Tax Reform Options
Presented by Tony Quain
ECON-825 Professor Klein
October 24, 2006
ECON-825 (Prof. Klein)
Tony Quain
“Tax Reform Options”
1
Contents
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Introduction
The Federal Income Tax
Five Tax Reforms
Efficiency Comparison
Equity Expectations
Administration, Intrusion, Compliance, Evasion
Transition Issues
Political Viability
Recommendation
References
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Tony Quain
“Tax Reform Options”
3-6
7-11
12-28
29-32
33-37
38-42
43-47
48-51
52-53
54-58
2
Introduction
Our Inquiry



What are the main problems with the current federal income tax?
What are some tax reform alternatives to the federal income tax?
How do these tax reform options compare in the following aspects?
1)
2)
3)
4)
5)

Efficiency
Equity
Administration, Intrusiveness, Compliance, and Evasion
Transition Issues
Political Viability
Which type of tax reform is most desirable, given the relative advantages and
political viability?
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Introduction
Assumptions

During our discussion, we will use the following assumptions:
1)
2)
3)
4)
Reform would be limited to U.S. federal government revenue
Reform would eliminate federal taxes on personal income and corporate income,
but not payroll taxes, excise taxes, estate taxes, customs, or other miscellaneous
taxes
Income taxes were $1.205 trillion in 2005 ($927 bln. Individual, $278 bln.
Corporate), or 56% of all U.S. federal taxes
Reform must be revenue neutral, i.e. it must replace the 56% of federal revenues
or indicate what part of the income tax would remain in place
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Introduction
Five Tax Reforms

The five types of tax reform to be examined will include (in order of the degree
of change, least radical to most):
1)
2)
3)
4)
5)

Flat Tax
Retail Sales Tax (RST)
Value-Added Tax (VAT)
Geo-Rent Tax (GRT)
Head Tax
All of these have many variations; I will use the most simplified (or popular)
variation where possible, but will explain other significant variations
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Introduction
Tax-inclusive and Tax-exclusive Rates




For consistency, all rates will be quoted as tax-inclusive unless specified
Tax-inclusive: the tax rate is the percentage of the tax base given up in taxes;
the tax is “carved out”
Tax-exclusive: the tax rate is a percentage of the tax base added to the base;
the tax is “added on”
Example:
1)
2)



A 15% tax-inclusive sales tax rate on a sale of $2,000 yields a tax of $300 and a
total sale price of $2,000; the equivalent tax-exclusive rate is 17.65% (of $1,700)
A 15% tax-exclusive sales tax rate on a sale of $2,000 yields a tax of $300 and a
total sale price of $2,300; the equivalent tax-inclusive rate is 13.04% (of $2,300)
Tax-exclusive rates are always higher than the equivalent tax-inclusive rate
Income taxes and VAT taxes are usually quoted as tax-inclusive rates
Sales taxes are usually quoted as tax-exclusive rates
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The Federal Income Tax
Problems with the Federal Income Tax
1.
Economic Inefficiency
Provisions in the tax code cause distortions in economic decision-making
a) The income tax creates an “excess burden” beyond the tax itself by making
people substitute untaxed activities for taxed activities (Slemrod 2005)


$200 bln. annually (est.); 17% of revenues (Jorgenson 2001)
30%-50% of revenues (Slemrod 2005)
Particularly damaging distortions include: (Hubbard 1997)



b)
Saving and investment decisions
Inter-sectoral and Inter-asset distortions (corporate vs. non-corporate; owneroccupied housing vs. business capital)
Financial distortions (corporate debt/equity structure; dividend decisions)
Tax expenditures: losses of revenue due to deductions and carve-outs

$945 bln. (FY2006 est.); 78% of revenues (Hungerford 2006)
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The Federal Income Tax
Problems with the Federal Income Tax (contd.)
c)
Tax avoidance: the elasticity of taxable income, not simply labor supply, responds
to the income tax rate; as a result, tax revenues experience diminishing (and
possibly negative) returns to increases in tax rates (Slemrod 2005)

2.
$284 bln. annually for individual income tax alone (Feldstein 1999)
Inequity
a)
b)
Equity only seen as a problem by those who disagree with current progressivity
Progressive tax rates transgress Adam Smith’s principle of proportionality; they
violate “vertical equity” (proportional tax: the more you get, the more you pay) and
replace it with “ability to pay” redistribution (Hall 1995)


c)
Six individual tax brackets: 10%, 15%, 25%, 28%, 33%, 35%
Eight corporate tax brackets: 15%, 25%, 34%, 39%, 34%, 35%, 38%, 35%
Tax expenditures (“targeted” tax provisions) and widespread evasion violate
“horizontal equity” (people in similar circumstances should bear equal tax
burdens) (Hall 1995)
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The Federal Income Tax
Problems with the Federal Income Tax (contd.)
3.
Administration and Enforcement
a)
Enforcement costs are high due to complexity and evasion:

4.
Intrusiveness
a)
b)
5.
$10.2 bln. (FY2005) to fund enforcement by the IRS (ERP 2006)
Inhibitions of personal and business privacy
Costly measures taken to avoid intrusiveness
Complexity and Compliance
a)
Complexity: income taxes are inherently complex because of (1) complicated
timing rules for capital expensing and (2) inflation distortions of interest payments
(McClure 1995)

b)
Complexity causes taxpayers, the IRS, and tax experts to make errors (CHC 2003)
Compliance: represents deadweight losses of productive capacity

$200 bln. annually in direct and opportunity costs of compliance (CHC 2003)
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The Federal Income Tax
Problems with the Federal Income Tax (contd.)
6.
Evasion
a)
Evasion includes non-filing, underreporting, and underpayment

7.
IRS claims the “Tax Gap” for income taxes is $230 bln. annually: $197 bln.
(individual), $33 bln. (corporate) (IRS 2004)
Rent-seeking
a)
Lobbyists spend society’s resources obtaining tax expenditures
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The Federal Income Tax
Adam Smith’s Four Taxation Maxims
1.
2.
3.
4.
Proportionality (“The subjects of every state ought to contribute to the support
of the government … in proportion to the revenue which they respectively
enjoy”) (Smith 1981) Federal Income Tax fails (see (2) Inequity)
Certainty (“The tax which each individual is bound to pay ought to be certain,
and not arbitrary”) (Smith 1981) Federal Income Tax fails (see (5) Complexity)
Timeliness (“Every tax ought to be levied at the time, or in the manner in
which it is most likely to be convenient for the contributor to pay it”) (Smith 1981)
Federal Income Tax fails (does not permit immediate expensing of capital)
Unobtrusiveness: (Smith 1981)
a.
b.
c.
d.
No excess enforcement Federal Income Tax fails (see (3) Enforcement)
No excess burden Federal Income Tax fails (see (1) Inefficiency)
No excess evasion Federal Income Tax fails (see (6) Evasion)
No intrusion Federal Income Tax fails (see (4) Intrusiveness)
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Five Tax Reforms
1. Flat Tax – How it Works



The variant I use is the Hall-Rabushka Flat Tax, introduced in 1981
The Flat Tax is a reform of the income tax system that eliminates tax
expenditures (itemized deductions, credits, etc.) and tax brackets; individuals
and businesses would both be subject to one “flat” rate
Businesses would be subject to a “Business Tax”:
1)
Taxable income would be gross revenue minus “Allowable Costs”:



2)
Purchases of goods, services, and materials
Wages, salaries, and pensions
Purchases of capital equipment, structures, and land
Note that for purposes of this tax businesses would use cash accounting; there
would be immediate write-off of investment (with a carry-forward provision)
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Five Tax Reforms
1. Flat Tax – How it Works (contd.)

Individuals would be subject to an “Individual Wage Tax”:
1)
2)
Total compensation includes wages and salary plus pension and retirement
distributions
Personal allowances deducted from total compensation:

Personal allowance for filer:
1.
2.
3.

3)
4)

Single: $12,800 (H-R: $9,500)
Married filing jointly: $25,600 (H-R: $16,500)
Head of household: $19,200 (H-R: $14,000)
Allowance for each dependent (not incl. spouse): $6,000 (H-R: $4,500)
Interest, dividends, and capital gains would not be taxed
Non-wage earners (sole proprietors, etc.) would file a Business Tax only, unless
they paid themselves a wage
Variant A: no personal allowances
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Five Tax Reforms
1. Flat Tax – Problems



Retains the income tax: leaves open the possibility of returning to a more
complicated and graduated system over time
Foreign goods bias: domestic goods for export are taxed while foreign goods
for import are not; this puts domestic goods at a disadvantage
Government bias: while government workers are subject to the wage tax,
government enterprise (such as USPS) is not subject to the business tax
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Five Tax Reforms
1. Flat Tax – Factfile
In Operation:
Estonia 26% (1994-)
Lithuania 27% (1995-)
Latvia 25% (1996-)
Russia 13% (2001-)
Ukraine 13% (2003-)
Iraq 15% (2004-)
Slovakia 19% (2004-)
Romania 16% (2005-)
Illinois 3%
Indiana 3.4%
Massachusetts 5.3%
Michigan 3.9%
Pennsylvania 2.9%
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Revenue neutral rate: 17.25%
(Hall 1995) adjusted
Origins: Income tax introduced by Pitt the Younger in 1798
Ideology: free-market political establishment;
bargainers; those who are resigned
to keeping the income tax but want to
eliminate the inefficiencies and
inequities of tax expenditures and tax
brackets
Aliases: Yield-Exemption Tax
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Endorsements:
Arthur Laffer
Bruce Bartlett
Milton Friedman
Steve Forbes
Dick Armey
Arnold Schwarzenegger
15
Five Tax Reforms
2. Retail Sales Tax – How it Works








The Retail Sales Tax is assessed on retail (final) sales only; wholesale
producers do not pay the tax; it is added on to goods at the point of final sale
To avoid “cascading” (whereby businesses pay the tax on investment
purchases that are sold again and therefore taxed again), businesses would
be able to recover taxes paid on goods purchased for resale
Government purchases and investments are subject to the tax, to avoid
economic distortions
Businesses would collect the tax, but incidence falls on consumers
Individuals would not file tax returns
Exports are excluded; imports sold domestically are included
Variant A: “FairTax” includes a rebate to poverty level income for all
Variant B: lower rate or exclusion of certain goods or services
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Five Tax Reforms
2. Retail Sales Tax – Problems


No current experience of use at the national level
Unlike the VAT, enforcement of a sales tax at the necessary percentage would
be onerous due to lack of audit trail; evasion would be a crucial problem
(Slemrod 2005)
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Five Tax Reforms
2. Retail Sales Tax – Factfile
Origins: Spain introduced a sales tax in 1342;
Kentucky was first state in 1934
In Operation:
45 U.S. states
California highest (7.25% tax-excl)
9 Canadian provinces
PEI highest (10.6% tax-excl)
Revenue neutral rate: 13% (tax-incl)
(Edwards 2005) adjusted
Aliases: FairTax,
National Sales Tax
Ideology: abolitionists (sixteenth amendment must be
repealed); nativists (sales taxes as “American”
practice)
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Endorsements:
Stephen Moore
Laurence Kotlikoff
Grover Norquist
Wayne Angell
Paul Rubin
Vernon Smith
John Linder
18
Five Tax Reforms
3. Value-Added Tax – How it Works





The Value-Added Tax is assessed on every business as a fraction of each
sale, net of purchases made by that business; in this sense it taxes the “value
added” at each stage of production, rather than only the final value sold at
retail; nevertheless, the same percentage of a retail and a value-added tax
should theoretically net the same revenue
Businesses would collect the tax, but incidence falls on consumers
Individuals would not file tax returns
Exports are excluded, except for that (wholesale) portion which is transacted
between businesses within the U.S.; imports are taxed on any value added by
American wholesalers/retailers
Variant A: lower rate or “zero rate” of certain goods or services
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Five Tax Reforms
3. Value-Added Tax – Problems


Coordination with state retail sales tax schemes is fraught with major
complications; states would need to change their sales tax schemes to a VAT
piggy-back (Mack 2005) (McClure 1995)
Since it is somewhat hidden from the retail consumer (it can be stated but is
nevertheless absorbed in the price), it obscures the cost of government (Slemrod
2005)
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Five Tax Reforms
3. Value-Added Tax – Factfile
In Operation:
25 EU nations
U.K. 17.5%
France 19.6%
Germany 19%
Sweden 25%
39 other nations
Australia 10%
China 17%
Mexico 15%
All Canadian provinces 6%-14%
Michigan 1.9% (1975-2009)
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Revenue neutral rate: 13% (tax-incl)
(Edwards 2005) adjusted
Origins: Invented by French economist Maurice Lauré in 1953
Aliases: Goods and Services Tax (GST),
Single Business Tax (SBT),
Business Transfer Tax (BTT)
Ideology: Mainstream economists;
Euro-philes; “Big-government”
conservatives
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Endorsements:
Bruce Bartlett
Bill Thomas
21
Five Tax Reforms
The Flat Tax, RST, and VAT as Consumption Taxes


The Flat Tax, RST, and VAT call themselves consumption taxes since saving
and investment are not taxed
The Hall-Rabushka Flat Tax is actually a modification of a classic ValueAdded Tax: (Slemrod 1997)
From the Hall-Rabushka Flat Tax:
1. Eliminate the personal and dependent exemptions in the personal income tax
2. Abolish the personal income tax
3. Disallow the deductibility to business of payments to labor and pensions
= The traditional consumption-based Value-Added Tax

Macroeconomic identities show that various consumption taxes are
equivalent: (Auerbach 1997)
Consumption
RST
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= Income – Savings = Wages + Returns to Capital – Investment
= USA Tax
= VAT or Flat Tax
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Five Tax Reforms
4. Geo-Rent Tax – How it Works




The Geo-Rent Tax is a tax on the implicit rental value of land, exclusive of the
value of improvements; “land” includes all surface area (including water),
airway corridors, and the electro-magnetic spectrum
The tax would apply to all owners of land, including household, commercial,
and government-owned real estate; taxing government land adds pressure to
manage, maintain, and retain an efficient amount of public land
Land values would be assessed as they are presently for property taxes,
which usually distinguish between site and improvement value
Assessment would be done either by adapting existing state/local assessment
systems or by a national revenue collection agency
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Five Tax Reforms
4. Geo-Rent Tax – Problems


Insufficient revenue: Even if geo-rents are taxed at 100%, the revenue raised
would not be sufficient to replace income taxes (Foldvary 2005)
Assessment: Valuation is inexact and subject to manipulation; land site values
can only be determined in the exchange of the market (Rothbard 1957)
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Five Tax Reforms
4. Geo-Rent Tax – Factfile
Origins: Invented by American political economist Henry
George in 1879 (but the idea of taxing the non-labor
value of land has been around since John Locke)
In Operation:
Estonia
Taiwan
Singapore
Hong Kong
Sydney, Australia
Canberra, Australia
Fairhope, AL
Arden, DE
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Revenue neutral rate: 69%
(Tideman 2002) adjusted
Ideology: Progressives;
Environmentalists (“we all own the world”)
Geo-libertarians (libertarians who believe
in the private possession of land
but not land as private property)
Aliases: Land Value Tax, Site Value Tax
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Endorsements:
Adam Smith
John Stuart Mill
Milton Friedman
Thomas Paine
William F. Buckley, Jr.
Albert Jay Nock
Sun Yat Sen
Winston Churchill
Ralph Nader
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Five Tax Reforms
5. Head Tax – How it Works







The Head Tax is a tax of a nominal dollar amount assessed to every individual
over a certain age (for our example, over 18)
It is not based on income, or consumption, or any economic activity; since the
amount of tax paid does not vary due to economic choices, it has no impact
on economic activity
Businesses would not be assessed a tax
Individuals who are citizens or residents would be assessed a tax
Variation A: No age limitation (include children)
Variation B: Exclude the insane, the infirm, or the incarcerated
Variation C: Tax amount is based on age (to attempt to coincide with lifetime
income stream), with young paying lower
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Five Tax Reforms
5. Head Tax – Problems

Insolvency: some people simply would not be able to pay (not in the normal
sense of “I must pay for food, shelter, cable first”, but in the sense that they
would not actually have enough money at all); a “carry forward” provision
could ameliorate but not solve this
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Five Tax Reforms
5. Head Tax – Factfile
Origins: Assessed by John of Gaunt in England in 1380
Revenue neutral rate: $5,407 (annual)
In Operation:
Not presently in operation anywhere
Recent trials:
England/Wales (1990-92)
Scotland (1988-92)
Aliases: Poll Tax; Lump-sum Tax
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Endorsements:
Steven Landsburg
Keith Joseph
Margaret Thatcher
Ideology: Libertarian academics
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Efficiency Comparison
Taxes and Incentives

The effects of the five tax reforms on economic activity:
1)
2)
3)
4)



Income taxes discourage work, investment, and entrepreneurial activity
Consumption taxes (RST, VAT) discourage consumption
Geo-Rent Taxes arguably do not discourage anything (sprawl?)
Head taxes are non-contingent and do not discourage anything (is this true?)
Is complete elimination of tax incentivization desired?
Is any economic activity good in itself (positive externalities or ethical merit)?
Work? Saving?
Is any economic activity bad in itself (negative externalities or vice)?
Consumption? Work?
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Efficiency Comparison
Consumption Taxes and Labor Supply

Because of inter-temporal substitution, there is no long-term effect on labor
supply arising from the shift in taxation from income (work) to consumption
(Auerbach 1997)



However, the reduction of tax rates at the margin (whether on income or on
consumption) and the investment potential in deferred consumption should
result in an increase in labor supply (Auerbach 1997)
Any consumption tax would increase labor supply by 6% initially, then decline
eventually to original level (Jorgenson 1997)
The Flat Tax would add 4% more work hours and 3% total output to GDP (Hall
1995)

The Retail Sales Tax would add 5% more work hours initially, eventually to
diminish to 1% in 20 years (Kotlikoff 1995)
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Efficiency Comparison
Consumption Taxes and Saving




Consumption taxes eliminate the inter-temporal consumption distortion that
arises from taxing savings (Metcalf 1995(1))
If the savings elasticity with respect to the interest rate is positive, a
consumption tax should increase the savings rate (Metcalf 1995(1))
The Flat Tax would raise the ratio of capital stock to GDP from 5.0 to 6.2; this
would result in a 3% increase in GDP; interest rates would fall by 20% to
reflect a new after-tax rate similar to a tax-free rate (Hall 1995)
The Retail Sales Tax would raise the capital stock by 8%; this would result in
a 6% increase in GDP; interest rates would fall by 8% (Moore 1995)
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Efficiency Comparison
GRT and Head Tax Efficiency
GRT:



While the improvement value of land has some supply elasticity, the site value of
land (which GRT taxes) is theoretically completely supply inelastic
The demand for land, however, could shift to alternatives (e.g., internet over brickand-mortar) and would change the use and development of land
Head Tax:



The Head Tax is theoretically completely non-contingent, and thus completely
efficient
Caveats:
1)
2)
The age breakpoint and carry-forward rules may influence behavior in light of
borrowing constraints
Decisions of American residency and citizenship may be influenced
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Equity Expectations
Measuring Distribution


Taxation per dollar of annual income is traditional distributional measure
Distribution measures (progressivity/regressivity) and taxes that target them:
1)
2)
3)
4)
5)

Distribution timeframes:
1)
2)

Taxation per dollar of wealth (GRT)
Taxation per dollar of income
Taxation per dollar of consumption (Flat Tax; RST; VAT)
Taxation per dollar of benefits
Taxation per person (Head Tax)
Annual timeframe (politician view; affects political viability)
Lifetime timeframe (economist view; true equity)
Distribution adjusted for evasion:
1)
2)
Measured by how much tax is owed (this is used)
Measured by how much tax is paid
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Equity Expectations
Annual and Lifetime Measurement


Distinction between annual income and lifetime income makes consumption
taxes appear proportional with respect to income (Metcalf 1995(2))
Two caveats: (Metcalf 1995(2))
1)
2)
Non-taxed consumption (leisure): to the extent that the income elasticity of leisure
exceeds one, leisure is not taxed and consumption taxes are progressive;
however, evidence shows that income elasticity of leisure is one or less
Non-taxed bequests: to the extent that the income elasticity of bequests is less
than one, bequests are not taxed and consumption taxes are regressive;
however, bequests may be implicitly taxed in the sense that the value is reduced
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Equity Expectations
Distribution Estimation
Flat Tax (B+) is income and consumption progressive, due to personal
deductions
RST (A-) and VAT (A) are income regressive and consumption flat on an
annualized basis, but are both income and consumption flat over a lifetime
GRT (A-):









Adherents claim that all of the incidence is on present landowners
Realistically, incidence falls on land users, whether renter or owner
Businesses which use land push incidence onto consumers
On an annual basis, GRT is probably loosely income and consumption
progressive, since renters use less land per dollar of income than owners
On a lifetime basis, GRT is probably loosely income and consumption regressive,
since differences in lifetime income will not be wholly captured by land use
Head Tax (D) is income and consumption regressive
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Equity Expectations
Tax Distribution Elasticity Matrix
Annual
Lifetime
Stock
Income
Cons
Benefit
Income
Cons
Benefit
Wealth
Person
Current Income Tax
▲
▲
▼
▲
▲
▼
▼
NA
Flat Tax
▲
▲
▼
▲
▲
▼
▼
NA
RST
▼
▬
▼
▬
▬
▼
▼
NA
VAT
▼
▬
▼
▬
▬
▼
▼
NA
GRT
▲
▲
▼
▼
▼
▼
▬
NA
Head Tax
▼
▼
▼
▼
▼
▼
▼
▬
▲ = Tax increases more than proportionally with increases in measure (“progressive”)
▬ = Tax increases in proportion with increases in measure (“flat”)
▼ = Tax increases less proportionally (or decreases) with increases in measure (“regressive”)
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Equity Expectations
Distribution Flexibility



Flat Tax can extend progressivity by augmenting the personal deductions or
introducing new deductions
RST and VAT can introduce progressivity by reduced-rating or zero-rating of
low-income goods and services or by rebates or consumption credits to all
adults
Head Tax can reduce annual regressivity by varying with age
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Administration, Intrusion,
Compliance, Evasion
Administration and Enforcement Costs
Current income tax (C): $10.2 bln. annually (ERP 2006)
Flat Tax (B): higher than VAT or RST because of individual returns, less than
current income tax
RST (B+): $12 bln. annually (1% of revenues); this is a credit to cover costs,
not an estimate of costs (Burton 1997)







VAT should be more expensive to administer than RST because more information
is collected and audited (Bickley 2004)
VAT (B+): $1.8 bln. annually (Metcalf 1995)
GRT (A-): assessment formulas and property registration; should be low
Head Tax (A-): some enforcement difficulties but otherwise easy; should be
very low
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Administration, Intrusion,
Compliance, Evasion
Intrusion






Current income tax (C): heavy intrusion on personal and business privacy
Flat Tax (B): intrusion on business transaction privacy and on individuals, but
limited
RST (A-): intrusion on retail business, but less than VAT or Flat Tax
VAT (B+): intrusion on business transaction privacy, but limited
GRT (A): no intrusion
Head Tax (A): no intrusion
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Administration, Intrusion,
Compliance, Evasion
Compliance Costs







The most dramatic gains over the current system are in compliance costs
Current income tax (C): $200 bln. annually (CHC 2003)
Flat Tax (B): no estimate; while individuals would need to comply, compliance
costs would be similar to other consumption taxes because business would
bear the overwhelming majority of compliance costs in tracking credits
RST (B+): $6 bln. annually (0.5% of revenues); this is a credit to cover costs,
not an estimate of costs (Burton 1997)
VAT (B): $5 bln. annually (Bickley 2006)
GRT (A-): no estimate; record-keeping of property transactions; should be
very low as property does not turnover as quickly as general consumption
Head Tax (A): no estimate; since only individuals comply, and computation
and record-keeping are not necessary, costs should be extremely low
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Administration, Intrusion,
Compliance, Evasion
Tax Evasion





Evasion is higher the higher the tax rate; there will be more total evasion with
a 20% tax on either sales or income than with a 10% tax on each
For most taxes, there is a tax rate above which avoidance and evasion result
in lower tax revenues
Current income tax (C): 23% of collected revenue (IRS 2004)
Flat Tax (B+): since under-reporting of non-wage income is the largest
problem of current evasion, this would substantially diminish evasion
RST (C):
1)
2)
3)
Estimate of state evasion: 13%; likely to be higher if rates are higher (Due 1994)
Since the high rate would apply to the total sale and is paid completely by
retailers, the incentive for evasion is higher than Flat Tax or VAT
Shorter audit trails than Flat Tax or VAT facilitates evasion
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Administration, Intrusion,
Compliance, Evasion
Tax Evasion (contd.)
VAT (B+):

1)
Reduced evasion compared to a national sales tax: (Mack, 2005)


2)
Demand for input credits creates self-enforcement mechanism and paper trail
Reduced tax liability for each business (includes retailers, wholesalers, producers)
European estimates of evasion are generally under 10% (Bickley 2006)

United Kingdom 2%-4%; France 3%; Netherlands 6%; Belgium 8%; Italy 40%
GRT (A):


Land can not be hidden; taxes on land are extremely difficult to evade
Head Tax (B):



Head taxes are theoretically difficult to evade, since proof of compliance can be
tied to any government service (driver’s license, benefits, etc.)
Nevertheless, there is a very strong incentive for evasion and many people may
be able to go “underground”
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Transition Issues
Out with the Old: Tax-preferred vehicles

Saving and investment vehicles:
1)
Retirement accounts $125 bln. (FY2006) (Hungerford 2006)

2)
Tax-exempt municipal bonds $26 bln. (FY2006) (Hungerford 2006)


Interest rates would be higher for these projects but lower for other bonds; eliminates
excessive local government debt financing
Housing deductions:
1)
Mortgage financing $69 bln. (FY2006) (Hungerford 2006)


Savings are not taxed under any reform; tax would not be paid on distributions
Eliminates excessive property inflation
Health care financing:
1)
Elimination of employer deduction of health care expenses $91 bln. (FY2006)
(Hungerford 2006) (one step towards correcting America’s ailing health sector!)
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Transition Issues
Out with the Old: Current System Parasites

Tax professionals: not all would go (the replacement tax and other taxes still
need due attention), but a majority cover federal income taxation
1)
2)
3)
4)
5)


Tax collectors (35,010) (BLS 2006)
Tax preparers (58,850) (BLS 2006)
Tax accountants
Tax attorneys
Tax lobbyists
Should they be compensated or retrained (GI Bill)? Compensation opens
itself up to fraud; retraining is debatable
Depending on transition period to new tax, retraining may be unnecessary
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Transition Issues
In with the New

Consumption Taxes:
1)
Double taxation of wealth: switching from income to consumption taxation entails
double taxation of all existing wealth and inventory, since it was taxed once as
income (in the old scheme) and will be taxed again when it is used for future
consumption (in the new scheme); this is the biggest transition issue


2)
Possibility of a large consumption binge before transition
Should existing holders of wealth be compensated? Public finance theorists are split,
but the case (on both efficiency and equity grounds) for not compensating is
compelling (Metcalf 1995(2))
Price changes: businesses will either “pass forward” the new tax in the form of
higher prices, or reduce the cost of factor inputs (wages)



If higher prices, people and businesses with money instruments suffer a real loss
If lower wages, businesses and individuals with inventories suffer a real loss
Generally, it is expected that higher prices will occur and nominal wages will stay the
same (Hall 1997); monetary policy would make a one-time adjustment (Bradford 1995)
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Transition Issues
In with the New (contd.)
3)
4)
5)
Depreciation: businesses with existing depreciation balances will need to be able
to write-off the remaining balance; this will cost $108 bln. a year in lost revenue
for 5 years (Hall 1995)
Interest deductions: individuals with mortgages or other deductible interest may
ask for relief; but then the interest should become taxable to the lender (Hall 1995)
Housing: to avoid the distortion between the purchase of new and existing
housing, new housing should be taxed upon first sale and existing housing should
be taxed upon first sale after tax enactment (Metcalf 1995(2))
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Transition Issues
Transition Summary





Flat Tax (B): 1-2 years; works within existing tax system; transition would be
similar to Tax Reform Act of 1986
RST (C): 5 years (Burton 1997); new at the federal level
VAT (D): more time to implement than RST, since it is new (Bickley 2004)
GRT (F): 20 years; compensation of existing landowners would require a very
gradual phase-in (Foldvary 2005)
Head Tax (A-): depends on equity issues
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Political Viability
The Equity Problem






The equity problem is perhaps the largest political issue for tax reform
All other arguments (efficiency, compliance, etc.) in favor of tax reform may
not be able to overcome the opposition created by the equity problem
All consumption taxes (Flat, RST, VAT) and the Head Tax are vulnerable to
attack on the grounds that they are less progressive than the current income
tax system, and thus “favor” the rich and harm the poor
The change from progressivity to a “flat” treatment per dollar of consumption
(or per head) is in fact one of the intended goals of all four of these reforms
The reduction of vertical inequity (generally considered unfair) is somewhat
ameliorated by the reduction of horizontal inequity (considered more fair)
The Flat Tax is less vulnerable on these grounds because the personal
allowances retain some progressivity; in effect, the low-income and highincome earners are better off and middle-income earners worse off
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Political Viability
Flat Tax Popularity

The Tax Foundation asked over 2,000 adults the following question in 2005
and 2006: “If you could choose one plan to collect all federal taxes, of these
listed, which federal tax plan would you prefer?”
2005 2006
1)
2)
3)
4)
A flat-rate income tax with no deductions
A national sales tax
The current graduated income tax with deductions
Unsure
37%
19%
19%
25%
33%
20%
21%
26%
(Chamberlain 2006)

This shows the continued popularity of the Flat Tax over both the current
system and a national Retail Sales Tax; note that personal and dependent
deductions were not even mentioned for the Flat Tax
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Political Viability
Passage Hurdles


All five tax reforms can be enacted by Congressional passage of a law,
signed by the President
Some notes:
1)
2)
3)
4)

VAT: States with RSTs should pass legislation to change to VAT
RST: States with RSTs may need legislation to better combine with federal RST
GRT: As this is not an indirect tax, it may require a constitutional amendment
Head Tax: Constitutional amendment repealing Amendment XXIV should not be
necessary (only applies to taxes on voting)
All except the Flat Tax should pass a constitutional amendment to repeal
Amendment XVI, which gave Congress the authority to tax income
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Political Viability
Political Challenge





Flat Tax (A-): popular in Congress; has decade of somewhat positive
exposure outside the beltway; easily understood
RST (B): more popular in Congress than the Flat Tax; gaining momentum
recently; evasion problems raised by opponents
VAT (C+): difficult to explain; European flavor suppresses support; not wellknown in the United States; opposed by right-wing as “money machine”
GRT (B-): esoteric; unknown; could easily garner support from left and right;
will be vehemently opposed by land owners
Head Tax (F): very radical; scary; equity concerns a killer; political
Armageddon; hated in Canada, Britain, and elsewhere
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Recommendation
Grand Comparison
Flat Tax
RST
VAT
GRT
Head Tax
B+
B+
B+
A-
B+
A
AA-
A
D
B
B
B
B+
AB+
B+
B+
B
AA
A-
AA
A
B+
B
A-
C
C
B
B+
D
C+
A
F
B-
B
AF
Efficiency
Equity
Administration
Intrusion
Compliance
Evasion
Transition
Politics
The current income tax baseline grade is a “C” in all categories (except Transition)
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Recommendation
Flat Tax


All reforms appear better than the current income tax
The Hall-Rabushka Flat Tax is recommended because:
1)
2)
3)
4)

It is competitive with other reforms in all aspects of reform, including efficiency,
equity, administration, intrusiveness, compliance, and evasion
It has the easiest and fairest transition route of all reforms, and is thereby the
least risky reform
It appears the least radical way to a consumption tax; and thus,
It is the most politically viable
The Geo-Rent Tax is a powerful and attractive idea that should be tested at
the state level to assess the revenue, incidence, and equity implications
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References
A-C
Auerbach, Alan J. "The Future of Fundamental Tax Reform." The American Economic Review 87.2
(1997): 143-46.
Bartlett, Bruce. "Flat-Tax Comeback." National Review Online, 2003.
Bickley, James M. A Value-Added Tax Contrasted with a National Sales Tax. Washington, DC:
Congressional Research Service, Library of Congress, 2004.
---. Value-Added Tax: A New U.S. Revenue Source? Washington, DC: Congressional Research
Service, The Library of Congress, 2006.
Boskin, Michael J., ed. Frontiers of Tax Reform. Hoover Institution Press, 1995.
Bradford, David F. "Consumption Taxes: Some Fundamental Transition Issues." Frontiers of Tax
Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 123-50.
Burton, David R. and Mastromarco, Dan R. Emancipating America from the Income Tax: How a
National Sales Tax Would Work. Washington, D.C.: The Cato Institute, 1997.
Cato Handbook for Congress. Washington, DC: The CATO Institute, 2003.
Chamberlain, Andrew. 2006 Annual Survey of U.S. Attitudes on Tax and Wealth. Washington, DC: Tax
Foundation, 2006.
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References
D-H
Due, John F., and John L. Mikesell. Taxation. 3rd ed. Washington, DC: Urban Institute Press, 1994.
"The Economic Report of the President." Ed. Council of Economic Advisers: U.S. Government Printing
Office, 2006. 1-410.
Edwards, Chris. Options for Tax Reform. Washington, D.C.: The Cato Institute, 2005.
Feldstein, Martin. "Tax Avoidance and the Deadweight Loss of the Income Tax." The Review of
Economics and Statistics 81.4 (1999): 674-80.
"Flat Tax." Wikipedia.
Foldvary, Fred E. "Geo-Rent: A Plea to Public Economists." Econ Journal Watch 2.1 (2005): 106-32.
Hall, Robert E. "Potential Disruption from the Move to a Consumption Tax." The American Economic
Review 87.2 (1997): 147-50.
Hall, Robert E. and Rabushka, Alvin. The Flat Tax. Second ed: Hoover Institution Press, 1995.
Hubbard, R. Glenn. "How Different Are Income and Consumption Taxes?" The American Economic
Review 87.2 (1997): 138-42.
Hungerford, Thomas L. Tax Expenditures: Trends and Critiques. Washington, D.C.: Congressional
Research Service, Library of Congress, 2006.
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References
I-M
IRS Strategic Plan, 2005-2009. Washington, DC: Internal Revenue Service, 2004.
Jorgenson, Dale W. "The Long-Run Dynamics of Fundamental Tax Reform." The American Economic
Review 87.2 (1997): 126-32.
Jorgenson, Dale W. and Yun, Kun-Young. Investment Volume 3: Lifting the Burden: Tax Reform, the
Cost of Capital, and U.S. Economic Growth. Cambridge, MA: MIT Press, 2001.
Kies, Kenneth J., et al. Discussion of Issues Relating To "Flat" Tax Rate Proposals. Washington, D.C.:
Joint Committee on Taxation, U.S. Congress, 1995.
Kotlikoff, Laurence J. "Saving and Consumption Taxation: The Federal Retail Sales Tax Example."
Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995.
160-80.
"List of Soc Occupations". Washington, DC, 2006. Bureau of Labor Statistics, Department of Labor.
10/12/06. <http://www.bls.gov/oes/current/oes_stru.htm#13-0000>.
Mack, Connie III, et al. Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System.
Washington, D.C.: The President's Advisory Panel on Federal Tax Reform, 2005.
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References
M-P
McClure, Charles E. Jr. and Zodrow, George R. "A Hybrid Approach to the Direct Taxation of
Consumption." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover
Institution Press, 1995. 70-90.
McGeveran, William A. Jr., ed. The World Almanac and Book of Facts 2006. New York, NY: World
Almanac Books, 2006.
McNulty, John K. "Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United
States: A Tax Policy Discussion of Fundamental Tax Reform." California Law Review 88.6
(2000): 2095-185.
Metcalf, Gilbert E. "The Role of a Value-Added Tax in Fundamental Tax Reform." Frontiers of Tax
Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 91-109.
---. "Value-Added Taxation: A Tax Whose Time Has Come?" The Journal of Economic Perspectives
9.1 (1995): 121-40.
Moore, Stephen. "The Economic and Civil Liberties Case for a National Sales Tax." Frontiers of Tax
Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 110-20.
"Poll Tax." Wikipedia.
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References
R-Z
Rothbard, Murray. The Single Tax: Economic and Moral Implications. Irvington-on-Hudson, NY:
Foundation for Economic Education, 1957.
Slemrod, Joel. "Deconstructing the Income Tax." The American Economic Review 87.2 (1997): 15155.
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Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. Vol. 2. 2 vols.
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Tait, Alan A. Value Added Tax: International Practice and Problems. International Monetary Fund,
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Tideman, Nicolaus, et al. "The Avoidable Excess Burden of Broad-Based U.S. Taxes." Public Finance
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"Value Added Tax." Wikipedia.
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