL

  INCLUDED

  Sales of consumption        x         x          x

  Sales of goods and                    x          x

  DEDUCTED

  Purchases of goods and                x          x

  Wages                                            x

INDIVIDUAL LEVEL

  INCLUDED

  Wages                                            x              x

  Cash flows received: interest                                   x

  Distributions from sole pro-                                    x

  DEDUCTED

  New saving: purchases of                                        x

  Contributions to sole pro-                                      x

National Retail Sales Tax

[144] The consumption tax that Americans are most familiar with is the retail sales tax, which in many states, is levied when goods or services are purchased at the retail level. The RST is a consumption tax because only goods purchased by consumers are taxed, and sales to businesses, including sales of investment goods, are generally exempt from tax. In contrast to an income tax, then, income that is saved is not taxed until it is used for consumption.

[145] Under a national RST, different tax rates could be applied to different goods, and the sale of some goods could carry a zero tax rate (exemption). However, directly taxing different individuals at different rates for the same good would be very difficult.

Value-Added Tax

[146] The second column in table III.3 shows the components of a VAT, which like the RST, is a business-level consumption tax levied directly on the purchase of goods and services. The two taxes differ in the manner in which the tax is collected and paid. In contrast to a retail sales tax, sales of goods and services to consumers and to businesses are taxable under a VAT. However, businesses can either deduct the amount of their purchases of goods and services from other businesses (under a subtraction VAT) or can claim a credit for tax paid on purchases from other businesses (under a credit VAT). Under either method, sales between businesses do not generate net tax liability under a VAT because the amount included in the tax base by businesses selling goods is equal to the amount deducted by the business purchasing goods. The only sales that generate net revenue for the government are sales between businesses and consumers, which is the same case as the RST.

Flat Tax

[147] The flat tax was developed in the early 1980s by economists Robert Hall and Alvin Rabushka. /5/ The Hall-Rabushka flat tax proposal includes both an individual tax and a business tax. As described by Hall and Rabushka, the flat tax is a modification of a VAT; the modifications make the tax more progressive (less regressive) than a VAT. In particular, the business tax base is designed to be the same as that of a VAT, except that businesses are allowed to deduct wages and retirement income paid out as well as purchases from other businesses. Wage and retirement income is then taxed when received by individuals at the same rate as the business tax rate. By including this individual-level tax as well as the business tax, standard deductions can be made available to individuals. Individuals with less wage and retirement income than the standard deduction amounts would not owe any tax.

Personal Consumption Tax

[148] A personal consumption tax would look much like a personal income tax. The major difference between the two is that under the consumption tax, taxpayers would include all income received, amounts borrowed, and cash flows received from the sale of assets, and then deduct the amount they saved. The remaining amount would be a measure of the taxpayer's consumption over the year. When funds are withdrawn from bank accounts, or stocks or bonds are sold, both the original amount saved and interest earned are taxable because they are available for consumption. If withdrawn funds are reinvested in another qualified account or in stock or bonds, the taxable amount of the withdrawal would be offset by the deduction for the same amount that is reinvested.

[149] While the personal consumption tax would look like a personal income tax, the tax base would be the same as an RST. Instead of collecting tax on each sale of consumer products at the business level, a personal consumption tax would tax individuals annually on the sum of all their purchases of consumption goods. Because it is an individual-level tax, different tax rates could be applied to different individuals so that the tax could be made more progressive, and other taxpayer characteristics, such as family size, could be taken into account if desired. /6/

Alternative Types of Income Taxes

[150] Table III.2 also shows three alternative integrated income taxes: a business-level tax (income VAT), a mixed business/individual-level tax (Comprehensive Business Income Tax (CBIT)), and an individual-level income tax (integrated individual income tax).

[151] All income taxes, including the current tax, differ from consumption taxes in their treatment of investment. To produce the goods and services they sell to customers, businesses purchase a variety of goods and services themselves. While some of the goods and services that businesses buy are used up immediately in production, other goods and services, such as plant and equipment, for example, can be used for production over time. The purchase of goods and services of this type is referred to as investment, and such goods and services are also referred to as business assets.

[152] Under consumption taxes, investment is either exempt from tax or deducted immediately (expensed). In fact, all business purchases of goods and services, regardless of how long they are used in production, are exempted or expensed because business purchases generally do not represent consumption. /7/

[153] Investment is treated differently under an income tax. Under an income tax, income is calculated by deducting costs from revenue; therefore, the costs that businesses incur from purchasing goods and services, including the costs from owning assets, should be deductible. For goods and services that are used up or become worthless in the same year as they were purchased, the economic cost to the business will be the entire amount they paid for the goods and services, and therefore the entire amount should be deductible immediately (in the same tax year as the goods or services were purchased). However, business assets do not lose all their value immediately; rather, they wear out or become obsolete over time (the assets depreciate). The economic cost incurred by owning an asset during a particular year is the reduction in the value of the asset during that year, so under an income tax businesses should be allowed a deduction for depreciation that reflects this reduction in value. Depending on the rate at which an asset loses economic value, a proportion of the amount originally paid for the asset can be deducted for depreciation each year until the total amount deducted over time is equal to the amount originally paid. /8/

[154] The current income tax differs from the other three income tax options in that the current corporate income tax is not integrated with the personal income tax. For example, under the current tax, corporations cannot deduct dividends paid to shareholders, and shareholders pay tax on the dividends they receive. Noncorporate income, however, is taxed only once, at the individual level. The three options would tax all forms of business income, corporate and noncorporate, once.

[155] Table III.4 shows the components of the current tax and three alternative income taxes that would integrate the business and individual taxes. The alternative income taxes differ in that they would tax income at different levels. The income VAT would tax all income income would be taxed at the business level by denying businesses a deduction for wages. The CBIT option would tax business income, including profits and the interest income earned by lenders, at the business level. Wage income would be taxed at the individual level.

                            TABLE III.4:

BUSINESS LEVEL

  INCLUDED

  Sales of goods and services       x         x        x

  Interest, dividend income         x

  DEDUCTED

  Purchases of goods and services,  x         x        x

  Depreciation on investment        x         x        x

  Wages                             x                  x

  Interest paid                     x

  Dividends paid

INDIVIDUAL LEVEL

  INCLUDED

  Wages                             x                  x          x

  Interest income                   x                             x

  Dividend income                   x                             x

  Capital gains                     x                  x          x

  Income from sole propri-          x                             x

  Share of undistributed                                          x

Integrated Individual Income Tax

[156] An integrated individual-level income tax would be much like the current tax. Individuals would be responsible for filing returns containing information on all taxable forms of income. The taxation of business income would change so that all business income, corporate and noncorporate, would be taxed at the individual level. The tax rate would apply to all forms of income that an individual receives, and individuals could be taxed according to graduated rates if desired. Other taxpayer characteristics, such as the number of dependent family members, could be taken into account.

CBIT

[157] The CBIT option would move much of the taxation of business income to the business level, leaving a simplified individual tax return (primarily wages). Business deductions for interest and dividends would not be allowed, so this form of income would be taxed at the business level. The business tax would effectively withhold tax on business income at the tax rate that was applied to the business. Since individuals would file returns, standard deductions and dependency exemptions could be part of the system. A flat rate could be levied at the individual level, or multiple rates chosen, but the multiple rates would only apply to the simplified base.

Income Value-Added Tax

[158] An income VAT would move the taxation of wage income to the business level as well. No individual returns would be necessary, so the burden of complying with the tax law would be eliminated for individuals. An income VAT would not allow businesses to deduct dividends, interest, or wages, so the income VAT remitted by businesses would include tax on these types of income. Calculations would not have to be made for different individuals, which would simplify tax administration and compliance burdens but not allow for treating different individuals differently.

HOW CONSUMPTION TAXES OR A REFORMED INCOME TAX COULD AFFECT

[159] If Congress decides to reform the current tax, it could incorporate existing tax preferences into a new tax system or eliminate the current preferences and replace them with direct expenditure programs. These preferences are referred to as "tax expenditures" because they earl be thought of as alternatives to direct outlay programs. They may take the form of exclusions, credits, deductions, preferential tax rates, or deferral of tax liability. /9/

Tax Expenditures for Saving and Investment

[160] The current tax system taxes some types of income from saving and investment but exempts others. The alternative tax systems would treat all types of income from saving and investment uniformly either by exempting all types of income from saving or by taxing all types of income from saving. Consumption tax proposals would expand existing incentives and narrow the tax base by effectively exempting all saving and investment from tax, and an income tax reform could end the incentives by including income from all forms of saving and investment in the tax base.

[161] Table III.5 shows a list of major projected fiscal year 1997 tax expenditures for saving and investment in the current tax code. For instance, under current law, some forms of saving, such as those producing pension and certain interest income, are already effectively exempt from tax. A move to a broad-based consumption tax would effectively exempt all saving, treating it like pension or tax- exempt interest income is treated today. While some types of investment are granted relatively favorable tax treatment currently, under a consumption tax all investment would be expensed (deducted immediately). A tax reform designed to tax all income would also move toward uniformity by removing the relative preference now given to some forms of saving and investment to tax income of all types equally.

                            TABLE III.5:

Exclusion of employer plan pension earnings and                $70.5

                      FOOTNOTES TO TABLE III.5

     /a/ Tax expenditures of $1 billion or less would also be

     /b/ Investments in the following categories are also expensed:

     /c/ The tax credit for qualified research expenditures, as well

                   END OF FOOTNOTES TO TABLE III.5

Source: Joint Committee on Taxation data on tax expenditures;

Other Current Tax Expenditures

[162] Table III.6 shows a number of other tax expenditures under current law and fiscal year 1997 revenue loss estimates associated with them. Both income and consumption tax reform could eliminate these preferences, thereby broadening the tax base. Any tax reform would have to decide whether to continue the relative tax preference for certain fringe benefits, government benefits, and a number of other items.

                            TABLE III.6:

FRINGE BENEFITS (OTHER THAN PENSIONS)

GOVERNMENT BENEFITS

OTHER

CONSUMPTION TAX DESIGN ISSUES AFFECTING TAX ADMINISTRATION

[163] In addition to the issue of whether currently tax-favored items should maintain some tax preference in a new system, some other issues in the design of a potential consumption tax would have an effect on tax administration. A transition from the current tax to a consumption tax base could raise significant administration issues. In addition, if a consumption tax base is chosen, important decisions would have to be made regarding whether particular hard-to-tax goods and services are included in the tax base.

Implementing a Consumption Tax May Tax Existing Wealth

[164] Under an income tax, no deduction for saving is allowed, and the income from saving is taxed as it is earned by the saver. However, the amount that was saved is not subject to further tax. For example, a bondholder will pay tax on interest income but does not owe tax on the principal when it is repaid.

[165] If the income tax was replaced by a consumption tax, the saving that has been done in the past using taxed funds might be subject to tax again. For example, suppose that an individual buys a bond while the income tax is in effect. Then suppose that the income tax is replaced by a national RST, and the bondholder receives interest income and the principal is returned as the bond matures. If the bondholder uses all of these funds for consumption, all -- interest income and principal -- would be subject to tax. In this way, replacing the income tax with a consumption tax could levy a one-time additional tax on saving done before the tax change.

[166] If it is thought to be unfair to subject prior saving to tax again, transition rules would have to be written so that prior saving could be recovered tax-free, as it would have been under the income tax. One difficulty is that to replicate the treatment that saving and income from saving would have received under the income tax, income from saving would have to be separated from the return of the original amount saved. Otherwise, taxpayers might get a windfall gain if they were able to get their previous capital income back tax- free along with their prior saving. The particular administrative challenges that would have to be addressed for a transition to the alternative consumption taxes are briefly discussed in appendixes V through VIII.

A Consumption Tax May Be Difficult to Administer for

[167] Any consumption tax proposal would have to address several areas where levying tax might be difficult in terms of compliance and administration. These items can be taxed if special rules are developed and taxpayers and administrators devote resources to compliance. Including these items would broaden the base of a consumption tax, enabling the same amount of revenue to be raised at a lower rate than otherwise. Exempting these items would also be possible, but exempting some goods and services while taxing others would create administrative difficulties. /10/

Fringe Benefits

[168] Some fringe benefits can be thought of as consumption that takes place within a business. As such, no separate transaction between an individual and a business takes place that would be subject to tax under the normal rules for an RST or a VAT, and there is no cash flow to an individual that would normally be included under a personal consumption tax. The same difficulties are present for the current income tax and would be present for any modification of the income tax that sought to broaden the income tax base.

[169] To illustrate, consider employer-provided health insurance, perhaps the most significant fringe benefit aside from employer-provided pensions. The purchase of an employer-provided health insurance plan is a business-to-business transaction, and the payment of medical bills by insurance companies is also a business- to-business transaction. Ordinarily, business-to-business transactions are ignored under an RST and deductible (or creditable) under a VAT, so under normal rules, the consumption of medical services would not be taxed.

[170] If the purchase of health insurance was to be taxed under tax reform proposals, exceptions to the general rules would have to be written. Under a national RST, the purchase of health insurance or medical services could be taxable regardless of whether they were purchased by an individual or a business. For a VAT, the purchase of health insurance or payments for medical services by businesses for their employees could be nondeductible (or noncreditable). In either case, the taxable transactions or purchases that would not be deductible would have to be specified.

[171] Similarly, under the personal consumption tax, a business- to-business transaction would never be reflected in an individual's cash flow, so under general rules, the consumption would not be taxed. To include this consumption in the tax base, the value of the fringe benefit would have to be imputed or allocated to the employee so that it could be included in taxable receipts. The same steps would have to be taken to include the value of this form of compensation for income tax purposes.

Financial Services

[172] Financial services can be difficult to tax under a consumption tax because the recipients of the services are not always charged explicit service fees. Financial institutions typically do not charge explicit service fees for maintaining checking and saving accounts and for arranging loans. Instead, they charge higher interest rates on loans and offer lower rates on deposits than otherwise. To include financial services in the tax base, consumption taxes that do not include all types of cash flows in the tax base (such as an RST, VAT, or flat tax) would include some rules to impute the value of the sale of the financial service. /11/

Housing

[173] Taxing the consumption of services from owner-occupied housing poses a potential problem for consumption taxes. /12/ Housing, like other durable consumption goods, provides consumption services over time. For rental housing, this is not a problem; rent could be taxed like any other consumption item because there is a transaction between an individual and a business (owner of the rental unit), so the normal rules can apply. For owner-occupied housing, the individual consuming housing services and the supplier of the house are the same person, so there is no transaction to tax.

[174] Consumption taxes could overcome this problem by subjecting the full purchase price of owner-occupied housing to tax at time of purchase, even though the house will not be consumed all at once. This essentially prepays the consumption tax. However, this raises potential problems of liquidity (the one-time payment of tax may be very large), and taxing existing housing, as well as new housing, may be difficult. To tax new housing, a business (the developer, for example) could charge tax on the purchase price of the house.

Government and Nonprofit Services

[175] As under income taxes, consumption taxes must include rules for sales and purchases of goods and services by government entities and nonprofit organizations. In theory, consumption taxes could tax all goods and services used for consumption in the same way, regardless of whether they are produced by governments and nonprofit organizations or by private for-profit businesses. However, because governments and nonprofit organizations do not charge a price for many of the goods and services they provide, these goods and services would be undertaxed relative to those sold by the private sector under the normal application of an RST or VAT. Under an RST, goods and services produced by governments and nonprofit organizations could be implicitly taxed to some extent by treating these entities as consumers rather than businesses. This would tax the purchases they make from businesses. Under a credit method VAT, governments and nonprofit organizations could be exempted from tax; this means that they would be unable to obtain credits for taxes they paid on purchases they made from businesses.

[176] Under the flat tax, governmental entities, nonprofit organizations, and businesses could be treated more uniformly than under the RST and VATs because wages paid to employees of all these organizations can be taxable and government entities and nonprofit organizations would be taxed on fringe benefits provided for workers. A personal consumption tax could tax state and local government services by not allowing a deduction for state and local taxes. /13/

DEFINITION AND MEASUREMENT OF COMPLIANCE COSTS

[177] Taxes impose three types of costs on society as a whole as resources are transferred from the private sector to the public sector. First, taxpayers must use resources to comply with the requirements of the tax system (compliance costs). Second, resources must be provided to the public sector to administer the tax, including collecting the revenue and ensuring that taxpayers comply with the requirements (administration costs). Third, taxes can also distort economic behavior, leading to a misallocation of resources (excess burden). Ideally, in determining the amount of revenue to be raised and the type of tax used to raise the revenue, the level and distribution of each of these costs would be weighed against the benefits derived from the use of the revenue by the public sector. /14/

[178] Compliance costs are costs that individuals and businesses incur, in terms of both time and money directly spent, because of the requirements of the tax system. Ideally, compliance costs should be measured by calculating the value of the time and the resources used doing tax-related tasks in their best alternative use (opportunity cost) net of any value derived from the information produced by complying with the requirements. /15/

[179] Compliance costs and administrative costs are interrelated because some of the tasks that need to be done to collect taxes can be done by the public sector or by the private sector. As a result, costs can be shifted from one sector to another. For example, in the United States, businesses take on some responsibilities that encourage compliance by withholding tax on wages and providing information returns on payments of interest and dividend income. As a result, a high level of compliance on those forms of income may be achieved at lower administrative cost because matching information returns with tax returns can substitute for large numbers of audits. Also under the current system, taxpayers receive information and help with their tax filing responsibilities through both the private sector paid preparer industry and IRS taxpayer service activities.

[180] The distribution of compliance costs among different businesses and individuals is also important for understanding the full effects of a tax system. For example, withholding tax on wages and providing information returns are costly tasks for businesses, but receiving these documents lowers compliance costs for individuals. /16/ Some studies have indicated that small businesses may bear higher compliance costs as a percentage of sales than larger businesses, and some businesses may receive cash flow benefits from being able to retain tax they collect for a period until remittance to the government is required. A full analysis of the distributional effects of different tax policies would take these effects of compliance costs into account.

Measurement of Compliance Costs

[181] A major difficulty in measuring compliance costs is disentangling accounting and recordkeeping costs due to taxes from the costs that would have been incurred in the absence of the tax system. For example, where the rules regarding the calculation of income for tax purposes coincide with rules for determining income for financial statement or regulatory purposes, the additional costs of taxation can be minimal. Because public corporations must report financial statement income under the rules of the Securities and Exchange Commission, some recordkeeping useful in calculating tax liability may be done for nontax purposes. For other businesses, calculating financial statement income may be required by banks or other potential lenders. Some individuals may need to calculate their income in order to apply for mortgages or financial aid for college. However, significant compliance costs may arise when the tax code requires businesses or individuals to keep records and calculate income differently than they do for other purposes.

[182] A related issue is whether other government agencies would require taxpayers to produce the same or similar information if it is not required for tax purposes. For example, the federal government might need a measure of individuals' income to determine eligibility for means-tested transfer programs, and state and local governments that now rely on federal income tax records might need to have similar information for their own tax and transfer programs even if the federal income tax were eliminated. To the extent that income tax requirements would be recreated by other government agencies if the income tax were repealed, compliance costs would have to be considered to be government compliance costs rather than stemming solely from the tax system.

[183] The reliability of the results of most compliance cost studies that have been done to date is limited by several factors, which are commonly acknowledged by the authors of the studies. First, written or telephone questionnaires have generally been used to ask individuals or businesses how much money or time they spend on tax matters. In evaluating these studies, it is difficult to know whether respondents can differentiate between recordkeeping that would have been done anyway and recordkeeping that is only done for tax purposes. Reported compliance costs may be exaggerated if respondents include costs for nontax purposes. In addition, it is not known whether respondents did everything required to fully comply with the tax law. For example, if a particular tax rule was so complex that taxpayers did not even attempt to comply, respondents might truthfully answer that they spent no time or money to comply with the rule. The compliance costs as measured by the survey would be zero, so the results of the survey would not give an indication of just how complex the rule really is. Finally, response rates for these studies have generally been low, so the results from the surveys may not reliably estimate costs for taxpayers in general.

FOOTNOTES TO APPENDIX III

/1/ For a similar discussion, see Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate Over Tax Reform (Cambridge, Mass.: The MIT Press, 1996), pp. 168-71.

/2/ Michael Graetz, "Expenditure Tax Design," in Joseph A. Pechman, ed., What Should Be Taxed: Income or Expenditure? (Washington, D.C.: The Brookings Institution, 1980), pp. 172-73, lists the conditions that must hold for the taxes to be equivalent. For example, the tax rate an individual faces must be constant over time, taxpayers must consume all the income they earn during their lifetime, and individuals must be able to borrow and lend unlimited amounts at a constant rate of interest. Consumption taxes effectively exempt the "normal" or competitive rate of return on investment but can tax rates of return above this level. For a discussion of whether consumption taxes exempt the return for risk-taking, see William M. Gentry and R. Glenn Hubbard, "Distributional Implications of Introducing a Broad-Based Consumption Tax," in James M. Poterba, ed., Tax Policy and the Economy, Volume 11 (Cambridge, Mass.: MIT Press, 1997).

/3/ "Alternatively, the same $22 tax liability could be expressed as 25 percent of consumption. Since RSTs are computed as a percentage of consumption rather than as a percentage of income (less saving), the appropriate RST rate would be 25 percent. The result would be the same -- under either an RST or a personal consumption tax, income (less saving) would be reduced by 20 percent by the tax, and the tax liability would amount to 25 percent of consumption.

/4/ For example, most economists would agree that the economic burden of a tax on wages would be generally borne by workers, regardless of whether workers directly remit tax (send a payment) to the government, businesses withhold tax from paychecks and remit the tax, or businesses are required to remit tax on wages they paid. Alternatively, because taxes can be shifted through price changes and changes in income, the statutory incidence of a tax (who is legally responsible to remit tax to the government) "tells us essentially nothing" about economic incidence (whose real income is changed as a result of the tax). See Harvey Rosen, Public Finance, 3rd ed. (Burr Ridge, Illinois: Irwin, 1992), pp. 274-77.

/5/ See Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford, Calif: Hoover Press, 1995).

/6/ To tax certain types of consumption that can occur within a business, such as fringe benefits or the personal use of goods such as cars, many personal consumption tax proposals also include a business-level "cash flow" tax. Investment would be expensed under such a tax to ensure that the overall tax base would be consumption. See appendix VIII for more details.

/7/ Investment in plant and equipment, like the purchase of financial assets such as corporate stock or bonds, is a form of saving. By investing in assets like plant and equipment and using them over time to earn income from the production and sale of goods and services, owners of businesses postpone consumption today to make possible additional consumption in the future.

/8/ This tax treatment would be appropriate if there is no inflation. In appendix IV, we discuss how inflation creates problems in measuring depreciation.

/9/ For a more extensive classification of current tax expenditures according to whether current tax treatment would be automatically provided for under consumption taxes, see Martin A. Sullivan, Flat Taxes and Consumption Taxes: A Guide to the Debate (New York: American Institute of Certified Public Accountants, Dec. 1995), pp. 91-96.

/10/ For a discussion of the specific items in this section in the context of a VAT, see Congressional Budget Office (CBO), Effects of Adopting a Value-Added Tax (Feb. 1992).

/11/ See David F. Bradford, "Treatment of Financial Services Under Income and Consumption Taxes," in Henry J. Aaron and William G. Gale, Economic Effects of Fundamental Tax Reform (Washington, D.C.: Brookings Institution Press, 1996) and references he cites for arguments on whether financial services should be included in a consumption tax base. Bradford also points out that financial services pose similar difficulties for income taxes as well as for consumption taxes.

/12/ Housing services may be more difficult to tax under an income tax than a consumption tax. See appendix IV for information on the treatment of housing under an income tax.

/13/ "For more details on these issues, see Joint Committee on Taxation, Impact on State and Local Governments and Tax-Exempt Organizations of Replacing the Federal Income Tax (JCS-4-96), April 30, 1996. Also, for a discussion of whether state and local business taxes should be deductible under consumption tax alternatives and other issues, see Douglas Holtz-Eakin, "Fundamental Tax Reform and State and Local Governments," National Tax Journal Vol. XLIX, No. 3 (Sept. 1996), pp. 475-86.

/14/ Compliance cost assessments are done in the United Kingdom for major tax provisions. For examples of these assessments and summaries of several recent studies on compliance costs, see Cedric Sandford, ed., Tax Compliance Costs: Measurement and Policy (Perrymead, England: Fiscal Publications in association with the Institute for Fiscal Studies, 1995).

/15/ Some experts believe that some businesses may derive managerial benefits from accounting information produced for tax purposes. See Cedric Sandford, Administrative and Compliance Costs of Taxation (Perrymead, England: Fiscal Publications, 1989), p. 13.

/16/ The economic burden of these costs may not reduce business profits if they result in higher prices, lower wages, or lower interest payments.

END OF FOOTNOTES TO APPENDIX III

* * * * *

APPENDIX IV

INCOME TAX REFORM OPTIONS

DESCRIPTION

[184] In this appendix, we describe several options for reforming the income tax and also the administrative issues that would be important if these options were considered. The four options we describe are based on past and current proposals and academic discussions and analyses. The options were chosen to best describe the trade-offs and choices that would have to be made in reforming the income tax and to best facilitate comparisons of income tax reform options and consumption tax proposals.

[185] The goal of each of the four income tax reform options we discuss is to have a more comprehensive and accurately measured income tax base than under the current income tax. To do this, all of the reform options could make three major changes to the current system. First, the income tax base could be broadened so that most forms of income would be taxed annually. This could be done by including more types of income in the tax base and by eliminating some adjustments, credits, and deductions. Second, the calculation of income could include explicit inflation adjustments so that the tax base would better measure the real income of individuals and businesses. Under the current tax, inflation can lead to an overstatement or an understatement of real income. Third, the corporate and personal income taxes could be integrated so that business income would be taxed once annually, regardless of the legal form of the business. Under the current tax, corporate income is taxed differently than the income of noncorporate businesses, such as sole proprietorships and partnerships.

[186] The income tax options we discuss would integrate the corporate and personal taxes but would do so in different ways. Just as consumption taxes can be levied on businesses, individuals, or both, the income tax options would levy the income tax at different levels. Two options would tax individuals directly on most or all of their income. These options, like the current system, would allow for many individual characteristics to be taken into account when determining tax liability. Administration of these options would also be similar to that under the current system, with individuals filing returns and information returns used to check compliance. Two other options would tax most or all income at the business level, essentially withholding tax before income is received by individuals. These options could reduce the need for individual returns and information reporting; administration efforts would be focused primarily on business returns. These options would not be as able to take individuals' characteristics into account and would be facilitated by a flatter tax rate structure.

[187] This appendix first describes the changes that any of the four income tax reform options could make to more comprehensively and accurately measure income and elaborates on the options themselves. Then, it discusses the potential impact of these options on taxpayers' compliance burden and on tax administration.

Broadening the Income Tax Base

[188] The income tax base could be broadened by taxing certain types of income that are now exempt from tax and by eliminating some adjustments, deductions, and credits. Broad-based taxes can offer several advantages in meeting the goals of the tax system -- promoting economic efficiency and equity and reducing taxpayer compliance burden and administration costs. By making fewer distinctions among activities, a broad-based tax can be simpler and easier to administer, and because under a broad base a given amount of revenue can be raised with a relatively low tax rate, economic efficiency may be enhanced. However, a more narrowly defined tax base, while generally requiring higher tax rates to raise the same amount of revenue, could be preferable to a broad tax base if exemptions, credits, or deductions promote economic efficiency and equity or simplify compliance and administration to a sufficient extent.

[189] Broadening the tax base could in some respects increase the complexity of the tax system, but it could simplify it in other respects. For example, including some forms of income in the tax base could in some circumstances complicate compliance and administration, particularly if these forms of income are difficult for taxpayers to calculate and administrators to verify. However, if one form of income was exempted and other forms were taxed, rules and definitions would have to be developed to differentiate one form of income from the others. These rules would have to be followed by taxpayers and compliance with the rules checked by tax administrators.

Taxing Additional Types of Income

[190] Table IV.1 shows major types of income that are currently reported on Form 1040 and the number of returns that reported some amount of each type of income in tax year 1993. It also shows how the tax treatment of some items that are currently reported could change under a more broadly based tax, and it shows some additional income items that are not taxed or reported under current law. The major changes from the current system are discussed following the table.

   TABLE IV.1: INCOME ITEMS AND NUMBER OF RETURNS REPORTING THEM,

                                          Millions

Currently reported

  Salaries and wages    Taxed               98.0         Taxed

  Taxable interest      Taxed               65.2         Taxed,

  Tax-exempt interest   Taxed under          4.7         Taxed,

  Dividends             Taxed               24.7         Taxed

  Net capital gain      Taxed when          18.4         Taxed on

  Distributions from    All distributions   17.4         Not taxed

  Unemployment          Taxed                9.7         Taxed

  Social Security       Taxed under          5.7         Amounts

  Business or           Taxed                15.6        Taxed

  Rental and royalty    Taxed                11.0        Taxed

  Partnership and S     Taxed                 5.5        Taxed

  Estate and trust net  Taxed                 0.5        Taxed

  Farm net income       Taxed                 2.3        Taxed

Additional income items

  Contributions to      Not taxed             N/A        Taxed

  Employer-paid fringe  Not taxed             N/A        Taxed

  Government benefits   Not taxed             N/A        Taxed

  Imputed service       Not taxed             N/A        Taxed

Sources: IRS, Statistics of Income Division, Individual Income Tax

[191] TAX-EXEMPT INTEREST INCOME. Current law allows interest income from bonds issued by state and local governments and tax- exempt organizations to be exempt from tax if the bonds are used for certain purposes. While in some circumstances this interest income can be taxable and is therefore reported on tax forms, it is not subject to information reporting. The income tax base could be broadened by removing the tax exemption for this interest income.

[192] ACCRUED CAPITAL GAINS. Under current law, capital gains are generally subject to tax only when assets are sold or otherwise disposed of. Owners of assets that have appreciated in value over the course of a year but have not been sold generally do not report the increase in asset value as income. Since such income is not reported until the asset is sold, tax on this income is deferred. /1/

[193] Capital gains could in effect be taxed as they are earned (on an accrual basis) in two ways. First, the owner of the asset could calculate the difference between the value of the asset at the end of the year and the value of the asset at the beginning of the year. Tax would be paid on the amount of the difference, regardless of whether the asset was actually sold. This could be done most readily for assets that are bought and sold frequently, such as publicly traded corporate stock, because the market values of the assets would be relatively easy to obtain and check. Under a second approach, taxation of gains could occur only when assets are sold, as under current law. However, an interest charge could be imputed and added to the gain so that the tax saving from the deferral of income would be offset. /2/ This approach could be applied to assets for which market values are not readily available because they are bought and sold infrequently, or for all assets generally.

[194] CONTRIBUTIONS TO PENSION PLANS AND RETIREMENT ACCOUNTS; EARNINGS FROM RETIREMENT ACCOUNTS AND LIFE INSURANCE, ANNUITY, AND PENSION PLAN RESERVES. In general under an income tax, income that is saved is taxed, and income from saving is taxed when it is earned. Under the current tax, there are significant exceptions to this general rule, and in some cases saving is treated as it would be under a consumption tax. In particular, contributions to pension plans and certain individual retirement arrangements (IRA) are not included in an individual's income, and earnings in these plans are not taxed until they are distributed. In addition, earnings in certain life insurance and annuity plans are not taxed until they are distributed. The income tax base could be broadened by taxing contributions to pension plans and IRAs, and by taxing earnings in pension, IRA, life insurance, and annuity plans when they are earned.

[195] EMPLOYER-PAID FRINGE BENEFITS. In addition to pensions, under current law businesses can provide several types of fringe benefits to employees on a tax-favored basis. /3/ Qualified expenditures on these fringe benefits, including premiums paid for employer-provided health insurance, are deductible for the business as are other forms of compensation. However, unlike many other forms of compensation, the value of the benefits is not taxable to the employee.

[196] The income tax base could be broadened either by making expenditures for fringe benefits nondeductible for businesses or by including the value of the benefits in the taxable income of the employee. If benefits were not deductible, they would in effect be taxed at the tax rate that the business faces. If benefits were included in the taxable income of the individual, they would be taxed at the individual's tax rate.

[197] GOVERNMENT BENEFITS. Currently, several types of government benefits are not taxed, including Medicare benefits and workers' compensation. Also, Social Security benefits under a certain level are not taxed when they are received. The income tax base could be broadened by including more of these benefits in taxable income.

[198] INCOME FROM OWNER-OCCUPIED HOUSING. Under the current tax and income taxes in general, income earned through the ownership of assets is generally subject to tax, and the costs of earning the income are deductible. However, under the current tax, the treatment of owner-occupied housing represents a significant exception to the general rule. If a home is rented, the income earned by the owner of the home is taxed much like the income earned from owning other assets is taxed. In this case, the owner of the house would receive rent in exchange for the housing services provided to the renter. The rent received by the owner would be taxable, and costs, such as depreciation, maintenance, and interest expense, would be deductible. In contrast, if the homeowner occupies the house, the value of the housing services received by the owner is not included as income, and maintenance and depreciation are not deductible. However, mortgage interest is deductible.

[199] Most analysts believe that it would be very difficult to tax income from owner-occupied housing precisely. The major administrative difficulty in taxing income from owner-occupied housing like income from other investments is the lack of a transaction, the rent payment, that would measure the income earned. An amount would have to be estimated, or imputed, possibly based on the market value of the house. Estimating market values for housing on an annual basis is a challenge for local property tax administration. Here, too, the problem is a lack of a transaction on which to base a measurement because only a fraction of houses are sold within a given year. /4/

Eliminating Some Deductions and Credits

[200] As noted in Treasury's 1984 study of tax reform, broadening the income tax base by eliminating certain adjustments, deductions, and credits would also be possible. /5/ To measure income accurately, an income tax should allow deductions for the costs of earning income, and the current income tax allows some costs to be deducted. Other adjustments, deductions, and credits represent subsidies designed to encourage certain types of spending thought to be socially beneficial. Still, others represent additional modifications of the income tax base to better measure an individual's ability to pay tax. For example, individuals with sufficiently large medical expenditures may not be as able to pay tax as individuals without such expenditures. Table IV.2 shows adjustments, deductions, and credits in the current tax code and how these items might be treated under an income tax with a broader base. Items that are considered to be tax expenditures could be eliminated, while items that can be considered costs of earning income could be deductible. Other items, such as the standard deduction and the foreign tax credit, could be retained as a part of the overall structure of the income tax.

  TABLE IV.2: CURRENT TAX CODE ADJUSTMENTS, DEDUCTIONS, AND CREDITS

______________________________________________________________________

Adjustments

Deductions

Credits

Indexing the Tax System for Inflation

[201] The current tax code does not include explicit adjustments to take inflation into account in calculating business income. As several studies, including the Department of the Treasury's 1984 proposal for tax reform, have shown, without adjustments for inflation (indexing), taxable income could be overstated or understated relative to the real income of the taxpayer. That study and others have concluded that business income would be better measured if inventories, depreciation, interest income, interest expense, and capital gains were all indexed for inflation. /6/ Some analysts have stated that concern about added complexity was one reason why indexing was not adopted in the Tax Reform Act of 1986. /7/

[202] An example can illustrate the income mismeasurement problem caused by inflation. Suppose a business bought equipment for $1,000 in 1985. Suppose also that the equipment was expected to be used for 10 years, and the business was allowed a deduction for depreciation over the course of the 10 years. The total amount deducted over time would add up to $1,000, the historical cost or purchase price of the equipment. Suppose further that the business could deduct $100 in each of the 10 years for depreciation. With inflation, the value of the deduction for depreciation erodes over time because the $1,000 is fixed in terms of 1985 dollars. In other words, a $100-deduction in 1995 would understate the real economic cost of operating the equipment because $100 was not worth as much in 1995 as it was in 1985. Thus, the income of the business would be overstated because its costs as calculated would not represent the real costs to the business.

[203] While inflation adjustments could correct this problem, the tax code has featured accelerated depreciation to indirectly offset inflation. If an inflation adjustment for the historical cost of the machine were made, the $1,000 historical cost figure would be increased to reflect inflation each year, and the deduction for depreciation would therefore be increased so that it reflected the real economic cost of operating the equipment. Instead, the tax code has allowed accelerated depreciation (allowing relatively larger deductions in the first few years after the asset is purchased) but kept historical basis calculations. While it is possible to develop accelerated depreciation schedules that offset the effects of a given rate of inflation, depreciation schedules would have to be changed to prevent renewed overstatement or understatement of income if the rate of inflation changes.

[204] A similar problem exists in the calculation of capital gains. As noted above, capital gains on the sale of assets are taxed when assets are sold. To calculate gain or loss, the sale price of the asset is compared to the price that was originally paid for the asset. /8/ Part of this gain may be the result of inflation. Assets that have lost value on an inflation-adjusted basis could show a gain when the effect of inflation is ignored. This problem is one justification for applying a preferential tax rate to capital gains income to, albeit imperfectly, offset the overstatement of income. However, having a preferential tax rate, in turn, creates incentives for taxpayers to structure transactions so that income is characterized as a capital gain rather than as ordinary income, and further rules are designed to prevent or limit this activity. /9/

Integrating the Corporate and Individual Income Tax

[205] Another objective of income tax reform could be the integration of the corporate and individual income taxes. /10/ The differences in the current tax code between the tax treatment of corporations and noncorporate businesses, such as partnerships and sole proprietorships, have long been criticized. Some forms of corporate income can be taxed twice, while income earned by noncorporate businesses is taxed once. Under the current tax, corporate income paid out as dividends to individual shareholders is taxed twice; it is first taxed in effect at the corporate level because dividend payments are not deductible, and it is generally taxed again when shareholders receive the dividend payment as income.

[206] Table IV.3 details several options for integrating the corporate tax with the individual tax so that all business income, whether earned by a corporation or a noncorporate business, would be taxed once annually. Under all the income tax reform options, business income would be taxed at either the business level or the individual level, but the same income would not be taxed at both levels. In contrast to the consumption tax options that would allow an immediate deduction for investment spending, each income tax option would allow a deduction for depreciation of investment assets over time. The income tax options differ in the degree to which income would be taxed at the business level or the individual level.

    TABLE IV.3: OVERVIEW OF ALTERNATIVE INCOME TAX REFORM OPTIONS

___________________________________________________________________

                                            Integrated   Integrated

Business level

  Sales of

  Interest,

  Deducted

  Purchases

  Depreciation

  Wages             x                   x         x

Individual level

Integration Options That Tax Most Types of Income at the

[207] Two options would be similar to the current tax in that most types of income would be taxed at the individual level. Like the current income tax, the structure of these taxes would allow for any combination of rates and standard deductions and exemptions. Large standard deductions and a single rate would be possible, or the tax could feature graduated tax rates and subsidies such as the earned income credit. Family size and individual circumstances, such as being over 65 or blind, could be taken into account if desired.

[208] INTEGRATED INDIVIDUAL INCOME TAX. Under an integrated individual income tax, all corporate income would be taxed at the individual level at the individual's tax rate. As under the current tax, income earned by corporations and distributed to shareholders as dividends would be taxed at the individual level. Undistributed corporate income would be allocated to shareholders and taxable to them much as income earned by partnerships and S corporations is taxed currently. If the tax base was broadened, fringe benefits would be similarly allocated to the employees receiving the benefits.

[209] INTEGRATED CORPORATE INCOME TAX. An integrated corporate income tax would differ from the integrated individual tax in that undistributed corporate income would not be allocated to shareholders; rather, it would be taxed separately at the corporate level. Corporations would be allowed to deduct dividends paid to shareholders, and shareholders would pay tax on dividends they receive. Deductions for expenditures on fringe benefits could be disallowed, effectively taxing this income at the corporate level rather than as income to employees. Compared to the integrated individual tax, this option would tax more types of corporate income at the corporate level at the tax rate that applies to corporations rather than at the individual's tax rate.

Integration Options That Tax Most Types of Income at the

[210] The other two options would move the taxation of most types of income to the business level. Many of the simplifications made in the consumption tax proposals come about because more of the tax base is taxed at the business level than at the individual level. For example, the national retail sales tax (RST) and valued-added taxes (VAT) have no individual filing, and the flat tax reduces the number of items taxed at the individual level substantially. Taxing all or most of the tax base at the business level could also be done while maintaining an income tax, eliminating or substantially reducing the scope for individual filing. Any income or consumption tax that is levied primarily at the business level gains simplicity for individuals but sacrifices the ability to tax individuals according to their individual circumstances.

[211] INCOME VAT. It would be possible to tax income with only a business-level tax by using an income VAT. The difference between an income VAT and the consumption VATs we describe in appendix VI is the treatment of purchases of capital assets. Under the consumption VATs, these investments are deducted immediately, or expensed. Under an income VAT, businesses would deprecate capital goods over time, as they now do under the income tax. Wages, interest, and dividends would not be deductible, so these forms of income would effectively be taxed at source. Under such a system, as under a consumption VAT, individuals would not have to file returns themselves, and tax administration would be limited to business returns. Also, like a consumption vAT, individual characteristics could not be taken into account to make the tax more progressive or better reflect ability to pay.

[212] COMPREHENSIVE BUSINESS INCOME TAX (CBIT). It would be possible to tax most types of income at the business level and have a simplified individual tax that included only a few income items. For example, one of the prototypes for corporate integration analyzed by the Treasury Department, the CBIT would not allow deductions at the business level for interest and dividends, essentially collecting tax on these forms of income at the business level. Under such a system, individuals would pay tax on only wages and certain capital gains. /11/ The CBIT would modify the income VAT by allowing a deduction for wages at the business level and taxing wages at the individual level. Including personal exemptions, a standard deduction, and other features in the individual tax could then make the tax more progressive than an income VAT.

POTENTIAL IMPACT ON TAXPAYERS' COMPLIANCE BURDEN

[213] Table IV.4 summarizes some of the ways in which a reformed income tax could affect taxpayers, and a more detailed discussion follows.

   TABLE IV.4: SUMMARY OF SOME KEY POTENTIAL IMPACTS OF INCOME TAX

                    Characteristics of

Return filing       116 million returns      Individual taxes:

                                             CBIT: Limited base;

                                             Income VAT: No

Records kept        Records supporting       Individual taxes:

                                             Income VAT: Eliminated

Calculations made   Complicated calcula-     Individual taxes: Cal-

                                             CBIT: Made for certain

                                             Income VAT: Eliminated

Complexity faced    Many pages of in-        Individual taxes: Com-

Return filing       24 million returns       All options: Returns

Records kept        Records supporting       All options: Records

                                             Integrated individual:

Calculations made   Complicated calcula-     All options: Calculations

Complexity faced    Detailed rules in-       All options: Income

Requirement to      1.1 billion information  Integrated individual

                                             CBIT: No need for

                                             Income VAT: None related

Number of Tax Returns

[214] Under the individual tax options, as under the current income tax, both businesses and individuals might file returns. Under current law, individuals must file returns if their gross income exceeds certain thresholds. These thresholds vary according to filing status and are determined by the amount of the applicable standard deduction and the value of personal exemptions. If individuals with gross income below these thresholds have had tax withheld during the year, they can file a return to claim a refund. If these thresholds were unchanged by tax reform and the income tax were broadened to include more types of income, more individual returns might be filed. For example, individuals who have small amounts of wage income and some tax-exempt interest income might not have to file a return under current law; these individuals might have to file a return under the individual income tax options because all interest income would be taxable. However, if the additional revenue acquired from broadening the tax base were used to increase standard deduction or personal exemption amounts, the number of filers might be reduced.

[215] Business filing under these options could be similar to the current system. Sole-proprietorship income could be included with individual tax returns. Partnerships could continue to file information returns, and partners would report their share of the income earned by the partnership on their individual returns. Depending on the type of corporate integration reform adopted, corporations would either pay tax separately or file partnership-like information returns that allocate corporate income to shareholders.

[216] The number of information returns would be greater than under the current system if such reporting were extended to newly taxable income. Currently, interest on tax-exempt bonds is not subject to information reporting like taxable interest income; information reporting might be extended to all forms of interest income. The value of fringe benefits received by employees and income earned in pension fund reserves could also be reported.

[217] In contrast to the individual tax options, the number of individuals filing returns could fall under the CBIT. Rather than increasing the number of types of income subject to tax at the individual level, the CBIT would reduce the number of types of income reported by individuals to wages and certain capital gains, and other forms of income would be taxed at the business level. Therefore, individuals whose income is limited to interest, dividends, and small amounts of wage income would not have to file returns. If taxes continued to be withheld on wages, for many individuals the amount of tax withheld could very closely match their annual tax liability. As under the flat tax, a return-free filing system would be more feasible.

[218] Under the CBIT, all businesses, including sole proprietorships, would have to file tax returns, withhold tax on wages paid to employees, and file certain information returns. If interest on bonds issued by governments and nonprofit organizations were made taxable, these entities would have to file returns and remit tax on interest on any debt they had issued. Governments and nonprofit organizations would also have to withhold tax on wages paid to employees. However, businesses, governments, and nonprofit organizations would not have to file information returns for interest or dividend income.

[219] An income VAT could reduce the number of tax returns still further. Businesses, governments, and nonprofit organizations would remit tax and file returns, but no individual filing would be required. As a consequence, information returns related to individuals' receipt of interest or dividends would not be needed.

Recordkeeping

[220] Under either of the individual income tax reform options, broadening the tax base would both increase the need for recordkeeping in some areas and possibly decrease it in other areas. Eliminating various tax credits and deductions in the current tax code would reduce individuals' need to keep records on these items. For example, broadening the tax base by eliminating deductions for state and local taxes, charitable contributions, health insurance payments, and large medical expenditures would eliminate the need for taxpayers who now itemize deductions to keep records on these expenditures.

[221] However, broadening the tax base by taxing additional types of income could lead to additional recordkeeping. For example, records might have to be kept by individuals for interest income that is currently tax-exempt, pension earnings, fringe benefits, and government benefits, particularly if information reporting is not extended to these types of income. If owners of assets were required to pay capital gains tax on increases in the value of an asset, regardless of whether it was sold, they would have to obtain information to determine or estimate the value of the asset. This requirement would increase burden relative to the current tax, but the need to keep records over long periods of time might be reduced because capital gains from prior years would have already been subject to tax.

[222] In some areas, however, including additional types of income might eliminate the need to distinguish between different types of income, reducing the need for recordkeeping. For example, currently taxpayers must use separate accounts for IRAs and other saving. A reformed income tax could treat savings more uniformly, eliminating the need for separate accounts and the associated recordkeeping. Similarly, under current law, interest expenses must be characterized according to many different rules to prevent taxpayers from deducting interest expense from debt used to generate tax-exempt income. A more uniform treatment of income may in turn allow for a simpler, more uniform treatment of interest expense.

[223] Although a more uniform treatment of all forms of income might require more complicated rules for some forms of income, it might also reduce incentives for tax planning and reduce the number of transactions undertaken for tax reasons. For example, the Tax Reform Act of 1986 instituted some complex rules to reduce the attractiveness of tax shelters. While complying with these rules may be burdensome and costly, if they succeed in reducing the amount of resources used in structuring tax shelters, the result might be that overall, fewer resources will be used complying with the tax code and attempting to minimize tax liability.

[224] If many of the tax preferences in the current tax code were eliminated and if tax rules measured economic income more accurately, Congress might conclude that the corporate or individual alternative minimum taxes (AMT) were no longer needed. Under the AMT, taxpayers must account for a number of items differently than they do for regular tax or financial statement purposes. The requirements to keep two or more sets of records for certain items and make special calculations might be eliminated if Congress decided that an AMT was no longer needed after income tax reform. /12/

[225] The need for individuals and businesses to keep records under a reformed income tax would also depend on the option chosen. For the individual taxes, the integrated individual tax would require corporations to allocate all their income to shareholders. This would likely lead to additional recordkeeping, especially for widely held corporations whose shareholders may have owned stock only briefly during a year. Integrating the corporate tax by allowing a deduction for dividends might not significantly complicate the tax system. Both integration plans would reduce the need to distinguish between debt (for which interest payments are currently deductible) and equity (for which dividend payments are currently not deductible).

[226] The CBIT option would reduce recordkeeping requirements for individuals. Since taxes on wages could continue to be withheld, other forms of compensation would be in effect taxed at the business level, and interest and dividend income would not be taxable to individuals, individuals' recordkeeping responsibilities would be limited to certain capital gains. If the income tax base was also broadened to include fringe benefits, businesses would need to keep records that identified business expenditures that could be considered nonwage compensation of employees because these expenses would not be deductible. The distinction between debt and equity would not have to be made under the CBIT because neither interest nor dividends would be deductible.

[227] The income VAT would eliminate all recordkeeping for individuals. If the tax base was broadened, all compensation would be nondeductible for businesses, so records would not have to distinguish between forms of compensation for income tax purposes. However, businesses would have to distinguish between compensation and other expenses that would be deductible. Businesses would not be required to withhold income tax on wages; however, withholding for payroll taxes would still have to be done unless the payroll tax was eliminated as a part of tax reform.

Calculations Required

[228] Both the introduction of indexing the tax base for inflation and taxing capital gains on an accrual basis would affect the calculations required for computing income tax liability. Under all the tax reform options we are discussing, depreciation and inventories could be indexed. For the options that tax capital gains or interest income at the individual level, these items could be indexed as well. For individuals, indexation would make the calculation of capital gains more complicated, and adopting a system of taxing capital gains as they accrue could increase the frequency with which capital gains calculations would need to be made. Indexing interest income might add to individuals' calculations unless it was actually done for individuals by businesses or financial institutions. For businesses, indexation would also increase the number of calculations required for depreciation and inventories, and under some options for interest expense deductions and interest income. These calculations are not done for financial reporting purposes.

[229] Under the CBIT option, individuals would have to make capital gains calculations, but since interest income would not be taxable for individuals, no indexing calculations would have to be made for interest income. For businesses, inflation adjustments would be needed for depreciation and inventories, but inflation adjustments for interest expenses would not be needed because neither real nor nominal interest expense would be deductible.

[230] The income VAT would eliminate taxes on individuals, so no calculations would have to be made by individuals. Businesses would also have fewer calculations. The calculations for computing tax liability would be similar to those for the CBIT except that calculations related to deductions for wages and withholding tax on wages would not be needed for income tax purposes.

Effects of Income Tax Reform on Compliance Costs

[231] Joel Slemrod recently estimated potential compliance cost savings from a reformed income tax similar to the integrated corporate income tax option. /13/ The reformed income tax he described would simplify the income tax base by eliminating itemized deductions except for the mortgage interest deduction; restricting business deductions for fringe benefits; and ending the child care and elderly credit, the tax-exempt status for interest on state and local government bonds, and savings incentive programs like IRAs and Keogh plans. AMTs would be eliminated, and a dividend credit would be established to integrate the corporate and individual taxes. A 10- percent tax rate would apply to about 75 percent of individual taxpayers, and withholding would be extended to interest payments, making tax return filing unnecessary for many taxpayers. Slemrod estimated that such reforms could reduce individual compliance costs by at most 15 percent and business compliance costs by about 5 percent.

POTENTIAL IMPACT ON TAX ADMINISTRATORS

[232] Table IV.5 shows some of the effects that various income tax options could have on tax administrators, and a more detailed discussion of those effects follows.

          TABLE IV.5: SUMMARY OF SOME KEY POTENTIAL IMPACTS

_____________________________________________________________________

Item           Current income tax       Income tax reform options

Impact on      Hundreds of millions     Individual taxes: Possibly

                                        CBIT: Fewer individual

                                        Income VAT: No individual

Impact on      92 million refunds       Individual taxes: Possibly

                                        CBIT: Possibly fewer refunds

                                        Income VAT: Individual refunds

Impact on      Tax returns matched      Individual taxes: Similar to

Continuation   Compliance problems      All options: Compliance

Resolution of  Not applicable           All options: Compliance

Creation of    Not applicable           All options: Indexing

                                        CBIT: Capital gains only

Impact on      Millions of taxpayer     Individual options: Possibly

Impact on      Millions of taxpayer     Individual taxes: Most

                                        Income VAT: Only questions

Processing of Returns

[233] The individual tax reform options, combined with a broadened income tax base, would have several effects on the need to process returns. Broadening the tax base by adding income items would lead to some additional line items and perhaps some additional schedules and more information returns. These changes would, by themselves, increase returns processing workloads. However, the elimination of some deductions, adjustments, and tax credits would eliminate some line items, reducing the workload. In addition, if added revenue from a broadened tax base were used to increase the standard deduction, the number of taxpayers required to file could decrease, which would also reduce the processing workload.

[234] The CBIT option would be more likely to reduce returns processing workload because the number of individual tax returns could be reduced, the individual tax return would contain fewer line items, and fewer information returns might be needed. While taxing additional types of income, such as accrued capital gains, could generate additional schedules and information returns as mentioned above, other types of income, such as interest and dividends, would no longer be reported on individual returns. Information returns for these types of income would not be needed, so the need to process them and match them with tax returns would be eliminated.

[235] An income VAT would have the most significant impact on the returns processing workload because individual returns and most information returns would be eliminated. Returns would need to be processed for businesses (approximately 24 million in 1995) and nonprofit organizations and government entities.

Noncompliance and Enforcement

[236] Income tax reform, like the other tax reform alternatives, could resolve some compliance and enforcement issues, create some new issues, and leave some issues unresolved. In general, issues concerning the measurement of income from saving and investment would remain because the reforms would continue to tax this income. As under the consumption tax alternatives, unreported sales or income would remain an issue for tax administration, as would separating deductible business expense from personal consumption in areas like automobile use and meals and entertainment deductions. Issues involving differential treatment of some types of capital income would be resolved, although the added calculations used to uniformly measure capital income would have to be checked.

[237] Under any of the income tax options, a broadened tax base would eliminate some administrative tasks but create others. The elimination of some credits and deductions would simplify administration. Because mortgage interest is the only deduction currently covered by information reporting, the elimination of other deductions would not reduce the need to match information returns with tax returns, but would reduce the need to audit tax returns. However, taxing some additional types of income would increase administrative tasks. Some types of income such as currently tax- exempt interest income and pension income could be subject to information reporting, so the identification of underreporting of these types of income could result from matching. To identify unreported or underreported accrued capital gains, audits would be necessary unless information returns were filed for owners of assets, not just for the sellers of assets as is done currently.

[238] As under the current tax, issues involving the calculation of income from saving and investment would remain because the tax base would include these types of income. The capitalization or deductibility of business expenses, contentious in cases where it is difficult to determine whether a business expenditure creates an asset for the business, would likely remain an issue for tax administration. However, issues that arise because of differences in the tax treatment of certain types of income from saving and investment may be reduced because this income would be treated more uniformly. For example, checking that the rules and limitations on IRA, 401(k), and pension accounts had been followed would not be necessary.

[239] Under all the income tax options, as well as all the alternative consumption taxes, identifying unreported or underreported amounts would remain a major concern for tax administration. Issues involving consumption in a business, as under consumption taxes, also would continue under any reformed income tax.

[240] The CBIT and income VAT options would simplify examination by eliminating the need to verify many types of income for individuals. Under the CBIT, the compliance of individuals could be checked largely through information return matching on wages. Identification of certain capital gain income would also be necessary, as would the verification of filing status and the proper number of dependents. However, the identification of other forms of income and verification of deductions would not be needed, and administrators could focus relatively more attention on business returns. Under an income VAT, clearly all examination and compliance efforts would involve business returns.

Collections

[241] As under the current income tax, under any of the reform options, there would likely be taxpayers who do not file returns or who file but do not pay the correct amount of tax. Under the individual income tax options, the number of such balance-due or delinquent accounts might increase for two reasons. First, if withholding is generally limited to wages as it is currently, the amount withheld might not be as close to the actual tax liability because additional types of income would be subject to tax. Second, some of the types of income that might be taxed under a reformed income tax, such as accrued capital gains, are not received as cash. Unless individuals carefully adjusted their withholding to take this additional income into account, more individuals might have to pay tax when they filed. These individuals might not pay the correct amount or might not file if they do not have cash available to pay the tax. However, if a broadened income tax was accompanied by lower tax rates, some individuals who have difficulty paying their tax liability currently might be able to pay the tax they owe.

[242] Collections activity might fall under the CBIT option simply because fewer individuals would be liable for tax and, for individuals, fewer types of income would be subject to tax. As noted in appendix II, in 1995, about two-thirds of delinquent accounts were individual accounts. Under the CBIT option, tax withheld on wages might closely match actual tax liability, especially for taxpayers without capital gains income. An income VAT would do away with individual payments; businesses would be responsible for remitting all tax. Therefore, collections activity would be focused on business tax liability.

Taxpayer Services

[243] In terms of taxpayer calls to IRS for assistance, most calls now received concern procedural issues, refunds, notices, and other account information. Additional calls concern filing status, dependents, and exemptions. The extent to which this assistance would still be needed under the various reform options would depend on the number of individual taxpayers filing returns under each option.

[244] The tax reform options would likely generate additional demand for taxpayer services and education in the areas of indexation (how to make adjustments for inflation) and calculations of accrued capital gains. On the other hand, some currently asked questions concerning pensions and deferred compensation and individual adjustments and deductions might no longer be asked if the tax base was broadened to tax income more uniformly.

OTHER ISSUES

Transition Issues

[245] While transition issues would likely arise from any type of tax reform, some issues that could be particularly significant in a transition from the current tax to a consumption tax might not be as significant under income tax reform. The tax treatment of existing business assets, a significant issue in transition to a consumption tax, would not be as significant an issue for income tax reform. For example, indexing depreciation deductions for inflation would be a less significant change than adopting expensing as under most of the consumption taxes. Existing business net operating loss carryforwards could continue with a new system.

[246] Some other transition issues raised by income tax reform could be significant and could create administrative problems. If pension income were made taxable and if the old treatment was maintained for existing pension assets, taxpayers would have to segregate old from new accounts, and administrators would have to check these accounts. Individuals receiving dividends could receive a windfall gain if dividend taxes were eliminated or if dividend deductibility was granted; again maintaining the old system for current equity shares would be difficult. Under the CBIT option, ending the deduction for interest at the corporate level and ending the taxation of interest at the personal level is an issue that could be handled through tax rules or might be ignored if it was thought that the private sector would renegotiate the terms of the debt.

Federal/State Issues

[247] Currently, 35 states and the District of Columbia levy income taxes that conform to some degree with the federal income tax. Many states also rely on federal enforcement efforts and information to administer their income taxes. /14/ If the federal income tax were changed, the states could make adjustments in their income taxes to conform to the reformed federal tax. Under the income tax options that include an individual-level tax, the states that now follow the federal tax could continue to tax individual income and rely on federal administration efforts. The inclusion of additional income items could expand state and local income tax bases if those governments chose to conform with the federal tax base. On the other hand, under the CBIT or income VAT, the ability of states to tax individual income would be reduced, as would be the case with the VAT, national RST, or flat tax, because much of the information, such as information returns, that are currently used to administer the federal individual income tax would no longer be available.

International Issues

[248] Under the current income tax, the income of U.S. citizens and corporations is subject to tax wherever it is earned -- that is, income is taxed on a worldwide basis. Income earned abroad may also be taxed by foreign governments, so the United States provides a limited credit for foreign income taxes paid (the foreign tax credit) to prevent double taxation. Income earned in the United States by foreign corporations and foreign residents is also taxed, and withholding taxes are levied on certain interest and dividends paid to foreign investors. These withholding taxes are commonly reduced through income tax treaties with foreign governments. /15/

[249] Under current law, income earned abroad by U.S. corporations may not be subject to U.S. tax until it is distributed to the United States (repatriated). However, taxpayers' ability to defer tax by retaining income abroad is limited for some types of income by the so-called subpart F rules. If income tax reform included taxing accrued capital gains for domestic assets, it would be consistent to tax all types of income earned abroad when they are earned rather than when repatriated. The current rules to limit deferral are considered complex, but extending these rules might reduce tax planning by treating different types of income uniformly, might simplify the foreign tax credit, and might reduce transfer pricing controversies for U.S. corporations with foreign operations. /16/

[250] For foreign corporations operating in the United States, transfer pricing would likely continue to be a difficult area for taxpayers and tax administration as long as the U.S.-source income of these corporations is taxed. A related policy issue would arise regarding whether the benefits of corporate tax integration should be extended to foreign corporations and investors automatically or through treaty. The integrated individual tax option (by eliminating the corporate-level tax) and the integrated corporate tax (by allowing a deduction for dividends) would pass integration benefits to foreign shareholders automatically. On the other hand, the CBIT and income VAT options would retain a corporate-level tax and replace an explicit withholding tax on certain distributions to foreigners with implicit withholding through the nondeductibility of interest and dividends. /17/

FOOTNOTES TO APPENDIX IV

/1/ The current tax code contains several provisions to force the recognition of income to prevent deferral of gain in some circumstances. Shuldiner notes that Internal Revenue Code sections 475 and 1256 require mark-to-market for the inventory of security dealers and certain financial instruments; sections 453A and 1291 impose interest charges on deferral. Reed Shuldiner, "Indexing the Tax Code," Tax Law Review, Vol. 48 (1993), pp. 556-57, notes 70, 72.

/2/ For details of such an approach, see Alan J. Auerbach, "Retrospective Capital Gains Taxation," The American Economic Review, Vol. 81, No. 1 (Mar. 1991), pp. 167-78. Also, see David J. Shakow, "Taxation Without Realization: A Proposal For Accrual Taxation," University of Pennsylvania Law Review, Vol. 134, No. 5 (June 1986), pp. 1111-1205.

/3/ More detail on the tax treatment of fringe benefits is presented in Tax Policy: Effects of Changing the Tax Treatment of Fringe Benefits (GAO/GGD-9243, Apr. 7, 1992).

/4/ Several European countries that also tax net wealth have, at certain times, levied a tax on imputed rent by including a certain fraction of the assessed value of a house in the income tax base. See OECD Studies in Taxation, The Personal Income Tax Base: A Comparative Survey (Paris: 1990).

/5/ U.S. Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth Vol. 1 (1984), pp. viii-ix.

/6/ For a more detailed analysis of indexing, see Shuldiner (1993); Bradford (1986), Ch. 3; Daniel Halperin and Eugene Steuerle, "Indexing the Tax System for Inflation," in Henry J. Aaron, Harvey Galper, and Joseph A. Pechman, eds., Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax (Washington, D.C.: The Brookings Institution, 1988); and Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate Over Tax Reform (Cambridge, Mass.: The MIT Press, 1996), Ch. 8. For information about foreign experience with indexation provisions, see Milka Casanegra de Jantscher, Isaias Coelho, and Arturo Fernandez, "Tax Administration and Inflation," in Richard M. Bird and Milka Casanegra de Jantscher, eds., Improving Tax Administration in Developing Countries (Washington, D.C.: International Monetary Fund, 1992).

/7/ Shuldiner (1993), p. 598, and Slemrod and Bakija (1996), p. 238.

/8/ For depreciable assets, the calculation of gain or loss would also take into account depreciation deductions taken over time.

/9/ See Treasury, pp. 180-81.

/10/ For a comprehensive study of the issue of integration, see U.S. Department of the Treasury, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (Jan. 1992).

/11/ "Certain capital gains" are increases in the value of stock that are unrelated to undistributed business income, which is already taxed at the business level under the CBIT. Such increases in the value of stock might result from anticipation of increases in future earnings or from increases in the value of assets owned by the business itself. See Treasury (1992) Ch. 8 for more details on how capital gains might be taxed under different corporate tax integration options.

/12/ Under the reformed income options that include a business- level tax and indexing, taxable income as measured by tax rules would be different from income reported on financial statements. Congress would need to decide whether an AMT was needed to ensure that corporations that reported income to shareholders in a particular year also paid tax in that year.

/13/ See Slemrod (1996), pp. 377-80, for further details.

/14/ Joint Committee on Taxation, Impact on State and Local Governments and Tax-Exempt Organizations of Replacing the Federal Income Tax (JCS-4-96), Apr. 30, 1996, pp. 6-8.

/15/ For a summary of U.S. international tax rules and policies, see Hugh J. Ault and David F. Bradford, "Taxing International Income: An Analysis of the U.S. System and Its Economic Premises," in Assaf Razin and Joel Slemrod, eds., Taxation in the Global Economy, (Chicago: University of Chicago Press, 1990).

/16/ For further details, see U.S. Department of the Treasury, International Tax Reform: An Interim Report (Jan. 15, 1993).

/17/ In its report on corporate tax integration, the Treasury recommended integration options that did not automatically pass benefits to foreigners because these provisions might simply transfer tax revenue from the United States to foreign governments. See Treasury (1992), Ch. 7, for a detailed discussion of international issues regarding corporate tax integration.

END OF FOOTNOTES TO APPENDIX IV