Chapter 25 Fundamental Tax Reform
Fundamental Tax Reform
Chapter 25
25.1 Why Fundamental Tax
Reform?
25.2 The Politics and
Economics of Tax Reform
25.3 Consumption Taxation
25.4 The Flat Tax
25.5 Conclusion
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Improving Tax Compliance
tax compliance Efforts to reduce
the evasion of taxes.
tax evasion Illegal nonpayment
of taxation.
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Improving Tax Compliance
Theory of Tax Evasion
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Improving Tax Compliance
Evidence on Tax Evasion
Tax evasion is pervasive in the United States and around the
world. In the United States, the most recent estimates place the
“tax gap” between taxes owed and taxes paid at $280 billion.
Why Should We Care About Tax Evasion?
There are three reasons why we should care about tax evasion and
want to reduce it:
The first is efficiency.
The second is vertical equity.
Finally, tax evasion is one of the clearest violations of horizontal
equity that we have discussed.
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Making the Tax Code Simpler
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Improving Tax Efficiency
Changing the tax rate changes tax revenues through five channels:
1. Direct effect: A higher tax rate raises revenues on a fixed base of
taxation.
2. Indirect effects: A higher tax rate that lowers the size of the revenue
base on which taxes are levied.
a. Gross income effect: A higher tax rate may reduce gross income
generated by lowering the amount of labor supplied, the savings
undertaken, or risk taking.
b. Reporting effect: For a given level of gross income, a higher tax rate
will cause individuals to reclassify income in ways that are not
subject to a tax.
c. Income exclusion effect: For a given reported income, a higher tax
rate will cause individuals to take more advantage of the deductions
and exclusions from gross income that are used in defining taxable
income.
d. Compliance effect: Finally, higher tax rates may reduce revenues
through increased tax evasion.
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Improving Tax Efficiency
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Improving Tax Efficiency
Evidence on the Revenue Consequences of Higher Tax Rates
It wasn’t until the late 1980s that economists began to assess the
overall impact of taxes on revenues.
Since that time, a large number of studies have modeled the impact
of changes in individual tax rates on the tax revenues collected
from those individuals.
These studies have provided several clear messages about how tax
revenues respond to tax rates.
First, the indirect effects we listed do offset the direct effect of
raising tax rates to a significant degree.
Second, most of this response comes from the indirect effects of
reporting, income exclusion, and compliance, and not from the
indirect effect of gross income earning.
Third, most if not all of this response comes from the rich.
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25 . 1
Why Fundamental Tax Reform?
Chapter 25 Fundamental Tax Reform
Summary: The Benefits of Fundamental Tax Reform
Fundamental tax reform such as a flat tax, or even the system put in
place by the Tax Reform Act of 1986, helps address all three of the
tax reform goals (increasing tax compliance, simplifying the tax
code, and improving tax efficiency).
By expanding the tax base and lowering tax rates, fundamental tax
reform improves tax compliance and tax efficiency.
By ending large numbers of detailed exemptions and deductions
from taxation, and taxing different forms of income at the same
rate, fundamental tax reform also makes tax filing simpler.
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25 . 2
The Politics and Economics of Tax Reform
Chapter 25 Fundamental Tax Reform
Political Pressures for a Complicated Tax Code
Political pressures for policy changes are strongest when the
winners from these changes are concentrated, well-organized, and
have much to gain, and the losers are diffuse and don’t lose much
per person.
A particularly strong pressure for tax code complication is the
perception of politicians that naïve voters are opposed to new
government spending programs but support the same goal when
financed by a tax expenditure, despite identical budget
implications.
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25 . 2
The Politics and Economics of Tax Reform
Chapter 25 Fundamental Tax Reform
Economic Pressures Against Broadening the Tax Base
tax shelters Activities whose
sole reason for existence is tax
minimization.
Background: Tax Shelters
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25 . 2
The Politics and Economics of Tax Reform
Chapter 25 Fundamental Tax Reform
Economic Pressures Against Broadening the Tax Base
Transitional Inequities
tax capitalization The change in
asset prices that occurs due to a
change in the tax levied on the
stream of returns from that asset.
transitional inequities from tax
reform Changes in the treatment of
similar individuals who have made
different decisions in the past and are
therefore differentially treated by tax
reform.
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25 . 2
The Politics and Economics of Tax Reform
Chapter 25 Fundamental Tax Reform
The Conundrum
Political and economic pressures are significant barriers to moving
to a broad-based system.
Political forces are constantly pushing for the use of the tax code to
deliver benefits to particular groups, at the cost of potentially
inefficient and inequitable holes in the tax base.
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 APPLICATION
Chapter 25 Fundamental Tax Reform
TRA 86 and Tax Shelters


TRA 86 closed many of the egregious tax shelters that had emerged in the wake of
the 1981 tax reform.

A straightforward means of doing so would have been to eliminate the tax
shelters directly, by stopping the special treatment of oil and gas investments.

This reform would have increased equity and efficiency, and would have made
the tax code simpler.
Congress addressed the shelter problem indirectly, by dividing income into three
categories: ordinary (earned) income, investment income, and passive income.


Passive income was defined as income in which the individual did not take an
active role, such as tax shelters or real estate income.
These changes were largely effective at ending the most egregious use of tax
shelters, but they came at a cost: they made the tax code more complicated.
One clear lesson is that both goals can be served if politicians take more direct routes to
improving the tax code, such as simply removing tax shelters, rather than indirect routes,
such as those pursued by TRA 86.
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Chapter 25 Fundamental Tax Reform
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25 . 4
Chapter 25 Fundamental Tax Reform
The Flat Tax
Consider the tax described in the example that opened this chapter, the flat
tax, which was first popularized by economists Robert Hall and Alvin
Rabushka in 1981. Their plan has several features:
1. Corporations pay a flat-rate VAT on their sales, but also get to deduct
wage payments to workers from their VAT tax base. There is no
corporate income tax.
2. Individuals pay a tax on labor income only, not capital income, at that
same flat rate.
3. All tax expenditures would be eliminated (health insurance
expenditures would be treated like wage payments, charitable
contributions and home mortgage interest would no longer be
deductible, and so on) and would be replaced by a single family-level
exemption.
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25 . 4
The Flat Tax
Chapter 25 Fundamental Tax Reform
Advantages of a Flat Tax
There are several major advantages of a flat tax.
The most important are the efficiency gains from having one flat rate on a
broad income definition.
The flat tax would have enormous benefits in terms of simplicity.
Compliance would also likely improve because the simpler tax system would
make it harder to find ways to evade taxes; for almost all taxpayers, their
entire tax bill could be collected through withholding from earnings.
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25 . 4
The Flat Tax
Chapter 25 Fundamental Tax Reform
Problems with the Flat Tax
The problems with the flat tax are similar to those raised with consumption
taxation.
First, while a flat tax can be made fairly progressive for low- and middleincome earners, it will be much less progressive for high-income earners than
our current system.
Second, there are difficult transition issues raised by the flat tax.
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Chapter 25 Fundamental Tax Reform
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25 . 3
Chapter 25 Fundamental Tax Reform
Consumption Taxation
taxing consumption Taxing
individuals based not on what
they earn but on what they
consume (such as through a sales
tax).
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Chapter 25 Fundamental Tax Reform
Once Considered Unthinkable, U.S. Sales Tax Gets Fresh Look
Levy Viewed as Way to Reduce Deficits, Fund Health Reform
By Lori Montgomery
Washington Post Staff Writer
Wednesday, May 27, 2009
Being discussed as a revenue source for financing health reform
Alternate revenue source for deficit
Based on European experience
Multiple concerns
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25 . 3
Chapter 25 Fundamental Tax Reform
Consumption Taxation
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25 . 3
Consumption Taxation
Chapter 25 Fundamental Tax Reform
Why Might Consumption Make a Better Tax Base?
Improved Efficiency
A single-rate sales tax could reduce many of the inefficiencies
associated with the current tax system.
A particular source of inefficiency in our current tax system is the
lack of a “level playing field” across investment choices.
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25 . 3
Consumption Taxation
Chapter 25 Fundamental Tax Reform
Why Might Consumption Make a Better Tax Base?
Fairer Treatment of
Savers and Less Distortion
to Savings Decision
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25 . 3
Consumption Taxation
Chapter 25 Fundamental Tax Reform
Why Might Consumption Make a Better Tax Base?
Simplicity
Another advantage of the consumption tax is simplicity.
In principle, it is much more straightforward to simply tax
individuals on their purchases than on a complicated definition of
income.
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25 . 3
Consumption Taxation
Chapter 25 Fundamental Tax Reform
Why Might Consumption Be a Worse Tax Base?
The efficiency, horizontal equity, and simplicity advantages of
consumption taxation are offset by five disadvantages.
Vertical Equity
Asymmetric Information
Transition Issues
Compliance
Cascading
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25 . 3
Consumption Taxation
Chapter 25 Fundamental Tax Reform
Designing a Consumption Tax
Value-Added Tax
value-added tax (VAT) A consumption
tax levied on each stage of a good’s
production on the increase in value of
the good at that stage of production.
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25 . 3
Consumption Taxation
Chapter 25 Fundamental Tax Reform
Designing a Consumption Tax
Expenditure Tax
expenditure tax A consumption tax
levied on yearly consumption rather than
on specific sales.
Backing Into Consumption Taxation: Cash-Flow Taxation
cash-flow tax A tax on the difference between cash income and savings.
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 APPLICATION
Chapter 25 Fundamental Tax Reform
The 2005 Panel on Tax Reform

In January, 2005, President Bush appointed the President’s Advisory Panel on
Federal Tax Reform, charging them to recommend options that would make the tax
code “simpler, fairer, and more conducive to economic growth.”

This panel issued a series of recommendations on November 1, 2005. In particular,
the panel proposed several fundamental changes to the structure of the tax code:
Move to a broader definition of income and flatter tax rates, simplify and condense
complicated aspects of the tax code, and reduce capital taxation.

The Tax Panel therefore proposed the following changes:
►
Replace the mortgage interest deduction with a flat 15% credit for all taxpayers
for mortgage payments up to the mean home price in the area.
►
Allow a deduction for charitable giving for all taxpayers who give more than 1%
of their income (with the goal of subsidizing marginal, rather than inframarginal,
gifts to charity).
Continued
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 APPLICATION
Chapter 25 Fundamental Tax Reform
The 2005 Panel on Tax Reform (continued)
►
Limit the exclusion of health insurance premiums from taxation to premiums
below the national average level of premiums (for example, employer-provided
insurance payments of more than $11,500 for a family would be taxed like wage
income).
►
Remove the deductibility of state and local tax payments.
►
Move from the current system of six brackets to three or four brackets.
Despite fears that this report would be highly partisan, these recommendations were
generally bipartisan and followed the recommendations that economists of all types have
been making for tax reform for years.
The panel was equally criticized for going too far (by those opposed to reducing capital
taxation on equity grounds) and for not going far enough (by those in favor of a pure
consumption tax).
The one consistent complaint about the analysis was that this plan claimed to be revenue
neutral, raising the new revenues necessary to pay for reduced capital taxation and the
removal of the AMT.
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25 . 5
Conclusion
Chapter 25 Fundamental Tax Reform
Complaints about the taxation of income in the United States abound.
The complications, economic distortions, and redistribution inherent in the
U.S. system of income taxation leave many unhappy with the income tax as
the nation’s primary source of revenue raising.
Fundamental reform of the income tax is not easy.
Moving to fundamental reform, such as replacing income taxation with
consumption taxation or a flat tax, raises difficult issues about the
appropriate trade-off between efficiency and equity in our tax code.
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