Tax Reform - What's on the
Table and What Might It Mean
for You and Your Clients?
Annette Nellen, CPA, Esq.
San José State University
December 14, 2005
Agenda
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Why tax reform?
Income tax versus consumption tax
Design features versus type of tax
Advisory Panel’s 2 proposals
How to evaluate
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Impediments to reform
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Where to find more information
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Why Tax Reform is on
the National Political Agenda
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President Bush not happy  with current
tax system
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January – formed the President’s Advisory
Panel on Federal Tax Reform
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Tax reform discussions occur every decade
anyway
Work of the Advisory Panel
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Gather and analyze information
Hold public hearings
Solicit public comments
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“The Panel received thousands of
comments describing complexities and
burdens, unfair aspects and distortions in
the current tax system, in response to its
first request [for public comments].”
Report issued 11/1/05
Why are President Bush and
others unhappy?
Our current federal tax system is …
1.
Too complex (!)
2.
Anti-savings
3.
An impediment to international competitiveness
4.
Ineffective in collecting all tax that is owed
5.
Not neutral
6.
Not perfect in measuring income
7.
Violates the equity and fairness principle
Here is some evidence of these hypotheses …
Complexity
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Nat’l T/P Advocate - the “confounding complexity of
the tax code” is the most serious problem facing
taxpayers
2003 – 56% of individuals and over 70% of those
claiming EITC had a paid preparer
Only 16% of individuals know how long to live in a
home to get an exclusion
Code and regs – over twice as long today as 20 years
ago
High costs of complexity
Level of U.S. Savings is Low
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Taxes earnings from savings (but not all)
Household net savings rates for 2003:
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France
Germany
U.S.
11.1%
10.7%
1.4%
Impedes Int’l Competitiveness
of U.S. Firms
U.S. tax system different from many trading partners:
1.
Worldwide rather than territorial
2.
Not border adjustable
3.
No VAT
The world has changed since U.S. int’l provisions created:
1.
U.S. share of world GDP declining
2.
Int’l operations by all size of firms
The Tax Gap is Too Large
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Difference between taxes owed and taxes paid on
time
Between $312 and $353 billion annually for all types
of federal taxes
Translates to a non-compliance rate of 15% - 16.6%
Individual taxpayers pay, in effect, $2000 annually to
“subsidize” non-compliance
Size of tax gap is increasing
More and more people think it is ok to cheat
The Tax System is Not Neutral
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View that tax system can fix anything!
Often non-tax alternatives are not considered.
Often, rule is broader than what is needed:
 Home mortgage rule
 Charitable contributions
Or too many attempts to help:
 Child credits
 Education preferences
Result – complexity + often, higher costs to economy
and gov’t
Advisory Panel on Neutrality
“We have lost sight of the
fact that the fundamental
purpose of our tax system is
to raise revenues to
fund government.”
4/13/05 statement
Measure of Income has
Imperfections
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Double taxation of corporate income
Preference for debt over equity
Limitations on capital losses
Taxation of inflationary gains
Lack of conformity with GAAP
Depreciable lives not always tied to actual life
Marriage penalty
Preferences for some types of income
Equity and Fairness Problems
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Why are some things deductible and not
others even though important and affects
ability to pay?
If have ER provided health insurance – much
better tax deal than buying your own
If live in state with high income and property
taxes – you get a subsidy from states with
lower taxes
Some Impending Problems
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AMT taxpayers growing per Advisory Panel:
 Today – about 4 million
 Next year – about 20 million
 2015 – 50 million (45% of taxpayers)
Many favorable provisions from Economic Growth and
Tax Relief Reconciliation Act of 2001 expire after 2010
Continuing concerns over tax shelters
Deficits
Income Tax Versus
Consumption Tax
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“Major” – “Fundamental”
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Often a call for replacing income tax with a
consumption tax
Or could be significant changes to the
income tax
Consumption
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Tax on spending
Tax income when spent, not when
saved
Various forms: sales tax, VAT, flat tax,
consumed income tax
Consumption Tax Perspectives
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Exempts savings
Businesses currently deduct investment in
capital (no depreciation)
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Removes expected future income from the
investment from taxation
Doesn’t penalize t/p who earns and saves in
early years and then consumes in later years.
Taxes people the same regardless of when they
consume. So, encourages savings.
How to tax consumption
1.
2.
At point of consumption (sales tax, credit invoice
VAT)
Consumption = Income less savings
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A. Cash flow approach – use formula to
determine annually how much money was used
for consumption (can be complicated)
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B. Tax prepayment approach – exclude income
from investments from the tax calculation
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Example – the “flat tax”
Consumption Tax
Considerations
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Is education consumption or investment?
Should there be exemptions (food, medical care,
anything)?
What is best type of consumption tax for the US  Flat tax?
 National retail sales tax?
 Some form of VAT?
 Formula approach?
 Hybrid income and consumption tax?
Design features vs.
Type of tax
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Problems noted earlier can exist with any type of tax
EX – does income tax have to be complex? (no)
Is tax gap unique to income tax? (no)
Can income tax fit on a postcard? (yes)
So, really need to ask – Why would/should we
replace the income tax with a consumption tax? And
how can our system avoid the problems noted
earlier?
Advisory Panel’s Final Report
The Panel’s Instructions
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Options for reform proposed by Panel must:
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Be revenue neutral
Simplify to reduce administrative and compliance costs
and burdens
Have progressivity
Recognize importance of home ownership and charity
Promote LT economic growth and job creation
Strengthen U.S. competitiveness in global market by
encouraging work effort, saving and investment.
Include one option based on the income tax
A few observations
Some specific proposals rejected – VAT and
national sales tax
Flat tax rate structure rejected
1.
2.
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3.
4.
Revenue neutral rate = 21%
Not distributionally neutral
(p 55)
No call to completely move to a
consumption tax
Tax design query – what is better, a
deduction or credit?
A few observations - 2
5. Proposes to consolidate many overlapping
provisions in our current system
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Could be done w/o the other pieces of the
proposals
6. Revenue neutrality was tough
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Assumed that 2001 and 2004 tax cuts would be
made permanent
What to do with AMT?
7. Several commonalities among the two
proposals, particularly for individuals (see
chart in handout)
A few observations - 3
8.
Plans designed to help improve savings
and investment by:
1.
2.
3.
4.
Provisions to allow for ways to save tax-free
Simplification for small businesses should
save them lots of compliance dollars
Moves tax system towards corporate
integration (less double taxation)
Improves int’l tax rules
The Panel’s Final Report
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2 proposals:
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Simplified Income Tax
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“streamlined version” of our current system
(p 59)
Growth and Investment Tax
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Moves us in a “new direction” by reducing burden
on savings and investment so as to boost
economic growth w/o fundamentally changing
how the tax burden is distributed. (p 59)
Moves us closer to a consumption tax.
The Two Proposals
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Some similarities among the two
proposals
(see chart in outline)
Many differences – see overview +
Panel’s summary table in the outline
Basics of the Simplified Plan
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Base broadened
Double taxation almost completely removed
Business taxation depends mostly on the size based on gross
receipts
Businesses with $10 million or less of GR must use “designated
bank accounts”
Attempt to have only a single layer of tax at entity level
Simplified cost recovery system – 4 categories of assets
Territorial rather than worldwide for active business income
Only tax preference for business that remains is accelerated
depreciation. Credits, §199, and even state and local tax
deduction and exclusion for tax-exempt income gone.
Basics of Growth &
Investment Tax Plan
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Moves us closer to a consumption tax.
Dividends, capital gains and interest income (other than taxexempt) subject to 15% rate for individuals.
Business cash flow base; subject to 30% rate (other than sole
proprietorships)
All business purchases are immediately expensed
International transactions taxed on destination basis (tax
rebated on exports and imports not deductible from base)
Losses not refundable. Panel recommends interest factor be
added to loss carryforwards.
Transition rules suggested.
Missing pieces
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How much does federal gov’t need to
raise?
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Need to look at spending?
Need to consider the appropriate baseline
– should it be one producing deficits? One
that expects that proposed tax cuts will
happen?
Missing pieces - 2
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How progressive should a system be?
Simplified plan removes very top and
very bottom brackets. W/o changes,
top bracket in 2011 will be 39.6%, so
33% top rate in plan is low.
What social policies do we want in the
tax law? How much benefit for lowincome?
Missing pieces - 3
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Int’l tax policy discussion – not there
How do the plans tie to needed reforms
in Social Security and Medicare?
Is ability to pay met? It appears that
medical, casualty and unreimbursed EE
business expenses are eliminated.
How to Evaluate Proposals Principles of Good Tax Policy
AICPA’s Tax Policy Concept Statement 1 –
Ten Principles
1. Equity and fairness
2.
Certainty
3.
Convenience of payment
4.
Economy in collection
5.
Simplicity
Principles of Good Tax Policy 2
6.
Neutrality
7.
Economic growth and efficiency
8.
Transparence and visibility
9.
Minimum tax gap
10.
Appropriate government revenues
10 principles - Questions
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Equity and Fairness
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What is the distributional effect?
How does the mix of tax on labor and
capital change?
Is there transitional relief?
Is it regressive? Less progressive?
What will be the likely perception of
fairness among different groups of
taxpayers?
Certainty
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Are key principles stated so taxpayers
can determine how the system applies
to all transactions?
What is the relationship of the effective
date and when the IRS can issue forms
and guidance?
Convenience of Payment
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Will there be more taxpayers or fewer
required to file returns?
Have technological solutions been
considered for collection and
assessment?
Economy of Collection
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Is there an estimate of compliance
costs and gov’t administrative costs?
Have less expensive alternatives been
considered?
Simplicity
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Has a complexity analysis been
performed?
Have practitioners been consulted?
Have consistent definitions been used?
If states don’t also conform, will
simplification be achieved?
AICPA Tax Policy Concept Statement #2 - Simplification
Neutrality
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Does the proposal favor one type of
taxpayer or industry over another? Or
one type of income over another?
Have the direct and indirect effects of
the proposal been considered in
determining if any type of t/p is favored
or disadvantaged?
Economic Growth & Efficiency
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Economic analysis to show impact to all types of
t/ps, federal and state governments?
If states don’t conform, will economic goals be
achieved?
How will transition impact the economy?
Are preferences targeted narrowly to achieve the
intended purpose?
How do tax liabilities move in relationship to
changes in economic conditions?
Transparency and Visibility
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How will t/ps know how much of the tax they are
paying and when it is being imposed upon them?
Is t/p’s effective marginal tax rate same as statutory
rate? (example – no phase-out provisions)
Have deceptive provisions, such as AMT, been
avoided?
Have multiple effective dates and sunset dates been
avoided?
AICPA Tax Policy Concept Statement #3 - Transparency
Minimum Tax Gap
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How will compliance be enforced? At
what cost?
Will the tax gap likely go up or down?
Appropriate Government
Revenues
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Revenue neutral?
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Which levels of gov’t will be impacted?
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Impact to state and local gov’ts if provisions are
eliminated that produce direct or indirect benefits to
them, such as muni bond interest exclusion,
enterprise zone credits, etc.
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Will states be able to conform?
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Will revenues likely be stable over time?
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Will revenues grow as economy grows?
Impediments to major reform
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The significance of the change
Transition rules – should there by any? Cost?
 Any benefit of income tax carryovers?
 What about previously taxed funds that will get
taxed again when consumed?
 What about debt financing for massive
consumption before consumption tax starts?
Every current provision has a group that will fight to
keep it.
Concerns of state and local governments
Impediments to major reform 2
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Impact to current systems and ways of thinking – will
taxpayers want a major change?
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Personal financial planning
Employee benefits
Debt financing strategies
Form of entity
Many others
Uncertainty of impact on economy now and later
Lack of specific goals for change
Impediments to major reform 3
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How to do the revenue estimate under
a vastly different system?
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What if we get it wrong? What is the
impact to the economy?
Dealing with the missing details
(business vs investment,
reorganizations, accounting rules, etc.)
Politics
Where to Get More
Information
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Numerous reports exist – JCT, CBO, CRS,
trade associations, AICPA, others
Advisory Panel website
Tax Reform Website with more information
+ many links:
http://www.cob.sjsu.edu/nellen_a/