Flat-Rate Tax Proposals

In recent months there has been a growing congressional interest in the advantages and disadvantages of revamping our current tax system for a flat-rate tax method. Supporters of the new proposal argue that such a plan would promote productivity, simplify present IRS tax forms, save the public billions of dollars that presently go to tax-preparation professionals, and enhance Federal revenue by closing numerous tax loopholes and special deductions that are now enjoyed by relatively few. Opponents believe, however, that the tax burden under a flat-rate plan might fall more heavily upon the middle class and, unless exceptions were made, would hurt educational institutions and charities. Problems with popular tax deductions, such as home mortgage interest, would have to be addressed. This packet provides background materials which discuss the practical and theoretical issues that surround a flat-rate tax, including the probable redistribution of the tax burden under various rates and income bases.

Washington, D.C. 20540 FLAT-RATE TAX PROPOSALS IP0212F I n r e c e n t months t h e r e h a s b e e n a growing c o n g r e s s i o n a l i n t e r e s t i n t h e a d v a n t a g e s and d i s a d v a n t a g e s o f revamping o u r c u r r e n t t a x s y s t e m f o r a f l a t - r a t e t a x method. S u p p o r t e r s o f t h e new p r o p o s a l a r g u e t h a t such a p l a n would promote p r o d u c t i v i t y , s i m p l i f y p r e s e n t IRS t a x f o r m s , s a v e t h e p u b l i c b i l l i o n s of d o l l a r s t h a t p r e s e n t l y go t o t a x - p r e p a r a t i o n p r o f e s s i o n a l s , and e n h a n c e F e d e r a l r e v e n u e by c l o s i n g numerous t a x l o o p h o l e s and s p e c i a l d e d u c t i o n s t h a t a r e now e n j o y e d by r e l a t i v e l y few. Opponents b e l i e v e , however, t h a t t h e t a x b u r d e n u n d e r a f l a t - r a t e p l a n might f a l l more h e a v i l y upon t h e m i d d l e c l a s s a n d , u n l e s s e x c e p t i o n s were made, would h u r t e d u c a t i o n a l i n s t i t u t i o n s and c h a r i t i e s . Problems w i t h p o p u l a r t a x d e d u c t i o n s , such a s home mortgage i n t e r e s t , would h a v e t o be addressed. T h i s p a c k e t p r o v i d e s background m a t e r i a l s which d i s c u s s t h e p r a c t i c a l and t h e o r e t i c a l i s s u e s t h a t s u r r o u n d a f l a t - r a t e t a x , i n c l u d i n g t h e p r o b a b l e r e d i s t r i b u t i o n o f t h e t a x b u r d e n u n d e r v a r i o u s r a t e s and income b a s e s . A d d i t i o n a l i n f o r m a t i o n on t h i s s u b j e c t , p r i m a r i l y i n p e r i o d i c a l s and n e w s p a p e r s , may b e found i n a l o c a l l i b r a r y t h r o u g h t h e u s e o f i n d e x e s such a s t h e R e a d e r s ' Guide t o P e r i o d i c a l L i t e r a t u r e , t h e P u b l i c A f f a i r s Information ~ e r v i s Times Index. k Congressional n a l Q u a r t e r l y Weekly Report and t h e ~ o m m e r ~ n ~ r e s s i o Index a r e commercial p u b l i c a t i o n s which t r a c k t h e s t a t u s o f c u r r e n t l e g i s l a t i o n and a r e a v a i l a b l e i n l a r g e r l i b r a r i e s . Congressional Reference Division AN OVERVIEW OF THE ISSUES CONCERNING A FLAT-RATE INCOME TAX by Gregg A. Esenwein - -- Gregg A. Esenwein is an economic analyst i n the Economics Division of the Congressional Research Seivice (CRS) i n The Library of Congress. This special report is a reproduction of a May 26, 1982 CRS research report prepared by him. INTRODUCTION The idea of a flat-rate or proportional income tax has generated considerable legislathe and popular interest in recent months.' Many individuals, including some prominent tax experts, believe that the current income tax system has become a burden on the economy. They consider it to be far too complex, to provide too many tax breaks for upper income individuals and to promote economic inefficiencies. They see a flat-rate tax, on the other hand, as the antithesis of the current system. embodying the principles of simplicity, efficiency and fairness. Much of the criticism of the current income tax system has some justification. It has become an extremely complex and unwieldy system. It may seem that over the years the main rationale for the income tax-to collect the revenue needed to operate the federal government-has been obscured in the pursuit of secondary goals. However, most of the complexity of the current income tax system is a result of the desire to promote specific social goals which have broad-based constituencies supporting them. To give just two examples consider the cases of the deductibility of mortgage interest payments and charitable contributions. In each case the current income tax promotes what is widely viewed as socially acceptable and desirable goals, making home ownership more affordable to a majority of the populace and promoting charitable contributions. Additionally, the current income tax structure reflects attempts to achieve what is perceived as an equitable distribution of the tax burden. Although these attempts have produced some inefficiencies in the economy, the benefits must also betaken into account. It should be kept 'The concept of a flat-rate income tax has been periodically discussed as an alternative to the current tax system. For an example of an earlier review of the debate see U.S. Library of Congress. Congressional Research Service. Progressivity in Income Taxation: A Pro-Con Discussion. By Robert Tannenwald, Dec. 1976. TAX NOTES, June 21,1982 in mind that adoption of a flat-rate income tax would in all probability entail a major redistribution of the tax burden. To simplify the current income tax system, any proposal for a flat-rate tax would have t o address these and many other similar issues. Given the difficult choices involved in adopting a flat-rate tax, the purpose of this report is threefold. First, the practical considerations of defining the appropriate taxable income base for a flat-rate tax are analyzed. A discussion of the probable redistribution of the tax burden under each alternative income base is included. Second, the practical and theoretical issues surrounding a flat-rate tax are analyzed. Questions of behavioral responses, economic efficiency and equity are addressed. Third, an overview of recent legislative initiatives in the area of flat-rate income taxes is presented in an appendix. \ I. ALTERNATIVE INCOME BASES FOR A FLAT- RATE INCOME TAX The definition of the appropriate income base represents one of the more difficult issuesfaced by proponents of a flat-rate income tax. The flat tax rate needed t o generate the required revenue will vary with the tax base used. The broader the tax base, the lower the necessary flat tax rate. There are three basic ways that a flat-rate income tax could be applied. It could be applied to the current law base of taxable income, adjusted gross income, or some expanded income concept. Each of the three income bases for a flat-rate income tax possess certain benefits and drawbacks. Regardless of the income base used, the transition to a flat-rate income tax would affect the distribution of the tax burden. The precise change i n the distribution of the tax burden would depend on the income base which is used. However, unless some form of low to middle income relief were included (say an exemption of a portion of income or a tax credit) a flat-rate income tax would produce a tax burden which would fall more heavily on lower t o middle income taxpayers than the present tax system. It should be kept In mlnd that adoption of a flat-rate Income tax would In all probablllty entall a major redlstributlon of the tax burden. A. Taxable Income The drawbacks to using taxable income as defined in current law as the income base for a flat-rate tax are substantial. First, with taxable income as a base, the complexity of the current income tax system would be maintained. Itemized deductions and the treatment of investment income account for a substantial portion of the complexity of the current income tax system. If taxable income were used as the base, there would be little reduction in the complexity of the income tax system, since both of these items would be retained. Over the years the main rationale for the Income tax-to collect the revenue needed to operate the federal government-has been obscured In the pursult of secondary goals. Second, taxable income is the narrowest of the potential tax bases. Asa result, the flat-rate tax which would have to be applied to taxable income to raise the required revenues would be quite high. This high flat tax rate would produce two results. One, i t would causeasubstantial shift in the tax burden. Low to middle income households would experience major increases in both their effective and marginal income tax rates. Only the upperincome households would experience reductions in their effective and marginal tax rates. Two, since the flat tax rate would be quite high, the benefits in terms of increased economic efficiency would be small. Only a small percentage of households would experience reductions i n their marginal tax rates and these reductions would have a negligible effect on resource allocation. The only benefit to using taxable income as defined in current law as the tax base is that it would avoid the dislocations that would occur if the current deductions and preferential tax treatment of certain income were curtailed. 8. Adjusted Gross Income Adjusted gross income (AGI) would be a somewhat broader income base than taxable income. AGI is usually less than money income, because certain types of income are excluded i n calculating AGI. For example, social security, railroad retirement, unemployment compensation and 60 Dercent of c a ~ i t aaains l income are excludable from gross income. ~ d d / t i o n & certain ~, other items such as contributions to individual retirement accounts can be excluded from AGI. AGI, whilenot as broad a tax baseas a comprehensive incomeconcept. would be a much broader tax base than taxable income (which allows exemptions and deductions from income). AGI would allow use of a lower flat tax rate to raise the required level of revenues. However, there are still considerable drawbacks to using AGI as the income base. First, the required flat-tax rate would probably still be higher than the tax rate faced by most low-middle income households under the current tax system. As a result, the distribution of the tax burden would shift toward the low to middle income groups. Second, the removal of itemized deductions would produce serious financial ramifications for middle income households. The economic behavior of these households has been heavily influenced by the deductibility of certain expenses such as interest on home mortgages and interest on consumer credit. Eliminating the deductibility of these items would severely penalize these households for past behavior. Finally, although the tax code would be somewhat simplified with the removal of itemized deductions, many sources of complexity in the tax code, such as the preferential treatment of long-term capital gains and the depreciation allowances, wolrld remain intact. C. Comprehensive Income Another, still broader tax base would be provided by comprehensive income. Although there are alternative definitions as to the specific Items which can be included in a comprehensive income base, under most definitions comprehensive income would represent a quite broad tax base.: For example, a comprehensive income base could include wage income, social security and pension benefits, all realized net capital gains, dividends, property income, and imputed corporate retained earnings. In the case of a comprehensive income base, the flat-tax rate required to raise the appropriate level of revenue would be substantially lower than the comparable rates under a taxable income or adjusted gross income base. However, many of the same problems would remain, such as the probable shift in the distribution of the tax burden toward the lower and m ~ d d l eincome taxpayers and the dislocations and distortions resulting from the exclusion of previously deductible items. 11. OVERVIEW OF PRACTICAL AND THEORETICAL CONSIDERATIONS In addition to the technical issues of instituting a flatrate tax, there are several practical and theoretical considerations which are important. For example, in terms of practical considerations it is of interest to know whether a flat-rate income tax is sensitive to inflation and how it affects the marriage penalty. In terms of theoretical considerations, it is Important to understand how a flatrate income tax would affect horizontal and vertical equity, economic efficiency and individual behavior. This, section presents an overview of these issues. A. Simplicity Probably the most commonly heard critique of the current income tax system is that its complexity promotes both administrative and econornlc inefficiencies. There are two basic issues involved; one, the administrative and compliance costs associated w ~ t hthe current income tax system and two, the economic costs. Administration and compliance with thecurrent income tax code are costly and time consuming. Due to its complexity, a myriad of specialists have evolved whose primary function is to sort through and interpret provisions of the tax code. In lieu of contnbuting to the economy in a productive manner, these specialists spend their time developing methodsio minimize the impact of the current tax code. These efforis represent a resource drain on the economy. =Fora detailed analysis of the components of a comprehensive income base see Dept. of the Treasury. Blueprints for Basic Tax Reform, Jan. 1977. TAX NOTES, June 21,1982 As a corollary, the massive amount of regulations which accompany the current income tax code promotes inefficiencies in the compliance and collection of taxes. The average taxpayer is confronted with a multitude of forms and procedures when filing his income tax. As a result, due toeither outright avoidance or lack of full information, compliance with the tax regulations for a full reporting of income has declined over the years. This has produced a significant loss of revenue for the federal g ~ v e r n m e n t . ~ In addition to the compliance and administrative costs, there are also economic costs associated with the current progressive tax system. Under the current tax system there are incentives to artificially shelter income from taxation at high marginal tax rates. These shelters take oneof two basic forms. First, investors time the realization of their gainstocoincide with periods when they are in low marginal tax brackets. Second, investments are made in instruments which receive preferential tax treatment. Both of these factors distort the efficient allocation of resources. Proponents contend that these excess administrative' and economic costs could be eliminated by broadening the income base under a flat-rate income tax. Since a flat-rate income tax would be extremely simple compared to the current system, there would be a dramatic decrease in the amount of resources needed to administer and interpret the tax code. Additionally, the simplicity of a flat rate income tax would promote better compliance and hence help prevent the loss of tax revenues. It should be noted, however, that by broadening the income base. much of the decrease in complexity could be achieved under the current income tax system. Proponents also argue that a flat-rate tax would remove most of the incentives to shelter income artificially. Since most taxpayers would face the same low marginal tax rates, there would be no tax advantage from timing the realization of economic gains. Finally, under most proposals for a flat-rate income tax, similar activities would be taxed at similar rates. As a result, investment would flow into those vehicles which offer the highest pretax return promoting the efficient allocat~onof resources. B. Inflation Sensltlvlty Under the current progressive income tax system, inflation-induced increases in income push individuals into higher marginal income tax brackets. For most individuals, the increase in income tax liability is proportionately greater than the inflation-induced increase in income. As a result of the combination of a progressive income tax and inflation-induced increases in income, most taxpayers experience a reduction in their real aftertax purchasing power. Under provisions contained in the Economic Recovery Tax Act of 1981 the problem of bracket creep would be resolved by indexing the rate structures, zero bracket amount and personal exemptions beginning in 1985. However, a flat-rate income tax would also eliminate inflation-induced bracket creep. With only one marginal tax rate, inflation-induced increases in income would not push taxpayers into higher tax brackets and would have relatively little effect on their average or effective income tax rates. Under a flat-rate tax, taxpayers would experience little change in their real after-tax purchasing power as a result of inflation. =For a background discussion of this issue see: Molefsky, America's Underground Economy, CRS Report 81-181 E. TAX NOTES. June 21,1982 C. Marriage Penalty Under the current income tax system two income earning individuals who file a joint return in all probability pay more in income taxes than they would if they were to file separate returns as singles. This is commonly referred to as the marriage penalty tax. It is the result of the different marginal tax rate schedules for joint and single returns. Provisions contained in the Economic Recovery Tax Act of 1981 attempt to correct this inequity by allowing the lower income earning spouse to deduct a percentage of his or her income from taxation. However, in many instances the penalty is only partially offset, while in others the provisions create a marriage bonus. The problem of a marriage penalty or marriage bonus would beeliminated underaflat-rate income tax. Applying the same flat tax rate to both joint and single returns would eliminate the source of the penalty: marginal tax rate schedules based on filing status. D. Horizontal Equity If a tax system taxes individuals in similar positions equally, then the tax system possesses horizontal equity. Under the current income tax system, the principle of horizontal equity is violated, since individuals in similar circumstances are taxed at different rates. For example, consider the case of an individual with $10,000 of wage income and another individual with $10,000 of capital gains income. Under the current income tax system, the individual with only wage income would pay a substantially higher tax than the individual with capital gains income (capital gains income receives preferential treatment under current tax law). I Horizontal equity is a function of how comprehensively income Is defined for tax purposes; It is not a function of the type of tax rates that are applied to taxable income. Most proposals for a flat-rate tax system include provisions which would broaden the income base and end the preferential treatment of certain types of income. Under this type of flat-rate tax horizontal equity would improve. However, the same degree of horizontal equity could be achieved under the current income tax system if the income base were broadened and the preferential tax treatment of certain types of income were curtailed. Horizontal equity is a function of how comprehensively income is defined for tax purposes; it is not a function of the type of tax rates that are applied to taxable income. E. Vertlcal Equity Vertical equity concerns the incidence of a tax among people with unequal incomes. The standard interpretation of vertical equity has been that tax burdens should be distributed according to taxpayer's ability to pay. In other words, an individual with a larger income should pay proportiondtely more of his income in taxes than an individual with a smaller income. With respect to income taxation, this concept of vertical equity is the rationale for progressive tax rates. Most empirical studies of vertical equity conclude that, taken in isolation, the current income tax system ranges from slightly to highly progressive. However, when other taxes are included, it appears the overall tax burden (federal, state, and local) is roughly prdportional: Adopting a flat-rate tax does not necessarily entail the loss of all progressivity. If aflat-rate taxexempted afixed dollar amount of income from taxation then it would be a moderately progressive system. For example, consider a flat-rate tax of 10 percent which exempts the first $5,000 of income from taxation. An individual with $10,000 income would pay $500 or 5 percent of his income i n taxes. An individual with a $20,000 income would pay $1,500 or 7.5 percent of his income in taxes. Hence, a flat-rate tax coupled with an income exemption is not incompatible with the concept of progressivity. However, regardless of the particular provisions for exemptions, adoption of a flat-rate tax would in all probability reduce progressivity when compared to the current income tax system and hence could result i n an overall tax burden that is regressive. Adopting a flat-rate tax doer not necessarily entall the loss of all progresslvlty.. It should be noted, however, that the principle of vertical equity is a highly subjective concept because it is based on the assumption of declining marginal utility of income. That is, a dollar of income is considered to be more valuable t o a lower income individual (who is more likely to spend it on necessities) than it is to an upper income individual (who is more likely to spend it on non-necessities). A number of tax experts and laymen contend that the concept of declining marginal utility of income is much too subjective and arbitrary to serve as the basis for determining the structure of the tax system. their marginal tax rates while others would experience decreases in their marginal tax rates. Unless some form of low to mlddle lncome rellef were included a flat-rate lncome tax would produce a fax burden which would fall more heavily on lower to mlddle income taxpayers than the present tax system. ... Taxpayers whose marginal tax rates decrease would experience a reduction in the distortion between the price of income versus leisure. This would tend to reduce the inefficiency of the tax system. On the other hand, taxpayers whose marginal tax rates increase would experience an increase in the distortion between the price of income versus leisure, which, in turn, would increase the inefficiency of the tax system. Because of these offsetting effects it is not clear whether a flat-rate tax would increase the overall economic efficiency of the tax system. Proponents of a flat-rate tax also contend that in response to reductions in marginal tax rates, individuals will tend to increase their work efforts. That is, since the price of leisure will rise relative to the price of income, individuals will substitute income for leisure. However, as pointed out earlier, under a flat-rate tax, some individuals would experience reductions while others would experience increases in their marginal tax rates. Therefore, while some individuals might substitute income for leisure (since the price of leisure will rise relative to the price of income) others might substitute leisure for income (since the price of leisure will fall relative to the price of income). For this reason, the effects of a flat-rate tax on the aggregate work level are uncertain. The effects of a flat-rate tax on the aggregate work level are uncertain. F. Economlc Efflclency The economic efficiency or inefficiency of a tax system can be judged by its effects o n relative prices. If the tax system distorts relative prices it is inefficient, since this distortion prevents the efficient allocation of resources. An income tax, regardless of whether it is progressive or proportional, distorts relative pricesand affects economic choices such as the choice between income and leisure and the choice between present and future consumption. For example, i n the presenceof an income tax, the price of leisure is reduced relative t o an individual's wage income. That is, to acquire an extra hour of leisure an individual would need only give up something less (depending on his marginal tax rate) than an hour's worth of wages. Since all income taxes are inherently inefficient, the goal is to design a tax which minimizes distortions in relative prices. It is often argued that a flat rate income tax is more efficient than a progressive income tax, since it would minimize relative price distortions. However, in the transition from the current progressive tax system to a flat rate tax some individuals would experience increases in An additional factor to consider when discussing behavioral responses is the income effects of a change in relative prices. As opposed to the substitution eftect, which depends on the change in the marginal rate of tax, the incomeeffect is a function of the change in the average rate of tax. If a reduction in an individual's marginal tax rate coincides with a reduction In his average tax rate, then the substitution effect might be offset by the income effect. In this case, the individual's income will increase (due to the reduction in his average tax rate) and he will be able to consume more of everything, including leisure. Most empirical studies indicate that the substitution and income effects of a reduction in marginal and average tax rates tend to cancel each other producing little or noeffect on work effort5 S e e Pechman and Okner. Who Bears the Tax Burden? Brookings Institution. 1974. 5See Dept. of Treasury, Can Tax Revenues Go Up When Tax Rates Go Down?, by Don Fullerton, OTA Paper 41. Sept. 19.30. TAX NOTES, June 21,1982 APPENDIX Legislative Initiatives Nine bills have been introduced (six in the House and three in the Senate) all of which address the issue of a flat rate lncome tax or an expanded income base. A brief synopsis of the pertinent aspects of each of these bills follow^.^ H.R. 3181. (Introduced: April 9, 1981; Sponsors: Rep. Leon E. Panetta. D-Calif.,et al.) Synops~s.Repeals all itemized deductions for individuals except deductions relating to the production of income or alimony or support payments. Substitutes an income tax credit for the personal exemption. Abolishes the tax schedule for heads of households. H.R. 4821. (Introduced: October 22.1981; Sponsor: Rep. George Bansen, R-Idaho.) Synopsis: Amends the lnternal Revenue Code to repeal the income tax tables. Provides for an income tax rate of 14 percent for all indtviduals, estates, and trusts. Redefines "adjusted gross income" to eliminate the deductions from gross income for the following: (1) long-term capital gains; (2) moving expenses; (3) retirement savings;, and (4) repayments of supplemental unemployment compensation benefits. Deflnes "allowable itemized deductions" as any deduction attributable to: (1) expensesfor the production of income; (2) contributions to a church or convention or association of churches: (3) medical and dental expenses; and (4) alimony or separate maintenance payments. Repeals the deduct~onsfor: (1) interest, taxes, and depreclat~onof cooperative housing; (2) moving expenses; (3) retirement savings; (4) abortion expenses; and (5) long-term capital gains. H.R. 5513. (Introduced:February 10,1982;Sponsor: Rep. Philip M Crane. R-Ill.) Synopsis: Amends the lnternal Revenue Code to repeal the income tax T h e abstracts of these bills were prepared by the Bill Digest unit of the American Law Division of the Congressional Research Service tables. Provides for an income tax rate of 10 percent for all individuals, estates, and trusts. Repeals all special tax deductions, credits, and exclusions from incomes for individuals. Amends the Economtc Recovery Tax Act of 1981 toincrease to$2.000 the deduction for personal exemptions. S. 2147. (Introduced: March 1, 1982; Sponsor: Sen. Denn~s DeConcini, R-Ariz.) Synopsis: Requires that the lnternal Revenue Code be amended to provide that after 1985, all income should be taxed at a rate of 20 percent or less. Sets forth guidelines for a new income tax scheme. Requlres the Secretary of the Treasury to propose legislation to implement this Act. S. 2200. (Introduced: March 15, 1982; Sponsor: Sen Jesse Helms. R-N.C.) Synopsis: Companion bill to H.R. 5513. H.R. 5868. (Introduced: March 17, 1982; Sponsor: Rep. Kent Hance, D-Tex.) Synopsis: Directs the Secretary of the Treasury or his delegate to conduct a study of the advisability of replacing the current federal income tax system for individuals and corporations with a system under which income tax is imposed on gross income. H.R. 8070. (Introduced: April 5, 1982; Sponsor: Rep. Leon E. Panetta, D-Calif. et el.) Synopsis: Eliminates most deductions, credits and exclusions. Establ~shesa 19 percent tax on gross income, less basic business expenses. Establishes tax credits of S1,OOOfor an individual. $l,WOfora spouse, $200 per dependent, and $200 for individuals who are blind or over 65. S. 2376. (Introduced: April 15. 1982; Sponsor: Sen. Charles E Grassley. R-Iowa.) Synopsis: Directs theTreasury Department to study the feasibility of replacing the current income tax for individuals and corporations with a flat-rate tax on various income bases. H.R. 6352. (Introduced: May 11, 1982; Sponsor: Rep. Ron Paul, R-Tex.) Synopsis: Amends the lnternal Revenue Code to provide that a 10 percent income tax rate shall apply to all individuals. Repeals all deductions, credits, and exclusions for individuals other than an exemption of $10,000. ESTIMATES OF FLAT INCOME m TAX RATES USING VARIOUS TAX BASES by Louis Alan Talleyl Louis Alan Talley is a Research Analyst i n Taxation i n the Economics Division of the Congressional Research Service (CRS) i n The Library of Congress. This special report is a reproduction of a June 2, 1982 CRS research report prepared by him. The concept of a flat-rate, or proportional, income tax has long held wideattraction becauseof its simplicity and its underpinnings with regard to tax equity. Proposals for the institution of a flat-rate federal income tax are advanced perennially, and the potential revenue implications of the proposals are among the foremost issues debated. A resolution, directing the Treasury Department to complete a study on the feasibility of replacing the current tax system with a flat percentage rate of tax on all forms of personal and corporate income, was introduced by a bipartisan gtoup of House Ways and Means Committee members. The resolution callsfor the study to assume that economically disadvantaged families would be exempt, paperwork reduced, and economic disincentives removed by the new tax system. Additionally, strengths and weaknesses are to be identified with possible solutions. Thestudy would be in two parts; the first would look at only replacing the current personal income tax while the second would focus on replacing both business and personal income taxes.2 The chief purpose of any tax system, proportional or progressive, is to raise the revenue needed for the operations of government. This report examines the flat tax rates necessary to generate the 1980 level of federal individual income tax revenues, under various income tax bases.) It is intended as a companion piece to the CRS reports, Progressivity i n :ncome Taxation: A Pro-Con Discussion (December 28, 1976) by Robert Tannenwald, and An Overview of the Issues Concerning a Flat-Rate Income Tax (May 26, 1982) by Gregg A. Esenwein. The rate of tax necessary to generate a level of revenue equal to that generated by current law will vary according to the income tax base with which it is used; the broader the tax base, the lower the necessary income tax rate. Therefore, proposals for the institution of a flat-rate federal individual income tax often have as corollaries the broadening of the tax base.' The broadening of the tax base would entail the reduction of or the outright elimination of various tax exemptions, deductions, exclusions, and preferences which the tax code now includes. (Some proposals also call for the imputation of net undistributed corporated income to shareholders and the elimination of the-corporate income tax.) This report examines the flat tax rates necessary to raise 1980 levels of individual income tax revenues given various income tax bases, which range from the narrow (taxable income) to the quite broad (comprehensive income). Besides the simple revenue effects the institution of a flat-rate tax would bring about, a switch to a proportional income tax could entail distributional effects. These effects would be changes in how the aggregate tax burden is distributed over income classes. For example. one would expect to find that a greater percentage of the overall tax burden would fall on lower income classes under a proportional tax than under a progressive tax rate system. The precise change in the distribution of the tax burden over income classes would depend partly upon the income tax base which is used. A truly comprehensive tax base with no exemptions whatsoever coupled with a flatrate income tax would result in a tax burden which falls 'Interested readers should see: U.S. Treasury Department. Blueprints for Basic Tax Reform. Washington. U S . Govt. Print. Off.. January 17.1977; and: Pechman, Joseph, ed. Comprehensive Income Taxation. Brookings Institution. Washington, D.C., 1977. Also of interest is: Brazer, Harvey E. "The Income Tax in the Federal Revenue System." in Musgrave. Richard A,. ed. Broadbased Taxes, New Options and Sources. --- 'This paper is based on an earlier report: U.S. Library of Congress. Congressional Research Service. Estimates of Rat lncome Tax Rates Necessary to Raise 1976 Level of Federal lncome Tax Revenues, Using Various Tax Bases, by John Karr. June 21. 1978. ?Tax Legislation: Tax Writers Introduce Resolution on Gross Income Tax Study. Daily Tax Report, The Bureau of National Affairs, Inc. March 17, 1982, No. 52, p. G5 and G6. lstatistics for 1980 are the most recent available which provide information by size of adjusted gross income. 952 The tlat-rate taxes necessary. . .to generate the 1980 level of. . .revenues are: system one, 11.8 percent; system two, 18.5percent; system three, 15.7 percent; and system tour, 18.7 percent. TAX NOTES, June 21,1982 mined. The revenue a flat-rate tax must generate to provide an amount equal to total federal individual income tax collections (at 1980 levels) is about $248.4 billion. The first income base measure examined is taxable income (TI). T I is the most narrowly defined income tax base, consisting of gross income after exclusions, adjustments, exemptions, and d e d ~ c t i o n s . ~ T huse e of T I as a tax more heavily on lower income classes than the same tax rate on a less comprehensive tax base. However, the intent behind the institution of a flat-rate tax may be i n fact t o avoid the "progressive" distribution of the tax burden over income classes (i.e., a tax burden which falls more heavily on upper-income taxpayers than on lower-income taxpayers). Table 1 below presents actual 1980 levels of adjusted gross income (AGI), taxable income (TI), and federal individual income tax liability by category of AGI. From the table, the tax rate necessary to generate equivalent revenues according to the tax base used can be deter- SDefinitions of these terms can be found in: U.S. Library of Congress. Congressional Research Service. An Explanation of Federal Individual lncome Tax Terms, by Morgan Frankel and Louis Talley. May 17, 1980. (Repolt No. 80-98 E). Table 1 FEDERAL INDIVIDUAL INCOME TAX LIABILITIES, 1980 - Adjusted Gross lncome $ 1-$4,999 5,000- 9,999 10,000-1 9,999 20,000-29,999 30,000-49,999 50,000 and over Totala Total AGI (thousands) $ Total Taxable lncome (thousands) Total lncome Tax (thousands) Percent of Total Tax $1,273,558,004 $248,400,602 100.1 Cumulative Percent 38,907,194 136,656,653 369,991,037 390,438.849 405,720,568 264,551,386 $1,606,265,685 'Not equal to 100.0 percent due to rounding. Source: U.S. Internal Revenue Service. Statistics of lncome Bulletm, winter 1981-82. Washington, D.C., 1982. Table 2 ESTIMATED TAX REVENUE GENERATED BY A FLAT-RATE 19.5 PERCENT TAX ON TAXABLE INCOME AT 1980 LEVELS Adjusted Gross Income $ 1-$4,999 5,000- 9,999 10,000-1 9,999 20,000-29,999 30,000-49,999 50,000 and over Total' Total Taxable Income (thousands) $ 26,042,856 97,138,635 293,346,121 314,863,747 328,697,987 213,468,658 $1,273,558.004 Estimated Tax Revenues Percent of Total Cumulative Percent (thousands) 5,078,357 18,942,034 57,202,494 61,398,431 64,096,107 41,626,388 2.0 7.6 23.0 24.7 25.8 16.8 2.0 9.6 32.6 57.3 83.1 99.9 $248,343,811 99.0 99.9 $ 'Not equal to 100.0 percent due to rounding. Source: Author's calculations based on IRS data Table 3 ESTIMATED TAX REVENUE GENERATED BY A FLAT-RATE 15.5 PERCENT TAX ON ADJUSTED GROSS INCOME A T 1980 LEVELS Total AGI (thousands) Adjusted Gross lncome $ 1-$4,999 5,000- 9,999 10.000-19,999 20,000-29,999 30,000-49,999 50,000 and over Total' $ 38,907,194 136,656,653 369,991,037 390,438,849 405,720,568 264,551,386 $1,606,265,685 'Not equal to 100.0 percent due to rounding. Source: Author's calculations based on IRS data. TAX NOTES, June 21,1982 Estimated Tax Revenues (thousands) $ 6,030,615 21,181,781 57,348,610 60,5118,021 62,886,688 41,005,465 $248,971,180 + base would not provide much simplicity due to the many rules regarding allowable deductions, limits on adjustments. etc. TI for 1980 totaled about $1,273.6 billion. In order to generate income tax collections of approximately $248.4 billion, a tax rate of roughly 19.5 peccent would have to be applied. Table 2 presents estimates of the tax revenues that would be collected in each category of AGI under a 19.5 percent tax on TI (at 1980 levels). Adjusted gross income (AGI) would be a somewhat broader income base. AGI is usually less than money income because certain types of income are excluded in calculating AGI. For example, social security, railroad retirement, and unemployment compensation are excludable from gross income. Additionally, certain other items, such as contributions to individual retirement accounts, can be excluded from AGI. AGI, while not as broad a tax Table 4 DISTRIBUTION OF TAX LIABILITIES UNDER FOUR ALTERNATIVE FLAT-RATE TAX SYSTEMS COMPARED TO 1984 TAX LAW1AT 1981 INCOME LEVELS Prennt Law System 1 Expanded income N u m k r of Taxable Returns Tax Liablllty 1984 Law (thousands) (thousands) (millions) Syskm 2 Chango Tax Liability Change (millions) (Percent) (Dollars Per Return) Change Tax Llabllity Change (millions) (Percent) (Dollars Per Return) t < 52 5- 10 10- 15 15- 20 20- 30 30- 50 50-1 00 100-200 > 200 Total Prennt Law System 3 System 4 Change Expanded Income Numbw of Taxable Returns Tax Liabliity 1984 Law Tax Llablilty Change (thousands) (thousands) (millions) (millions) (Percent) (Dollars Per Return) Change Tax Liability Change (millions) (Percent) (Dollars Per Return) < 52 5- 10 10- 15 15- 20 20- 30 30- 50 50-100 100-200 > 200 6,482 15,057 13,092 10,737 16,800 13,568 3.580 631 164 403 5,772 12,526 17,462 44,080 63,833 38,687 18,656 16.385 2,232 7,854 15.720 20,778 49,978 66,466 32,658 12.459 10,050 453.7 36.1 25.5 19.0 13.4 4.1 -15.6 -33.2 -38.7 282.1 0 138.26 243.97 308.88 351.06 194.08 -1,684.20 -9,821.59 -38,630.67 1,996 5,345 12,698 18,802 48.170 68.804 36.1 04 14,344 11,843 395.2 -7.4 1.4 7.7 9.3 7.8 -6.7 -23.1 -27.7 245.71 -28.33 13.11 124.76 243.45 366.41 -721.60 -6.833.56 -27,692.33 Total 80,110 217,803 218,194 0.2 4.88 218,106 0.1 3.78 SOURCE: Joint Committee on Taxation. lTofacilitatecomparison, 1984lawdoesnotincludetheearned income credit, the two-earner couple deduction, or the IRA or Keogh provision. The flat rate tax systemssimilarly do not include those provisions. - - - 20utcomes under the flat-rate tax for tax returns of under 55,000 of Income would be highly uncertain' Some laxpayers at that income level currently make use of tax preferences that would be terminated under the flat-rate tax, and those taxpayers would thus face substantial tax increases. A particular problem would arise under System 1, in which all income would besubject to tax without exemption or deduction; many households with very low incomes who are excused from filing tax returns under the 1984 law are therefore not represented in the table, but would have to file returns and pay taxes under System 1 The impact of 954 this factor on the table would likely be small, though it would significantly change administrative burdens under the tax system. System 1: 11.8 percent tax on adjusted gross Income with longterm cap~talgains ~ n c l u d e din full. System 2: 18.5 percent tax on ,984 law taxable Income less zero bracket amount. less zero system 3: 15.7 percent tax on ,984 lawtaxable income bracket amount, wlth long-term capital galns ~ n c l u d e d in full, and no itemized deductions. System 4: 18.7 percent tax on taxable incomeas in system 3 with increased exemption and zero bracket amount. TAX NOTES, June 21,1982 base as personal income or comprehensive income, would be a much broader tax base than taxable income ( w h i c h i n c l u d e s e x e m p t i o n s and d e d u c t i o n s f r o m income). Table 3 presents the estimated revenue which would be generated by a 15.5 percent tax on AGI, with no other exclusions or exemptions. Another possible income base would be personal, or money income. Because money income includes items such as retirement benefits received, the sum of all dividends received, as well as wage and salary income, it would be a broader tax base than AGI. Total 1980 money income received by families and unrelated individuals totaled roughly $1.739.0billion, as reported by the Census Bureau.=In order t o generate $248.4billion in tax revenues, a tax rate of 14.3percent would have t o be applied t o the $1,739.0figure, with no exemptions or exclusions. Another, still broader tax base would be that provided by comprehensive income. Although there are alternative definitions as t o the specific items which can be included in a comprehensive income base, under most definitions combrehensive income would represent a quite broad tax base. For example, in the Treasury study, Blueprints for Basic Tax Reform (Blueprints s t u d y ) , a comprehensive income definition was developed which includes not only net money wage income, but also social security and pension benefits received, all realized non-corporate capital gains, dividends, and property income, and imputed corporate retained earnings.' This report examines the fiat tax rates necessary to raise 1980 levels of individual income tax revenues given various income tax bases, which range from the narrow. . .to the quite broad. . . T h e foregoing analysis has presumed the institution of a flat-rate tax on income, under various income definitions. It would be possible t o design a simple, yet more progressive, income tax based on a broad tax base by adjusting tax rates or including personal exemptions. However, by including exemptions or exclusions from income the income tax base is narrowed, thus requiring higher tax rates in order t o generate a prescribed amount of revenue. T h e Blueprints study as well as the Brookings study edited by Pechman, Comprehensive Income Taxation, presented examples of simple and progressive federal income tax structures based on comprehensive income which yielded equivalent revenues as the then current tax system. Issues w h i c h are raised in a consideration of progressive versus proportional income taxation are more explicitly discussed in the CRS report previously mentioned, Progressivity i n lncome Taxation: A Pro-Con Discussion. 6U.S.Bureau of the Census. Current Population Reports, Series P-60. No. 127. Money Income and Poverty Status of Families and Persons in the United States: 1980 (Advance Data from the March 1981 Current Population Survey). U.S.Govt. Print. Off.. 1981. 'Another definition of the items to be included in a comprehensive income tax base can be found in: Pechman, Joseph, ed. Op. cit. p. 277-298. TAX NOTES, June 21,1982 T h e T r e a s w y ' s Blueprints study included a proposal for a simple three-tiered income tax rate structure, based on comprehensive income, w h i c h would provide the same degree of progressivity as that contained in the current tax system. T h e Treasury tax rates ranged from eight percent t o 38 percent on comprehensive incomes of over $40,000, and the structure included very few exemptions and deductions. T h e proposal was designed t o generate revenue equivalent t o the then current system, and distribute the tax burden in approximately t h e same manner as the then current system. However, because the tax base would have been broadened d u e t o the lack of the myriad deductions of the then current tax code, tax rates could have been lower, and the entire income tax system would have been simplified without sacrificing any of the progressivity of the then current tax system. In a letter t o t h e Senate Appropriations Committee dated February 25, 1982,J . Gregory Ballentine, Deputy Assistant Secretary of the Treasury, wrote of the tax rates and revenue potential of a proportional tax and such a tax combined with a surtax o n individual income. He states in part: This is in response t o your letter dated November 30, 1981, regarding a proportional tax rate and surtax for individuals. In order t o maintain the individual income tax liability levels of the 1983 budget, a proportional tax o n all individual income would require a tax rate of 10.6 percent i n 1983 increasing t o 11.3 percent in 1987. If Old Age, Survivors, and Disability (OASDI) benefits were excluded from the tax base, and a 20 percent charitable contributions bredit were allowed, the required tax rates would b e 11.6percent i n 1983 and 12.4 percent i n 1987. In your letter you suggest a 10 percent proportional tax o n all individual income combined with a surtax of 15 percent o n income exceeding $50,000 and 20 percent o n income exceeding $100,000. Assuming a January 1, 1983, effective date and corresponding changes i n tax withholding schedules, the direct effect of this proposal would b e a $25 billion reduction i n 1983 tax receipts and a $30 billion increase in 1984 and 1985 receipts compared t o the 1983 budget. The exclusion of OASDI benefits and the allowance of a 20percent charitable contributions credit would increase the 1983 revenue loss t o $36 billion and reduce the revenue gain t o approximately $2 billion i n 1984 and less than $1 billion i n 1985. In arriving at these estimates the new tax base includes capital gains, pensions, personal contributions t o socialinsurance, and allsources of personal money income except income currently associated with fraudulent underreporting.8 Paul Craig Roberts, a former Assistant Secretary of t h e Treasury for Economic Policy, looked at flat income tax rates needed t o balance t h e 1983 budget using t h e comprehensive base of the Blueprints study. He states: An update o f former Treasury Secretary William E. Simon's "Blueprints for Tax Reform" (1976) reveals OEleven Percent Proportional Tax Needed to Meet 1983 Revenue Targets. Tax Notes, v. 14, no.11, March 15,1982. p. 705. Letter sent to Senate Appropriations Committee. that a 16 percent flat-rate tax o n persdnal and corporate income would balance the 1983 budget. There are variations of the flat-rate tax that retain elements of progressivity without defeating the purpose of the tax. A 19 percent flat-rate fax, for example, would balance the 1983 budget and allow the first $6,000 of income to be excluded from tax. That drops the tax rate On a $10,000 income to 7.6 percent and o n a $20,000 income to 13.3 percent. Alternatively, an 18 percent flat tax would balance the 1983 budget and allow all transfer payments including social security to be excluded from the tax ba~e.~ The fourth system uses the tax base of the previous system but increases relief to low-income taxpayers by increasing the personal exemption to $1,500 and thezero bracket amount to $3,00Ofor singletaxpayers and to $6,000 for joint returns. The flat-tax rates necessary under these systems are as follows: System 1: 11.8 percent; System 2: 18.5 percent) System 3: 15.7 percent; and System 4: 18.7 percent. The distribution of tax liabilities under these alternative flatrate systems is shown in Table 4. Astudy by Joseph J. Minarik, Deputy Assistant Director, Tax Analysis Division, Congressional Budget Office,Io entitled The Future of the lndividuallncome Tax, contains a section o n a flat rate income tax. I n his work, Minarik examines four flat-rate tax systems: System one represents7a gross income tax o n AGI (including capital gains in full) yielding the equivalent of current scheduled 1984 law tax revenues, applied to the various tax bases for 1981 income. System two represents the change to a flat tax rate with currently scheduled 1984 tax law unaltered. Under system three, the tax base is made broader by including long-term capital gains in full and prohibiting itemized deductions. In general, lower income taxpayers would find their tax iiablilties greatly increased, while upper-income taxpayers would find their tax liability greatly reduced, unless large exemptions are adopted. . 9Roberts. Paul Craig. How to Break the Stalemate over the Budget. Wall Street Journal, May 3. 1982. p. 30. 'OAs stated on the cover of the Minarik study, the author of that paper takes the responsibility for opinions and any errors, and none should be attributed to the Congressional Budget Office or any of the individuals who helped through comments, advice, or execution of portions of the paper. .. The "proper" amount of progressivity an income tax should entail is a judgment which depends upon personal notions regarding equity and social utility. Despite one's judgment regarding the appropriate degree of progressivity the federal income tax should embody, it is clear that the institution of a flat-rate l.ax on any income base would greatly shift the burden of the individual income tax. In general, lower-income taxpayers would find their tax liabilities greatly increased, while upper-income taxpayers would find their tax liability greatly reduced, unless large exemptions are adopted which are designed to provide income tax relief to lower-income individuals. THE LIERARY C" CONGRESS Congressional Research Service WASHINGTON. D.C. 20W PROGRESSIVITY IN INCOME TAXATION: A PRO-CON DISCUSSION R o b e r t Tannenwald A n a l y s t In T a x a t i o n and F i s c a l P o l i c y E c o n o m i c s Division D e c e m b e r 28. 1976 PROGRESSIVTTY IN INCOibIE TAXATION: -4 PRO-CON DISCUSSION Although i t h a s b e e n a f e a t u r e of the F e d e r a l i n c o m e t a x f o r f o r t y y e a r s , p r o g r e s s i o n d o e s not enjoy u n i v e r s a l s u p p o r t . Periodically, a few tax e s p e r t s p r o p o s e a s a s u b s t i t u t e t o the c u r r e n t i n c o m e t a s a broad-based, simplified, f l a t - r a t e s y s t e m . F o r e x a m p l e . in 1969 C h a r l e s 0. Galvin, Dean of the Southern Methodist U n i v e r s i t y School of Law, p r o p o s e d a c o m p r e h e n s i v e l y - b a s e d i n c o m e t a x with a f l a t tax -11 r a t e of 1 3 p e r c e n t . Recently, R u s s e l l T r a i n , D i r e c t o r of t h e E n v i r o n m e n t a l P r o t e c t i o n Agency and f o r m e r judge of the United S t a t e s T a x C o u r t , a d v o c a t e d a s i m i l a r tax of 10 p e r c e n t s u p p l e m e n t e d 21 by a n e x p e n d i t u r e tax. O t h e r s , although not having a d v o c a t e d a - f l a t - r a t e tax, h a v e advocated expansion of the t a x b a s e with a n a c r o s s t h e - b o a r d r e d u c t i o n in r a t e s that l e a v e s t h e t a s nominally l e s s p r o g r e s s i v e than i n i t s c u r r e n t f o r m . In D e c e m b e r , 1975, f o r e x a m p l e , S e c r e t a r y of the T r e a s u r y William E. Simon p r o p o s e d a n e x p a n s i o n of the i n c o m e t a x b a s e and the u s e of r a t e s ranging roughly f r o m 10 to 30 o r 40 p e r c e n t . Senator M a r k Hatfield i n t r o d u c e d a hill i n the 94th C o n g r e s s (S. 802) p r o p o s i n g a s i m i l a r s y s t e m . T h i s r e p o r t i s a n evaluation of t h e s e and o t h e r b a s e - b r o a d e n i n g , p r o g r e s s i o n - r e d u c i n g i n c o m e tax p r o p o s a l s . It e m p h a s i z e s the i s s u e CRS - 2 of p r o g r e s s i v i t y r a t h e r than that of income tax base definition. Given limitations of time, the d i s c u s s i o n in the following p a g e s is brief, failing to do complete justice to the complexity of the i s s u e s with which i t deals. Tax e x p e r t s have delineated a t l e a s t s i x c h a r a c t e r i s t i c s of a d e s i r a b l e tax s y s t e m . T h e s e include equity, efficiency ( n e u t r a l i t y ) , simplicity, l u c r a t i v e n e s s , effectiveness i n promoting stabilization, and effectiveness in promoting growth. Equitv. At l e a s t t h r e e p r i n c i p l e s of tax equity o r " f a i r n e s s " have been expounded, none of which is u n i v e r s a l l y e m b r a c e d . First, some a r g u e that tax b u r d e n s should be distributed a c c o r d i n g to t a x p a y e r s ' "ability to pay. " The incidence of a tax, in o t h e r w o r d s , should r e f l e c t the m e a n s of those who pay it. With r e s p e c t to i n c o m e taxation, this p r i n c i p l e is usually thought to imply t h e d e s i r a b i l i t y of p r o g r e s s i o n . This implication follows f r o m the assumption of declining m a r g i n a l utility, i. e., that a d o l l a r of income foregone i s m o r e valuable to a p o o r p e r s o n (who is m o r e likely to have spent it on a n e c e s s i t y ) than t o a r i c h p e r s o n (who i s m o r e likely to have spent i t on a luxury). A nominally p r o p o r t i o n a l tax, given this hypothesis, would place a disproportionate tax burden on the poor. CRS - 3 P r o p o n e n t s of a f l a t - r a t e tax r e j e c t the assumption of declining m a r g i n a l utility. Even if one a c c e p t s it, they maintain, the concept of utility is m u c h too vague to s e r v e a s a b a s i s f o r the distribution a of tax burdens. They doubt whether one can c o m p a r e the "utility" of one t a x p a y e r with the "utility" of another without making e x t r e m e l y a r b i t r a r y and subjective judgements. Those who a r g u e in f a v o r of p r o g r e s s i o n do not deny that the principle of ability to pay and the assumption of declining m a r g i n a l utility of income a r e subjective. They a s s e r t , however, that those a r g u i n g in f a v o r of proportionality a r e on no f i r m e r ground. To what objective law can t h e proponents of proportionality r e p a i r in support of t h e i r conception of a f a i r tax b u r d e n ? None, a r g u e the s u p p o r t e r s of p r o g r e s s i o n , because p r i n c i p l e s of equity a r e n e c e s s a r i l y f i r s t p r i n c i p l e s , based on v a l u e s r a t h e r than fact. Some who a r g u e i n f a v o r of proportionality a d m i t that a p r e s u m p t i o n in f a v o r of a given p a t t e r n of burden distribution i s n e c e s s a r i l y s u b j e c t i v e . Many of them imply that i f one i s going to choose a r b i t r a r i l y a guideline f o r future tax r a t e s t r u c t u r e s , the burden distribution of the c u r r e n t tax s y s t e m i s the a p p r o p r i a t e one. Finding l i t t l e o r no p r o g r e s s i o n in c u r r e n t effective tax r a t e s , t h e s e tax e x p e r t s conclude that a f l a t r a t e tax b e t t e r r e p r e s e n t s c u r r e n t r e a l i t i e s than the c u r r e n t s y s t e m of p r o g r e s s i v e r a t e s . CRS -4 C h a r l e s Galvin, f o r example, a f t e r citing evidence that the effective r a t e of the F e d e r a l income tax does not v a r y substantially a c r o s s income c l a s e s , concludes .. . we a r e not taxing. even now n e a r l y a s p r o g r e s s i v e l y a s we s a y we a r e . T h e r e f o r e , a n outright recognition of proportionality would recognize r e a l i t i e s a s they a r e and not a s the tax t a b l e s 3/ r e p r e s e n t them to be. R u s s e l l T r a i n a r g u e s along s i m i l a r l i n e s : I believe c u r r e n t economic a n a l y s i s h a s in fact concluded that the p r e s e n t o v e r a l l s y s t e m , taking into account the s o c i a l s e c u r i t y t a s , is quite definitely r e g r e s s i v e in i t s effect in any event. . . . t h e r e being s o little honest p r o g r e s s i v i t y i n the p r e s e n t s y s t e m , i t s p r e s e r v a t i o n h a r d l y justifies continuance of the p r e s e n t m o r a s s of complexity and s p e c i a l t r e a t m e n t . 4/ P r o p o n e n t s of p r o g r e s s i v i t y cite s t u d i e s which d e m o n s t r a t e that, c o n t r a r y to the c l a i m s of Galvin and T r a i n , the effective r a t e s of both the F e d e r a l income tax and the o v e r a l l F e d e r a l tax s t r u c t u r e a r e p r o gressive. A study p e r f o r m e d by Richard A. and Peggy B. Musgrave indicates that in 1958 effective individual income tax r a t e s r a n g e d f r o m 2. 0 p e r c e n t f o r individuals with i n c o m e s u n d e r $4, 000 to 18. 5 p e r c e n t f o r individuals with i n c o m e s o v e r $92, 000 [Table 1, line 11. Another study, conducted by Joseph P e c h m a n and Benjamin Okner, a l s o concluded that the income tax is p r o g r e s s i v e in i t s incidence, even a f t e r loopholes and the shifting of t a x e s a r e taken into account. A s Table 2 indicates, t h e s e two economists found that t h e i r r e s u l t s v a r i e d with t h e i r assumptions concerning such shifting. Under one s e t of assumptions, they found that a t the l o w e r end of the income s c a l e , (individuals with adjusted family i n c o m e s between 0 and 3 thousand d o l l a r s ) the a v e r a g e effective r a t e of the F e d e r a l income tax in 1966 w a s 1 . 4 p e r c e n t . The a v e r a g e effective r a t e climbed s t e a d i l y with i n c r e a s i n g i n c o m e until it reached a peak of 15. 3 p e r c e n t f o r individuals with adjusted f a m i l y i n c o m e s between 100 and 500 thousand dollars. The a v e r a g e effective r a t e declined a t higher income l e v e l s , falling to 1 2 . 4 p e r c e n t f o r individuals with adjusted family incomes of one million d o l l a r s o r m o r e . T h i s p a t t e r n of effective r a t e s did not change substantially when different incidence a s s u m p t i o n s w e r e -6 / utilized. The r e s u l t s of t h e s e two s t u d i e s roughly substantiate R u s s e l l T r a i n ' s a s s e r t i o n that the burden distribution of a l l F e d e r a l t a x e s combined i s p r o p o r t i o n a l o r r e g r e s s i v e . The conclusions, however, depended on the underlying incidence a s s u m p t i o n s . Musgrave and Musgrave [See Table 1, line 57 and P e c h m a n and Okner [See T a b l e 31, when using incidence a s s u m p t i o n s the l a t t e r though w e r e regressive:::, found a l l F e d e r a l taxes combined w e r e roughly p r o p o r tional a c r o s s m o s t of the income s c a l e although mildly p r o g r e s s i v e -7 / However, P e c h m a n and Okner, a t the l o w e r and u p p e r s e g m e n t s . using a s s u m p t i o n s they considered to be progressive::":', found the burden distribution of a l l F e d e r a l t a x e s combined to be distinctly p r o g r e s s i v e throughout the income s c a l e [See Table 31. -8 / :: See Table 6 , Variant 3b f o r a description of t h e s e a s s u m p t i o n s . 'r* See T a b l e 6, V a r i a n t l c , f o r a description of t h e s e a s s u m p t i o n s . CRS -6 Some of those who a d h e r e to the p r i n c i p l e of p r o p o r t i o n a l i t y a r g u e p r o g r e s s i o n in the F e d e r a l i n c o m e tax i s n e e d e d to offset the r e g r e s s i v i t y or s t a t e and l o c a l t a s e s . They m a i n t a i n t h a t the o v e r a l l i n c i d e 6 c e of F e d e r a l , s t a t e , and l o c a l t a x e s is p r o p o r t i o n a l . Switching to a p r o p o r t i o n a l F e d e r a l i n c o m e tau, t h e r e f o r e , would r e n d e r the overall incidence r e g r e s s i v e . E s t i m a l e s of the b u r d e n d i s t r i b u t i o n of s t a l e and l o c a l t a s e s a p p e a r s to be highly s e n s i t i v e to a s s u m p t i o n s c o n c e r n i n g how t h e s e t a x e s a r e shifted. P e c h m a n and Olcner found, u n d e r t h e i r " p r o g r e s s i v e " s e t of a s s u m p t i o n s [See T a b l e 6, V a r i a n t l c ] that this d i s t r i b u t i o n w a s curvilinear. Effective s t a t e a n d l o c a l tax r a t e s s t a r t e d a t 9. 8 p e r c e n t f o r individuals in the $0-3 thousand b r a c k e t , d r o p p e d to 6. 5 p e r c e n t f o r those in the $10 to $20 thousand b r a c k e t , and r o s e a f t e r that to 13. 8 p e r c e n t o n i n c o m e s o v e r $1 m i l l i o n [See T a b l e 31. II Under t h e i r r e g r e s s i v e s e t of a s s u m p t i o n s [SeeTable 6, V a r i a n t 3b] the b u r d e n d i s t r i b u t i o n was c l e a r l y r e g r e s s i v e , r a n g i n g f r o i n 14. 0 p e r c e n t to 4 . 2 p e r c e n t f o r the l o w e s t a n d h i g h e s t b r a c k e t s r e s p e c t i v e l y [See Table 31. Under the p r o g r e s s i v e s e t of a s s u m p t i o n s , t o t a l F e d e r a l , s t a t e , a n d l o c a l effective r a t e s w e r e c l e a r l y p r o g r e s s i v e i n t h e i r i n c i d e n c e , r a n g i n g f r o m 18. 7 p e r c e n t to 49. 3 p e r c e n t . Undcr the " r e g r e s s i v e " s e t of a s s u m p t i o n s , o v e r a l l b u r d e n d i s t r i b u t i o n was roughly p r o p o r t i o n a l ranging between 24. 3 and 30. 3 p e r c e n t . [See T a b l e 31 CRS - 7 Some maintain that, in evaluating the distributive i m p a c t of the introduction of a flat r a t e tax, one m u s t take into account the incidence of the total budget, expenditures a s well a s taxes. Because t h e benefits of public expenditures a c c r u e s o disproportionately to l o w e r inconle individuals, s o the a r g u m e n t goes, the c u r r e n t total f i s c a l incidence is p r o g r e s s i v e . Reducing o r eliminating t h e p r o - g r e s s i v i t y of the F e d e r a l income tax, t h e r e f o r e , would move this incidence c l o s e r to proportionality. Studies of the distribution of governmental benefits by income c l a s s e s a r e based on even s t r o n g e r incidence a s s u m p t i o n s than those underpinning s t u d i e s of the burden distribution of taxes. However, t h e r e s u l t s of those s t u d i e s which have been p e r f o r m e d a r e not o v e r l y s e n s i t i v e to t h e s e assumptions. Benefit distribution a p p e a r s to be c l e a r l y r e g r e s s i v e (i. e . , benefits in g e n e r a l a c c r u e disproportionately to t h e poqr. ) Musgrave and Musprave, f o r example, e s t i m a t e d that benefits f r o m a l l l e v e l s of government in 1959 a c c r u i n g to individuals with i n c o m e s u n d e r $4, 000 constituted between 123.7 and 1 8 0 . 4 p e r cent of income. T h e s e e s t i m a t e d p e r c e n t a g e s declined steadily with income until they r e a c h e d between 12. 3 and 24. 4 p e r c e n t f o r individuals with i n c o m e s between $35, 000 and $92, 000, (figures w e r e not given f o r individuals with i n c o m e s above $92, 000) [See Table 4. l i n e s 19-21]. ILlusgrave and ~ u s g r a v kfound the distribution of net benefits and burdens (benefits m i n u s t a x e s ) of a l l l e v e l s of government to be skewed in f a v o r of the poor. [See Table 5, line 91 CRS -8 Some f e e l that s t u d i e s such a s that p e r f o r m e d by Musgrave and lMusgrave fail to e n t e r t a i n the possibility that the benefits of public goods and s e r v i c e s a c c r u e disproportionately to the r i c h r a t h e r than the poor. B o r i s B i t t k e r , f o r example, m a i n t a i n s that the benefits of governmental expenditures on defense, police, f i r e protection, and adjudication should be distributed in proportion to p r o p e r t y o w n e r s h i p because they s e r v e p r i m a r i l y to p r o t e c t p r o p e r t y rights. Similarly he believes that e.upenditures on education, health, and w e l f a r e g e n e r a t e l a r g e amounts of benefits to individuals in high income b r a c k e t s by improving society in general. If t h e s e benefits w e r e accounted f o r , Bittker concludes, one might even find that o v e r a l l f i s c a l incidence in the United S t a t e s is r e g r e s s i v e and that i n t r o -5 / ducing a proportional income tax would m a k e it even m o r e so. CRS - 9 TABLE 1 Estimated Distributipn of Tax Burdens by Income Breckets, 1968 flaxes a s Percent of Total Farndv Incornel INCOME BRACKETS , $5,700- $7.900- $10.400- $12.500- $17.500- $22,600- $35,500- $92.000All $4,000 $5,700 $7.900 $10,400 $12,5DO $17.500 $22.600 $35.500 $92.000 ahd over Brackets Under $4 000- Taxes Federal Taxes 1. Individual income tax 2. Estate and gift tax 3. COrporation income tax 4. Excises and customs 5. Payroll tax 6. Total 7. Total excluding line 5 State and Local Taxes 8. Individual income tax 9. Inheritance tax 10. Corporation income tax 1 1. General sales tax 12. Excises 13. Property tax 14. Payroll tax 15. Total 16. Total excluding line 14 2.0 5.1 2.5 5.5 15.2 9.7 2.8 6.1 2.8 6.3 17.9 1 1.6 5.9 5.0 3.1 7.0 20.8 13.9 28.5 30.5 32.8 22.9 23.7 25.0 - All Levels 17. Total 18. Total excluding lines 5 and 14 Source: For brief explanation of estimates, see text. Notes: Uneven bracket limits are used for computational reasons. Line 12: Includes motor vehicle licenses, excises. and miscellaneous revenue. Totals may not add due to rounding. Source: Richard A. Musgrave and Peggy B. Musgrave. Public finance in theory and practice. New York, McGraw Hi11 [l973], p. 368. CRS - 10 TABLE 2 Effective Rates of Federal, State, and Local Taxes, by Type of Tax, Variants l c and 3b, by Adjusted Family Income Class, 1966 in Income classes i n thousands o f dollars; t a x rates percent - ~~~~~ Personal Indi- Corpo- Sales property Adjusted viduai ration family income income Property excise and Payroll vehicle Total income lax tox fax taxes taxes taxes taxes Variant 0-3 3-5 5-1 0 10-1 5 15-20 20-25 2.1 2.2 1.8 1.6 2.0 3.0 a n d motor 1c 2.5 2.7 2.0 1.7 2.0 2.6 9.4 7.4 6.5 5.8 5.2 4.6 25-30 30-50 50-1 00 100-500 500-1.000 1,000 a n d over A l l classesb Variant 0-3 3-5 5-1 0 10-15 15-20 20-25 6.1 5.3 4.3 3.8 3.8 4.0 6.5 4.8 3.6 3.2 3.2 3.1 3b 9.2 7.1 6.4 5.6 5.1 4.6 25-30 30-50 50-1 00 100-500 500-1.000 1,000 a n d over A l l classesb Source Computed from the 1966 MERGE dato flh.For on erplonotion of the incidence voriontr, seeloble 3-1. Note; Voriant I c i s the most progr.srive and 3b the Ieost progressive $01of incidence osrumptims .xomined in this study. Less thon 0.05 percent. b lnclv>r-rnegative incomes not shown seporotdy. Source: Joseph A. Pechman and Benjamin A. Okner. Who bears t h e t a x burden? Washington, Brookings I n s t i t u t i o n [1974], p. 59. CRS - 11 TABLE 3 Effective Rates of Federal and State-Local Taxes, Variants lc and 3b, by Adjusted Family Income Class, 1966 I n c o m e classes i n thousands o f dollars; t a x rates i n percent Variont Adjusted 1c Variont 36 income Fedeml Sfafe-local Total Federal State-local Tot01 25-30 30-50 50-1 0 0 100-500 500-1,000 1,000 and over 17.4 18.2 21.8 30.0 34.6 35.5 7.7 8.2 9.7 11.9 13.3 13.8 25.1 26.4 31.5 41.8 48.0 49.3 17.2 17.7 20.1 24.4 25.2 7.1 6.7 6.3 6.0 5.1 24.3 24.4 26.4 30.3 30.3 24.8 4.2 29.0 Source: Computed from the 1966 MERGE data file. For on explanation of the incidence voriontr, see Tablo 3-1. Details may not odd to totals becouse of rounding. Note, Variant I c i s tho mort progressive and 3b'tho least progrenivo set of incidence assumptions examined in this study. Includes negative incomes not shown separately. Source: Joseph A. Pechman and Benjamin A. Okner. Who bears the tax burden ? Washington, Brookings Institution [I 9741, p. 62. CRS - 12 TABLE 4 Distribution of Expenditure Benefits (Benefits as Percent of Total Family Income) SELECTED INCOME BRACKETS Under $4.000- $5.700- $7,900- $12,500- $35.500$4.000 $5,700 $7.900 $10,400 $17,500 $92.000 All I. SPECIFIC BENEFIT ALLOCATIONS Federal 1. Purchases: 2. 3. 4. 5. 6. 7. Transfers 8. Total State and Local 9. Purchases: 10. II. 12. 13. 14. Transfers 15. Total All Levels 16. Purchases 17. Transfers 18. Total Education Interest Highways Agriculture Medical Total Education Interest Highways Medical Total 1.9 5.2 78.3 83.5 1.1 2.0 0.8 0.2 1.8 5.9 19.8 25.7 1.1 1.2 0.9 0.3 1.0 4.5 8.8 13.3 I.O 0.6 0.8 0.4 0.5 3.3 4.3 7.6 0.6 0.8 0.7 0.4 0.2 2.6 2.1 4.7 5.5 0.1 1.2 5.7 12.5 14.5 27.1 9.9 0.1 1.6 5.6 17.2 1.6 18.7 10.4 8.7 5.4 t 1 ; 1.9 2.9 15.2 0.6 15.8 1.8 1.5 12.0 0.2 12.2 1.5 0.5 7.4 L * 7.4 2.2 1.3 1.1 7.7 0.7 8.4 17.8 92.8 110.6 23.0 21.4 44.4 19.7 9.4 29.1 15.3 4.5 19.8 10.0 2.1 12.1 7.5 0.2 7.7 11.5 6.9 18.4 28.8 29.2 26.2 24.4 24.5 12.3 35.1 35.1 35.1 0.6 2.1 0.6 * * 0.2 2.3 0.2 2.6 * 5.3 0.2 5.5 1.5 0.1 0.5 0.1 2.2 0.6 1.5 0.6 0.7 0.4 3.8 6.2 10.0 5.2 * II. TOTAL BENEFIT ALLOCATION All Levels 19. Variant A 20. Variant B 2 1. Variant C 127.3 123.7 180.4 61.1 58.9 77.0 45.8 45.2 57.9 36.5 36.3 40.8 *Less than 0.05 percent. Notes: Lines 2 and 10: Interest is included here under purchases, although according to national income accounts it should appear as a separate category. Lines 19, 20. 21: For explanation, see text. Source: Richard A. Musgrave and Peggy B. Musgrave. Public finance in theory and practice. New York, McGraw Hill [1973], p . 373. CRS - 13 TABLE 5 Distribution of Net Benefits and Burdens (Net as Percent of Total Family Income) INCOME BPACKETS Under $4,000$4.000 $5,700 $5.700- $7.900- $10,400$7.900 $10,400 $1 2,500 $12,500- $17.500$17,500 $22,600 $22,600- $35,500- $92,000 $35,500 $92.000 and over Federal 1. Specific allocation 2. General, variant A 3. Total State and Local 4. Specific allocation 5. General, variant A 6. Total All Levels 7. Specific allocation 8. General, variant A 9. Total Notes: Lines 2. 5. and 8: General expenditures are allocated in propornon to family income levels and tax distributions as in Table 15-1. 'Less than 0.05 Source: Richard A. Musgrave and Peggy B. Musgrave. Pub1 i c finance in theory and practice. New York, McGraw Hill [1973], p. 375. CRS - 14 TABLE 6 Tax Incidence Assumptions Used in Pechman-Okner Study Tax and basis o f ollocotion o b -- - Variant 3 Variant 2 Variant 1 c o b a b c lndividuol income fox To taxpayers X X X X X X X X X X X X X X X X X X X X X X X X X ... Soles and excise foxes To consumption o f t a x e d commodities Corporofion income fox To dividends To property income in generol Half t o dividends; holf to property income in general Half t o dividends; one-fourth to consumption;one-fourth to employee compensation Half t o property income in general; half t o consumption Property fox on Iond To Iondowners To property income in generol Property tax on improvemenfs To shelter ond consumption To property income in general Holf t o shelter and conrumption; half t o property income in generol Poyroll fox on employees TO employee compensation Poyroll fox on employers To employee compensation Holf t o employee compensation; holf t o consumption -- . . . . . . . . . . . . X . . . Source: Joseph A. Pechman and Benjamin A. Okner. Who bears the tax burden? Washington, Brookings Institution 119741, p. 38. Some proponents of a f l a t - r a t e income tax have advocated the maintenance of a d e g r e e of p r o g r e s s i o n in the tax s t r u c t r u r e through a n expenditure tax with a l a r g e exemption. m o s t r e c e n t l y by R u s s e l l E. T r a i n . 61 - T h i s suggestion was m a d e Because consumption a s a proportion of income d e c r e a s e s with income, the exemption would have to be huge in o r d e r to m a k e the tax p r o g r e s s i v e . Some tax a n a l y s t s r e j e c t the ability to pay principle a s a guideline to tax equity in f a v o r of the "benefit" principle. According to t h i s p r i n c i p l e , tax b u r d e n s should be allocated according to the value of the benefits g e n e r a t e d by public goods and s e r v i c e s . Obviously, the implications of this principle f o r the d e s i r a b l e amount of p r o g r e s s i o n i n the income tax depends o n o n e ' s beliefs concerning the distribution of benefits by income c l a s s . Because Boris Bittker believes that t h i s distribution is skewed in f a v o r of high income individuals, he u s e s t h e benefit principle t o defend the c u r r e n t p r o gressive rate structure. F o r others, II benefit p r i n c i p l e s taxes. horizontal equity" r a t h e r than the ability-to-pay o r i s t h e m o s t important c r i t e r i o n f o r evaluating In s h o r t this principle s t a t e s that individuals with equal i n c o m e s should b e a r equal tax burdens r e g a r d l e s s of the s o u r c e s of incomes. Many existing tax p r e f e r e n c e s violate this principle. For e s a m p l e , o t h e r things being equal, a t a x p a y e r who e a r n s h i s income through the realization of capital gains p a y s l e s s in t a x e s than one whose s o u r c e of income i s s a l a r y . Thus, much base-broadening is advocated under the banner of horizontal equity, too. Some believe that the principle p e r t a i n s to the i s s u e of p r o g r e s s i v i t y a s well. It h a s been argued that p r o p e r t y i n c o m e should be taxed m o r e heavily than e a r n e d income because i t is m o r e c e r t a i n . A p r o g r e s s i v e income tax r a t e s t r u c t u r e effects this differential, s i n c e p r o p e r t y income a s a percentage of total i n c o m e i n c r e a s e s a s one p r o c e e d s up the income s c a l e . B e f o r e leaving i s s u e s of equity, one should note that not even the m o s t adamant i n h e r e n t s to a proportional income tax s t r u c t u r e bel i e v e that income below s u b s i s t e n c e l e v e l (however that may be defined) should be subject to i n c o m e taxation. How s u b s i s t e n c e income is f r e e d f r o m taxation a f f e c t s t h e p r o g r e s s i v i t y of o v e r a l l budget incidence. The advocates of Senator Hatfield's s i m p l i f o r m proposal p r a i s e i t f o r i t s u s e of c r e d i t s r a t h e r than exemptions o r deductions 71 in achieving this goal. The credit, i s a m o r e p r o g r e s s i v e i n s t r u m e n t . - of tax relief than a deduction o r exemption. While the tax s a v i n g s resulting f r o m a d o l l a r of exemption depends on the t a x p a y e r ' s r n a r g i n 4 tax r a t e , the tax savings resulting f r o m a d o l l a r ' s worth of c r e d i t is the s a m e f o r everyone, r e g a r d l e s s of that r a t e . Some a r g u e that e v e r y d o l l a r or income should be subicct to taxation. These individuals believe that the s u b s i s t e n c e problem should be rcrnetiicd thr-ough the expcnditurc s i d c of thc budget. CRS - 17 EFFICIENCI- (NEUTRALITY) One of the 1no.st fundamental canons of m a i n s t r e a m economic theory and the ideology of c a p i t a l i s m is that p u r e l y competitive m a r k e t s a r e m o s t efficient. Left alone, such m a r k e t s will s a t i s f y c o n s u n l e r p r e f e r e n c e in t h e cheapest possible way. A c o r o l l a r y of t h i s b a s i c tenet i s that a tax s y s t e m should d i s t o r t private economic decisions.rnade under purely competitive conditions a s little a s possible. Many opponents of p r o g r e s s i o n believe that it d i s t o r t s the p a t t e r n of s e v e r a l types o f economic decisions. F i r s t , it allegedly d i s t o r t s the w o r k e r l s choice between l a b o r and l i e s u r e , causing him to choose l e g s of the f o r m e r and m o r e of the l a t t e r . T h i s distortion r e s u l t s f r o m the penalty that p r o g r e s s i v i t y i m p o s e s on the w o r k e r f o r attempting to rnove up the income s c a l e . In combination with the c u r r e n t e r o s i o n of the income tax base, it a l s o induces taxp a y e r s to w a s t e t i m e and e n e r g y in seeking ways to avoid the o n e r o u s effects of pr*gxessivity. With r e s p e c t to the purported i m p a c t of p r o g r e s s i v i t y on work effort, one could a r g u e that reducing p r o g r e s s i v i t y might d e c r e a s e a s well a s i n c r e a s e s u c h effort. i n c r e m e n t i n efSo~-tg a r n e r i n g with e a c h hour worked o r each a l a r g e r net wage, the w o r k e r who - l a b o r s until h e h a s achieved a fixed iricome l e v e l might r e d u c e h i s eMort, reasoning that h e n e e d w o r k l e s s to achieve that level. CRS - 18 Anyway it i s not c l e a r that people have e i t h e r the capacity o r t h e d e s i r e to a l t e r t h e i r work e f f o r t i n r e s p o n s e t o changes in net s a l a r y . As f o r the a r g u m e n t that p r o g r e s s i v i t y l e a d s people to w a s t e t i m e and e n e r g y in seeking ways to avoid i t s impact, f i r s t removing a v e n u e s of avoidance through the enactment of a c o m p r e h e n s i v e income b a s e would d r a s t i c a l l y r e d u c e this type of behavior, even if proportionality w e r e not enacted. Secondly, one could a r g u e that people would spend a l m o s t a s much t i m e in the p u r s u i t of. tax s h e l t e r s even with a p r o portional r a t e s t r u c t u r e , s i m p l y because i t is n a t u r a l to a t t e m p t to m i n i m i z e tax liabilities u n d e r any c i r c u m s t a n c e s . It should a l s o be noted that the broadening of the i n c o m e tax would eliminate important investment incentives c u r r e n t l y embedded in the income tax s t r u c t u r e , such a s favorable t r e a t m e n t of longt e r m capital gains, the investment tax c r e d i t , and a c c e l e r a t e d depreciation. Thus, even if one m a i n t a i n s that the c r e a t i o n of a proportional income tax r a t e s t r u c t u r e would s t i m u l a t e investment, it does not follow that a complete base-broadening p r o g r e s s i o n reducing proposal would. Besides, t h e r e a r e ways of stimulating saving and investment through the expenditure s i d e and through the m o n e t a r y s y s t e m which might be just a s effective a s changes in tax policy. A s f o r R u s s e l l T r a i n ' s suggestion that a consumption tax be enacted, one could a r g u e that such a tax would r e v e r s e t h e direction of the distortion in the consumption/ s a v i n g s decision - CRS a s well dampen c o n s u m e r demand. 19 Yet the s t r e n g t h of c o n s u m e r demand i s an important f a c t o r in the investment decision. Train's proposal, t h e r e f o r e might have only a l i m i t e d effect on capital f o r mation. In r e s p o n s e , one could a r g u e that the government could maintain o v e r a l l demand s t r e n g t h through m o n e t a r y policy and the e s p e n d i t u r e s i d e of the budget. SIhIPLICITY T h e r e i s a g e n e r a l a g r e e m e n t that taxes should be s i m p l e to collect and s i m p l e to comply with. s y s t e m i s e x c e s s i v e l y co.mplex. Many believe that the c u r r e n t The multitude of schedules, the n u m b e r of o p e r a t i o n s the t a x p a y e r m u s t p e r f o r m in o r d e r to d e t e r mine his o r h e r tax liability, the i n c r e a s i n g l y f r e q u e n t n e c e s s i t y of obtaining p r o f e s s i o n a l a s s i s t a n c e to f i l l out r e t u r n s have imposed a s u b s t a n t i a l burden on the public, diverting i t s e n e r g i e s f r o m m o r e productive a c t i v i t i e s , T h i s burden purportedly h a s contributed to t h e disillusionment of the A m e r i c a n people with government in general. A broad-based p r a p o r t i m a l tax, s o i t s s u p p o r t e r s a r g u e , would e l i m i n a t e much of t h i s complexity, . Eliminating tax p r e f e r e n c e s - obviously would simplify the s y s t e m . Eliminating o r reducing p r o - g r e s s i o n in the r a t e s t r u c t u r e would s t i f l e the motivation to r e i n s t a t e those prcl'erences. CRS - 20 Some maintain. however, that broadening the t a s b a s e would g e n e r a t e as m u c h complexity as i t would eliminate. B o r i s Bittker h a s argued that base expansion would c r e a t e new valuation p r o b l e m s not r a i s e d under c u r r e n t law, p a r t i c u l a r l y i f u n r e a l i z e d a p p r e c i a t i o n and depreciation, the m a r k e t value of annuities, and imputed income f r o m the ownership of p r o p e r t y become tasable. Furthermore, he a r g u e s , base augmentation might r e q u i r e distinctions noL r e q u i r e d under the p r e s e n t s y s t e m . F o r example, if deductions of p e r s o n a l expenditures a r e disallowed, it would be n e c e s s a r y to e s t a b l i s h viable c r i t e r i a f o r t h e i r identification and distinction f r o m -. b u s i n e s s expenses. How will such a distinction be m a d e ? B i t t k e r g i v e s s e v e r a l e x a m p l e s of situations in which the distinction would be difficult. Would the p e r s o n injured in t h e c o u r s e of h i s work be p e r m i t t e d to deduct the physician's bill a s a b u s i n e s s e x p e n s e ? Would a n individual be a b l e i o deduct the i n t e r e s t on h i s home m o r t gage i f h e i n c u r r e d o r continued the debt in o r d e r to finance a business o r p u r c h a s e investment s e c u r i t i e s ? T h e s e e x a m p l e s give a taste, according to Bittker, of the complexity that base-broadening could entail. The f l a t - r a t e consunlption t a s with a l a r g e exemption, which R u s s e l T r a i n h a s suggested a s a p r o g r e s s i v e supplemcnt to income taxation, would entail e n o r m o u s a d m i n s t r a t i v e complexities. R'lusg~.aveand h'lusgr.ave have suggested that the m o s t f e a s i b l e p r o c e d u r e f o r determining the t a x p a y e r ' s annual consumption would be the following: 1. R e c o r d the bank balances a t the beginning of the y e a r 2. Add r e c e i p t s 3. Add n e t borrowing (borrowing m i n u s debt r e p a y m e n t o r lending) 4. Subtract net investment ( c o s t s of a s s e t s purchased minus proceeds from a s s e t s sold) 5. Subtract bank b a l a n c e s a t end of the y e a r The r e s u l t i n g f i g u r e would equal consumption f o r t h e y e a r . T h i s p r o c e d u r e would r a i s e m a n y problems. F i r s t of a l l imputed consumption--e. g., housing and gome grown food--would have to be included if the tax b a s e is to r e f l e c t a l l consumption. borrowing m u s t be accounted for. Secondly, Such accounting would be difficult when the c r e d i t o r s a r e institutions, not subject to the expenditure tax. The expenditure tax would a l s o have to deal with the p r o b l e m of long-lived consumption goods, s u c h a s housing. T h e s e might be taxed e i t h e r a s imputed consumption o v e r t h e i r useful life, o r a t the t i m e of initial outlay, with a p p r o p r i a t e averaging permitted. Diffi- c u l t i e s m i g h t a l s o a r i s e in distinguishing between consumption and investment. S e v e r a l expenditures have both consumption and investment c h a r a c t e r i s t i c s , e. g. s h a r e s in 3 country club. . education o r the pur-chase of - Finally, it might be possible Tor a high- consumption t a x p a y e r to e s c a p e the tax by convincing a low CRS - 22 consumption taxpayer to m a k e p u r c h a s e s f o r him, dropping both below the t a x - f r e e l e v e l in the p r o c e s s . 81 - STAB ILIZA T I 0 N It is d e s i r a b l e f o r a tax to p r o m o t e s t a b l e p r i c e s and dampen swings i n the b u s i n e s s cycle. P r o g r e s s i o n h a s often been p r a i s e d a s an automatic s t a b i l i z e r that a s s i s t s the tax s y s t e m i n achieving these goals. When the economy is booming and i n c o m e s a r e i n c r e a s i n g , the bite of p r o g r e s s i o n m o d e r a t e s the expansion, thereby allegedly controlling inflationary f o r c e s . When the economy is declining and incomes a r e d e c r e a s i n g , the a v e r a g e m a r ginal tax r a t e declines under a p r o g r e s s i v e r a t e s t r u c t u r e . As a consequence the reduction i n disposable income r e s u l t i n g f r o m the r e c e s s i o n and concomitant reductions in demand and employment a r e moderated. Opponents of the d e g r e e of p r o g r e s s i o n c u r r e n t l y f e a t u r e d in the income tax c l a i m that the r a t e s t r u c t u r e not only d a m p e n s expansion but r e t a r d s r e c o v e r y . In o t h e r w o r d s they c l a i m that p r o g r e s s i o n h a s such an o p p r e s s i v e effect on the economy that i t p r e v e n t s i t f r o m achieving i t s potential. Growth It h a s been alleged that p r o g r e s s i v i t y d a m p e n s growth b e c a u s e - i t f a l l s m o r e heavily on s a v i n g s than does a p r r o p o r t i o n a l o r r e g r e s sive income tax. T h i s a r g u m e n t follows f r o m the a s s u m p t i o n that CRS - 23 the m a r g i n a l propensity to s a v e i n c r e a s e s with income, i. e . , that f a m i l i e s k i t h r e l a t i v e l y high i n c o m e s tend to change t h e i r savings by a l a r g e r f r a c t i o n of a change in t h e i r disposal income than do f a m i l i e s with r e l a t i v e l y lpw incomes. Studies designed to t e s t the i m p a c t of p r o g r e s s i v i t y on savings have found that a p r o g r e s s i v e t a x d o e s in f a c t f a l l m o r e heavily on savings than would a proportional income t a s . The s t u d i e s d i s a g r e e on the extent of the differences in impact on s a v i n g s of these a l t e r n a i v e tax r a t e s t r u c t u r e s . 9/ - Some e c o n o m i s t s r e f u t e the c l a i m that an income tax which falls heavily on s a v i n g s will r e d u c e household savings. Those e m b r a c i n g this a r g u m e n t a s s u m e that the s a v e r h a s a fixed s a v i n g s t a r g e t ; f o r example, adequate r e t i r e m e n t o r enough to p r o vide f o r h i s c h i l d r e n ' s education. If the s a v e r ' s income i s reduced, he will have to s a v e a t a g r e a t e r r a t e in o r d e r to m e e t h i s t a r g e t . Reddcing tax r a t e s and p r o g r e s s i v i t y , i t follows, would d e c r e a s e the r a t e of s a v i n g by higher income tax p a y e r s . This effect might off- s e t t h e g r e a t e r tendency of higher income people to substitute s a v i n g s f o r consumption when t h e i r disposable incomes a r e i n c r e a s e d . YIELD (LUCRATIVENESS) Advocates of base-broadening and p r o g r e s s i o n - r e d u c t i o n point out that augmentation of the tax b a s e would p e r m i t r a t e reduction without revenue l o s s . Galvin,for example, s u g g e s t s that under h i s proposed f l a t - r a t e tax, the income tax r a t e could be s e t a t 13 p e r cent without any l o s s in revenue. T r a i n s u g g e s t s that r a t e could be a s low a s 10 p e r c e n t under his scheme. Some even contend that r e v e n u e s would i n c r e a s e u n d e r plans such a s those of Galvin and T r a i n because the s t i m u l u s provided by t h e i r proposed r a t e r e d u c tions would i n c r e a s e taxable income. Introducing a 10 o r 13 p e r c e n t flat r a t e income tax without reducing revenue below i t s c u r r e n t level would be p o s s i b l e only if the income t a s base w e r e broadened to include unrealized c a p i t a l gains, whose identity a s "income" i s a point of contention among e c o n o m i s t s and accountants. Otherwise, even if a l l national i n c o m e w e r e included i n the tax base, with no exemptions, deductions, o r exclusions, a I 6 p e r c e n t r a t e would be n e c e s s a r y t o avoid revenue losses. In evaluating Galvin's and T r a i n ' s p r o p o s a l s , one should keep in mind the e x t r e m e n a t u r e of the b a s e broadening involved. A s f o r the a r g u m e n t that revenues would actually i n c r e a s e u n d e r these p r o p o s a l s because of t h e i r sizeable s t i m u l u s to the economy, one can point out that no c o n c r e t e evidence h a s been unearthed that the p r o p o s a l s would have such a l a r g e i m p a c t on taxable income. FURTHER COMMENTS s e v e r a l of those who have advocated simplified income t a x e s with reductions in p r o g r e s s i o n have d i s c u s s e d integration of the individual income tax with o t h e r F e d e r a l taxes, such a s the c o r p o r a t i o n income CRS tax and the payroll tax. a-k.e beyond the scope - 25 Although these questions a r e important, tXey of this r e p o r t . O n e ' s beliefs concerning the a p p r o p r i a t e d e g r e e of p r o g r e s s i v i t y fii F e d e r a l irrcofie taxation a r e i m p o r t a n t components of h i s im-3ge of C j ~ s society. t &; The i s s u e of p r o g r e s s i v i t y ultimately m u s t be r e s o l v e d tlie b a s i s of value judgements, not on deductions based on objective laws. Footnotes -I /. Galvin, C h a r l e s 0. and B o r i s I. B i t t k e r . T h e i n c o m e tax: how p r o g r e s s i v e should i t b e ? Washington, A m e r i c a n E n t e r p r i s e histitute [ I 9691. -2 1 T r a i n , R u s s e l l E. A plan f o r r e a l tax r e f o r m . Oct, 24, 1976: B1, B4. Washington P o s t , Ne w s p -31 Galvin, C h a r l e s 0. a n d B o r i s I. Uittker, op. c i t . , p. 19. -4 / T r a i n , R u s s e l E . , op. c i t . , B4. 5/ - Galvin a n d B i t t k e r , op. c i t . , pp. 52-54. -G / -71 T r a i n , op. cit. , 134. IIatfield, M a r k 0. S i m p l i f o r m on i n c o m e tax. R e m a r k s in the Senate. C o n g r e s s i o n a l R e c o r d [daily ed. ] v. 121, F e b . 24. 1976: S 2442. -8 1 R i c h a r d A. h l u s g r a v e and P e g g y B. ILlusgrave. P u b l i c f i n a n c e in t h e o r y and, p r a c t i c e . New York. McGraw Hill [ I 9731, p. 316. -91 See R i c h a r d Goode. The individual i n c o m e tax. Washington, The RI-ookings Institution [I9641 p. 67; a l s o , M u s g r a v e , R i c h a r d A. E f f e c t s of tax policy on p r i v a t e c a p i t a l f o r m a t i o n , i n f i s c a l a n d debt m a n a g e m e n t policies, R e s e a r c h Studies i o r the Commiss'ion on nloney and C r e d i t [Englewood Cliffs, N. J. : P r e n t i c e - H a l l , 19631, pp. 65, 58.