Order Code RL32603
CRS Report for Congress
Received through the CRS Web
The Flat Tax, Value-Added Tax, and National
Retail Sales Tax: Overview of the Issues
December 14, 2004
Gregg A. Esenwein
Specialist in Public Finance
Government and Finance Division
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Congressional Research Service { The Library of Congress
The Flat Tax, Value-Added Tax, and National Retail
Sales Tax: Overview of the Issues
Summary
The current income tax system is criticized for costly complexity and damage
to economic efficiency. Reform suggestions have proliferated, including a national
retail sales tax, several versions of a value-added tax (VAT), the much-discussed
“Flat Tax” on consumption (the “Hall-Rabushka” tax), the “USA” proposal for a
direct consumption tax, and revisions of the income tax. The President has indicated
that major tax reform will be a priority item in his second term.
Most reform proposals are based on the notion that switching to a consumption
tax base or exempting savings from tax would increase the savings rate and improve
economic efficiency. Although theoretical inter-temporal models predict that saving
and efficiency would increase, evidence from past tax cuts does not bear out this
prediction. Any effect on savings would depend crucially on the transition
provisions. It is also argued that these taxes could improve the country’s trade
balance. Trade balances, however, depend on capital flows and would be affected
by these tax changes only if they do bring about an increase in the U.S. savings rate.
There is no reason to expect trade benefits from any of the tax changes per se.
A broader tax base would have diverse effects on economic sectors. Sectors that
might be adversely affected include the non-profit sector (loss of charitable
contributions deductions), the state and local sector (loss of state tax deductions,
change in their own tax structures), and the health care sector (taxation of fringe
benefits). Shifting the tax base from income to consumption, while generally
increasing business investment, would differentially affect firms, depending on their
growth rate, capital structure, and employee benefit structure. Such a shift would
also make investment in pensions, insurance policies, owner-occupied housing, and
tax-exempt bonds relatively less attractive.
There are macroeconomic problems with a transition to a consumption tax, and
these problems are extremely serious for transiting to a system that collects all
revenue from business (VAT or retail sales tax). For these tax shifts, avoiding a
serious economic contraction would be quite difficult. The flat tax would not have
these problems but it can cause significant windfall losses in asset values.
A flat-rate tax is also intended to simplify the system and reduce compliance and
administration costs. Many of the proposals, if kept simple while being enacted,
would reduce costs; however, many individual taxpayers are currently under a flat-
rate income tax, so their lot would not be much improved. An enacted law, however,
might not be as simple as the proposals.
Consumption taxes also change the distribution of tax burdens, especially on
generations. The old consume more of their incomes, and their burden would
increase; younger people save more, and their burdens would fall. Higher income
individuals would see a reduction in taxes.
This report does not track current legislation and will not be updated.
Contents
Proposed Alternatives to the Present Tax System . . . . . . . . . . . . . . . . . . . . . . . . . 1
Three Main Tax Bases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Current Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Can Switching to a Different Tax System Help the Economy? . . . . . . . . . . . . . . . 3
Efficiency Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Effects on Saving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Competitiveness of U.S. Companies Under Different Tax Systems . . . . . . . . . . . 7
The Balance of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Border Tax Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Effects of Tax Policy on Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
How Will Different Economic Sectors be Affected? . . . . . . . . . . . . . . . . . . . . . . . 9
Sector Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
State and Local Governments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Owner-Occupied Housing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Non-Profit Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Health Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Pensions/Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Differential Effects on Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Special Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Transition Costs and Macroeconomic Adjustments . . . . . . . . . . . . . . . . . . . . . . 11
Price Accommodation and Short-run Contractions Under a Retail Sales
Tax or VAT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Windfall Losses for Equity Investments Under the Flat Tax . . . . . . . . . . . . 13
Stock Market Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Effect on Tax Administration and the Underground Economy . . . . . . . . . . . . . . 15
Taxpayer Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
What is the Current Burden? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Would Tax Reform Relieve the Burden? . . . . . . . . . . . . . . . . . . . . . . 16
Administrative Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
The Underground Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
How Would the Distribution of the Tax Burden and the Level of Tax
Revenues be Affected by a Different Tax System? . . . . . . . . . . . . . . . . . . . 18
Revenue Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Distributional Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Income Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Generations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
A Lifetime Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Marriage Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Additional CRS Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
The Flat Tax, Value-Added Tax, and
National Retail Sales Tax: Overview of the
Issues
The current tax system, with its graduated tax on individual incomes, its
separate tax on corporate profits, its gift and estate taxes on the transfer of wealth,
and its separate wage tax to fund the Social Security and Medicare systems, has many
critics. It is said to cost the country in lost time, economic efficiency, trade, and
contentment. Reform proposals have proliferated, ranging from a broader-based,
flatter-rate income tax to scrapping the system altogether in favor of a national sales
tax or some other form of national consumption tax.
This report surveys some of the issues to be considered in debating such drastic
tax changes, considering not only a broader based income tax but also three basic
forms of consumption taxes: the Hall-Rabushka “flat tax,” the value-added tax
(VAT), and the national retail sales tax. After a brief overview of some of the current
proposals, the sections that follow discuss economic efficiency issues, foreign trade
issues, effects on different economic sectors, short-run adjustment costs, compliance
and administration, and revenue and distributional implications.
Proposed Alternatives to the Present Tax System
The idea of replacing our current income tax system has been a topic of
perennial congressional interest. Although many recent proposals are referred to as
“flat taxes,” most actually go much further than merely adopting a flat-rate tax
structure and would change the tax base from income to consumption. More
recently, the President has indicated some interest in such fundamental tax reform,
specifically referring to a national retail sales tax.
Three Main Tax Bases
Theoretically, one could construct a tax system using one or a combination of
three main tax bases: income, wages, or consumption. Income- and wage-based
taxes are familiar and relatively easy to understand.
Under a comprehensive income tax, all income, whether from labor or capital,
would be included in the tax base. A wage-based tax would be levied only on
income from labor; income from capital would be excluded from the base.
Obviously, wages provide a smaller tax base than income and would therefore
require higher tax rates to raise the same revenue as a tax based on all income.
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With the exception of sales taxes, the American people are not very familiar
with other forms of broad-based consumption taxes and so there is some confusion
about how they might be measured and levied. The easiest way to understand the
basis of consumption taxes is to first define and understand the economic concept of
income.
In its broadest sense, income is a measure of the command of resources that an
individual acquires during a given time period. Conceptually, an individual has two
options with respect to his income; he can consume it or save it. This relationship
means that by definition income must equal consumption plus saving.
This relationship helps in understanding how a comprehensive consumption-
based tax might be levied at the individual level. An individual would add up all his
income as he does under the current tax system but would then subtract out his net
saving (saving minus borrowing) or add net borrowing. The result would produce
a tax based on consumption at the individual level.
A consumption tax could also be collected at the retail level as a retail sales tax
on final consumption. (A retail sales tax exempts, in theory, the sale of intermediate
goods including capital goods to be used in a business). Or it could be collected at
each stage of the production process in the form of a value-added-tax (VAT). With
the VAT, firms face a tax on gross receipts less purchases of materials, goods for
resale and capital to be used in the business. A VAT can be implemented using
either a credit-invoice method or a subtraction method.1 Another way of collecting
the tax, the Hall-Rabushka flat tax, would split the VAT base between firms and
individuals. Firms would deduct wages from their tax base and individuals would
pay a tax directly on their wages. Although the point of collection differs (individual
level, retail level, or firm level), when defined comprehensively, the tax base is the
same: consumption.
Regardless of the point or form of collection, however, a consumption tax is
ultimately paid by the individual consumer. Because consumption is smaller than
income, a comprehensive consumption tax would require higher tax rates than a
comprehensive income tax to raise the same revenue, although with a low savings
rate, the bases (and thus tax rates) are very close.
Other developed nations have VATs (of the credit-invoice type), but also have
income taxes. Their VATs do not replace income taxes, but rather finance a higher
level of government spending. Most of these nations do not have a retail sales tax,
which is an important subnational tax in the United States.
1 Under the credit-invoice method, a firm pays the VAT on total output and receives a credit
for taxes paid by its intermediate suppliers. Under the subtraction method a firm pays tax
on total output less the costs of intermediate inputs. The credit invoice method is commonly
used in other countries and because of multiple reporting tends to lead to a high level of
compliance. The credit invoice method allows differential rates to be applied to final
products based on the tax at the last stage, while the subtraction method is appropriate for
a single uniform rate.
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Current Proposals
There is currently no serious proposal to shift the entire tax system to a wage-
based tax as such. The current proposals are almost all based on a switch to some
form of consumption taxation, either a national sales tax or some form of value-
added tax. They differ principally in their point of collection rather than their tax
base. These proposals include several versions of the value-added tax widely used in
Europe, a national sales tax such as those used in the states, and more exotic
variations, such as the “Flat Tax” devised by economists Robert Hall and Alvin
Rabushka and the Unlimited Savings Account or “USA” tax originally introduced
in the 104th Congress by Senators Dominici and Nunn. There is also some interest
(and at least one serious proposal) in a broader-based, flatter rate income tax.2 No
bill for this type of fundamental tax reform has had sufficient detail to be operational,
and no such bill has ever received a floor vote.
The President indicated that fundamental tax reform would be a major priority
of his second term, although the shape of that reform is uncertain at this point. Such
a reform might include the shift to a consumption tax as discussed above, it might
include an expansion of the income tax base, or it might be some hybrid of the two.
Many of the issues discussed in this paper, especially sectoral effects on currently
favored industries would also apply to a broader based income tax.
Can Switching to a Different Tax System
Help the Economy?
Probably the most often repeated argument in favor of switching to a flat-rate
consumption tax is that it will make the economy more efficient and will increase
private savings. When evaluating this argument, however, comparisons should not
be made between the current income tax system and an ideal consumption tax.
Compared to a theoretically ideal tax (whether the base is consumption or
income), the existing tax system will always appear flawed. For policy evaluation,
therefore, a more appropriate comparison is between a theoretically pure
consumption tax and a theoretically pure income-based tax.
Efficiency Issues
The economic efficiency or inefficiency of a tax system may be judged by its
effects on behavior. To the degree that the tax system distorts economic behavior
(from what it would be in the absence of the tax), it is economically inefficient. The
distortion prevents the efficient allocation of resources. Basically, with the exception
of lump-sum or head taxes, all taxes, regardless of whether they are based on income
or consumption, distort behavior and affect the allocation of resources.
2 For a summary of current bills and proposals, see CRS Issue Brief IB95060, Flat Tax
Proposals and Fundamental Tax Reform: An Overview, by James M. Bickley.
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Both an income and a consumption tax distort the choice between labor and
leisure. For example, under either tax, the price of leisure is reduced relative to the
consumption an individual could finance with an extra hour of labor.
An income tax also distorts the choice between present and future consumption
(saving). Under an income tax, the return to savings is subject to tax. This reduces
the resources an individual will have available for consumption in the future, and
hence raises the price of future consumption relative to the price of present
consumption. In contrast, a tax on consumption is neutral with respect to the choice
between present and future consumption. The relative price of future consumption
in terms of present consumption is the same as if there were no taxes.
In theory, adopting a consumption tax may or may not increase overall
economic efficiency. Under a consumption tax which yielded revenue equal to an
income tax, the tax rates would have to be higher than the tax rates on the income tax
base because consumption is smaller than income. The higher tax rates under a
consumption tax would increase the distortion between work and leisure choices.
The efficiency gain from removing the present/future consumption distortions,
therefore, might be offset by the efficiency loss inherent in the larger distortion
between work and leisure decisions.
Many economists have argued, however, that a consumption tax is superior in
achieving economic efficiency (i.e., in leading individuals to consume and work in
a more optimal fashion) because of the elimination of the distortion between present
and future consumption. They base this argument on the simulated outcomes of
inter-temporal models, which virtually always predict a gain in efficiency from the
shift from flat rate income to flat rate consumption taxes.3 One reason for this
predicted efficiency gain — which often does not occur with a shift from an income
to a wage tax base — is that a consumption tax is the equivalent of a tax on wages
and a lump sum tax on existing wealth. The lump sum tax allows tax rates to be
much lower with a consumption base than with a wage base, even though neither tax
the return to new investment. In fact, when an economy’s saving rate is very low, the
consumption tax base is quite close to the income tax base. (There are distributional
consequences to this feature that will be discussed subsequently). Thus, even though
tax rates may be higher under a consumption tax than under an income tax and
increase the distortion between work and leisure, this increase is a relatively small
effect — the lump sum tax on old wealth has made this efficiency gain possible.
The existence, and even the magnitude, of this efficiency gain, however, is not
entirely clear under a less abstract modeling of the tax. First, under current law the
income tax imposes higher marginal tax rates on capital income than on labor income
(primarily because of the corporate income tax). To replace both corporate and
individual revenues by a flat consumption tax would require a higher consumption
tax rate and the tradeoff between the labor leisure distortion and the present and
future consumption distortion is less clear. There may be potential gain from moving
3 For a discussion of these models and their effects on savings, see CRS Report RL31949,
Issues in Dynamic Revenue Estimating, and CRS Report RL32517, Distributional Effects
of Taxes on Corporate Profits, Investment Income, and Estates, both by Jane G. Gravelle.
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from graduated tax rates to flat rates, but such gains could be accomplished within
an income tax reform; moreover many consumption tax proposals include some
form of relief for lower income individuals.
Perhaps more importantly, there is a good deal of uncertainty about whether
these intertemporal models actually reflect how people behave. The presumed
sophistication and information requirements of such models is high and there is
evidence and reason to believe that most individuals decide their savings behavior
based on fairly straightforward rules of thumb that suggest savings does not respond
positively to higher rates of return (although it could decline). There is even less
evidence that individuals are able to shift their leisure (and therefore their working
hours) over time, a behavior that is an important feature of many of these
intertemporal models. If the behavioral responses are small, then the efficiency
gains are small.
There are certain practical aspects of consumption taxes, however, that may give
them some advantages over income taxes. For example, the problems and
complexities of measuring income from capital are eliminated under a consumption
tax. Eliminating the current law differential in the tax treatment of different forms
of capital could improve resource allocation and economic efficiency. In practice,
of course, there may be pressure for differential taxes on different types of
consumption goods, a differential that is quite feasible with the retail sales tax and
with some forms of the VAT, but much less likely under a tax on consumed income.
Moreover, in some types of taxes (particularly the retail sales tax) it is very difficult
to separate out intermediate purchases from final purchases and administer such
rules. As a result, some final goods are likely to escape the tax and some
intermediate goods and capital goods are likely to be subject to the tax.
It appears that, on the whole, switching from an income to a consumption tax
would probably not produce great improvements in economic efficiency.
Nonetheless, even small efficiency gains may be important because they continue
year after year. However, similar gains might also be achieved though income tax
reform.
Effects on Saving
Intertemporal models also tend to predict an increase in savings in switching
from income to consumption taxes and this effect is often viewed to be a positive
result of a consumption tax (separate from the efficiency gains described above). An
increase in the savings rate, however, cannot be determined to be necessarily
desirable, since it trades off current consumption for future consumption. Moreover,
under a consumption tax the old (retirees who are dissavers because they are drawing
down their accumulated capital to finance consumption) would pay higher taxes and
the young would pay lower taxes. Because of their higher tax liabilities, retired
workers would have to reduce their consumption (or return to the work force). Since
some of the increase in savings, at least in these models, is the result of a windfall tax
on assets of the old, it is even more difficult to determine the extent to which the
savings effects are desirable.
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For the young, a consumption tax is the equivalent of exempting the rate of
return on savings from tax. Normally, the effect on savings of increasing the rate of
return (via a tax cut) is ambiguous. There is a substitution effect — because the
return is higher, one has to give up less consumption today in order to consume a
given amount in the future. This lower “price” of future consumption encourages
more of it. At the same time, there is an income effect — because the rate of return
is higher one can actually consume more in the future, while saving less, allowing
more consumption today. The net effect of these two forces is uncertain.
A consumption tax has another important feature, however, that overwhelms
this income effect. Unlike a mere exclusion of tax on the return, the consumption tax
allows an up-front deduction for savings, but requires the payment of tax on both
principal and return when consumption occurs in the future. Thus, individuals need
to save today to pay these taxes due in the future; they can do so while still
consuming more today because of their large tax cuts. Thus, while the young may
consume some part of their tax cut, the old reduce their consumption by much more,
and the overall effect is to increase aggregate savings in the economy.
As with the case of efficiency gains, some of the results regarding the effects of
a consumption tax on savings are based on intertemporal models which rely on
somewhat idealized assumptions. For instance, they assume that all taxpayers have
perfect information, and the sophistication to map out their consumption choices over
a long period of time, and that they are certain that the tax system will not change
during their lifetimes. If these idealized assumptions are relaxed, then the results are
not conclusive that switching from an income tax to a consumption tax would
increase savings.
In addition, the empirical evidence regarding the effect of tax incentives on
savings is inconclusive. For example, the Economic Recovery Tax Act of 1981
significantly reduced marginal income tax rates, expanded the availability of
individual retirement accounts (IRAs), and accelerated depreciation deductions.
Life-cycle models would predict that these changes should dramatically increase
private savings, but that did not happen.
Finally, it is critical to note that any transition rules that are enacted to mitigate
the increased taxes on the elderly at the time of transition to a consumption tax would
tend to reduce the stimulus to new saving. A crucial part of the savings effect is the
reduced consumption of the old; moreover, any increase in taxes on the young would
be more likely to come partly at the expense of savings. Indeed, if enough
transitional relief were given to the elderly, the income effect could be reduced to a
point where there may be no effect, or even a negative effect, on new saving, at least
in the short run. In addition, the elderly, particularly those with high incomes, often
do not exhibit the dissaving associated with life cycle model savings, and it then
becomes crucial to determine their motive for leaving bequests.
Because of these ambiguities and the lack of conclusive empirical evidence, it
cannot be determined definitively that a consumption tax would significantly increase
the level of saving in the economy.
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Competitiveness of U.S. Companies Under
Different Tax Systems
Among the arguments for switching from an income tax to a consumption tax
is the assertion that a consumption tax would make U.S. industries more competitive
and help the U.S. balance of trade.
When analyzing the effects of tax policy changes on international trade it is
important to differentiate between a nation’s perspective and a firm’s perspective.
A nation engages in trade because through trade it can obtain the goods and services
its people want or need at a smaller resource cost than if it were to produce those
goods and services itself. A nation exports its products as a means of paying for what
it imports.
On the other hand, a firm’s ultimate goals are to sell its products and maximize
its profits. Exports provide a means to achieve these goals.
The Balance of Trade
Popular perceptions about trade tend to reflect a firm’s perspective on trade.
Most people believe that if the United States could produce goods at costs
comparable to or lower than those abroad, our exports would increase and our
imports decrease. This in turn would improve our trade performance and reduce our
trade deficit.
In the aggregate, however, the United States is not like a firm that can
continually capture larger shares of the world market by producing output at lower
costs than foreign firms. A nation engaging in trade cannot be a market winner in all
products.
Indeed, without borrowing and lending (international capital flows), trade
between nations would always be balanced. The only way trade can be out of
balance is if one nation lends another nation the resources to pay for the extra goods
it imports but does not pay for with its current exports. Capital flows and trade
balances are always mirror images of one another; a capital inflow produces a trade
deficit while a capital outflow produces a trade surplus.
Hence, tax policy designed to reduce the cost of traded U.S. goods and services
will have little effect on trade performance or the balance of trade.
Border Tax Adjustments
For example, consider the argument that if the United States were to replace its
income tax with a border-adjustable VAT, then U.S. trade performance would
improve and the trade deficit would diminish.
Under the World Trade Organization (WTO) rules, indirect taxes such as a VAT
may be rebated on exports and imposed on imports. Direct taxes, such as income
taxes, however, cannot be adjusted at the border. The existence of these border tax
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adjustments has led some to conclude that nations with VATs have a trade advantage
over the United States.
On the surface, this appears to be a plausible argument; reduce the price of U.S.
goods and exports will rise, increase the price of foreign goods and imports will fall.
Trade, it is said, will move into balance.
A simple response to this argument is that most European countries with VATs
also have income tax structures similar to the United States. Their VATs are not
displacing income taxes; they are permitting a higher level of government spending.
But, at a more fundamental level, border tax adjustments don’t matter, other
than in the composition of trade (and in this case, they serve to preserve relative
prices in each country in accord with that country’s own consumption taxes). This
is because the balance of trade is a function of international capital flows, not the
flow of traded goods and services.
Therefore, in the absence of changes to the underlying macroeconomic variables
affecting capital flows (for example, interest rates), any changes in the product prices
of traded goods and services brought about by border tax adjustments are ultimately
offset by exchange-rate adjustments. Border-tax adjustments would have no effect
on a nation’s balance of trade or its basic competitiveness.
The Effects of Tax Policy on Trade
That is not to say that changes in the tax structure could not influence trade
levels or patterns. Changes in tax policy which affect the underlying macroeconomic
variables that govern capital flows (for instance, by increasing either public or private
savings, which in turn would lower interest rates, or by making investment in the
United States more attractive) could affect the balance of trade. For example, if a tax
policy change caused domestic savings to rise, then a likely outcome would be a fall
in interest rates and a reduction in the net inflow of capital, which would reduce the
level of imports relative to exports. This effect of capital flows is transitory,
however. As foreigners adjust their portfolios these effects would reverse, as the
smaller stock of capital would result in smaller earnings and an increase in the net
inflow of payments (outside of trade). These last effects would be small but
permanent and offset in present value the initial short run effect.
In addition, tax reforms which increase the overall efficiency of the U.S.
economy will ultimately have a positive effect on this nation’s terms of trade.
Defined simply, terms of trade reflect the amount of domestic resources that have to
be given up in order to acquire a given quantity of imported goods. If a nation’s
terms of trade improve, it gives up fewer domestic resources to acquire the same
level of imports. If its terms of trade deteriorate, then it gives up more domestic
resources to acquire the same level of imports.4
4 See CRS Report RL32591, U.S. Terms of Trade: Significance, Trends, and Policy , by
Craig Elwell, for a discussion of the concept.
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Taxes distort the allocation of resources in the economy. If tax reforms reduce
the distorting effects of the tax system, then resource allocation will become more
efficient which will increase domestic economic welfare.
When the allocation of domestic resources is less distorted, domestic goods can
be produced at a lower total resource cost than they could before the tax reforms. So,
to acquire the same amount of imported goods, the nation gives up fewer domestic
resources, which represents an improvement in the U.S. terms of trade. The gain,
however, is likely to be small.
Finally, tax policy can and does affect the composition of trade. For example,
if the tax change increased the tax burden of some firms relative to others, then those
firms with an increased tax burden might see their market share and their exports
decline. On the other hand, those firms that experienced a relative decline in their
tax burden might see their market share and their exports increase. These relative
shifts in the inter-firm tax burdens, and the resultant shift in market output, could
affect the composition of both exports and imports. Indeed, the purpose of allowing
rebates of value added taxes is to prevent one country’s pattern of differential
consumption taxes from being imposed on another by stripping out the relative taxes
on exports and allowing the importing country to impose their own pattern of taxes.
How Will Different Economic Sectors be Affected?
The proposed tax reforms would affect the allocation of economic resources.
Some sectors, generally those that are capital intensive and growing, will gain.
Slower growing firms will lose. Other sectors that might be adversely affected by
broadening the base to more fully reflect income and by removing itemized
deductions are the non-profit sector, the state and local sector, the residential real
estate industry, and the health care sector. These are sectors that receive special
benefits under the income tax.
Proposals to shift the tax base from an income base to a consumption base (most
proposals), while generally increasing business investment, would differentially
affect firms, depending on their growth rate, capital structure, and employee benefit
structure. They would also make investment in pensions, insurance policies, owner-
occupied housing, and tax-exempt bonds relatively less attractive, and investments
in ordinary stocks and bonds more attractive.
Sector Effects
Firms and sectors that would be adversely affected by tax change may face a
difficult transition period, which could lead to some economic disruption. Moreover,
for certain types of tax structures, there would be a need for a major one-time price
inflation to avoid an economic contraction. Some tax revisions present design
challenges regarding the treatment of some industries, such as financial institutions.
These firms and sectors are likely to be opposed to this type of tax shift:
CRS-10
State and Local Governments. Most states rely on the federal government
for income tax administration and compliance, and to some extent conform to the
federal tax base. States would either face increased enforcement costs and lost
revenues if they retained current rules, or they would have to adapt their systems to
the federal system. Also, for the reform proposals that do not tax capital income, tax-
exempt bonds would become less attractive, and borrowing by states and
municipalities more costly. Also, proposals that disallow the deductibility of state
and local taxes would make increases in these taxes more costly to taxpayers.
Finally, for some proposals state and local governments would need to remit taxes
on employee fringe benefits.
Owner-Occupied Housing. Generally, businesses include receipts in
income and deduct costs. Owner-occupants of housing do not include the imputed
income (rental value of living in the house), while mortgage interest and property
taxes remain deductible. Thus, the federal income tax favors owner-occupied
housing. Changes in the tax structure that restrict deductions of interest and taxes or
that exempt income from new investments from tax would divert investment out of
this sector and into the business sector. The likely magnitude of this effect is
uncertain.
Non-Profit Institutions. Proposals that would eliminate the charitable
contributions deduction could decrease charitable giving to some degree. The
incentive for higher-income individuals (and, hence, charitable giving to the
recipients of their contributions) would be most affected, since they are the ones who
itemize. Non-profit institutions might also need to remit taxes paid on fringe benefits
for their employees under some proposals.
Health Care. Health insurance fringe benefits are favored under current tax
law, which allows firms a deduction for contributions but does not include benefits
in employees’ income. Flat-tax proposals that would eliminate the employer
deduction might discourage firms from offering health insurance. Indeed, proposals
that provide wage exemptions would make health plans overtaxed relative to wages
for low-income individuals who have not exhausted a wage exemption.
Sales tax and VAT structures might, however, exempt medical care from the
base, lowering its relative price. It is extremely difficult, however, to exempt a
product under a subtraction-method VAT. A subtraction method VAT taxes income
minus intermediate goods, so that any tax paid in the intermediate states of
production would still affect the tax on the final product. Credit- invoice methods,
where firms pay a tax (which could be zero) on total receipts and get a credit for
previous taxes can be used to vary tax rates and exempt goods and services. The
VAT proposals have been for subtraction method approaches.
Pensions/Insurance. Pensions are favored under current tax law because
they are effectively tax exempt (treated on a consumption-tax basis). While firms
would still have reasons to provide pensions, proposals that would extend this
treatment to all investments would make pensions relatively less attractive, and might
discourage their use. If some individuals now save more through a pension plan than
they would on their own, overall savings could be adversely affected as well.
CRS-11
Currently tax-favored insurance policies (e.g., whole life insurance) would also
become relatively less attractive.
Differential Effects on Firms
A consumption tax would encourage investments in business equity capital. In
the case of the flat tax, or a VAT, the firms would not be allowed interest deductions
and new investments would be expensed rather than depreciated. Firms that are
growing slowly, or contracting, would find expensing of new investment to be of
little benefit over annual depreciation deductions. Firms that rely more heavily on
debt would also find their tax bills rising. Investment would be favored under a sales
tax because investment goods are exempt.
Some proposals would tax certain employee fringe benefits, which would
increase the relative cost of compensation for firms that have a large share of these
fringe benefits in their benefit package.
Growing firms that rely heavily on equity and offer few fringe benefits would
be the beneficiaries of these tax revisions.
Special Problems
The financial sector (banks, insurance companies, investment brokers), currently
accounting for substantial corporate tax, is difficult to tax under a consumption base.
Owner-occupied housing cannot be taxed directly, but can be accommodated easily
by leaving it out of the system.
Transition Costs and Macroeconomic Adjustments
One of the most difficult issues to address in considering a shift to consumption
taxes is the transition from the current system to the new tax regime.5 While all
shifts to a consumption tax cause some common transitional disturbances and
windfall gains and losses, the most serious problems arise from a shift to a national
retail sales tax or to a value added tax. In these cases, a tax formerly largely collected
from individuals is now collected at the firm level — either from retailers on total
sales or from both final and intermediate producers’ value added. Flat taxes avoid
this problem but can result in confiscatory taxes on existing assets.
Price Accommodation and Short-run Contractions
Under a Retail Sales Tax or VAT
Holding prices fixed, these firms would need to reduce payments to workers to
retain profit levels. In fact, many firms would not have enough of a profit margin to
5 See CRS Report 98-901, Short-Run Macroeconomic Effects of Fundamental Tax Reform,
by Jane G. Gravelle and G. Thomas Woodward for a more detailed discussion of these
issues.
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pay the tax without something else — either prices or wages — adjusting. Consider,
for example, a grocery retailer that may have a 1% or 2% profit margin now owing
a tax equal to 20% of receipts. This firm simply does not have the cash to pay the tax.
If it is difficult to lower wages (and presumably it would be), a significant one-time
price inflation, to allow these costs to be passed forward in prices instead, would be
required to avoid a potentially serious economic contraction. Note that the price
increase, were it possible to implement correctly and precisely, would solve the
transition problem because although prices would rise, individuals would have more
income to purchase the higher priced goods — and demand would not fall. It is
difficult, however, for the monetary authorities to engineer such a large price change.
Moreover, even with the monetary expansion in place to do so, the imposition of
such a tax would be disruptive if firms are reluctant to immediately raise prices, again
leading to an economic contraction. That is, firms could contract their business, or
even close down, until output had contracted enough to raise prices.
These disruptions are not minor in nature — imagine the difficulties of
engineering and absorbing a one-time price increase that is likely to be close to 20%
(the level, approximately, that might realistically be needed to replace the income
tax).6 Even if such an inflation could be managed, there are always concerns that any
large inflation could create inflationary expectations — it’s hard to manage a single
one-year price increase. In fact, economists who judge a consumption tax to be
superior to an income tax may nevertheless be skeptical about the advisability of
making the change because of these transition effects.
Despite the extensive analysis of the economic effects of fundamental tax
reform, however, little attention has been devoted to potential short-run
contractionary effects, particularly of proposals that would shift the liability for tax
payments from individuals to businesses. One may note, however, that when a major
macroeconomic forecaster (Roger Brinner from DRI/McGraw-Hill) modeled a VAT
replacement in a Joint Committee on Taxation study, he found output falling over the
first five years, reaching a height of 12.5 % in the fourth year.7 (The other forecaster
did not simulate a VAT, but only a flat tax which does not require this price
accommodation; the remaining modelers had full employment models).
Although the short run disruption from the retail sales tax and the VAT is most
pronounced, any shift to a consumption tax will likely cause short term economic
contraction due to sectoral shifts. In the Joint Committee on Taxation study, both
macroeconomic modelers who used cyclical models (that permitted unemployment)
projected the flat tax, which continues to tax individuals on their wages, to cause
contractions (albeit smaller) in the short run.
6 The rate would depend on whether and the extent of any family exemption. A 20% tax
exclusive rate would correspond to a tax inclusive rate between 16% and 17%.
7 U.S. Congress, Joint Committee on Taxation, Tax Modeling Project and 1997 Symposium
Papers, committee print, 105th Cong., 1st sess., Nov. 20, 1997, JCS-21-97 (Washington:
GPO, 1997), p. 24.
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Windfall Losses for Equity Investments Under the Flat Tax
The flat tax also produces some transitional effects on cash flow that can be
quite severe for owners of assets because it does not require a price accommodation.
A consumption tax can also be characterized as a wage tax plus a lump sum tax on
old capital. That is, it taxes the sources of income used, sooner or later, for
consumption purposes. (Individuals will eventually consume out of new assets but
the cost of those new assets will also have been deducted from income when
acquired.)8
One explicit manifestation of this effect is that businesses that have already
purchased assets and inventories, in the expectation of being able to deduct their
costs over a period of time (under a fixed depreciation schedule for plant and
equipment and when sold for inventories), will no longer be able to take such
deductions. If a firm is constantly growing, then the ability to deduct new
investments in full will more than compensate for this loss of old deductions, on a
cash flow basis (although the value of the firm will still fall). But for a firm that is
not growing, or is liquidating, or for an investor who wishes to shift from a physical
ownership (such as real estate) to financial asset, tax liability could rise dramatically.
Consider the following example. Suppose an investor purchases a building for
$450,000, with a mortgage of 95% ($427,500). Two years later, the price has
increased to $500,000 and he has taken $23,000 of depreciation deductions; to
simplify suppose he has refinanced to maintain the same mortgage. He decides to
sell and use the proceeds to buy a financial asset (such as a corporate stock). Under
current law, he would measure gain subject to tax as the sales price of $500,000 less
the basis (original cost of $450,000 less $23,000 in depreciation, or $427,000). This
gain would amount to $73,000 which is the sum of the appreciation in the property
of $50,000 and the depreciation he has already taken. Assuming for simplicity a 20%
tax rate, he would pay capital gains tax of $14,600. He pays the mortgage of
$427,500, and is left with net cash of $57,900.
Suppose, however, that a flat tax (consumption tax) had been enacted in the
interim at the same rate. Under the flat tax, he would pay a 20% tax on $500,000, or
$100,000. One can see that this tax is more than confiscatory: after repaying the
mortgage of $427,500 and paying the tax of $100,000 he has a loss in cash flow of
$27,500.
Why does this happen? It happens because the flat tax is collected in a way that
does not require a price increase and the lump sum tax on assets falls solely on the
8 Physical business assets (equipment, structures, and inventories) would be deducted from
income as an intermediate good under the flat and VAT approaches and not subject to the
retail sales tax. Sales of business assets, whether new or used, would be taxed under the
VAT and flat tax. Owner occupied housing would presumably be an exception because the
stream of imputed rental income is not taxed; newly constructed housing would presumably
be subject to the retail sales tax and the purchaser would not be allowed a deduction or
credit under a flat tax or VAT. Existing housing would presumably be neither taxed nor
eligible for deduction. The return to this new housing would still be exempt from tax, but
the method of doing so would be different.
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equity claim to an asset. The holder of the mortgage has had no loss in value. With
either a retail sales tax or a VAT and price accommodation, the investor would be left
with $73,000 in cash, whose purchasing power has decreased by 20%.9 The
mortgage holder’s asset would also lose 20% in value. Thus, the lump sum tax is
allocated to both debt holders and equity holders.
The problem with the flat tax would not occur under another form of
consumption tax that does not require a price accommodation — a direct tax on
consumed income. Under this approach, individuals would begin with the income
tax base, and deduct net investment or add net withdrawals of investments to income.
With this type of tax, both financial and physical investments would be included in
the calculation, and the individual would be able to deduct the mortgage repayment
as an investment. The direct tax on consumed income has not proven to be very
popular, however, as it would complicate rather than simplify tax calculations for the
individual and require unfamiliar and probably unpopular tax rules, such as including
loans in taxable income.
One could avoid this cash flow problem under the flat tax by allowing the
recovery of depreciation, inventory and basis. Such revisions would be costly to
include, and would require much higher tax rates, perhaps for a long period of time.
They would also zero out the tax for many firms. The lump sum tax on old capital
is an important contributor to the projected efficiency gains for switching to
consumption taxes, the major reason that so many economists favor a consumption
base.
Stock Market Effects
Note also that these physical effects on capital, and their variations across types
of assets, should also be transmitted to stock prices. If a tax is levied at a 20% rate,
with inflation to fully accommodate, all consumption prices would rise by 25%. A
dollar of financial (or physical) assets can purchase only 80% of the real consumption
goods it could purchase in the past. If there is no inflation, the nominal price of
consumption goods should be constant and debt retains its purchasing power, but
since new assets can be purchased at a 20% discount, the value of a firm’s old capital
would fall by 20%. If the firm has no debt, the stock should fall by 20%; if a third
of its assets are financed by debt (typical of the economy) the stock should fall by
9 The price level in the economy would increase by 25%. Why 25% rather than 20%?
This is simply the difference between the tax inclusive rate of 20% and the tax exclusive
rate of 25%. (The tax exclusive rate is t/(1-t) where t is the tax inclusive rate). If prices go
up by 25% you lose 20% of purchasing power. That is, an $80 basket of goods would now
cost 25% more, or $100 and you spend $100 to purchase goods that are worth only $80 —
your $100 has lost 20% of its purchasing power. In our example, in the case of the retail
sales tax, the individual keeps $72,500 (the $500,000 sales price less the mortgage
repayment, which is $72,500). He implicitly pays a tax of 20% because this amount can
only purchase $58,000 of goods before the application of a 25% retail sales tax. In the case
of a VAT, the price of the building would rise by 25%, to $625,000, and after paying a 20%
tax on receipts, the investor would have $500,000 less the mortgage payment — with the
same results ensuing.
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30%; if half is debt, the stock should fall by 40%. Individuals who have borrowed
to buy stock could be significantly affected.10
Effect on Tax Administration and the
Underground Economy
The complexity and cost of the current tax system is one of the most potent
arguments used by the tax reform advocates. Each of the proposals discussed in this
paper is advertised to be simpler and less costly to comply with and to administer
than the current income tax. Even tax evasion is sometimes blamed on the
complexity of the income tax.
Taxpayer Compliance
Easing the burdens of taxpayers in complying with the tax system is one of the
biggest selling points for the “flat tax” and other tax simplification proposals. The
current system is said to be a nightmare of complexity, requiring taxpayers to read
and understand volumes of tax law, regulations, and instructions, and to complete
page upon page of complicated forms.
The Internal Revenue Service (IRS) itself says it takes taxpayers an average of
13 hours and 29 minutes to prepare an individual income tax return (Form 1040).11
The cost in taxpayer time and expenditures for the individual income tax has been
estimated at $67 billion to $99 billion.12 Costs to big business have been estimated
at $2 billion.13 The complexity is accused of contributing to the perception of
unfairness, since the rich are seen as able to hire experts to help them escape their fair
share.
Two issues immediately present themselves: (1) how much of a burden is the
current system, and (2) to what extent would the tax reforms currently contemplated
relieve this burden?
What is the Current Burden? Certainly the current system is complex. The
Internal Revenue Code is thousands of pages long, and the regulations interpreting
10 Some people disbelieve that this price effect would occur, but if it did not, then in effect
the tax is not acting as a consumption tax and none of the investment incentives would work.
It is the fall in the price of stock that makes investment in corporate equity more attractive
and it corresponds to the ability, when directly investing, to deduct the cost of capital
acquisitions.
11 Instructions for Form 1040 (2003), p. 77.
12 Statement by Janet Holtzblatt in a presentation to the American Enterprise Institute,
reported in Brandt, Goldwyn, “Tax Administration Service Estimates Tax Compliance Costs
at $99 billion for Individuals in Year 2000,” Bureau of National Affairs Daily Tax Report,
no. 23, Feb. 5, 2004, p. G-2. The range reflects a value per hour between $15 and $25.
13 Joel B. Slemrod and Marsha Blumenthal, “The Income Tax Compliance Cost of Big
Business,” Public Finance Quarterly, vol. 24, Oct. 1996, pp. 411-438.
CRS-16
it run to tens of thousands of pages. The taxpaying public must file hundreds of
different types of forms and schedules; time spent on taxes has been estimated at 2-8
billion hours for individuals and 800 million hours for businesses.14
These kinds of numbers are a bit misleading, however, because they do not
apply to most taxpayers.
Most of the complex issues are of no concern to most taxpayers. Fewer than
35% of individual taxpayers itemize deductions. (The “very popular” mortgage
interest deduction is claimed on less than 29% of returns and the charitable
contribution deduction on about 31%.)15
Fewer than 16% of individual returns report business or farm income or loss,
fewer than 8% rental income or loss, and fewer than 5% partnership or S-corporation
income or loss.16 (These percentages overlap.)
Businesses do face more complexity and compliance burden under the tax
system than do most individuals, but it is hard to know its real extent.
Would Tax Reform Relieve the Burden? A national sales tax or value-
added tax that collected all taxes from businesses would obviously relieve the
compliance problems of individual taxpayers, since they would need to file no returns
at all.
Business taxpayers would not necessarily have compliance costs reduced by a
VAT, however; depending on how the taxes were structured, businesses might find
themselves facing two largely incompatible accounting systems. For financial
purposes, creditors and stockholders would still require net income calculations, with
depreciation, inventories, and all the other accrual accounting conventions. At the
same time, the tax system would require value-added computations on a cash-flow
basis.
A flat tax with a single rate would not, by itself, do much to simplify things for
most individual taxpayers. In fact, for many individuals, the current system is a flat
tax with a single rate and a large exemption. Almost 41% of all individual income
tax returns currently either owe no tax or are taxed at a 10% rate.
The flat tax, therefore, would not represent much of a simplification for many
individual taxpayers, who are already subject to a similar system, nor for larger
businesses, which would be relieved of only the marginal accounting costs associated
specifically with the income tax. Its simplifications would mostly benefit smaller
businesses and individuals with more complex income tax filings. Individuals with
14 For a survey of estimates, see Joel Slemrod, “Which Is the Simplest Tax System of Them
All?” in Henry J. Aaron and William G. Gale, eds., The Economics of Fundamental Tax
Reform (Washington: The Brookings Institution, 1996), pp. 367-368.
15 “Individual Income Tax Returns, Preliminary Data, 2002,” SOI Bulletin, Winter-Spring
2003-2004, Internal Revenue Service, 2003.
16 Ibid.
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businesses, however, would be required to file two returns, one for the business and
one for their wage income.
If a VAT or retail sales tax were to provide a mechanism to relieve the burden
for the poor, though a credit system, as many propose, individuals would still have
to file returns to claim the credit.
Administrative Costs
The current tax system relies heavily on the uncompensated (“voluntary”) labor
of the taxpaying public, which reduces the government’s administrative costs
considerably. In FY2003, IRS collected around $1.9 trillion with a budget of about
$9.8 billion, or a cost of less than ½ cent per dollar collected (not counting costs to
taxpayers).17
Most of the proposed tax reforms appear to rely even more heavily on
“voluntary” taxpayer efforts. Many proposals contemplate a reduced IRS presence
in taxpayers’ lives, and some even suggest abolishing the IRS altogether. Except for
the national sales tax proposals that would be collected by the states, no proposal has
specified how collection and enforcement activity is to be reduced.
Many of the problems that create administrative costs in the income tax system,
such as verifying inventory or depreciation accounting, would be reduced or
eliminated under most proposals, but major ones would still exist. A VAT or partial
VAT would involve every business entity, and businesses are the source of most of
IRS’s current enforcement costs. Administrative costs often arise from taxpayers’
attempts to avoid paying taxes, and no tax reform will produce a system in which
people do not wish to avoid taxes.
The Underground Economy
Another hope for the tax reform proposals is that a new tax structure would
reduce transactions taking place outside the tax system. This may depend on what
part of the “underground” economy is meant. The “informal” economy, which
involves evading taxes on legal activities, is partly a function of tax rates. Reducing
rates would reduce the rewards of evasion and thus the incentive to cheat (but some
proposals would result in a higher marginal rate for most smaller taxpayers, 17%
instead of 10%, for example). For the illegal economy, where tax evasion is
normally a minor part of the criminal activity, there is no reason to expect any
outcome except continued evasion, although a different tax structure would alter the
way in and degree to which income avoids tax, and, depending on behavioral
responses, the actual burdens. For example, under an income tax, producers in an
underground market pay no taxes, while their customers who operate in the legal
market do. Under a sales tax, producers effectively pay taxes on income when it is
spent in the market; their customers pay no tax on the segment of income that reflects
17 U.S. Department of the Treasury, The Budget in Brief FY2005, Feb. 2005. There are
some additional costs budgeted under Treasury and Justice Departments and the Judiciary
Branch.
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value added by the illegal part of the market (although tax is paid on intermediate
inputs).
In many ways certain forms of value added taxes and, to a greater extent, retail
sales taxes increase the incentive for firms to avoid tax. For a retailer with, say, a 2%
profit margin, the benefit of avoiding a profits tax is less than one percent of profits.
If the retailer stands to save 20% of each dollar, the incentive to avoid tax is much
greater. That is the reason that many tax administrators would recommend the
invoice credit form of the VAT used by Europeans (so that firms present evidence
on their intermediate purchases which helps to monitor the behavior of the seller)
rather than the subtraction method, where firms subtract from intermediate purchases
from their tax base. It is also a reason that many tax scholars doubt that a high retail
sales tax is feasible, and indeed no such high rate of the retail sales tax exists
anywhere.
How Would the Distribution of the Tax Burden
and the Level of Tax Revenues be Affected
by a Different Tax System?
Many of the tax reform proposals have not been subject to detailed analysis.
Based on those analyses that have been done, however, a number of the flat-tax
proposals could, in their current form, lose revenue, perhaps substantial amounts.
They would also reduce the progressivity of the tax.
Revenue Effects
Most proposals have been designed to be revenue neutral, but have not been
evaluated by official revenue estimators. The Treasury Department, however, has
analyzed a version of the flat tax with a proposed rate of 17%, finding a revenue
shortfall. (This estimate, however, was made in 1995 before the major tax cuts were
enacted).
The Treasury found that the revenue-neutral flat-tax rate in the proposal, given
the level of exemptions (ranging from about $10,000 for a single individual to about
$30,000 for a family of four), would be around 21% (20.8%), about four percentage
points above the proposed permanent rate of 17%.18
Alternatively, the 17% rate could be maintained and the exemptions cut by over
half to maintain revenue neutrality. With neither revision, Treasury estimated the
proposal would lose $138 billion annually.
Other proposals with lower rates and/or more exemptions would presumably
lead to larger revenue losses. Adding deductions, such as the payroll tax deduction,
18 U.S. Department of the Treasury, Office of Tax Analysis, Preliminary Analysis of a Flat
Rate Consumption Tax, Mar. 10, 1995.
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or restoring itemized deductions, such as those for mortgage interest and charitable
contributions, would cause larger revenue losses.
Value-added taxes or sales taxes (which are equivalent to the flat tax except that
they have no exemptions) could presumably raise adequate revenue at lower rates if
the base were kept broad. The required rates in other proposals will depend on the
base.
Any revenue losses would either lead to higher deficits and debt or require
spending cuts; generally the latter option has been proposed. Some proponents have
incorporated in their plans the presumption that tax rates can be lowered in the future
due to economic growth.
It is important to note that a number of these taxes have a consumption base;
thus any growth that arises from increased savings would contract, rather than
expand, the tax base in the short run. Increases in labor supply would increase the
tax base. Our knowledge of the likely effects on labor supply and savings is very
limited, however.
Distributional Effects
Any flattening of the tax rates would have distributional consequences across
income classes. In addition, a switch from an income to a consumption base for
taxation could cause large changes in the distribution of taxes across generations and
family types as well as income classes.
Income Classes. Holding revenue constant, flat-tax proposals would reduce
tax burdens on higher-income individuals; if the earned income tax credit (EITC) is
repealed, the burden would rise on low-income individuals, as well as the middle
class.
Based on the 21% tax rate, and using percentage change in disposable income
as a measure, poor individuals would experience decreases of 6%-7% under the flat
tax and middle income individuals decreases about 3% to 5%, while the highest
income class will gain about 9%, according to the Treasury analysis (again based on
estimates before the recent tax cuts).19 These effects would be more pronounced if
revenue neutrality were achieved through lower exemptions rather than a higher tax
rate.
Value-added and sales taxes would reduce tax progressivity further because they
do not permit exemptions, unless a credit mechanism were introduced. Proposals
with a graduated rate structure would be more progressive than other proposals, but
they have not been closely examined by the Treasury or the Joint Committee on
Taxation.
Generations. Proposals to shift the tax base from an income to a consumption
base (most proposals) would shift the tax burden substantially across generations.
19 Ibid.
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The flat tax, for example, has a consumption base, although it appears to be a wage
tax for individuals. The burden of tax would be shifted from wages and capital
income to consumption, which is equivalent to wages and old capital (both principal
and return). Since older individuals own capital, the burden would tend to be shifted
to those individuals.
A Lifetime Perspective. The ways in which a consumption tax burdens old
capital are complex, and the incorporation of generations as well as income in
distributional analysis is limited at this time. In general, however, younger
individuals who are in taxable status and who will save substantial sums over their
lifetimes would benefit relatively from the tax, while middle and higher income older
individuals consuming assets would bear a greater burden. Wealthy individuals
would have their tax burdens reduced over their lifetime if they maintain and increase
their assets. Poor individuals with little savings over their lifetime would be
relatively unaffected by the change in the base, as long as transfer payments are
indexed to changes in the price level needed by a tax revision. The rate structure is
more important for these low-income individuals.
Marriage Neutrality. The marriage neutrality of the tax system is a function
of the tax structure, not the choice of tax base - income or consumption. Hence, both
an income and a consumption based tax can be marriage neutral if the accompanying
tax structure is designed appropriately. Marriage penalties and/or bonuses can be
avoided if taxes are levied on individual rather than family income or consumption
and if standard deductions and tax rate brackets for married couples are twice the size
of those for single taxpayers.
Under the current income tax when married couples are compared to single
filers, marriage tax penalties are confined to very low-income married couples who
claim the earned income tax credit and to high-income married couples above the
25% marginal income tax threshold. All other married taxpayers receive marriage
tax bonuses, or at worst, a neutral tax treatment when compared to two singles with
the same combined income.
A flat-rate consumption tax, with two filing statuses - married and single, and
with a standard deduction for married couples that is twice the size of the standard
deduction for a single individual would eliminate all marriage tax penalties and
bonuses. The same result, however, could also be achieved under an income tax by
adopting a single tax rate and standard deductions that are twice as large for married
couples as for single individuals.
There are no marriage bonuses or penalties with a sales or value added tax.
CRS-21
Additional CRS Reports
CRS Report RL30351. Consumption Taxes and the Level and Composition of
Saving, by Steven Maguire.
CRS Report 98-248. A Federal Tax on Consumed Income: Background and
Analysis, by Gregg A. Esenwein.
CRS Report 96-379. The Flat Tax and Other Proposals: Effects on Housing, by
Jane G. Gravelle. (Archived, available from author).
CRS Report 95-1141. The Flat Tax and Other Proposals: Who Will Bear the Tax
Burden? by Jane G. Gravelle.
CRS Issue Brief IB9506. Flat Tax Proposals: an Overview, by James M. Bickley.
(Archived, available from author).
CRS Report 98-529. Flat Tax: An Overview of the Hall- Rabushka Proposal, by
James M. Bickley.
CRS Report 98-901. Short-Run Macroeconomic Effects of Fundamental Tax
Reform, by Jane G. Gravelle and G. Thomas Woodward.
CRS Issue Brief IB91078. Value-Added Tax as a New Revenue Source, by James
M. Bickley.
CRS Issue Brief IB92069. A Value-Added Tax Contrasted with a National Sales
Tax, by James M. Bickley.