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Tax reform, federal

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

C. Eugene Steuerle
The Urban Institute

A review of the federal government experience in adjusting its revenue system to changes in the national economy, demography, and its institutional and political arrangements. The term usually refers to broad rather than piecemeal change in law.

Changes to the tax laws are almost always labeled reforms, but reform as improvement, not merely amendment, generally is based upon bringing the law into closer adherence to certain principles or goals. The public finance principles of efficiency, growth, equal treatment of those in equal situations (horizontal equity or fairness), progressivity, and simplicity provide a useful listing around which tax changes can be analyzed.

Although tax changes are put forward for many reasons, the fundamental purpose of taxation is to raise revenues. Taxes generally are not good in and of themselves. They provide the means by which government programs are financed; hence, their benefits cannot be separated from the expenditure side of the budget. By themselves, taxes nearly always distort behavior, add complications to the lives of at least some taxpayers, and, in practice, create problems of equity between some who pay and some who are equally capable of paying, but from whom payment is more difficult to extract for administrative or political reasons. Much of traditional tax reform, therefore, is aimed at minimizing the costs of taxation- reducing the inefficiencies of taxation-more than at maximizing some efficiencies it somehow adds to society.

Historical context

At the end of the 19th century and the beginning of the 20th, many federal reform efforts were aimed at displacing or replacing old taxes with new taxes. During the 19th century, government was financed primarily through tariffs. Today large tariffs are generally viewed as both unfair and inefficient, but in the earlier period they could be assessed conveniently at the time that goods were transferred from sellers to buyers, and an accounting was engaged at the port or dock. With the rise of the corporation and the large organization, however, more elaborate accounting systems allowed better assessment of returns to factors of production such as labor and capital. It was this development, more than any other, that allowed replacement of tariffs by income and wage taxes as the primary sources of revenues to the federal government. At the same time, the growth of government was also made possible in part by the ability of business to manage larger scale tax systems, whether based on income or some other measure such as value added (see value-added tax, national).

As income taxes grew in size and importance, more and more attention was paid to their design, rather than their adoption, expansion, or contraction, as a major reform option. Many fights, of course, also ensued over the size of the tax system, but the revenue goal here was closely related to how large government expenditures should be, an issue that extends far beyond tax reform. Still, budget, expenditure, and tax issues were often combined and confused. Major changes to the tax system were often the consequence of budgetary rather than tax pressures. In some periods, such as wartime, consensus on the need for expenditures left as a remaining debate only the issue of who should pay. In other periods, many policymakers argued for higher or lower taxes primarily on the basis of what expenditures could be financed. In these cases, the tax debate often could not be separated from the issue of size of government.

Another confusion in the tax reform debate often arises from considerations of the design of the tax base and its interaction with the progressivity of the system itself. While tax progressivity generally can be determined by the setting of tax rates, reform often began with statutory rates considered fixed. Hence, when the base changed, the reform often had distributional consequences across income classes even if the initial goals of reform were unrelated to redistribution. For instance, barring offsetting changes in the tax rate structure, cutting back on a particular tax preference might be favored or opposed primarily on the grounds of what it did to the relative tax burdens of the rich or poor. If rates could be adjusted, however, then the distributional issue likely can be removed, and the issue is whether the particular preference for recipient groups is better than simply lowering their taxes by the same amount.

Still another source of confusion arose over use of the tax system for growth or macroeconomic purposes versus other improvements in well-being, such as might be achieved through more standard improvements in efficiency. In the United States, these issues arose particularly in tax reform debates in the post-World War II era. In tax reform options put forward in the early 1960s, for instance, President Kennedy made a strong pitch that tax reductions would help spur the economy and produce economic growth by expanding demand. At the same time, he proposed a number of changes to the tax base to make it more inclusive of different sources of income. The macroeconomic goal at the time was associated closely with Keynesian economics, and the argument put forward was that the additional money circulating in the economy would spur demand. In 1981, President Reagan put forward a tax reform proposal that also used macroeconomic arguments. Indeed, its primary features were very similar to those adopted during the Kennedy round of tax reform in the early 1960s: rate reduction and expansion of incentives for investment in physical capital, particularly equipment. In the 1981 round, however, the justification put forward was that lower tax rates would spur suppliers of labor and capital to work harder and save more; the term "supply side" was applied to this macroeconomic argument. Thus, a similarly designed tax change was justified in both cases by an appeal to macroeconomics, yet the theory or apologetics used were very different. In 2001, President George W. Bush argued for a tax cut emphasizing rate reduction. In this case, the argument initially was supply-side in nature and involved the spending of some temporary budgetary surpluses. As recession hit, the arguments for acceleration and expansion of those cuts became increasingly centered on Keynesian notions of stimulus.

Thus, whenever the macroeconomic justification was used, as it was for many other tax reductions, it often tended to dominate not only the debate, but the outcome. The goals- an expansion of the economy, a higher rate of growth, or a quicker turn out of recession-were given priority over such issues as defining the tax base properly. The last was a longerterm objective that could always be put off until another day. Thus, in the 1960s round the question of base definition was essentially abandoned and the macroeconomic goal given preference, while in 1981 and 2001 to 2003 almost no base broadening was proposed and new preferences were added.

For many tax reformers, the issues of defining the tax base in a way that would promote efficiency, fairness, and simplicity often have been given far too little weight because of the greater attention focused on size of revenues, progressivity of the system, and macroeconomic incentives to spur either supply or demand. To these reformers, the issues could and should be separated. Given a tax base, the level of revenues and degree of progressivity could be determined by adjusting the tax rate schedule, including allowances for low-income individuals. Hence, the issue of what would be included in the base for the most part was a separable issue. If a given deduction was eliminated, for instance, any revenue raised could be offset by a reduction in rates, and any effect on progressivity could be offset by a change in the rate schedule itself.

Base broadening to include more items of income, better compliance with respect to items that were reported poorly, and reductions in preferences did receive significant attention between 1982 and 1986. At the beginning of that brief reform period, the issue was again driven by a concern that went beyond tax reform: large levels of government deficit. Several base-broadening reforms in the 1980s were enacted as part of deficit reduction bills. President Reagan’s strong antipathy to raising tax rates, coupled with Congress’s reluctance or inability to deal with entitlement types of spending, left base broadening not so much a popular option as a less unpopular choice for reducing the deficit.

Between 1984 and 1986, the nation engaged in an extensive debate over a tax reform that would center almost entirely on the tax base itself and the lower rates that might be possible if that base were appropriately expanded. The effort for the most part attempted to put aside the issues of total revenues, progressivity, and short-term macroeconomic incentives for growth. Thus, the reform was designed approximately to be "revenue neutral" and "distributionally neutral." A large number of deductions, exclusions, credits, and other preferences were either pared or eliminated. Rates were reduced significantly, but unlike the Kennedy, Reagan, or George W. Bush rounds of rate reductions, they were paid for through other tax changes. Like all reforms, the Tax Reform Act of 1986 was made possible by a combination of opportunities: a president who especially disliked high tax rates, the rapid expansion of tax shelters, the increased income taxation of the poor, and growing concerns over taxation of the family.

By the time the 1986 act was signed into law, it involved the most comprehensive reform of this type ever achieved for the income tax. According to Witte (1991), "Of the 72 provisions which tightened tax expenditures, 14 tax expenditures were eventually repealed, a figure approximately equal to the total that had been repealed from 1913 to 1985." Treasury had advocated repeal of 38 tax expenditures.

Another detailed analysis, by Neubig and Joulfaian (1988), indicated that under some simplifying assumptions, this tax reform produced the equivalent of $193 billion in tax expenditure reduction for the year 1988 alone. Base broadening was directly responsible for $77 billion of this total, and the rate reduction it made possible indirectly reduced the value of tax expenditures by the remainder.

Further reform options

Debate over federal tax reform will continue as long as there is a tax system. Many discussions in the modern era combine different reform options into a single package. Among the principal reforms suggested are the following:

Conversion of income tax to a consumption tax

Should the tax base be reduced to exclude all purchases of capital equipment and net saving? Many current proposals would begin, as a base, with a subtraction method value-added tax applied to business—that is, by taking current income and subtracting net purchases of assets (Bradford 1996). To this system could be added an individual tax—either on wages at the individual level, or a complementary consumption tax at the individual level—which essentially would attempt to allow subtraction of savings from income. Some versions of these more elaborate reforms would maintain or expand an estate tax (Aaron and Galper 1985), and, thus, could be considered more as extending the accounting period for the income tax from a year to a lifetime, rather than excluding from taxation any income that was not consumed by the person who earned it.

Value-added taxes

More narrow reforms would simply add a value-added tax (VAT) to the existing tax system. In many cases, the VAT would follow more traditional types of consumption taxes adopted in other countries. The motives are diverse— increasing revenues to support some expenditure like health care, increasing the share of government burden paid by the elderly, who now receive a substantial share of government expenditures, financing the reduction in taxes on labor or on capital, adopting a tax with a border tax adjustment (rebate of taxes) for exports, or replacing a large portion (but not all) of the income tax and moving many people off the income tax rolls (Graetz 1997).

Flat rate taxes

Still other reforms would convert the tax system into one with a single rate of tax applying to most of the tax base. Strictly speaking, most of these proposals allow some income to be taxed at a zero rate, so they are not flat. Most current proposals also are consumption tax proposals in that they allow the cost of capital equipment to be written off (expensed) right away rather than depreciated over time (Hall and Rabushka 1985); many merge into one of the consumption tax type proposals noted above. If carried out throughout the tax structure, flat taxes have the advantage of dramatically reducing the requirements for individual filing. That is, if the same rate applies to all income, it is not necessary to know to whom the income accrues. A payer-employer, bank, corporation-could simply pay over a flat rate tax on the tax base, and the amount paid over or withheld on behalf of eventual recipients would be exactly equal to the final tax owed. No filing or reconciliation would be required. This goal might also be achieved in part through essentially flat taxes on particular items of income— a schedular approach more popular in many other industrialized countries. Generally speaking, a flat rate tax would also reduce taxes for those with the highest incomes and increase the share of the tax burden borne by those with incomes in the middle range.

Income tax reform

Many reforms would expand the efforts symbolized by the 1986 tax reform and other base broadening efforts between 1982 and 1986. A primary goal would be to define the tax base in a manner considered appropriate. Often such proposals involve eliminating social preferences, cutting back on the value of various exclusions or deductions, and eliminating the taxation of items that would not legitimately be included in a system that more purely taxed income once and only once. There might be a reduction in the special preferences applied to health insurance purchased by employers, for example. Or integration of corporate and personal income taxes would eliminate the double taxation of capital income earned and paid out to equity owners of corporations.

Integration of tax and transfer systems

In recent years, there has been increased realization not only that expenditures are hidden in the tax system, but that taxes are hidden in the expenditure system. Most transfers from the government involve some sort of implicit tax. The Social Security benefit formula, for instance, provides for lower returns on taxes of higher-income individuals. Welfare systems typically phase out benefits as income rises. Means testing may be applied to a variety of health benefits. Each of these tax systems tends to develop independently, leading to a combined tax system that is little understood or appreciated. Some reforms would aim themselves more directly at determining an integrated rate structure for the systems as a whole. Here, of course, tax and expenditure reform become inseparable.

Tax simplification

Seldom, if ever, has tax reform focused primarily upon simplification. Although it was one of the goals of the 1986 reform, it was achieved only in part for moderate-income taxpayers, while filing became more complex for many businesses or individuals with significant capital income. Simplification might be sought through one of the broader reforms listed above, or it could be pursued step by step within the existing income tax framework. The large potential growth in number of taxpayers paying the alternative minimum tax Tax reform, federal 423 (AMT) in the first part of the 21st century has spurred simplification efforts, as well.

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