Part IV - Looking Ahead - Chapter 18

This online chapter is not included in the printed textbook.
Last updated on September 1, 1998.
© 1998 Prentice-Hall, Inc. A Simon & Schuster Company

Table of Contents for Chapter 18

Part IV - Looking Ahead

Chapter 18

Possible Future Changes to the Tax Law and the Tax System

The growth of the global economy, changes in ways of doing business, improvements in technology, the expansion of entitlement spending, and the increasing complexity of the federal income tax will shape the future of the federal tax system.

The gap between Federal spending and revenues is growing rapidly. Absent policy changes, entitlement spending and interest on the national debt will consume almost all Federal revenues in 2010. ¹

Millions of taxpayers in at least 36 other countries that also have tax withholding systems do not have to prepare income tax returns because these countries have alternative filing systems not currently available in the United States.²

The solutions that emerge should be sufficiently general and flexible in order to deal with developments in technology and ways of doing business that are currently unforeseen.³

Because the tax laws and regulations of so many jurisdictions were established long before the Internet or interactive computer services, their application to this new medium in unintended and unpredictable ways threatens every Internet user, access provider, vendor, and interactive computer service provider.⁴

What we should all be talking about is lowering the tax on labor and job skills and increasing it on pollutants.⁵

Our current income tax system is broken.... It cannot be repaired by any tinkering or fine-tuning. It must be completely repealed and replaced.⁶

Chapter Snapshot

The above quotes, all from government officials, underscore the conviction of many people at every level of government that significant changes to our tax system are warranted. A $5-trillion-plus national debt, the revolution in ways of doing business brought by electronic commerce, the growing significance of the global marketplace, and the complexity of our present tax laws, all seem to call for some fundamental changes to the U.S. tax system. Proposals to change the current tax system in major and minor ways are discussed in this report.

Objectives

This material is designed to help you:

• Know what types of changes in the federal budget process, tax law, and tax administrative system in the future.
• Understand the factors driving such changes.
• Appreciate how such changes might affect decision making for a business.
• Be capable of discussing and evaluating these proposed changes in terms of their potential effects on different types of taxpayers and their overall advantages and disadvantages.

Introduction

If there is one constant in the federal tax system, it is that legislators and others are continually suggesting ways to improve it. These proposals range from minor changes, such as modifying the estimated tax payment formula, to drastic revisions, such as replacing the income tax with a consumption tax.

Proposed changes often affect more than just the calculation of taxable income. Many proposals are offered for economic reasons, such as to improve capital formation, while others have social ends, such as reducing tobacco consumption or cleaning up the environment. Some proposals even change the ways of doing business, such as by providing services over the Internet.

In addition to specific proposals to change tax provisions, proposals in other areas, such as health care reform, may have tax consequences for businesses and individuals. Also, proposals that affect government spending, such as a balanced budget amendment to the United States Constitution, have tax consequences.

This chapter discusses changes to the federal tax law, along with their possible effects on businesses in six broad areas:

• Nontax proposals with tax implications.
• Changes to the budget process.
• Compliance-related proposals.
• Proposals to implement economic and social policies through the tax law.
• Changes related to electronic commerce.
• Major federal tax reform.

The chapter concludes with some suggestions on how to stay informed about the progress of these and other proposals.

Nontax Proposals with Tax Implications

Health-care Reform

Any effort to reform national health-care policies will necessarily entail tax law changes. The forces driving health-care reform are the accelerating costs of health care, which affect businesses, individuals, and governments, and the lack of medical insurance for a sizable segment of the U.S. population. Proposals to encourage employers to provide health insurance to all employees are a part of every health-care debate. One suggestion to alleviate the costs to employers stemming from such a proposal is to allow them to deduct the cost of premiums in calculating taxable income. Another is to provide tax credits for providing this insurance.

Techniques to contain health insurance costs by involving employees have also been considered. Because medical insurance is often a tax-free fringe benefit, employees now have little incentive to consider the costs of health care. Some people have proposed requiring employees to include in their taxable income the cost of any employer-provided health care benefits over and above a basic health care policy. An alternative proposal is to deny employers a deduction for such costs. The tax revenues raised from these types of changes could be used by the government to help people without health insurance purchase a basic policy.

Entitlement Reform

Another area ripe for reform is entitlement programs---Social Security and Medicare. In 1995, the Bipartisan Commission on Entitlement and Tax Reform concluded that, in the absence of policy changes, spending on entitlements and interest on the national debt would consume almost all federal revenues by the year 2010, and that by the year 2030, federal revenues would not be sufficient to pay for entitlement spending. More urgently, the committee estimated that a portion of the Medicare program would be insolvent by the year 2001.⁷

Bipartisan Commission Chart

Proposals that come under the umbrella of entitlement reform are increasing the payroll tax rate, raising the Social Security base, and expanding the amount of Social Security benefits taxable to recipients. More proposals have also been offered, such as allowing workers to direct a portion of their Social Security contributions to a personal retirement account.⁸ Many people believe that Medicare funding problems should be addressed as part of any national health care reform program.

Obviously, the first proposal---to raise payroll taxes---would increase operating costs for businesses. Even though businesses may deduct payroll taxes, this proposal would add to the costs of employing workers. A payroll tax increase would have a far greater effect on service businesses than on manufacturers, for whom capital (such as equipment) is a larger expense than labor. Before implementing higher payroll taxes, legislators need to analyze whether these increases would lead companies to hire fewer workers and reduce retirement or fringe benefits for their present workers to compensate for the higher payroll taxes.

For more information, link to the Social Security Administration and the Joint Economic Committee.

Adjustment of the Consumer Price Index (CPI)

In late 1996, five economists issued a report on the Consumer Price Index (CPI) that recommended altering the CPI to make it more accurately reflect changes in the cost of living. According to this report, the CPI might be overstated by about one percentage point.⁹ Because the tax law now requires that annual CPI-based inflation adjustments be made to certain tax provisions, such as the standard deduction and personal exemption amounts, any alteration in computing the CPI would also alter tax liabilities. In 1997, the Joint Economic Committee of Congress reported that an adjustment in the CPI computation would increase the average taxpayer's tax liability by $208 per year by the year 2003.

Social Security benefits are also inflation-adjusted annually by the amount indicated by the CPI, so a decrease in the annual CPI would reduce the dollar amount of annual increases in these benefits. Thus if the government were to improve the accuracy of its CPI calculation, more tax dollars would be collected and lower Social Security benefits would be paid out.

Financial Reporting Changes

Certain financial reporting changes now being debated outside the legislative arena: by the Financial Accounting Standards Board (FASB), the AICPA, the Securities and Exchange Commission (SEC), and similar groups---could affect taxes if implemented. For example, changes in the valuation and reporting of contingent liabilities, such as environmental cleanup costs, would result in additional book-tax differences. Another frequently discussed financial reporting reform is recognition of the value of such intangible assets as a company's workforce and know-how. Today these are key assets of many companies, particularly those in high-technology industries, but they are not reflected on the balance sheet. Neither is the value of the intellectual property, such as patents and trade secrets created by expensed R&D expenditures. Any financial reporting change that involves valuing such assets would be useful for tax purposes if the business were sold.

Just as certain changes to financial reporting practices may have tax consequences, so would some changes to the tax law now being discussed affect financial reporting practices. To take one, the current guidance on reporting of income taxes in financial statements¹⁰ would need to be revised if the income tax were replaced with a consumption tax, such as a value-added tax (the VAT is discussed later in this report).

Changes to the Budget Process

There has been a movement in recent years to overhaul the processes used to set the federal budget, enact tax bills, and allocate federal funds to state governments. In this section, we consider the relevance of these proposed changes to businesses.

The Chronically Unbalanced Federal Budget

Every year since 1969, the federal government operated at a deficit.¹¹ In 1996, the federal deficit reached a recent low of $107 billion.¹² Because of economic growth, a small surplus is projected for 1999---three years earlier than anticipated under legislation enacted in 1997 to balance the budget by the year 2002. Still, decades of borrowing to cover federal expenditures in excess of revenues have left us with a national debt of over $5 trillion; interest on this debt now accounts for about 15% of federal spending every year.

Business has long been concerned about federal deficits and the large national debt because they adversely affect the ability of some businesses to grow and compete in the global marketplace. Some of the adverse effects of a chronically unbalanced federal budget and a gargantuan national debt identified by businesses, economists, and legislators are described below.

Higher Interest Rates and Lower Investment: Under a supply and demand theory, large borrowings by the federal government mean that fewer funds are available for private borrowing and investment. The demand for scarcer funds causes interest rates to rise, which not only increases federal government costs, but also drives up the cost of borrowing for businesses and individuals. In addition, the use of funds by the federal government diverts funds that could have been used for investment in businesses. Therefore some people view the federal debt as indirectly increasing the cost of capital for businesses and slowing job growth.

Slowed Economic Growth: Everyone knows that the more debt a business or individual has, the less net savings it will have to invest. The same is true of the federal government. The debt reduces Washington's ability to invest in the infrastructure (such as transportation and education), research and development, and other areas that could improve the national economic growth. The General Accounting Office (GAO) has estimated that the expected increase in entitlement spending and borrowing over the next few decades could cause the debt to exceed twice the size of the economy by the year 2025, and that level of debt "would place an unsustainable burden on the economy." Finally, about 23% of U.S. debt is held by foreign investors. The lenders' return on this portion of the debt flows outside the United States and therefore does nothing to benefit the national economy.¹³

Impact on Living Standards of Future Generations: Current spending primarily benefits people today, but decades of deficit spending to finance these benefits will have to be paid by future generations. Since future generations have to pay off the huge debt generated by today's benefit spending, their living standards will go down.

Solutions

The only plausible remedy for deficit spending by the federal government is the one used by businesses or individuals---some combination of increased revenues and reduced spending. The primary methods for increasing government revenues are tax increases and improved economic growth. However, tax increases are not popular solutions, and besides, some economists and legislators view them as counterproductive because they may lead to reduced economic activity and, consequently, reduced government revenues. If, for example, a tax increase causes businesses to produce less or hire fewer workers, tax revenues would fall rather than rise.

Revenue-Raising Options: Various tax law changes have been suggested to increase government revenues. In 1997, the Congressional Budget Office (CBO) issued a report entitled Reducing the Deficit: Spending and Revenue Options that listed and explained over 40 possible tax law revisions for reducing the deficit. A comparative sampling of some of these options is shown in Table 18-1.

Table 18-1

Revenue Options for Reducing the Deficit

Source: Congressional Budget Office (CBO), Reducing the Deficit: Spending and Revenue Options, March 1997, pp. 333--397.

None of the GAO's revenue options can realistically be viewed solely in terms of the revenue it might generate. Additional factors need to be considered, such as the option's effect on the tax base of state and local governments, its potential negative effects on the economy, its varying consequences across different industries, and coordination of the option with other government goals. For instance, eliminating the mortgage interest deduction might cause a decline in the value of homes, which would reduce property tax revenues for state and local governments. Legislators would also have to consider the ripple effects of certain changes. For example, if a tax law change resulted in a price increase, business deductions would go up and taxable income would go down, possibly netting to a negligible change in total revenues.

Additional options for eliminating annual budget deficits include changes in the legislative budget process. Two techniques that have already changed that process were discussed in Chapter 5 --- the pay-as-you-go (PAYGO) budget system and the line item veto. Some legislators would like to supplement these techniques with a constitutional amendment to require a balanced budget each year so that Congress will be ordinarily compelled to make spending equal revenues and the debt will stop growing.

The Balanced Budget Amendment: Proponents of a balanced budget amendment argue that it is the best technique for balancing the budget. They point out that most states have such a requirement, and it has worked well to prevent deficits at that level of government. Advocates of a balanced budget amendment insist that this is the only technique that will provide the fiscal discipline to force the President and Congress to cut spending and/or raise taxes. A constitutional amendment, they say, carries far more weight than a legislative rule that could be amended by Congress at a later date.

Opponents counter that a balanced budget amendment is, first of all, unnecessary because Congress and the President already have the authority and tools to balance the budget. Second, they argue that a balanced budget mandate would hurt the country in an economic recession because the government would be restrained from doing the kind of deficit spending often thought necessary in hard times. Another objection to the amendment is that it ignores the difference between ordinary and capital expenditures, such as road construction. Some opponents believe that special rules ought to apply to expenditures that produce long-term benefits. Another concern is how the amendment would be enforced. Would automatic spending cuts be implemented every time the budget went out of balance? Would the courts have to enforce the amendment, and would doing so upset the balance of powers among the three branches of government? Finally, state and local governments are worried that a balanced budget amendment would encourage Congress to shift some spending to them, compelling them to choose between raising revenues or cutting other spending.

Debate over a balanced budget amendment has also focused on its specific elements. For example, while many versions of the amendment have included a provision that spending could exceed revenues if approved by a two-thirds majority vote in Congress, few have included a similar vote requirement for tax increases. Thus some legislators fear that a balanced budget amendment will actually make it easier to increase taxes. Other arguments have centered on how revenues and spending should be measured, with some people insisting that any excess of receipts over spending in the Social Security system be excluded from the budget measure. Finally, some people have concerns over "rosy scenarios" where expected revenues are measured using very optimistic economic growth rates that merely mask a deficit in the budget.

Tax Limitation Proposals: A tax limitation rule uses some technique to limit or control legislative changes that include tax increases. One example is requiring a two-thirds majority vote to pass any bill that includes a tax increase. Other examples are measures that limit revenue increases to a certain percentage of gross domestic product (GDP) or gross national product (GNP). Limiting revenue and spending levels to specified percentages of GDP or GNP has been promoted as an alternative to a balanced budget amendment. Proponents of this alternative say that both the annual deficit and the total debt should be compared to national income rather than viewed in isolation. That is, a $107 billion deficit means nothing by itself. However, when compared to the size of the economy, the deficit amount, and its change from year to year, become more relevant.

Opponents of tax limitation measures typically argue that such measures focus solely on revenues, when the more appropriate focus is on revenues and spending. For example, they argue that a two-thirds majority requirement for tax increases should only be enacted if a two-thirds majority is also required for spending increases. Other critics of the limitation measures point to definitional problems, such as with the term revenue increase. For example, some economists view a reduction in tax rates as a tool for expanding the economy, which would lead to increased revenue. Thus, a tax rate decrease could be viewed as a revenue increase. This is one of those issues that people with different economic views find it impossible to agree on.

Increased Involvement of Taxpayers: Some people, believing that citizens don't pay enough attention to the elements of the federal budget and the process of setting it each year, have proposed moving the tax return filing date closer to election date. The rationale is that one of the few times people think about how their tax dollars are being spent is when they are filing their income tax returns. Proponents of changing the filing date to the first Tuesday in November hope that this heightened attention will make political candidates more responsive to the public's concerns about the deficit and the debt.

Federal-State Tax Allocations

A portion of federal revenues is distributed to state governments for a variety of entitlement and other programs. Some transfers are contingent on the states' following certain federal requirements. For example, years ago, a state that refused to go along with federally mandated speed limit on its roads could lose federal highway funds.

Other federal laws force the states to incur costs. For example, some environmental protection rules may require the states to perform inspections. In 1995, at the urging of state and local governments, Congress passed a law eliminating most unfunded federal mandates. Now, if Congress enacts legislation that will impose costs on state and local governments, it generally must also set aside funds to cover those costs.

Some people want to replace the current system of allocating funds and expenditures between federal and state governments with an alternative system that avoids fund transfers and compliance mechanisms. For example, certain legislators have proposed that Washington give the states more discretion in using certain gas tax revenues allocated to them.¹⁴ The sponsors believe this will reduce waste at the federal level and allow states to determine their own particular needs rather than have to follow guidelines established for all states.

As the federal government continues its efforts to reduce its size, some programs (such as welfare programs) will be transferred to state and local governments. These shifts are likely to lead to shifts in tax collections from federal to state governments. Such a shift will cause taxpayers to increase their efforts given to state tax planning.

Compliance-Related Proposals

The proposals discussed here are intended to make it easier for taxpayers to compute their taxable income and file their tax returns, and for the IRS to improve tax administration.

Simplification

Simplification of the federal tax law is a perennial topic among practitioners, taxpayers, tax administrators, and legislators. Simplification is viewed as the key to improving compliance rates, reducing errors, and lowering compliance costs for taxpayers and administrative costs for the IRS. As you will no doubt remember from our discussion of tax policy in Chapter 7, simplification is scarcely a new topic of debate. However, as both the tax rules and transactions they apply to have grown more complex in the last few decades, the debate has gained new urgency.

Several reasons underlie the complexity of the federal income tax, but the principal ones are the frequent changes to the law, the numerous exceptions to general rules, and multiple definitions for certain terms (Chapter 7). Simplification requires eliminating these problems in older tax laws and ensuring that new tax bills do not replicate them. Making tax laws easier to understand and simpler to follow is actually a hard task because it requires transforming the tax system in fundamental ways, such as reducing the number of rules and making those that remain more generally applicable.

Simplification proposals of the past few years have included such things as reducing the requirements to qualify as a dependent; applying certain complex provisions only to large taxpayers, eliminating the AMT, or at least some of the adjustments that make up AMTI; and doing away with some of the tax rules that differ from GAAP. Unfortunately, most of these and other simplification proposals are difficult to implement because they would lose revenue, and under our pay-as-you-go system, no revenue-losing law can be enacted without compensating spending cuts or tax increases.

Question 1 [Answer 1]

Complexity increases tax-compliance and -planning costs for businesses and raises the likelihood of making errors in calculating taxable income. Assume you are the tax director of a medium-size company who is concerned about these problems. What actions might you take to help simplify the tax law?

Compliance

One of the numerous ideas on how to reduce the tax gap is to simplify the tax law. Advocates of this idea argue that complexity leads to unintentional errors on tax returns. More importantly, perhaps, the multitude of intricate rules leads some taxpayers to suspect that the tax law is full of loopholes that allow the wealthy and influential to escape paying their fair share of taxes. These beliefs are detrimental to a voluntary compliance system.

Simplification might be dubbed the carrot approach to reducing the tax gap. Other ideas advocate using the stick. One such idea calls for increasing the penalties for failure to pay taxes or file a return.

Question 2 [Answer 2]

Some people take the position that increased penalties will not improve compliance. What do you think is the basis for this position?

Another suggestion for improving compliance rates is to increase the number of tax returns that are examined by the IRS each year. Here again, the rationale is that the threat of adverse consequences will motivate taxpayers to voluntarily comply.

Some people are convinced that a tax amnesty is the best answer to the gap problem. Such an amnesty gives people a specific period of time to pay all outstanding tax liabilities and file delinquent tax returns without the imposition of penalties. Some states that have tried the amnesty solution have increased their tax collections. However, many believe this solution would not work at the federal level, primarily because IRS enforcement efforts are greater than those at the state level. Others fear that a tax amnesty would increase noncompliance over the long term and be unfair to those who regularly comply.

Tax Administration

Most suggestions for improving tax administration by the IRS center on the improved use of technology. For example, the IRS now encourages many individuals to file their returns electronically rather than through the mail. Electronic filing reduces the error rate of recording data into the IRS computer system and lowers the costs of data entry and return storage. The IRS is working on expanding its electronic filing program so that it will be available to more types of taxpayers (such as those who include multiple types of forms with their tax returns).

Expanded use of technology is expected to enable the IRS to collect information from employers, banks, and other income payors more efficiently. In 1996, a pilot program was initiated whereby small businesses can file W-2 (wage) forms over the Internet.¹⁵ The advantage of such a program is that it allows taxpayers to record data directly onto IRS computer systems.

The GAO has studied whether administration systems used in other nations could be implemented in the United States.¹⁶ At least 36 countries have eliminated the need for many individuals to file a tax return. In some of these countries, the government prepares returns, using data it collects from the payers of income and taxpayers. In others, taxes are withheld from income paid to individuals, with the payers then remitting the withheld tax to the government after reconciling the individual's tax withholding and liability to the correct amount. The GAO has suggested that the government approach would be more appropriate in this country because it would not require any law changes. It noted that if the government prepared returns and then sent them to taxpayers for review, about 45% of individuals in the United States could avoid the need to personally file a tax return.

The main benefit of a system in which the government calculates individuals' tax liabilities is that it relies on data the government already has. For individuals whose only income is from wages, interest, and dividends, the IRS is already receiving Forms W-2 and 1099, with all the income and tax-withholding information it needs. In addition, employees indicate their filing status and number of dependents on forms (W-4) filed with their employers. The GAO estimates that if the government prepared returns in these situations where it has the necessary data to do so, individuals would save about 155 million hours per year in compliance time and avoid tax preparer fees. The government would benefit from a huge reduction in the volume of paper documents it normally processes and stores, saving perhaps 37 million per year.

However, the advantages of a government return-filing program must be weighed against its disadvantages. The GAO's list of disadvantages included these:

1. Some people will not trust the government to properly prepare their tax return.

2. There will be a negative impact on some tax return preparers.

3. More payers will have to be required to file Forms W-2 and 1099 electronically to enable the IRS to meet the April 15 filing deadline.

Proposals to Implement Economic and Social Policies through the Tax Law

In discussion of policies underlying the federal tax law in Chapter 7, it was noted that the tax law is designed to do more than just raise revenue for the government. It also contains provisions to encourage or discourage certain behavior by businesses and individuals. For example, deductions for home mortgage interest and property taxes are intended to encourage home ownership, and business credits, such as the work opportunity tax credit, are designed to encourage companies to hire certain categories of disadvantaged workers. New tax provisions created to implement some type of social or economic policy are constantly being offered. Several of the more frequently discussed proposals are explained in this section. Note that some of these proposals combine economic and social reforms, such as the environmental reforms designed to ensure that the social costs of pollution are considered in economic decisions.

Certain provisions of the U.S. tax law are viewed by some people as hindering capital formation and economic growth. In areas where the U.S. tax provisions are stricter than those of other countries, international competitiveness may be harmed as well. Discussed here are proposals for corporate integration, reducing taxes on capital gains, and providing targeted incentives to encourage investment in certain types of business ventures.

Corporate Integration

Elimination of the double taxation of corporate income is a probably the most popular proposal for lowering the cost of capital. Taxing corporate income only once is referred to as corporate integration because it would reduce the present corporate and shareholder taxes on income to a single level of tax. Most other industrialized countries, including Great Britain and France, do not tax corporate income twice.¹⁷ In addition to increasing the cost of capital, double taxation causes a preference for debt over equity and a preference for other business forms over C corporations. Proponents of corporate integration argue that this change would make the tax law more neutral by eliminating the consideration of tax consequences from many business decisions. For example, in deciding whether to obtain funds through a stock offering or borrowing, businesspeople would be less influenced by the tax law if dividends did not result in double taxation. In addition, corporate integration should eliminate the need for the personal holding company and accumulated earnings penalty taxes.

Various techniques can be used to achieve corporate integration. A C corporation could be taxed as if it were a pass-through entity. Or, dividend income could be exempted from tax. Other techniques would allow corporations to deduct dividends paid or eliminate corporate level taxes altogether. While the end result is intended to be the same under all these alternatives, they present varying levels of complexity and revenue costs. Suppose, for example, that a corporation has some shareholders that are tax-exempt entities, such as public charities. If corporate integration is achieved by allowing corporations to deduct dividends paid, the revenue loss to the government would be greater than if shareholders were allowed to exclude dividends.

Reducing the Capital Gains Taxes

Another frequently urged economic reform is to reduce or do away with the tax on capital gains. Some proposals call for a rate reduction or outright elimination of the tax on gains from all capital assets, while others call for targeted reductions. For example, some legislators and entrepreneurs would like to see the 50% exclusion on gains from qualified small-business stock expanded to cover more types of corporate businesses. It has also been proposed to increase this exclusion to 75%.

Targeted Incentives

Targeted investment incentives combine social and economic policies. For example, providing limited deductions or tax credits to people who invest in businesses owned by women or minorities is a targeted incentive.

Proposal to Encourage Businesses to Take Certain Actions

Numerous proposals are designed to encourage businesses to engage in certain activities. One suggestion is to give tax credits to businesses for training and hiring people now on welfare. Another is to offer lower tax rates and certain tax credits to corporations that engage in what the proponents view as socially responsible behavior. For example, in 1996 the American Workers Economic Security Act was introduced in Congress to encourage businesses to provide health, retirement, and training benefits to their employees. The bill's incentives included favored status in the awarding of certain government contracts, a permanent research tax credit, and an employee training credit.¹⁸

Sin Taxes

Increasing the federal excise taxes on alcohol and tobacco is a popular proposal. These so-called sin taxes are viewed as both revenue raisers (see Table 18-1) and tools for discouraging the consumption of alcohol and tobacco. Proponents of sin taxes argue that reductions in alcohol and tobacco consumption would lead to lower health-care costs, which would ultimately save the government money. An additional suggestion to reduce consumption of these items includes increasing the cost to businesses of advertising them by denying a deduction for all or a portion of advertising costs.

Green Incentives

Chapter 7 listed various environment-friendly tax provisions, such as the ozone-depleting excise tax, as well as several proposals made in this area in recent years. Some environmental groups argue that certain tax provisions are actually harming the environment. These provisions have been labeled subsidies for polluters by those seeking to eliminate them. The favorable percentage depletion rules have been identified as pollution subsidies by various environmental groups. Per these groups, allowing taxpayers to take depletion deductions greater than actual depletion costs encourages the kind of mining and drilling activities that are destructive to the environment.

Question 3 [Answer 3]

Elimination of the deduction for interest on mortgages for second homes has also been proposed by some environmental groups. Why would such a suggestion be considered an environment-friendly change?

Environmental groups have also proposed tax incentives, known as green incentives, to encourage environmentally responsible behavior by individuals and businesses. Allowing a current deduction for the cost of cleaning up hazardous waste sites is one such incentive. Cleanup work is viewed as having the added benefit of making it unnecessary to build factories in new locations. Another proposal is to give tax credits for donations of land for habitat management and conservation.

On a broader scale, some environmental groups, legislators, and economists have suggested using the tax system as a tool for forcing a fuller recognition of the costs of pollution. The premise is that the prices of many goods do not reflect the societal costs of pollution. For example, manufacturing processes that involve the emission of greenhouse gases (such as carbon dioxide) can lead to global warming and other environmental damage that affect everyone. Unless the cost of this damage is reflected in the prices charged for the goods, economic distortions result. In addition, reflection of the costs of pollution in prices (such as through an excise tax) can create incentives to adopt methods that generate less pollution.

Some economists believe that certain environmental policies are more efficiently implemented through market forces, such as emissions taxes and permit systems, than through regulatory action. Proposals that have been made in recent years to create a carbon tax are intended not only to encourage businesses and individuals to reduce harmful emissions but also to generate revenues. If these revenues are used to lower other taxes, such as payroll taxes, such policies may encourage job creation and economic growth.¹⁹

Question 4 [Answer 4]

Do you see any impediments to addressing the problems of global warming by changing the U.S. tax system?

Changes Related to Electronic Commerce

Businesses of all sizes are engaged in global transactions today. In just the last few years, use of the Internet for advertising, taking orders for goods, transferring software and digitized information, and providing services has expanded enormously. This expansion of Internet transactions has governments wondering how and where such transactions should be taxed. For example, if a sole proprietor in Arizona uses a server located in Michigan to provide consulting services and software to customers in New York and Canada via the Internet, where should the sole proprietor be subject to tax? Since electronic commerce is expected to grow even more rapidly in the next several years, the answer to this question is important to governments at all levels, as well as to taxpayers.

This introduction to taxing electronic commerce looks at considerations identified by the Treasury Department, selected state and local tax issues, and new types of taxes.

Treasury Department Concerns

In late 1996, the Treasury Department issued a report entitled Selected Tax Policy Implications of Global Electronic Commerce that identified some of the tax policy and administrative issues raised by the expanded use of electronic commerce. One of the report's themes is the importance of neutrality in taxing new types of transactions. The idea is new technologies should not be impeded by taxes or tax policies that treat them differently from existing technologies and transactions. So new rules should be avoided whenever possible. Instead, transactions that are economically and functionally similar should be taxed similarly. For example, the income tax consequences of selling music in digitized form over the Internet should be the same as those for selling music in a tangible medium (such as a CD-ROM),

The report also explains certain aspects of electronic commerce that pose challenges to tax administration. Some of these factors are the fading importance of state and national borders to many transactions, the ability to transfer digitized information anywhere, the fact that some transactions might be untraceable and/or the identity of the parties might not be necessary or available, and the ease of moving people and equipment around to avoid tax consequences. For example, in the scenario outlined at the beginning of this section, the sole proprietor could easily switch to an Internet server in another state or country.

The report also analyzes the greater opportunities for fraud with electronic commerce because it makes it easier to hide transactions. It acknowledges the need to consider new recordkeeping and verification systems as more and more transactions are completed electronically. The Treasury Department has already instituted procedures for filing tax documents electronically. Its 1996 regulations clarify the authority of the IRS to prescribe methods other than pen and ink signing to obtain authentication of returns, statements, and other documents.²⁰

State and Local Tax Issues

Electronic commerce raises several issues regarding state and local taxes. For example, many states have had telecommunication taxes since long before there were businesses (known as Internet service providers or ISPs). Some state and local governments have discovered that their definition of telecommunications is broad enough to encompass assessing taxes on ISPs, while others have not. Alternatively, some state and local governments have made policy decisions not to assess excise taxes on ISPs because they do not want to hinder the growth of this emerging business or increase the cost of access to the Internet for their citizens.

Another tax issue is whether businesses engaged in electronic commerce have created nexus in particular states. Recall from Chapter 3 that nexus generally only exists where a taxpayer has some type of physical presence. However, it is not always clear how much physical presence is needed to create nexus. For example, should the fact that a business uses a server in a particular state be enough to create nexus in that state? There is also the question whether nexus rules for the tangible world should apply similarly in the intangible world. For example, does nexus exist simply because customers can access the taxpayer's Web page in the state? And what about third-party relationships? Should a relationship with a third party providing telecommunications services and hardware be enough to create nexus where the third party is located?

The primary concern in applying nexus concepts to businesses engaged in electronic commerce is that if nexus is defined too broadly, compliance burdens could be so heavy that some businesses, particularly small ones, will not be able to afford to stay in business. Another concern is that if state and local governments fail to work together to develop appropriate nexus rules, a myriad of rules will appear that will lead to both intentional and unintentional noncompliance, as well as to the taxation of transactions and income in more than one state. Various industry and government associations have formed study groups to identify the tax problems associated with interstate electronic commerce and ways to resolve them. Congress has even considered imposing a moratorium to prevent state and local governments from taxing certain Internet transactions until these tax issues are resolved.²¹

New Types of Taxes

The expected growth in electronic commerce transactions has also led some economists to consider new types of taxes. Best known is the bit tax. A bit tax is one on data that is assessed based on the number of bits (binary digits) moving from place to place. Proponents of the bit tax tout it as the most efficient method for taxing electronic transactions because it can be assessed at fewer collection points than other types of taxes. Also, telecommunications companies that already track the volume of transmissions could collect the tax, which would be easier than having all users of telecommunications calculate the tax themselves. The bit tax would be a good revenue source for governments because with the expected growth in electronic transactions, the tax base is expected to be quite large.

Opponents of the bit tax argue that it would impede the growth of Internet transactions and hinder access to information, which would hurt the economy. Also, disputes would arise, as they already have with income and sales taxes, over which government is entitled to the bit tax. These issues would be complicated wherever data cross several borders or are transmitted through satellite communication instruments.

It may take some time to resolve the tax issues surrounding electronic commerce . Because location and borders are irrelevant to the Internet, resolutions will require the cooperation of governments at both the national and international levels. In addition to tax issues, electronic commerce has created some thorny problems in the areas of security, privacy, content, protection of intellectual property (such as copyrights), technical standards, and electronic payment that needs to be tackled. We are likely to see various international, national, and state groups working together to identify issues and solutions in all these areas.

Major Federal Tax Reform

Given its widespread discussion in national political campaigns and in the media, the notion of a flat tax is probably not new to you. However, because the discussion seldom goes much beyond the fact that this type of tax could be reported on a postcard-size tax return, most people don't really know what a flat tax is. The flat tax is one proposal that has come out of a movement to completely reform our tax system. It is a major reform because it would mean not just a change in tax rates, but a change in the tax base. The flat tax and other proposals that have come out of this movement, such as a national retail sales tax, would transform our tax system from an income tax to a consumption tax.

Major federal tax reform is not a new idea. It has attracted varying levels of interest among legislators and taxpayers for two decades. Most of the flat tax proposals being floated today are based on the work of Professors Hall and Rabushka of the Hoover Institution at Stanford University. These professors launched their flat tax idea in 1981, and published the first edition of their book on the subject in 1985 and the second edition in 1995.

The tax reform movement that began in 1994 has not faded away as similar movements did in earlier decades. Some of the factors keeping it alive are heightened public awareness of the flat tax because of its discussion in the 1996 presidential campaign, the persistent call for repealing the Sixteenth Amendment by House Ways and Means Chairman Bill Archer, and the belief among many people that it is impossible to simplify or improve our current income tax system by making minor changes.

Major federal tax reform is covered in this section by discussing its goals, how a consumption tax differs from an income tax (including an explanation of how a VAT works), the basics of key reform proposals, and some of the issues that must be addressed before reform can effectively occur.

The Goals of Major Tax Reform

The most commonly stated goal of major federal tax reform is simplification. Tax reform advocates insist that the income tax can't be simplified; it must instead be replaced with a new system that is simple to begin with. Congressman Armey, a key proponent of the flat tax, has claimed:

Each year Americans devote 5.4 billion hours complying with the tax code, which is more time than it takes to build every car, truck and van produced in the United States.²³

Another goal of major federal tax reform is to reduce the tax gap. Sponsors of the national retail sales tax believe that this tax will force those people who currently evade income taxes to pay taxes because a sales tax will be more difficult to evade. They are also convinced that a simpler tax system will improve compliance rates.

Improvement of U.S. savings and investment rates is another important goal of tax reform. The United States has lower savings rates than other industrialized countries. For instance, in 1993, net household savings as a percentage of disposable household income was 14.6% in Japan and 12.1% in Germany, but only 4.2% in the United States. In 1989, net national savings as a percentage of GDP was 20% in Japan, 14.1% in Germany, and only 3.2% in the United States.²³ People who favor replacing the income tax with a consumption tax reason that our savings rate is so low because we tax income from savings. They argue that taxing an activity lowers the level of that activity. Thus if consumption is taxed rather than savings, consumption should go down and savings go up. (It must be pointed out here there other people believe that a significant reason for our low savings rates is the huge dissavings represented by the $5-trillion-plus national debt.) Tax reform proponents also suggest that doing away with the income tax will lead to increased investment and capital formation because double taxation of corporate income would end.

Another goal of tax reform is the removal of incentives from the tax system to make it more neutral among taxpayers and also to lessen the effect taxes have on business decisions. For example, under a flat tax, no business credits are allowed. So if the government wants to spend money to help certain categories of people find employment, it would have to do it through a spending program rather than a tax credit. Tax reform proponents believe that eliminating economic and social policies from the tax system will improve government spending by requiring debate each year to authorize such spending, rather than enacting a credit that will receive less attention from legislators once enacted. Neutrality would also exist for individuals because under a flat tax they would only be allowed standard and dependency deductions.

Finally, another goal of tax reform is to reduce the effect of tax administration on the lives of individuals. While individuals must complete and file a tax return to pay income taxes, they do not need to do so to pay a sales tax on purchases made in the United States. Sponsors of the national retail sales tax proposal also want to repeal the income tax because they believe that it "unnecessarily intrudes upon the privacy and civil rights" of individuals.²⁴

Consumption Taxes versus Income Taxes

In basic terms, an income tax taxes income, while a consumption tax taxes spending. If you consider the following formula, it will be easier for you to understand the options for consumption tax systems.

Income = consumption + savings. 

That is, income is either spent or saved. If we modify the formula, we derive:

Consumption = income - savings. 

This formula suggests two ways that consumption can be measured and taxed. First, taxpayers could total their income and subtract the net amount of savings for the year. This method is also known as the cash flow approach.

Example 1

During the current year, Jane earned wages of $50,000 and interest income of $6,000. She also deposited $21,000 into her savings account and withdrew $2,000. Thus Jane's consumption for the year was $37,000 ($56,000 of income -- net savings of $19,000).

Second, consumption can be taxed by excluding income from savings from any measure of income. This method is referred to as the tax prepayment approach.

Example 2

Referring back to Example 1, Jane's tax base would be $50,000 under a tax prepayment approach.

In the long run, both methods for measuring consumption yield the same consequences, as Example 3 demonstrates.

Example 3

Assume a tax rate of 20% and a 5% rate of return. Mark earns wages of $40,000 per year. At the end of 19X1, he deposited $10,000 into a savings account. Under the cash flow approach for measuring consumption, Mark's tax base is $30,000 and his tax liability is $6,000 ($30,000 x 20%). Under the tax prepayment approach, Mark's tax base is $40,000, his tax liability is $8,000, and his deposit is $8,000 (after paying taxes on $10,000, he has only $8,000 to save).

In year 19X2, Mark withdraws his earlier deposit along with the interest paid on it. Under the cash flow approach, a $10,000 deposit yielded interest income to Mark of $500, while a deposit of $8,000 yielded only $400. Mark's tax base for 19X2 is $50,500 ($40,000 of wages + $10,500 withdrawal). His tax liability is $10,100 ($50,500 x 20%). Under the tax prepayment approach, Mark's 19X2 tax base is $40,000 and his tax liability is $8,000.

A comparison of Mark's after-tax cash flow under each consumption tax approach indicates:

Cash flow: $64,400 ($80,500 -- taxes paid of $16,100).

Tax prepayment: $64,400 ($80,400 -- taxes paid of $16,000).

A third approach for taxing consumption is to assess tax every time an individual spends money on goods and services. This is the approach of a retail sales tax.

One economic advantage a consumption tax has over an income tax is that it does not penalize taxpayers who save their income in their early years to use for consumption their in later years. Under an income tax, the early savers pay more tax than taxpayers who do not postpone consumption. because their income tax base includes investment income. Under a consumption tax, on the other hand, if we assume that over their lifetimes the early savers spend as much as the early consumers, both groups of taxpayers pay the same amount of lifetime consumption taxes. So, consumption patterns affect lifetime income taxes, but have no effect on lifetime consumption taxes.

Value-Added Taxes

A common form of consumption tax used throughout the world is the value-added tax (VAT). Several of the current tax reform proposals, including the flat tax, can be classified as either pure VATs, or modified VATs. Thus to comprehend these tax reform proposals, it is necessary to understand VATs. An understanding of VATs is also useful because these taxes are widely used throughout the world. In fact, Australia and the United States are the only major industrialized countries that do not use a VAT. Thus tax and business advisers to multinational businesses have to deal with VATs.

A VAT is similar in concept to a sales tax, although it is assessed differently. A sales tax is assessed just once---at the retail stage. That is, the sales tax is collected only from the final consumer. A VAT, on the other hand, is assessed on the value each taxpayer adds to goods and services as they move through each stage of production and distribution. That is, it is collected at many levels.

There are three forms of VAT:

1. The credit-invoice method, widely used in Europe and many other areas of the world.
2. The subtraction method.
3. The addition method.

If no taxpayers in the production and distribution chain are exempt and a single tax rate is used, each of these three methods produces the same amount of VAT. A VAT will raise as much revenue as would a retail sales tax that is collected only at the retail stage.

It is easier to understand the three VAT methods through examples indicating how each is computed. In Examples 4, 5, and 6, the product produced is furniture and the parties involved in the production and distribution chain are:

1. The grower of the trees for the lumber (raw materials).
2. The lumber mill that converts the trees into boards (Processor 1).
3. The furniture manufacturer (Processor 2).
4. The retail store that purchases the furniture from the manufacturer and sells it to the final consumers (retailer).

In each example, assume that the VAT rate is 20%.

Example 4

Credit-Invoice-Method VAT.

Under the credit invoice method, every business needs to maintain two types of records: (1) sales invoices showing VAT collected; and (2) purchase invoices showing VAT paid. At the end of each reporting period, the business totals VAT collected and VAT paid. If VAT collected exceeds VAT paid, the business pays the difference to the government. If VAT paid exceeds VAT collected, the business will receive a refund from the government.

Example 5

Subtraction-Method VAT.

The tax-reporting form for the subtraction-method VAT looks somewhat like an income tax return, except that certain deductions are missing. A subtraction-method VAT return reports total sales for the reporting period, less purchases made from other businesses. The VAT rate is applied to the difference. If sales exceed purchases, VAT is owed to the government. If purchases exceed sales, a VAT refund is received from the government. The types of purchases made from other businesses are raw materials, supplies, equipment, buildings, land, and services, including independent contractors. These items are subtracted from sales in computing VAT under the subtraction method.

The key expenditure not subtracted from sales is employee labor costs. Employee labor represents the value added by the employer. Thus it is taxed under a VAT. Other items that represent value added and are therefore taxed under any form of VAT are interest expense and owner profit.

Example 6

Addition-Method VAT:

Under the addition-method VAT, a business totals the value it added to goods and services purchased from other businesses during the reporting period. The VAT rate is then applied to the total of these items. The retailer in Example 5 above had sales of $36,000 and taxable purchases of $28,000. Under the subtraction method, this resulted in a tax base of $8,000. Assume that the retailer had wages of $5,000 and owner profit of $3,000. Under the addition method, the retailer's tax base would also be $8,000, comprising $5,000 of wages and $3,000 of owner profit.

Michigan uses a form of an addition-method VAT for its business taxes.

Example 7

Retail Sales Tax:

The application of a retail sales tax to the fact pattern in Examples 4, 5, and 6 would result in the retailer collecting $36 from the customer ($180 sale x 20% sales tax rate). This would be the only sales tax collected.

You have noticed, of course, that the total tax collected in all four examples, including the retail sales tax example, was $36. We were assuming no exempt taxpayers and a single VAT rate. If a taxpayer is exempt from the VAT, or if different rates are used for different types of goods and services, the calculations become more complex and the same amount of tax would not necessarily be computed under each method. A common exemption under some VAT systems is for small businesses. An exempt business has no obligation to file a VAT return. Thus it does not collect VAT on sales, but neither does it obtain a refund of VAT paid on business purchases.

Question 5 [Answer 5]

Why do you think that a VAT system might exempt small businesses?

Basics of Key Tax Reform Proposals

Many of the proposals for major federal tax reform are based on the subtraction-method VAT. The key proposals described here vary in terms of special provisions and use of either the cash flow or tax prepayment approach for excluding savings from the tax base of the individual tax.

The Flat Tax

The key flat tax proposal is that of Congressman Armey,²⁵ and it is based on the Hall-Rabushka flat tax model. Under the Armey flat tax, the same tax rate is applied to both individuals and businesses. The tax formula for businesses is similar to that used for a subtraction-method VAT, except that employee wages are deductible. Thus businesses are allowed deductions for inventory and equipment purchases, services, and employee wages. They may not deduct fringe benefits, interest expense, and most other types of taxes they pay. The business tax formula includes gross receipts from the sale of goods and services in the United States plus export sales. If a business has purchases greater than gross receipts, instead of applying for a tax refund, it would carry the excess forward to be used in the next tax year. With all types of business entities taxed at the same rate, the concept of a pass-through entity would no longer make sense, and so would be eliminated.

The tax formula for individuals is:

Wages + pension income + unemployment compensation 

Less: standard deduction based on filing status 

Less: dependency exemptions 

Tax base

The Armey flat tax is a modified form of subtraction VAT because while businesses can deduct wages, the wages are then taxed to the workers at the same tax rate. The rationale behind this system is to provide a mechanism to reduce the regressivity of this consumption tax by allowing an exemption amount to individuals. There are no tax credits provided under the Armey flat tax.

Question 6 [Answer 6]

Does the individual flat tax formula follow the cash flow approach or the tax prepayment approach?

Congressman Armey promotes his flat tax as having the virtue of taxing income at the source and taxing it only once. For example, dividends are not taxable to shareholders since that income was already taxed to the corporation when it was earned. Capital gain income is excluded from the tax base as well since such income is viewed as representing the capitalization of income earned by, and already taxed to, the corporation.²⁶

Another version of the flat tax introduced in Congress would allow individuals limited deductions for charitable contributions and mortgage interest. To compensate for the cost of these deductions, the tax rate would be higher than the Armey flat tax rate.²⁷

Information from Congressman Armey on the flat tax.

The USA Tax

The USA tax proposal²⁸ is a two-part tax system that includes a subtraction-method VAT for all business entities and a cash flow consumption tax for individuals. The USA proposal is a purer form of the business VAT than the Armey flat tax because no deduction is permitted for employee wages. However, a tax credit is allowed to both businesses and individuals for payroll taxes. Also unlike the Armey flat tax, the USA business tax excludes exports from the tax base, but does tax imports.

Individuals include wages, investment income, and fringe benefits in their tax base. Deductions include the unlimited savings allowance (USA), which represents net savings for the year. If withdrawals from savings exceed deposits for the year, the net amount is included in income (under the cash flow approach). Individuals are also allowed a deduction for mortgage interest and higher-education costs. Low-income individuals are allowed an earned income tax credit (EITC), and progressive tax rates are used.

The National Retail Sales Tax

The national retail sales tax is similar to the sales taxes now imposed by the states, except that it applies not just to tangible personal property but also to services and real property. Sponsors of this proposal hope that if it passes, the states will conform their sales tax systems to the federal one and then collect both the federal and state sales taxes. (The states would be compensated for collecting the federal tax.) The regressivity of the national sales tax would be alleviated by giving workers a tax rebate based on their family size and income level. The rebate would be provided through workers' paychecks.²⁹

Information from Congressman Tauzin on the national retail sales tax.
Information from Congressman Schaefer on the national retail sales tax.

An Income Tax with a Broader Base

Congressman Gephardt is an advocate of suggested changing the income tax system rather than replacing it with one based on a consumption tax. The major change he suggests is expanding the tax base to include fringe benefits, tax-exempt interest income, and pension contributions. It also proposes to eliminate several deductions, including the IRA and self-employed health insurance deductions to achieve the broader base that is necessary in order to lower tax rates. Under his proposal, business taxes would remain mostly unchanged, although he proposes to cut "corporate welfare" to allow for rate reductions for small businesses.

For links and further information on Major Federal Tax Reform - click here.

Selected Tax Reform Issues

Major reform of the income tax system involves many issues that would have to be resolved before change could occur. A sampling of these issues has been selected for explanation in this section.

How Well Does the Proposal Meet the Goals for Tax Reform?

Differences in the proposals lead to differences in how well each one could meet the goals for reform. For example, under the flat tax and USA proposals, individuals must still file tax returns. In contrast, under a national retail sales tax, most individuals would not need to file returns (sole proprietors would be an exception).

How Well Is Regressivity Addressed?

Consumption taxes are considered regressive because low-income taxpayers spend a higher percentage of their income on consumption than higher-income individuals do, and therefore use a higher percentage of their income to pay taxes. The Armey flat tax addresses regressivity by retaining the standard and dependency deductions for individuals. The USA tax retains the EITC for low-income individuals and employs progressive tax rates. The retail sales tax does not address regressivity concerns equally for all taxpayers because it provides greater relief to employees.

What About Other Federal Taxes?

The tax reform proposals we discussed differ in how they address other taxes. All the proposals described would keep payroll taxes in place. Estate and gift taxes would be eliminated under both the Armey flat tax and national sales tax proposals. It is essential to consider the treatment of all federal taxes to ensure that the goals of tax reform are met.

Is the Rate Revenue Neutral?

Any major change in the tax system presents economists with the challenging task of determining what tax rate would be necessary for the new tax to raise the desired amount of revenue. Uncertainties would be unavoidable in the first few years of a new tax, and they make revenue estimating a chancy affair. For example, consumption would probably decrease under a consumption tax (and savings increase), but by how much?

Should Transitional Rules Be Provided?

Taxpayers have made certain planning decisions based on the present income tax system, and created income tax consequences that may affect future years. Suppose a new company has generated NOL and tax credit carryforward amounts under the income tax that it expects to use in future years. If the income tax is replaced with a consumption tax, what should happen to these carryforward amounts? Should the taxpayer be allowed to get some benefit out of them? This is a particularly difficult issue to resolve because it involves both economic and political issues.

What Would Be the Effect on State and Local Governments?

Many states that have an income tax have based it on the federal system. If the federal income tax were repealed, these states would probably feel compelled to repeal their income tax too. If a state already has a sales tax and decides to replace its income tax with a federal-style consumption tax, it would then have two forms of consumption taxes. This would make the state's tax system more regressive and lead to administrative duplications (unless the systems could be consolidated).

Some of the proposed changes may have negative effects on state governments. For example, if the mortgage interest deduction were eliminated, some people believe that home values would decline, which would pull down property taxes and therefore negatively affect state and local governments' finances. Moreover, state and local governments now enjoy many indirect benefits from certain federal tax incentives, such as the low-income housing credit and the charitable contribution deduction. Removing these tax benefits could also negatively impact the finances of state and local governments.

Finally, under some consumption tax proposals, federal taxes would be imposed on state and local governments. For example, unless the states are made exempt purchasers, they will have to pay a national sales tax or VAT on all their purchases.

Question 7 [Answer 7]

Another concern of state and local governments is the effect major tax reform would have on their ability to borrow funds to finance their infrastructures. The concern stems from the treatment of interest income and expense under most of the consumption tax proposals, as well as under the expanded income tax proposal. How would the cost of borrowing by state and local governments be affected by the consumption tax proposals?

How Might Business Practices Change?

A new tax system would lead to changed business practices. Today, for example, most fringe benefits provided to workers are deductible by the employer and not taxable to the worker. Under a flat tax, employers would no longer be able to deduct fringe benefits, but they could still deduct wages. Might this cause some businesses to reduce or eliminate fringe benefits and pay higher wages instead? If yes, would workers use their increased wages to acquire their own health insurance and other benefits? A similar question exists with respect to retirement plans under both the flat tax and national sales tax proposals. The decisions workers make in these areas would have an impact on government spending. For example, if workers no longer have retirement plans through their employer and do not save for their retirement, more people will be dependent on government assistance after they stop working.

The tax treatment of exports and imports in the tax base would affect business decision making about the location of manufacturing and sales operations. The treatment of imports and exports differs under the proposals. For example, under the flat tax, revenues from exports are included in the tax base, while imports are not. In contrast, under a pure subtraction VAT, revenues from exports are not included in the tax base, but imports are subject to VAT upon import.

The debate on major tax reform is an interesting one. Given the difficulty of the issues involved and the variety of proposals on the table, the debate will probably last several years, with new versions of reform proposals likely to be introduced.

Summary

Several proposals to change the tax system and tax administration were presented in this chapter. Some of these changes would probably lead to tax increases (to help balance the budget), more targeted tax incentives, and perhaps even a completely new tax system. They would also change the decision-making process for businesses. For example, if the income tax were replaced with a VAT, businesses would need to apply new considerations in determining the tax effects of purchasing new equipment, designing employee benefit programs, and devising pricing strategies for their products and services.

The areas of potential change covered in this chapter will be topics of discussion for years to come. Business and tax advisers will need to follow the progress of these issues and proposed solutions. Advisers and businesses may also want to participate in the discussions by communicating their views to members of Congress.

There are a variety of techniques for keeping up-to-date on the types of issues and proposals discussed in this chapter. Information can be found in various business and tax periodicals, as well as in articles and papers posted on the Internet. Text and explanations of legislative proposals can be accessed on the Internet as well. Finally, industry and professional organizations follow these types of developments and keep their members (and others) informed.

Now you have the solid foundation in our current tax system and awareness of issues that will affect taxes in years to come that you need to begin analyzing the tax aspects of business decisions on your own.

Return to main page for this textbook.

Exercises

Review

1. Why have some health-care reformers recommended changing the tax law to require employees to include the value of employer-provided health insurance in their taxable income?

2. Explain why many people believe that entitlement reform is necessary.

3. How does the national debt potentially increase the borrowing costs for individuals and businesses?

4. Explain why some legislators favor adding a balanced budget amendment to the U.S. Constitution and why others oppose it.

5. What is meant by the term tax limitation provision?

6. What does corporate integration mean? Describe two techniques for achieving it.

7. What administrative concerns does the Treasury Department have concerning the growth of electronic commerce?

8. What are two of the goals of major federal tax reform?

9. How does a value-added tax (VAT) differ from a retail sales tax?

10. List and describe the three types of VAT.

Integration

11. Tax classification: If the limit on the maximum taxable earnings subject to Social Security tax were removed, would this tax become more regressive or less regressive? Explain your answer.

12. Reduced taxation of capital gains: Some opponents of reducing the tax on capital gains argue that there is no reason to provide a break for these types of assets relative to other types of assets. They contend that selling stock on the stock exchange does not lead to increased investment in capital or jobs. Some of these opponents prefer a targeted capital gains incentive that encourages investment in new companies. Others argue that job growth would be better stimulated by providing tax incentives to invest in worker training and education. Review the discussion of capital gains in this chapter and Chapter 12, and then apply your knowledge of finance and economics to the principles of capital gain taxation to prepare a letter to the editor of a business journal explaining why you are for or against lowering the tax rate on all long-term capital gains. (The letter only needs to be submitted to your instructor.)

13. Adam Smith and the flat tax: Review Adam Smith's maxims of tax policy in Chapter 7. Explain how he would evaluate the Armey flat tax and whether you think he would endorse it. Also explain whether you think any changes in the economy over the past 200 hundred years warrant ignoring some or all of Adam Smith's maxims.

14. Evaluation of our income tax system: If income equals spending plus savings, then a pure income tax would tax all spending and saving. Review the income tax formula for individuals (you may also want to review Form 1040 in Appendix A). Then list three features of our current income tax system that make it a combination income-consumption tax system.

15. Horizontal and vertical equity: Explain how each of the following tax reform proposals achieves or does not achieve horizontal and vertical equity (Chapter 3):

a. The flat tax proposal of Congressman Armey.

b. The expanded income tax proposal of Congressman Gephardt.

16. Simplification: Select a tax provision discussed in this text that you think could and should be simplified. Describe the basics of the current provision and how you would simplify it, and state whether you think your proposal would raise revenue, lose revenue, or be revenue-neutral. You might want to review the simplification materials in Chapter 7 before you do this exercise.

17. Simplification: Consider the simplification standards discussed in Chapter 7 and then evaluate each of the following simplification proposals in terms of how well it would simplify compliance. For each proposal, also provide an argument that might be raised against it.

a. Require sole proprietors to base their estimated tax payments on their tax liability for the prior year regardless of their expected taxable income for the current year.

b. Eliminate the passive activity loss limitation provision.

c. Reduce the research tax credit rate and redefine expenditures that qualify for the credit so that they are defined the same way as expenditures used to determine R&E deductions.

d. Allow all businesses with gross receipts of less than $10 million to use the cash method of accounting and to expense all assets when acquired.

18. Tax reform and choice of entity: Under the consumption tax proposals, all forms of business entities would be taxed the same. Would you expect any types of entities to change their form in this proposal to be enacted. Explain your answer.

Application

19. Corporate integration: A complaint sometimes raised against corporate integration is that it would pressure corporations to issue higher dividends. Describe the concept of corporate integration and explain the rationale for this complaint.

20. IRS audit of a business engaged in electronic commerce: Tangible Notes Corporation (TNC) sells all types of music on CD-ROMs. TNC has four retail stores located in California and Nevada. Digitized Notes Corporation (DNC) sells all types of music in digitized form over the Internet. DNC is headquartered in Nevada, where it has its computers and administrative office. DNC only sells to customers over the Internet, and its customers are located throughout the world. They pay using either credit cards or digital cash.

Assume you are the revenue agent assigned to audit both TNC and DNC. Explain how your techniques for verifying revenue for DNC will differ from those you will use to audit TNC. Also state how much confidence you are likely to have in your verification of revenues for both companies.

21. Tax reform: Compare the following tax reform proposals in terms of how visible each is---that is, how aware individuals would be of the amount of taxes they are paying to the government.

1. The Armey flat tax.

2. A pure subtraction method VAT with no individual-level tax.

3. A retail sales tax.

22. Tax reform and the marriage penalty: Under the Armey flat tax, the standard deduction for a married couple filing jointly would be twice the deduction for a single individual. Also, all income would be taxed at the same rate. Explain whether or not the Armey flat tax would eliminate the marriage penalty. Include in your explanation an example using the 20% tax rate and a standard deduction of $22,000 for a married couple.

23. Credit invoice VAT versus subtraction VAT: Contrast and compare the credit-invoice method VAT and subtraction-method VAT in terms of (a) ease of recordkeeping, (b) ease of auditing by the IRS, and (c) ability to use different rates for different types of goods and services.

24. VAT calculation: Tyber Corporation manufactures components for use in disk drives. Tyber has no imports or exports. During the current tax year, it had the following revenue and expenditures:

Gross receipts $1,700,000
Beginning inventory $50,000
Purchases of raw materials $450,000
Ending inventory $70,000
Cost of goods sold $430,000
Wages $600,000
Fringe benefits and payroll taxes $100,000
Payments to independent contractors $150,000
Purchase of equipment (7-year life) $300,000
Interest expense $40,000

Calculate Tyber's tax liability under (a) the credit invoice VAT, b) the subtraction VAT, (c) the addition VAT, and (d) the income tax. Show the formula you used for each calculation.

25. Tax reform and complexity: It is sometimes said that a new tax system will only substitute new complexities for old complexities. Actually, though, if sufficient analysis is given to proposals before they are enacted, it should be possible to eliminate at least some of the complexities. Assume that the flat tax has passed and consider the following taxpayer's situation. The issue it raises results from the exclusion of investment income from the flat tax formula for individuals and the need to file a separate business tax return.

In 19X8, Teresa purchased a painting for her home for $500 and sold it three years later for $5,000. Teresa needs to know whether her $4,500 gain is nontaxable investment income or taxable business income.

What rule would you recommend to enable individuals, such as Teresa, to distinguish nontaxable investment income from taxable business income?

26. Tax reform and the need for guidance: Various proposals for major federal tax reform are missing crucial details. Examples of such missing items are listed below. Explain how you would treat each item under the Armey flat tax and under the national retail sales tax, and why.

a. What accounting method a business should use.

b. Whether the deduction for meals and entertainment should be limited to 50% as under current law.

c. Whether the like-kind exchange rules should be continued.

d. What the basis of property acquired by inheritance should be.

27. Flat tax and compliance: Consider the tax base for individuals under the flat tax. Explain how the Armey flat tax simplifies reporting requirements for businesses.

28. Tax reform and charitable contributions: At issue in the tax reform debate is whether removal of the charitable contribution deduction will cause a decrease in charitable contributions. Evaluate this concern by explaining the likely influence that each of the following situations would have on charitable giving.

a. Proponents of replacing the income tax with a consumption tax suggest that doing so will lead to increased income growth for individuals.

b. Assume that the income tax is replaced with a 15% sales tax and that the tax is not assessed on charitable contributions. Evaluate each of the following taxpayers to determine if he would likely donate more or less to charity under the sales tax than under the income tax.

i. Sam has a marginal tax rate of 36% under the income tax. He usually makes an annual donation to charity each year that results in a $1,000 after-tax cash outlay. Thus Sam donates $1,563 [$1,000 ÷ (1 -- .36)] because the tax savings of $563 results in a $1,000 after-tax cash outlay. (Assume that Sam does not want to have a cash outlay greater than $1,000.)

ii. Tom claims the standard deduction under the income tax. Thus, he obtains no tax benefit for his annual charitable contribution of $1,000.

Tax Policy

29. Budget deficit: The CBO data included in this chapter indicated that a 5% VAT would probably raise $692 billion over five years.

a. List and briefly explain two advantages and two disadvantages of creating a new VAT at the federal level as a technique to reduce the national debt. The VAT would be in addition to the current income tax system.

b. List and explain two concerns you think the management and board of directors of a large publicly traded manufacturer might have about this option.

c. List and explain two opportunities the manufacturer might find in this revenue option.

d. Explain your personal view on this revenue option.

30. Balanced budget amendment: Write a letter to your representative in Congress explaining how you would like him or her to vote next week on a bill calling for a balanced budget amendment. Assume that the proposal allows for a two-thirds majority vote to implement deficit spending. Be sure your position is clearly explained. (You are not required to mail the letter.)

31. Balanced budget amendment: As you know from your reading the text, one concern of opponents to a balanced budget amendment is that it would make it easier for Congress to raise taxes rather than cut spending. Assume you are a proponent of a balanced budget amendment who is eager to address your opponents' concerns. Prepare a list of guidelines you could follow to reach a compromise with your opponents and explain why each guideline would address their concerns.

32. Changed budget process: Various proposals have been introduced to reform the annual budget process in Congress. One is to create a two-year budget at the start of a congressional term, rather than having Congress set a new budget every year. Proponents of this idea argue that if members do not have to go through the budget process twice in a two-year term, they would be able to spend more time in their districts meeting with constituents. They also claim that a two-year budget would result in better long-term planning and thinking.

a. Do you think that a two-year budget process would help or hinder obtaining a balanced budget in every term of Congress? Explain your answer.

b. What problems might arise if the two-year budget replaced the annual budget currently used?

c. If Congress established a two-year budget, government agencies, such as the IRS, would also have a two-year budget process. List and briefly explain the advantages and disadvantages of a two-year budget process for the IRS.

33. Voter involvement: Congressman Doe has introduced a bill to change the due date for the individual federal income tax return to the first Tuesday in November. List and briefly explain three advantages and three disadvantages of this proposal.

34. Tax amnesty: Assume that you have been asked to participate in a debate on whether Congress should institute a one-year tax amnesty program under which all taxpayers could file past due returns and pay outstanding tax liabilities without having penalties imposed on them. Decide whether you are in favor of such a program or against it. Then prepare a list of reasons to support your position, being certain to clearly explained each reason.

35. Corporate integration: The Equity Incentive Act (S. 701, 104th Congress) proposes to allow C corporations to deduct only 80% of their interest expense, but 50% of the dividends they pay out. Explain how well this act would achieve corporate integration.

36. Incentives analysis and critique: Assume that Congressman Roe has introduced a bill that would reduce income and payroll taxes for C corporations that meet certain requirements. The major requirements are: providing retirement, health-care, and training benefits to employees; conducting at least 50% of their R & D within the United States; and compensating top executives at a rate no greater than 50 times the pay of their lowest-paid full-time employee. Congressman Roe's proposal also calls for imposing a securities transfer excise tax on the sale of securities held for less than two years.

a. Explain the Congressman's possible reasons for proposing these corporate tax reductions and the securities excise tax.

b. What benefits might the government obtain, if any, from this proposal?

c. What alternatives to tax breaks and the excise tax might be used to encourage the desired corporate actions?

d. Would you support this proposal? Explain your position.

37. Comparing different environmental taxes: Assume that the following three options have been proposed to help reduce global warming. The tax rate for each tax has been set so that all three proposals would raise the same amount of revenues for the government.

1. A tax based on the carbon content of fossil fuels (coal, oil and natural gas). Because the carbon content of coal is much higher than oil or natural gas, the tax on coal would be higher. The tax would be assessed upon the producers.

2. A tax based on the heat content of all fuels, including coal, oil, natural gas, nuclear, and renewable sources (such as solar energy). The tax would be assessed on the producers. Because the heat content of different energy sources is more similar than their carbon content, the tax imposed on coal would not be as proportionately larger as it is in Option 1.

3. An ad valorum tax on all fuel sources that would be imposed at the retail level---for example, a tax of 4% of the retail price of gasoline, coal, and other fuels. The tax would be collected by retailers.

Prepare a report covering the following goals:

a. Explain how well each proposal meets the following goals:

i. Encouraging businesses and individuals to convert to energy sources that cause lower carbon emissions.

ii. Reducing the effect of the tax among different geographic regions of the country.

iii. Minimizing administrative costs for the government.

iv. Creating consumer awareness of the tax so that it might change consumer behavior.

b. Which proposal best attains Adam Smith's maxims of taxation? Explain your answer.

c. Which tax mechanism would you recommend and why?

38. Consumption tax and education costs: Should the costs of obtaining an education be treated as taxable consumption or nontaxable savings under a consumption tax? Should the answer to this question depend on the purpose of the education? Explain your answers.

39. Credit-invoice VAT versus subtraction VAT: A commonly voiced complaint against the reform proposals based on the subtraction-method VAT is that they create an unfair tax on labor.

a. Explain why this complaint is raised (recall the similarities in the formula for the subtraction-method VAT and the income tax).

b. Do you think that this complaint is valid? Explain your position.

c. Would you expect the people voicing this complaint to also raise the same complaint against the credit invoice VAT? Should they? Explain your position.

40. Tax reform and fringe benefits: Recall that under a subtraction method VAT, businesses do not deduct fringe benefits. Under the Armey flat tax, wages are deductible, but fringe benefits are not. In addition, wage income is taxable to individuals, but not fringe benefits.

a. What concerns might be raised by a proposed tax system that does not provide any tax incentives to businesses to provide fringe benefits, such as health insurance, to workers?

b. How might a business restructure employee compensation packages under the Armey flat tax to maximize its deductions? What would the effect be to workers? What is your view on this feature of the Armey flat tax?

41. Providing tax advice: Assume that the federal income tax has been replaced with a VAT. Also assume that you are a self-employed tax adviser with two employees. Mr. Grant of ABC Consultants, Inc., calls you and suggests that you fire your employees and let ABC hire them as employees who will be assigned as full-time consultants to you. He points out that this will be a tax advantage to you because, under the VAT, you cannot deduct employee wages, but you can deduct payments made to ABC Consulting, Inc. While the fee charged by ABC will be somewhat greater than the amount you currently pay in wages and benefits, Mr. Grant assures you that you will still come out ahead. You received another unusual request this week. This one was from one of your clients, Ms. Jasper. You are currently assisting her with an IRS audit of her personal tax return. Ms. Jasper is not fond of the new VAT and has indicated to you that she would like to pay you in cash and not be charged VAT by you. Explain how you will respond to Mr. Grant and Ms. Jasper and why.

42. Rules of conduct for tax practitioners: Assume that the income tax is replaced with a national retail sales tax. What changes, if any, should be made by the AICPA to the SRTPs and by the NAEA to their rules of conduct? Be specific in your explanation.

Research

43. Social Security funding---is there a problem? Some economists and others have argued, against the trend, that there is no real reason to be concerned about indications that the Social Security trust funds will be insufficient to pay benefits to recipients early in the next century. Find an article or paper that takes this point of view and explain the author's premise. State whether or not you agree with it and why. Be sure to give the source of your article.

44. Interpreting bill language: At the congressional Internet site, find H.R. 2001 (105th Congress), the national retail sales tax proposal. Locate the provision on the tax rate. Under this proposal, how much sales tax would be owed on the purchase of clothing with a retail price of $100 if:

a. The purchaser's state has conformed its sales tax system to the federal one and applies a 5% tax rate?

b. The purchaser's state has not conformed its sales tax system to the federal one and applies a 5% tax rate?

45. Major federal tax reform: Find an article that takes a position for or against one of the proposals for major federal tax reform discussed in this chapter. Explain the arguments made by the author and state whether or not you agree with them and why. Be sure to give the source of your article.

Technology

46. Digital signatures: Locate an article or report describing digital signatures. List and briefly explain three security and authentication requirements that the IRS would need to implement should it decide to accept a taxpayer's digital signature on an electronically filed tax return.

47. Technology and tax reform: One factor that could be used in evaluating proposals for major federal tax reform that was not discussed in the text is how well they would lend themselves to computerized reporting and payment systems. Explain how technology could be used to speed up collection, improve accuracy, and reduce taxpayer compliance burdens for both the credit-invoice VAT and the subtraction-method VAT. Which VAT method do you think would allow for better use of technology for tax compliance and administration? Explain your answer.

Progressive Exercise

48. Lynn has just completed a computer system that will enable customers to obtain advice and information from her over the Internet. With this system in place, she now views her business as a global one. Lynn has been asked by a small-business association of which she is a member to join a coalition of businesses working to simplify the tax law and get incentives added that would encourage investment in small businesses.

a. List some of the tax issues Lynn may have to deal with now that she has a global electronic consulting business.

b. List and briefly explain some of the simplification issues that the coalition would probably address.

c. List and briefly explain some of the investment and capital incentives that the coalition would likely address.

Answers to Questions in Chapter 18

1. The tax director could collaborate with tax directors of other companies to identify common areas of complexity, create workable solutions, and suggest to Congress that the relevant provisions be changed. She should also consider working with appropriate industry associations, as well as such organizations as the AICPA and TEI (Tax Executives Institute).

[Return to text]

2. If a person has not filed a return on time and knows that he will face penalties once he does file, he may be disinclined to file at all. Thus large penalties may actually discourage people from paying their taxes once they have already missed a filing deadline. A progression of penalties might lessen this problem by encouraging taxpayers to comply sooner rather than later to avoid ever-higher penalties.

[Return to text]

3. A second home is often a vacation home and common sites for vacation homes are the beach and the mountains. Some people view the mortgage interest deduction on second homes as encouraging people to buy vacation homes, and therefore builders to construct them, in places like beaches and mountains where the environment may be too fragile to withstand such congestion.

[Return to text]

4. Global warming is an international problem, not a national one. While U.S. tax policies may reduce greenhouse gas emissions in the United States, such harmful emissions will continue elsewhere in the world. Two possible solutions are multilateral agreements enforceable through international treaties and higher duties on imports from countries that do not impose a tax equivalent to the U.S. emissions tax.

[Return to text]

5. The reason is twofold: to reduce compliance costs for small businesses and to reduce administrative costs for the government. The revenue loss is typically viewed as small compared to the administrative costs of having many more taxpayers filing VAT returns. For example, a 1993 GAO report indicated that if businesses with annual gross receipts under $100,000 were exempt from a federal VAT, administrative costs for the IRS could be reduced by about 33% with a revenue loss of only about 3%. (GAO, Value-Added Tax: Administrative Costs Vary with Complexity and Number of Businesses, GAO/GGD-93-78, May 1993, pp. 3, 4, and 63.)

[Return to text]

6. The individual tax formula under the Armey flat tax follows the tax prepayment approach because investment income, such as interest income and capital gains, is excluded from the tax base.

[Return to text]

7. Under most of the proposals, such as the Armey flat tax and the national sales tax, interest income would no longer be taxable. All interest income would be tax-exempt. Under our current income tax system, only interest income on certain state and local bonds is tax-exempt. Because this interest is tax-exempt, state and local governments can offer lower interest rates than those paid on taxable bonds. State and local governments believe that under a system where their debt is no longer tax-favored, they will incur greater borrowing costs.

[Return to text]

Notes

1. Bipartisan Commission on Entitlement and Tax Reform, Final Report to the President, 1995, p. 9.

2. GAO, Alternative Filing Systems, GAO/GGD-97-6, October 1996, p. 1.

3. Treasury Department, Selected Tax Policy Implications of Global Electronic Commerce, November 1996, p. 4.

4. S. 442, 105th Congress, introduced by Senator Wyden.

5. Congressman Stark, Congressional Record, January 22,1996, p. E46.

6. Congressman Armey, March 1997.

7. Final Report to the President from the Bipartisan Commission on Entitlement and Tax Reform, January 1995, pp. 9 and 17.

8. For example, see S. 824, 104th Congress, the Personal Investment Plan Act of 1995, which uses a portion of employee Social Security payroll deductions to fund a "personal investment plan" for employees. Also see H.R. 2768,105th Congress.

9. Joint Economic Committee, The Consumer Price Index and Tax Policy, March 1997, reporting on the CPI report, Toward a More Accurate Measure of the Cost of Living.

10. Financial Accounting Statement No. 109, Accounting for Income Taxes.

11. Federal Debt: Answers to Frequently Asked Questions, GAO/AIMD-97-12, November 1996, p. 14.

12. Congressional Budget Office (CBO), Reducing the Deficit: Spending and Revenue Options, March 1997, p. 1.

13. 1996 GAO report supra, note 11, pp. 33 and 36.

14. S. 667 and H.R. 1470 (105th Congress).

15. David Bank, "Social Security, Pitney Bowes to Test Filing of W-2 Forms on the Internet," The Wall Street Journal, October 25, 1996, p. B6.

16. GAO, Alternative Filing Systems, GAO/GGD-97-6, October 1996.

17. AICPA, Integration of the Corporate and Shareholder Tax Systems, 1993, pp. 13 to 14.

18. S. 1668, 104th Congress.

19. See, for example, proposals suggested by such groups as Redefining Progress and Worldwatch Institute and Congressman Stark (Congressional Record, September 12, 1995, p. E1761, and January 22, 1996, p. E46).

20. Reg. Sec. 1.6695--1(b)(1), Treasury Decision (T.D.) 8689 (December 12,1996).

21. For example, see S. 442, H.R. 1054 and H.R. 3529, 105th Congress.

22. Congressman Richard Armey, Flat Tax Summary, March 1997.

23. Selected Materials Relating to the Federal Tax System Under Present Law and Various Alternative Tax Systems, prepared by the Staff of the Joint Committee on Taxation, JCS-1-96, March 14, 1996, pp. 85 and 86.

24. H.R. 1325, 105th Congress.

25. H.R. 1040, 105th Congress.

26. Robert E. Hall and Alvin Rabushka, The Flat Tax, (2d ed.) Hoover Institution Press, Stanford, CA. 1995, p. 117.

27. See S. 593, 105th Congress.

28. S. 722, 104th Congress.

29. H.R. 1325, 105th Congress.

Go to Start of Chapter 18

Return to main page for this textbook