What are the major options for comprehensive tax reform?
In a nutshell, broaden the income base while lowering tax rates, tax consumption instead of income, or do a bit of both.
Income Tax Base-Broadening
Base-broadening involves increasing the portion of income subject to taxation. It is often accompanied by proposals to decrease tax rates. The Bowles-Simpson plan, the Tax Reform Act of 2014, and a proposal from the Domenici-Rivlin Debt Reduction Task Force all fit this category.
In calculating tax liability, taxpayers have the right to exclude portions of their income through deductions, credits, exclusions, and the preferential treatment of income from favored sources. This, of course, lowers the revenues that could be collected if all income were taxed at the given rate. There are more than 150 such “expenditures” in the tax code; the 10 largest account for approximately two-thirds of the budget impact and currently cost the government about $900 billion per year.
Switching to a Consumption Tax
A consumption levy taxes the purchase of goods or services rather than income. A move to such a system was proposed by the 2005 Panel on Tax Reform and forms the basis of Columbia University Law professor Michael Graetz’s “Competitive Tax Plan” and several other plans usually labelled as national retail sales taxes and flat taxes.
Retail Sales Tax: A national retail sales tax would levy a flat tax on all retail sales. In most proposals, the tax would have a broad base, exempting only expenditures for education, existing housing, purchases abroad by US residents, and food produced and consumed on farms. Proponents argue that the tax would be simpler to administer and create fewer economic distortions than the income tax. However, in most forms it would be regressive, disproportionately taxing low- and middle-income earners.
Value-Added Tax: Value-added taxes are collected from businesses at each stage of the production process. Under the “credit-invoice method,” all sales by businesses are taxable, while firms claim credits for all taxes paid on purchases from other businesses. The result is that the tax base is equal to the full value of the final sale to the end user. The United States is the only developed country that does not have a value-added tax, which tend to have lower administrative and compliance costs than income taxes.
Flat Tax: A flat tax is really a value-added tax divided into two parts. It was first proposed in 1983 by economists Robert Hall and Alvin Rabushka of Stanford University’s Hoover Institution. Their proposal called for a 19 percent tax at the business level on all value added other than wages. Households, for their part, would pay a 19 percent flat tax on all wages and pension benefits above a specified exemption level. The family exemption increases the progressivity of the tax. But the tax structure is regressive relative to the current system as it lowers taxes for households at the high end of income distribution.
X-Tax: The X-tax, proposed by the late David Bradford, is a variant of the flat tax. Businesses would still pay a single-rate value-added tax on all of their nonwage value added. But unlike the flat tax, the wage tax would be set at progressive rates, beginning at a zero rate and increasing until the business rate is reached. The plan would retain the earned income tax credit and the deduction for charitable contributions and would provide a credit for payroll taxes paid. A modified version of the X-tax was proposed in the 2005 reports of the President’s Advisory Panel on Tax Reform, in which the income tax would be replaced with a 30 percent tax on firms and top wage earners. (The panel would have supplemented the X-tax with a 15 percent tax on capital income earned by individuals.)
Consumed Income Tax: In general, all income can either be spent immediately or saved to be spent later. A consumed income tax would tax only current consumption, exempting all savings until it is spent. Proponents argue that the exemption of savings would encourage investment, which would increase economic growth. A variation of the consumed income tax, the Unlimited Savings Allowance Tax, was offered by Senators Sam Nunn (D-GA) and Pete Domenici (R-NM) in 1995 as a replacement for the income tax. Under their plan, households would be taxed with a progressive consumed-income tax. They would be able to deduct some education costs, mortgage interest, and charitable contributions. Businesses, for their part, would be taxed with a subtraction-method value-added tax with a flat rate of approximately 11 percent. Both households and businesses would be able to claim a payroll tax credit.
Toder, Eric, Joseph Rosenberg, and Amanda Eng. 2013. “Evaluating Broad-Based Approaches for Limiting Tax Expenditures.” National Tax Journal 66 (4): 807–832.
Gale, William G. 1999. “Flat Tax.” In Encyclopedia of Taxation and Tax Policy, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. Washington, DC: Urban Institute Press.
Gale, William, and Benjamin Harris. 2011. “A VAT for the United States: Part of the Solution.” In The VAT Reader: What a Federal Consumption Tax Would Mean for America, 64–82, Falls Church, VA: Tax Analysts.