Tax Reform for Fairness, Simplicity and Economics Growth

Volume I 

Overview 

Office of the Secretary 

Department of the Treasury 

November 1984

THESECRETARYOFTHETREASURY 

WASHINGTON DC 20220 

November 27, 1984 

Dear Mr. President: 

I am pleased to submit the Treasury Department's Report 

on Fundamental Tax Simplification and Reform that you 

requested in your State of the Union address in January. It 

contains proposals for a broad-based income tax that would 

allow us to lower marginal tax rates for individuals by an 

average of 20 percent and the corporate rate from 46 percent 

to 33 percent. The proposals would make the tax system 

simpler, fairer, and more economically efficient. 

The present U.S. income tax is complex, it is 

inequitable, and it interferes with economic choices of 

households and businesses. It is also widely perceived to 

be unfair. Because this perception undermines taxpayer 

morale, it may be as important as the actual defects of the 

system. 

In your State of the Union address, you said: 

"To talk of meeting the present situation by increasing 

taxes is a Band-Aid solution which does nothing to cure 

an illness that has been coming on for half a century, 

to say nothing of the fact that it poses a real threat 

to economic recovery.... 

There is a better way: Let us go forward with an 

historic reform for fairness, simplicity and incentives 

for growth. I am asking Secretary Don Regan for a plan 

for action to simplify the entire tax code so all 

taxpayers, big and small, are treated more fairly.... I 

have asked that specific recommendations, .;onsistent 

with those objectives, be presented to me by December 

1984." 

Further we believe we have followed your mandate of May 

1984 to design a sweeping and comprehensive reform of the 

entire tax code. The Treasury Department study focused on 

four options: a pure flat tax, a modified flat tax, a tax 

on income that is consumed, and a general sales tax, 

including a value-added tax and retail sales taxes. 

iii

The objectives of our study included: lower marginal 

tax rates; reduced interference with private economic 

decisions; simplicity; revenues equal to those of the 

existing tax system; fairness for families; equal treatment 

of all sources and uses of income; an unchanged distribution 

of tax burdens across income classes; and encouragement to 

economic growth. 

We believe that our proposals for a modified flat tax 

best reconcile these competing objectives. They include 

some features that are similar to those in flat tax pro 

posals that have been offered by members of Congress, but 

our proposals are much more comprehensive. 

The adoption of these reforms should have far reaching 

and positive effects on the U.S. economy. Rate reductions 

of the magnitude we propose will open wide the doors of 

opportunity to those who are willing to work, to save and 

invest, arid to innovate. With investment decisions being 

determined by economic consequences, rather than by the tax 

system, capital will be allocated more efficiently across 

industries, and growth will accelerate. 

If tax reform is not adopted, the complexities, inequities, 

and distortions of the present system will increase 

and continue to hinder our nation's progress. Moreover, 

taxpayer morale will continue to deteriorate, and the socalled 

tax gap will grow. 

The proposals presented in this Report form an integrated 

package. In some cases neutrality between competing 

industries can be achieved only if the special preferences 

benefitting each industry are eliminated. In other cases, 

changes are mutually dependent and must occur together to 

avoid inequities, distortions, and extraordinarily complex 

administrative rules arid increased compliance costs to taxpayers. 

Most importantly, any change in the package inevitably 

means that the proposed rate structure must be 

redesigned in order to keep tax burdens constant -- in total 

and across income classes. Each credit, deduction or 

deferral of tax that is retained in current law means that 

tax rates higher than those proposed in the Report will be 

necessary to attain the same level of revenues, Moreover, 

if any special tax benefits are left intact, it will be more 

difficult to resist appeals by others for special treatment. 

These proposals are bold, and they will be controver 

sial. Those who benefit from the current tax preferences 

that distort the use of our nation's resources, that compli 

cate paying taxes for all of us, and that create inequities 

iv

and undermine taxpayer morale will complain loudly and seek 

support from every quarter. But a far greater number of 

Americans will benefit from the suggested rate reduction and 

simplification. The achievement of fundamental tax reform 

-- and the manifest benefits it would entail -- will require 

extraordinary leadership. 

I am fully convinced that these proposals constitute the 

substance of tax simplification and reform that this nation 

so badly needs. I look forward to working with you and 

others to secure their enactment. 

Respectfully, 

Donald T. Regan 

The President 

The White House 

Washington, D.C. 

20500 

V

Summary of Proposals 

Introduction 

The present U.S. tax system desperately needs simplification and 

reform. It is too complicated, it is unfair, and it retards savings, 

investment, and economic growth. 

under the current progressive tax system, all taxpayers face 

higher marginal tax rates in order to make up for the revenue lost by 

numerous special preferences, exceptions, and tax shelters used by a 

relatively small number of taxpayers. 

AS a result, the tax system is complex and inequitable. It 

reduces economic incentives, hampers economic growth, and is perceived 

to be so unfair that taxpayer morale and voluntary compliance have 

been seriously undermined. 

As requested by President Reagan in his 1984 State of the Union 

Address, the Treasury Department has completed a thorough review of 

the U.S. tax system. This summary outlines the Department's 

proposals for a fundamental reform and simplification of the income 

tax system which wouLd raise approximately the same amount of revenues 

as current law with lower tax rates imposed on a broader tax base. 

The Treasury Department is proposing a new income tax system 

which is broad-based, simple, and fair. It reflects the enormous 

public input generated by a series of public hearings held throughout 

the country. 

The Treasury Department's recommendation reflects the broad 

political consensus of the American people that the present system is 

too complicated and favors special interests at the expense of the 

general public. While much more comprehensive and far-reaching than 

other proposals, it resembles several plans for tax reform advanced by 

members of Congress, especially the Kemp-Kasten and Bradley-Gephardt 

plans. This bipartisan congressional consensus augurs well for quick 

action by the Congress. 

Tax Simplification and Reform for Individuals 

The Treasury Department proposals combine lower tax rates, 

increased personal exemptions, and zero bracket amounts with the 

repeal O L modification of a number of existing deductions, exclusions 

and credits. The proposal does not generally change the distribution 

of individual tax burden across income classes, though it does reduce 

tax burdens more than proportionally for taxpayers with the lowest 

incomes. 

vii

Rate Structure 

The Treasury Department proposal replaces the present 14 brackets 

of tax rates ranging from 11 to 50 percent with a simple three-bracket 

system with tax rates set at 15, 25 and 35 percent. (See Tables S-1 

and S-2.) 

Fairness for Families 

In order to provide greater fairness for families, the Treasury 

Department proposal will increase the personal exemption for all 

taxpayers and their dependents to $2,000 and increase the zero bracket 

amounts to $2,800 for singles, $3,800 for joint returns, and $3,500 

for heads of households. 

These adjustments will virtually eliminate from taxation families 

with incomes below the poverty level. The individual tax brackets, 

the personal exemption, and the zero bracket amount would continue to 

be indexed. 

Impact on Individuals 

Under the proposal, 78 percent of all taxpayers will experience 

either no tax change or a tax decrease, and 22 percent will face 

higher taxes. Of those facing a tax increase, more than half will 

experience a tax increase of less than one percent of income. 

On average, marginal tax rates will be reduced by about 20 

percent and individual tax liabilities will be reduced by an averaqe 

of 8.5 percent. Because of the increased tax-free threshold, the 

average tax reductions are greater at the bottom of the income scale. 

Tax liabilities of families with incomes below $10,000 will be reduced 

by an average of 32.5 percent, and the reduction in taxes for families 

with incomes of $10,000 to $15,000 will be 16.6 percent. 

Broadening the Base 

In order to broaden the base, simplify the tax system, and 

eliminate special preferences and abuses, the Treasury Department 

proposals would modify or repeal a number of itemized deductions, 

exclusions, and special tax credits. 

These changes generally involve special preferences which are not 

used by the majority of individual taxpayers and include various 

fringe benefits, wage replacement payments, preferred uses of income, 

business deductions for personal expenses such as entertainment, and 

other areas of abuse. 

For most taxpayers who do itemize deductions, the marginal rate 

reductions and the increased personal exemption will offset the 

benefits lost from the various proposed reforms. However, those 

taxpayers who consistently make above-average use of deductions and 

exclusions to shelter their income in order to avoid paying a fair 

share of the tax burden will face an increase in taxes. 

viii

The Treasury Department proposal retains the existing itemized 

deductions above certain floors for medical expenses and for casualty 

losses. 

The home mortgage interest deduction is retained for a taxpayer’s 

principal residence. Certain other interest deductions, 

includins consumer interest and interest on second homes, are allowed 

up to $5;000 in excess of investment income. 

The itemized deduction for charitable contributions is retained, 

but allowed only for charitable contributions in excess of two -percent 

of adjusted gross income. 

The deduction for contributions to an Individual Retirement 

Account is retained and increased from $2,000 to $2,500 per employee 

The current $250 spousal IRA limit would be increased to $2,500 for 

spouses working in the home. 

The Social Security benefit exclusion, which generally excludes 

from taxation Social Security benefits, would be retained. 

The existing child care credit would be replaced with a child 

care deduction. 

The earned income tax credit would be retained and indexed for 

inflation. 

A new, single credit for the elderly, blind and disabled would be 

provided, and the current exclusions for workers’ compensation, and 

?or black lung and certain veterans’ disability payments would be 

folded into the credit. 

The two-earner deduction, no longer necessary under the revised 

rate brackets, would be repealed. 

The current exclusions for employer-provided pension and profit- 

sharing plans are retained as are the treatment of certain hard-to- 

value fringe benefits specifically addressed in the Deficit Reduction 

Act Of 1984. 

The exclusion of health insurance benefits would be retained, but 

capped at $70 per month for singles and $175 per month for a family. 

This change would affect only about 30 percent of all employees with 

such plans. 

The special exclusion of group-term life insurance and the 

special treatment of cafeteria plans would be repealed, as would the 

exclusion of other employer-provided fringe benefits, such as 

educational benefits, legal services, and dependent care. 

The tax-exempt threshold for unemkloyment compensation, currently 

set at $18,000 for a joint return, would be repealed. It is not fair 

that those receiving unemployment compensation pay no tax, while those 

ix

with equal incomes who work pay tax. With the personal exemption and 

zero bracket amount increased to $11,800 for a family of four, the 

impact of this change on low and moderate income taxpayers would be 

minimal. 

Itemized deductions for all state and local taxes would be 

repealed. These deductions are claimed on only a minority of tax 

returns, and disproportionately benefit higher income individuals in 

high-tax states and localities. 

The use of business deductions for personal expenses would be 

curtailed. Deductions for entertainment would be denied, and deduc 

tions for business meals would be limited. 

Income Distribution 

The Treasury Department proposals are designed to be basically 

neutral from a distributional point of view. The table below shows 

that the distribution of individual income tax burdens does not differ 

significantly from that under current law. 

Percent of Total Income Taxes Paid 

Income Class (0001 Current Law Treasury Proposal 

$ 0-10 

10-15 

15-20 

20-30 

30-50 

50-100 

100-200 

200+ 

Average Tax Rates 

0.5% 0.3% 

1.8 1.6 

3.3 3.1 

10.3 10.2 

24.3 24.1 

32.8 33.1 

12.3 12.6 

14.9 15.0 

The proposed tax reforms will reduce individual tax liabilities 

for all income classes by an average of 8.5 percent. However, those 

at the bottom of the income scale will receive substantial tax reductions, 

and those with incomes up to $50,000 will experience aboveaverage 

reductions in tax liability, as the following table shows. 

X

Average Tax Rate by Income Class 

Income Class (000) Current Law Treasury Proposal Change 

$ 0-10 1.4% 0.9% -32.5% 

10-15 3.2 2.7 1 -16.6 

15-20 4.6 4.0 -12.1 

20-30 6.2 5.7 - 9.1 

30-50 7.8 7.0 - 9.3 

50-100 9.4 8.7 - 7.4 

100-200 13.2 12.3 - 6.4 

200+ 20.9 19.3 - 8.0 

marginal Tax Rates 

The Treasury proposal would reduce marginal tax rates by an 

average of nearly 20 percent. Although marginal tax rates are reduced 

by a larger percent for those at the top, these income groups will 

experience smaller than average tax reductions, as shown in the 

preceding table. Marginal tax rates fall furthest at the top of the 

income distribution because that is where the tax base is increased by 

the largest fraction. 

Marginal Tax Rate by Income Class 

Income Class (000) Current Law Treasury Proposal Change 

$ 0-10 4.2% 3.7% -11.9% 

1045 9.4 8.5 - 9.6 

15-20 12.4 11.0 -11.3 

20-30 16 .O 14.0 -12.5 

30-50 20.9 16.5 -21.1 

50-100 27.6 22.1 -19.9 

100-200 37.5 30.5 -18.7 

200+ 46.1 33.2 -28.0 

Tax Simplification 

The Treasury proposal repeals or consolidates about 65 provisions 

in the tax Code. It eliminates the need for at least 16 tax forms and 

10 lines from the 1040 form. 

The proposed changes will reduce the number of individual 

taxpayers who itemize their deductions from 36 percent to fewer than 

25 percent of all individual taxpayers. 

In addition, the Internal Revenue Service is proceeding to 

develop a return-free tax system. Under such a system, the IRS would, 

at the election of the taxpayer, compute the tax liability of most 

taxpayers based on withholding and information reports. Institution 

of a return-free tax system could eliminate the actual filing of tax 

returns for half or more than half of all taxpayers. 

xi

Reform of Capital and Business Income 

The taxation of capital and business income in the United States 

is deeply flawed. It lacks internal consistency, and it is ill-suited 

to periods when inflation rates have varied and been unpredictable. 

It contains subsidies to particular forms of investment that distort 

choices in the use of the nation's scarce capital resources. It 

provides opportunities for tax shelters that allow wealthy individuals 

to pay little tax, undermine confidence in the tax system, and further 

distort economic choices. Equity investment in the corporate sector 

is placed at a particular disadvantage by the double taxation of 

dividends. Resulting high marginal tax rates discourage saving, 

investment, invention, and innovation. Moreover, high marginal rates 

encourage efforts to obtain additional special tax benefits which, if 

successful, further erode the tax base and necessitate higher rates in 

a never-ending cycle. 

The Treasury Department's tax reforms would rationalize the 

taxation of income from business and capital. An overriding objec 

tive is to subject real economic income from all sources to the same 

tax treatment. 

Implementation of the reforms proposed by the Treasury Department 

would cause improved reallocations of economic resources. The lower 

tax rates made possible by base-broadening and the more realistic 

rules for the measurement of income and calculation of tax liabilities 

will increase the attractiveness of industries that suffer under the 

weight of the current unfair and distortionary tax regime. Both 

established industries and new "high-tech" industries will benefit 

from tax reform. But the ultimate beneficiaries will be the American 

public. No longer will the nation's scarce economic resources--its 

land, its labor, its capital, and its inventive genius--be allocated 

by the tax system, instead of by market forces. The result will be 

more productive investment, greater opportunities for employment, more 

useful output, and faster economic growth. 

Lower Corporate Tax Rates 

The Treasury Department's proposals would allow the corporate tax 

rate to be reduced to 33 percent. All corporations would be subject 

to this single rate, which is 2 percentage points below the proposed 

top individual rate. 

Capital Gains 

Capital gains on assets he16 for at least a prescribed period have 

long benefitted from preferential tax treatment. Partial exclusion of 

capital gains has been justified by the need to avoid taxing 

fictitious gains that merely reflect inflation. 

The Treasury Department approach to the inflation problem is more 

direct--and therefore more equitable and more neutral. Under it the 

xii

asis (original cost) of assets used in calculating gains would be 

adjusted for inflation, so that only real gains would be subject to 

tax. With this inflation adjustment and a rate structure with only a 

few wide income brackets in place, there would be little need for 

preferential tax treatment of realized capital gains. Investment in 

capital assets will continue to enjoy the substantial benefits of 

deferral of tax until gains are realized. At even moderate rates of 

inflation, the taxation of real gains as ordinary income at the 

proposed rates is more generous than the taxation of nominal gains at 

the current preferential rates. The reduced rates proposed in this 

report would alleviate any problems of lock-in and bunching. 

Capital Consumption Allowances 

The investment tax credit (ITC) and the accelerated cost recovery 

system (ACRS) were introduced to stimulate investment and prevent 

capital consumption allowances from being eroded by inflation. Since 

the present tax system does not adjust the basis of depreoiable assets 

for inflation, these provisions were required to prevent confiscatory 

taxation of income from capital. 

At the lower rates of inflation prevailing today, the ITC and ACRS 

allow investment in depreciable assets to be recovered far more 

rapidly than under a neutral system of income taxation. As a result, 

the tax system favors industries that invest heavily in depreciable 

assets such as equipment over others such as high technology indus 

tries, service industries, and the trade sector that invests more 

heavily in inventories. 

Because the advantages of the ITC and ACRS are "front-loaded," 

these provisions are of relatively little value to new and rapidly 

growing firms or to ailing industries, neither of which can fully 

utilize their benefits. New firms are penalized and there are incen 

tives for tax-motivated mergers. The result is reduced competitive 

ness and less incentive for innovation. The front-loading of tax 

benefits also leads to the proliferation of tax shelters, many of 

which are abusive and create severe administrative burdens for the 

Internal Revenue Service. 

To assure that capital consumption allowances will be more nearly 

appropriate, regardless of the rate of inflation, the Treasury Depart 

ment proposes that the investment tax credit be repealed, that the 

basis of depreciable assets be indexed for inflation, and that 

depreciation allowances for tax purposes be set to approximate 

economic depreciation. 

Relief for Double Taxation of Dividends 

Under present law equity income originating in the corporate 

sector is taxed twice--first as corporate profits and then as divi 

dends. This double taxation of dividends discourages saving and 

discriminates against investment in the corporate sector. The 

Treasury Department proposes that the United States do what many other 

xiii

developed countries do, continue to levy the corporate income tax on 

earnings that are retained, but provide partial relief from double 

taxation of dividends. The proposal allows corporations to deduct a 

portion of the dividends paid out of previously-taxed earnings. 

subsidies for Specific Industries 

Certain industries benefit from special tax preferences that have 

no place in a comprehensive income tax. These include the energy and 

financial sectors. Moreover, the exclusion of interest on bonds 

issued by state and local governments for private purposes detracts 

from the fairness of the tax system, as well as distorting capital 

flows. 

Energy 

To be consistent with the goal of increased reliance on 

free-market forces underlying both this Administration's energy policy 

and these proposals for fundamental tax reform, the Treasury 

Department proposes that expensing of intangible drilling costs and 

percentage depletion should be replaced by cost depletion. The 

proposed rules are identical to proposed changes in the general rules 

for income measurement for all multi-period production, which require 

cost capitalization in order to match deductions with taxable 

receipts. 

Consistent with our objective to make the tax system neutral, the 

Treasury Department proposes to accelerate the phase-out of the 

Windall Profits Tax to 1988. 

Financial Institutions 

The Treasury proposal repeals the preferential tax treatment 

available to most types of financial institutions. Besides being 

unfair and distortionary, relative to the taxation of the rest of the 

economy, these tax preferences create distortions within the financial 

sector that are inconsistent with the Administration's efforts to 

deregulate financial markets. Equity and neutrality demand that all 

financial institutions be taxed uniformly, on all of their net income. 

These special preferences are especially inappropriate in a world in 

which the corporate tax rate is lowered and both individuals and other 

corporations are taxed more nearly on their economic income. 

These special preferences are especially inappropriate in a world in 

which the corporate tax rate is lowered and both individuals and other 

corporations are taxed more nearly on their economic income. 

State and Local Government .Bonds 

Interest ord debt issued by state and local governments for public 

purposes, such as schools, roads and sewers ("public purpose municipal 

bonds"), has long been exempt from tax. State and local governments 

have recently axpanded the use of tax-exempt bonds in ways that do not 

have any "public" purpose. Proceeds from tax-exempt bonds have been 

xiv

used for economic development (via industrial development bonds or 

IDBS), for low-interest mortgages on owner-occupied housing, for 

student loans, and for private hospital and educational facilities. 

In addition, state and local governments have routinely invested 

proceeds of tax-exempt bonds in higher-yielding taxable securities to 

earn arbitrage profits. 

The Treasury Department proposal would subject to tax the future 

issuance of all "private purpose" tax-exempt bonds and tighten the 

restrictions on arbitrage. 

The elimination of private purpose bonds should be of financial 

benefit to state and local governments. Reducing the volume of 

tax-exempt bonds will improve the market for public purpose bonds, 

thus reducing interest costs to governments. 

Curtailment of Tax Shelters 

As a result of the growth in tax shelter activity, there has been 

a significant erosion in the base of the Federal income tax, particularly 

among taxpayers with the highest incomes. Estimates from the 

1983 Treasury individual tax model indicate that partnership losses 

may shelter as much as $35 billion of all individual income from 

taxation. Roughly 82 percent of this total, or $28.6 billion in 

partnership losses were reported by taxpayers with gross incomes 

(before losses) of $100,000 or more, and 60 percent, or $21.0 billion, 

were reported by taxpayers with incomes in excess of $250,000. By 

comparison, these groups reported 9 percent and 4 percent, respectively, 

of all gross income before losses reported by individuals. 

Several of the Treasury Department's proposals--for example, lower 

tax rates, taxation of real capital gains as ordinary income, capital 

consumption allowances that approximate economic depreciation, 

indexing of net interest expense, matching expenses and receipts from 

multiperiod production, and tax treatment of certain large 

partnerships as corporations--will greatly reduce the attractiveness 

of tax shelters. Yet opportunities for tax shelters will remain, 

and several proposals are being made to further reduce these 

opportunities. 

xv

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xvii

Comuarison of Current Law 

and-Treasury Proposal Highlights 

1986 Current Law Treasury Proposal 

INDIVIDUAL TAX RATES i4 rate brackets 3 rate brackets 

from 11 to 50% 15, 25 & 35% 

EXEMPTIONS 

Self, spouse 

Dependents 

$1,090 

$1,090 

$2,000 

$2,000 

$2,510 $2,800 

$3,710 $3,800 

$2,510 $3,500 

INDEXED RATE BRACKETS, Yes Yes 

EXEMPI'IONS AND ZBA 

PERSONAL DEDUCTIONS 

Mortgage Interest Yes Yes, for principal 

residences 

Other personal intecest Limited to $5.000 

over investment income 

Medical expenses Yes (above 5% of Yes (above 5% Of AGI) 

AGI) 

Charitable contributions Yes Yes (above 2% Of AGI) but 

no deduction for 

unrealized gains on contributed 

property. 

State and local income tax Yes NO 

Other State and local Yes NO, unless incurred in 

taxes 

income-producing activity I 

Iwo-earner deduction Yes NO 

OI'IiER INDIVIDUAL IIEMS 

Earned Income Credit Yes Yes, indexed 

Child Care Credit Yes Deduction 

Unemployment Compensation Taxed if AGI over Taxed 

$12.000 ($18,000 

if marcied) 

Workers' Compensation Not taxed Taxed, but eligible for 

special credit for elderly 

and disabled 

Entertainment expenses Deducted NO 

Business Meals and 

Deducted 

Capped 

Travel Expenses 

Income shifting 

to children and 

Pemissible Curtailed 

via trusts 

xviii

RETIREMENT SAVINGS 

IRA 

spousal IRA 

$2,000 $2,500 

$ 250 $2,500 

corporate pensions 

social Security 

FRINGE BENEFITS 

Health insurance 

Group life and legal 

insurance 

CAPITAL AND BUSINESS INCOME 

Corporate Tax Rates 

Tax deferred 

Generally not taxed 

Excluded 

Excluded 

Graduated, up to 46% 

Tax deferred 

Generally not taxed 

Capped Exclusion 

Taxed 

33% flat rate 

Dividend relief 

$lOO/ZOO exclusion Exclusion repealed: 50% 

dividend-paid deduction 

Depreciation 

ACRS 

Economic depreciation, 

indexed 

Investment Tax Credit 

' capital gains 

6% - 10% Repealed 

60% excluded Indexed, taxed as ordinary 

income 

Interest income/expense 

Rehabilitation and energy 

credits 

Inventory accounting 

LIFO conformity required 

FIFO 

Uniform production 

cost rules 

Bad debt reserve 

deduction 

Installment sales 

OIL INDUSTRY 

Percentage depletion 

Expensing of intangible 

drilling costs 

Windfall profits tax 

FINANCIAL INSTITUTIONS 

special bad debt deduction 

Deduction or interest 

to carry tax-exempts 

Exemption of credit 

unions 

Fully taxed/deducted. 

Yes 

Yes 

Not Indexed 

NO 

Yes 

Deferral 

Yes 

Yes 

Yes 

Yes 

Yes 

Yes 

Indexed, partially 

excludable/nondeductible 

NO 

NO 

Indexed 

Yes 

NO 

No deferral if 

receivables pledged 

No: Indexed cost 

depletion 

NO 

Accelerate phase-out 

NO 

NO 

NO 

Deferral for life insurance Yes 

investment income and 

annuity income 

NO 

MUNICIPAL. BONDS 

Public purpose 

rax-exempt 

Tax-exempt 

Private purpose Tax-exempt Taxed 

xix

summary of proposals 

TABLE OF CONTENTS 

Volume One 

Page 

vi i 

Chapter 1: THE NEED FOR TAX REFORM: BACK TO BASICS 1 

The Federal Income Tax in 1954 

The Decline in Simplicity 

Erosion of the Tax Base 

Economic Distortions 

Inequities 5 

Unfair Treatment of the Family 5 

Inflation and the Income Tax 6 

The Rise of Tax Shelters 6 

The Decline in Taxpayer Morale 9 

Needed: Taxes That are Broad-based, 

Simple, and Fair 

11 

Chapter 2: GOALS OF FUNDAMENTAL TAX REFORM 13 

Economic Neutrality 13 

Lower Tax Rates 13 

Revenue Neutrality 14 

Equal Treatment of Equals 14 

Fairness for Families 14 

Fairness Across Income Classes 14 

Simplicity 15 

Perceived Fairness 16 

An Inflation-Proof Tax Law 17 

Neutrality Toward Business Form 10 

Economic Growth 10 

Trade-offs 10 

Fair and Orderly Transition 19 

Addendum: Implications for Spending 20 

Chapter 3: THE FOUR OPTIONS 21 

I. The Pure Flat Tax . 21 

A. Advantages of the Flat Tax 21 

B. Distributional Inequity of the Pure Flat Tax 21 

11. Reconcili,ation: The Modified Flat Tax 23 

A. Questions Common to Income and Consumed Income 

Tax 25 

8. Advantages of a Comprehensive Measure of 

Income 25 

C. Distributional Neutrality 26 

D. Issues in Income Measurement 26 

xxi

Page 

E. Disparities in Effective Tax Rates 21 

F. Simplification 28 

111. Consumed Income Tax 30 

A. Administrative Advantages 30 

B. Economic Advantages 31 

C. Transition Problems 31 

D. Perception Problems 32 

E. Complexity for Individuals 32 

F. The Dilemma of Gifts and Bequests 33 

G. International Aspects 33 

IV. Sales Tax 

33 

Chapter 4: SUMMARY OF TREASURY DEPARTMENT PROPOSALS 

AND THEIR EFFECTS 

31 

I. The Proposals in Brief 31 

A. Individuals 31 

B. Taxation of Capital and Business Income 40 

C. Economic Effects 42 

D. Transition 43 

11. Effects on Revenues 44 

111. Effects on Income Distribution and Incentives 46 

APPENDIX 4-A: Explanation of Concept of Economic Income 

Used in Distribution Tables 51 

APPENDIX 4-B: Provisions Included in the Distributional 

Analysis in Tables 4-3 and 4-4 

Chapter 5: INCOME TAX REFORM AND SIMPLIFICATION FOR 

INDIVIDUALS AND FAMILIES 

61 

63 

I. Summary 63 

11. Rate Reduction 63 

111. Fairness for Families 66 

IV. Fair and Neutral Taxation 73 

A. Excluded Sources of Income 13 

1. 

2. 

3. 

4. 

5. 

6. 

I. 

Fringe Benefits 13 

Retirement Savings 74 

Wage Replacements 75 

Scholarships and Fellowships 76 

Capital Gains 

I6 

Interest Indexing 

I1 

Dividends Received Exclusion 

I1 

B. Preferred Uses of Income I7 

1. State and Local Taxes 78 

2. Charitable Contributions 81 

3. Interest Expense 83 

4. Simplification Benefits 83 

xxii

Page 

C. Abuses 84 

1. Mixed Personal and Business Expenses 84 

2. Income Shifting 85 

IV. Simplification 86 

A. A Return-Free System 86 

B. Other Simplification for Individuals 86 

V. Reducing Noncompliance ai 

A. The Tax Gap 87 

B. Amnesties 91 

APPENDIX 5-A: List of Proposed Reforms: Income Tax 

Reform and Simplification for Individuals 

93 

Chapter 6: 

BASIC TAXATION OF CAPITAL AND BUSINESS INCOME 97 

I. Summary 97 

11. Lower Corporate Tax Rates 97 

111. Taxing Real Economic Income 98 

A. Capital Gains 100 

8. Capital Consumption Allowances 105 

C. Inventories 109 

D. Indexing Interest 111 

IV. Retirement Savings 

116 

V. Neutrality Toward Form of Business Organization 117 

A. Relief for Double Taxation of Dividends 118 

8. Tax Treatment of Large Partnerhips 120 

APPENDIX 6-A: List of Proposed Reforms: Basic Taxation of 

Capital and Business Income 

123 

Chapter 7: 

INDLJSTRIES - SPECIFIC SUBSIDIES, TAX SHELTERS, 

AND OTHER TAX ISSUES 

125 

I. Introduction 125 

11. General Issues of Income Measurement 126 

A. Multiperiod Production 126 

9. Use of Cash Method of Accounting 128 

C. Bad Debt Deductions 129 

D. Installment Sales 129 

E. Corporate Minimum Tax 130 

111. Subsidies for Specific Industries 130 

A. Energy and Other Minerals 130 

9. Financial Institutions 132 

C. Debt of State and Local Governments 135 

D. Special Rules 137 

IV. Further Curtailment of Tax Shelters 

138 

A. Limiting Interest Deductions 140 

B. At-Risk Rul.es 141 

V. International Issues 142 

xxiii

Page 

VI. Other Tax Issues 144 

A. Transfer Taxation 144 

B. Penalties 146 

C. Expiring Provisions 146 

D. Social Security Issues 146 

E. Items Not Included in the Tax Reform Proposal 147 

APPENDIX I-A: List of Proposed Reforms: Industry-Specific 

Subsidies, Tax Shelters and Other Tax Issues 149 

Chapter 8: COMPARISON WITH OTHER TAX REFORM PLANS 153 

I. Individual Income Tax 154 

A. Income Tax Rates 154 

8. Fairness for Families 154 

C. Fair and Neutral Taxation 156 

1. Excluded Sources of Income 156 

2. Preferred Uses of Income 151 

D. Tax Abuses 158 

E. Simplification 158 

1. The Return-Free System 159 

2. Other Simplification 158 

11. Basic Taxation of Business and Capital Income 159 

A. Corporate Tax Rates 159 

8. Investment Tax Credit 160 

C. Income Measurement: Inflation Adjustment 160 

D. Retirement Savings 161 

E. Neutrality Toward Form of Business 

Organization 162 

111. Industry - Specific Subsidies, Tax Shelters, and 

Other Tax Issues 163 

A. General Issues of Income Measurement 163 

B. Subsidies to Specific Industries 164 

1. Energy and Natural Resources 164 

2. Financial Institutions 165 

3. Insurance Investment Income 165 

4. State and Local Debt and Investments 165 

5. Other Specific Subsidies 166 

C. Further Curtailment of Tax Shelters 166 

D. International Issues 166 

IV. Other Tax Issues 16 7 

A. Taxation of Transfers 16 '7 

8. Expiring Provisions 168 

APPENDIX 8-A: Comparison of Treasury Proposal with 

Congressional Tax Reform Bills 169 

APPENDIX 8-B: Summary of Tax Reform Bills Introduced 

During the 98th Congress 185 

xxiv

Chapter 9: CONSUMED INCOME TAX 

Page 

191 

I. Consumed Income Tax Base, Rates, and 

Administration 

192 

A. The Tax Base 192 

B. Tax Rates 194 

C. Administration 194 

11. Advantages of A Consumed Income Tax 195 

A. Administrative Advantages 195 

B. Economic Advantages 198 

C. Equity Advantages 199 

111. Disadvantages of a Consumed Income Tax 200 

A. Administrative Disadvantages 200 

B. Economic Disadvantages 205 

C. Equity Disadvantages 209 

D. Transition Problems 210 

IV. Conclusions 

211 

Chapter 10: VALUE-ADDED TAX AND RETAIL SALES TAX 

213 

I. Introduction 213 

11. Alternative Forms of Sales Tax 213 

A. Retail Sales Tax 213 

B. Value-Added Tax 214 

C. Advantages of Uniform Rates 216 

D. Sales Taxes unworthy of Consideration 211 

111. Pros and Cons of a National Sales Tax 219 

A. Advantages of a Sales Tax 219 

B. Disadvantages of a Sales Tax 220 

1. Growth of Government 220 

2. Regressivity 221 

3. Effect on Prices 221 

4. Administrative Costs 221 

5. Federal Pre-Emption 221 

IV. Relevance of the European Experience 

222 

v. Tax Base and Revenue Potential 222 

VI. Reducing Regressivity 

223 

VII. Value-Added Tax versus Retail Sales Tax 

224 

vIII.Implementation 

226 

IX. Conclusions 

226 

APPENDIX A: Effective Dates and Transition Rules 229 

APPENDIX B: 

Fundamental Tax Reform: 

Change in Receipts by Source 

APPENDIX C: summary of International Comparisons 

xxv 

245 

255

Page 

TABLES 

1-1 

3-1 

3-2 

3-3 

4-1 

4-2 

4-3 

4-4 

4A-1 

5-1 

5-2 

5-3 

5-4 

5-5 

6-1 

How Tax Shelter Losses Reduce Gross Income 

Percentage Distributions of Individual Income Tax 

Liability Under Current Law, Pure Flat Tax and 

the Treasury Department Proposal, by Economic 

Income Class of Families 

Changes in Tax Resulting from a Pure Flat Tax 

and the Treasury Department Propsoal Distributed 

by Family Economic Income Class 

Illustration of Gisparities in Effective Tax 

Rates 

Proposed Tax Rates for 1986 

Unified Budget Receipts 

Distribution of Adjusted Gross Income, Taxable 

Income, Income Tax, and Tax Rates Under Present 

Law and Under Tax Reform Proposal 

Distributio of Families by Change in Tax as 

a Percent of Income Comparing the Tax Reform 

Proposal with 1986 Present Law 

Economic Income Equals 

Proposed Tax Rate Schedule and 1986 Current 

Law Rate Schedules 

Comparision of Personal Exemptions and Zero 

Bracket Amounts Under Current Law and Treasury 

Proposal 

Comparision of the Poverty Threshold and the 

Tax Free Level of Income Under Current Law 

and the Treasury Proposal 

Floors for Deductions on Individual Income Tax 

Returns 

Income Tax Gap -- 1981 

Effective Tax Rates or. Realized Capital Gains 

Under Current Law for 50 Percent Bracket 

Taxpayer with Different Real Rate of Return 

Assumptions 

10 

22 

24 

29 

38 

45 

41 

54 

59 

65 

67 

'70 

79 

88 

103 

xxvi

Page 

6-2 

6-3 

6-4 

6-5 

676 

6-7 

7-1 

10-1 

A- 1 

c-1 

Effective Tax Rates on Equity-Financed 

Investments with Various Rates of Inflation 

For a 46 Percent Taxpayer Under Current Law 

Effective Tax Rates on Equity Finance Investments 

in Equipment and Structures by Industry with 

Various Rates of Inflation for a 46 Percent 

Taxpayer Under Current Law 

Effective Corporate and Personal Income Tax 

Rates on Equity Financed Investment 

Effective Corporate Income Tax Rates 

Inventories as Percent of Total Physical Assets 

and Depreciable Assets 

Fractional Exclusion Rate Table 

Effective Tax Rate on Income Deferred by a 

50 Percent Taxpayer for Different Deferral 

Periods and Interest Rates 

Illustration of a Retail Sales Tax and a 

Value-Added Tax 

Effective Dates and Transition Rules 

Summary Comparision of Selected Aspects of 

Different Countries' Tax Systems 

107 

108 

110 

112 

113 

115 

127 

215 

233 

258 

xxvii

FIGURES 

Page 

1-1 Growth in Partnerships, 1965-1982 8 

4-1 Average Rates of Tax on Family Economic 

Income Under Current Law and the Proposal 48 

4-2 Percent Change in Tax Under the Proposal by 

Family Economic Income 49 

4-3 Marginal Rates of Tax Under Current Law and 

the Proposal 51 

4-4 Percentage Change in Taxable Income Resulting 

From the Treasury Proposal 52 

4-5 Families With Tax Change as a Percent of All 

Families by Family Economic Income 55 

4A-1 Distribution of Tax Returns by Adjusted Gross 

Income Class and Families by Economic Income Class 60 

5-1 Comparison of Tax Free Income Levels Under 

Current Law and Under the Proposal -- For 

Taxpayers Under Age 65 68 

5-2 Comparison of Tax Free Income Levels Under 

Current Law (1986) and Under the Proposal -- 

For Taxpayers Under and Over Age 65 12 

7-1 Volume of Long Term Tax-Exempt Bonds Issued 

in 1983 136 

9-1 Lifetime Pattern of Income and Consumption 

(Average Income and Consumption, Distributed 

by Age of Family Head) 207 

xxviii

Chapter 1 

THE NEED FOR TAX REFORM: BACK TO BASICS 

The present income tax is badly in need of fundamental 

simplification and reform. It is too complicated, it is unfair, and 

it interferes with economic choices and retards saving, investment and 

growth. 

In a real sense, the U.S. income tax has grown without any 

conscious design or overall planning since it was enacted in 1913. It 

was originally imposed at low rates and applied to fewer than 400,000 

individuals with very high incomes. The need to finance World War I1 

and expanded non-defense expenditures turned the individual income tax 

into a levy paid by most Americans. Tax rates were increased during 

World War 11, and at their peak individual income tax rates reached 94 

percent. The original income tax had serious flaws, and while some of 

these have been corrected over time, others have grown worse. With 

over 90 million individual tax returns now being filed, it is 

important to address these problems. 

It is one thing to decide to tax "income," and quite another to 

decide how to define taxable income. If inadequate attention is 

devoted to establishing a uniform and consistent definition of income, 

some sources and uses of income will escape tax, and others will be 

taxed twice, as in the United States. The result may or may not be a 

simple tax system, but it is certain that the tax system will contain 

inequities and interfere with the economic behavior of taxpayers. 

The U.S. income tax is not used simply to raise revenue. Instead, 

it is used to subsidize a long list of economic activities through 

exclusions from income subject to tax, adjustments to income, 

business deductions unrelated to actual expenses, deferral of tax 

liability, deductions for personal consumption expenditures, tax 

credits, and preferential tax rates. In some cases, deviations from a 

comprehensive definition of income originated in incomplete 

understanding of the concept of income or in outmoded ideas about the 

proper fiscal relationship between the Federal Government and state 

and local governments. But whatever its origin, in many cases bad 

public policy has become accepted -- virtually enshrined -- as 

appropriate. 

For seven decades, the Treasury Department has fought to protect 

Federal revenues and the fairness and economic neutrality of the tax 

system from those seeking to create and exploit gaps and 

inconsistencies in the definition of taxable income. As loopholes 

have been discovered or created, exploited, and then plugged, 

techniques of tax avoidance have become increasingly sophisticated and 

the complexity of the income tax has grown, in a never-ending cycle.

- 2 - 

The resulting tax system is both unfair and needlessly complex. 

Moreover, it interferes with economic behavior and, thus, prevents 

markets from allocating economic resources to their most productive 

uses. Perhaps worse, the complexity and inequity of the tax system 

undermine taxpayer morale -- a valuable, yet fragile, national asset 

and a prerequisite for a tax system based on voluntary compliance. 

During the past year, the Treasury Department has undertaken a 

thorough review of the U.S. tax system. The object has been to 

determine how to reduce the complexities, inequities, and economic 

distortions i n the tax system and make it more conducive to economic 

growth. Although the present report was prepared internally by the 

Treasury Department, it draws heavily on a vast national storehouse of 

knowledge about the tax system and its effects on the economy. The 

report also reflects information, views, and concerns which the 

Treasury Department received from taxpayers in the course of public 

hearings, meetings, and discussions, and in correspondence and in more 

formal written statements. 

The Federal Income Tax in 1954 

To understand better the need for tax reform, it is useful to com 

pare our present income tax system with the one that prevailed in the 

late 1950s, after enactment of the 1954 Internal Revenue Code. Though 

the 1954 income tax system exhibited some serious problems, it was 

relatively simple, it was more nearly neutral toward many economic 

decisions, and most citizens probably thought it was reasonably fair. 

Today the American economy is far more complex than it was 30 

years ago. The financial affairs of the typical American family are 

far more complicated than in previous generations. Ownership of both 

financial and nonfinancial assets is more widespread and varied. 

Families have a greater quantity and variety of income, both taxed and 

untaxed. Business transactions are more complicated, financial 

intermediation is more highly developed, and taxpayers are more 

sophisticated and better advised. We also know more about the adverse 

effects of taxation than 30 years ago. Therefore, it would not be 

desirable -- nor would it be possible -- simply to reinstate an 

earlier tax law that was not designed to deal with the more complex 

economy of the 1980s. But a useful perspective on the current need 

for tax reform and simplification can be gained by considering how the 

tax law -- and its impact on taxpayers -- has changed over the past 

three decades. 

One important defect of the 1954 income tax was a schedule of 

marginal rates that reached 91 percent for a small number of 

taxpayers. Besides creating severe disincentives for saving, invest 

ment, and work effort, the confiscatory rates may have spawned many of 

the vexing tax avoidance schemes that now riddle the income tax. But 

the advantages of the earlier income tax were also manifest. 

Virtually all taxpayers below the top 10 percent of the income 

distribution paid tax at an essentially uniform marginal rate of about

- 3 - 

20 percent. Only at the very top of the income distribution did rates 

become steeply progressive. The income tax was still being used 

primarily to raise public revenues, and not to guide households and 

private business enterprises into a multitude of activities -- some of 

dubious value -- through preferential tax treatment. With notable 

exceptions, the income tax was levied on a base that included most 

income. The erosion of that base by a multitude of exclusions, 

adjustments, deductions, and credits not required to measure income 

accurately had not reached its present stage. 

Compared to today, the 1954 income tax was simpler, more neutral, 

and fairer, in many respects. Perhaps as importantly, it was probably 

seen to be fair by most taxpayers, and the perception of fairness 

helped maintain the voluntary compliance so crucial to the American 

system of taxation. 

The Decline in Simplicity 

In 1954 the income tax was simpler for most taxpayers, in part 

because incomes were lower and the financial affairs of most families 

were simpler. There was little need for most taxpayers to work 

through a variety of complicated forms -- and even more complicated 

instructions -- to determine eligibility for a particular tax benefit. 

Only 25 percent of taxpayers itemized deductions in 1955, compared to 

35 percent in 1982. Thus, fewer taxpayers found it necessary to save 

receipts verifying a multitude of expenditures accorded tax-preferred 

status. There was also little need to engage the services of a tax 

professional to file an individual income tax return. Tax planning -- 

the rearrangement of one's economic affairs to minimize taxes -- was 

the concern of only a few. Most taxpayers did not even feel the need 

to consider the tax consequences of major decisions, much less 

everyday transactions. 

Today the proliferation and expansion of exclusions, adjustments 

to income, deductions, and credits create a major burden of paperwork 

and make part-time bookkeepers of many Americans. At present, about 

100 different Federal tax forms are used by individuals. Many 

decisions -- f3r example, whether and how to make a charitable 

contribution, whether to participate in insurance plans offered by an 

employer, and whether to contribute to a political party -- all have 

tax consequences. Ordinsry citizens are confronted with the alternatives 

of using a professional tax preparer, becoming knowledgeable in 

arcane tax law, running afoul of the tax administration, or possibly 

passing up available tax benefits. Today, over 40 percent of all 

individual income tax returns -- and some 60 percent of all long forms 

(form 1040s) -- are prepared by paid professionals. So-called tax 

shelters, once known only to the wealthy, are now attracting 

increasing numbers of middle-income Americans, many of whom do not 

have access to sophisticated tax advice and are misled by the 

misrepresentations of unscrupulous promoters of illegal shelters, 

often with disastrous effects. Legislative response to the tax

shelter problem over the last 15 years has involved a patchwork of 

solutions that has generally increased the complexity of the tax 

system without correcting the underlying causes of tax shelters. 

Erosion of the Tax Base 

In 1954, the income tax did favor certain economic activities over 

others. For example, even then, tax experts criticized the fact that 

income from oil and gas properties, interest on state and local 

securities, and appreciation on capital assets were accorded preferential 

tax treatment. These "loopholes," as they were called, 

created inequities and distorted the use of the Nation's resources. 

By comparison, most interest, dividend, and labor income was taxed in 

full, and few forms of personal expenditure were tax deductible. The 

most important itemized deductions were for state and local taxes, 

charitable contributions, interest payments, and medical expenses; 

some of these had valid or easily understood justifications. 

The last three decades have seen enormous erosion of the tax base. 

Compensation has increasingly taken the form of tax-free fringe 

benefits and legally taxable "perks" that many taxpayers improperly 

treat as tax-exempt. Interest on bonds issued by state and local 

governments has long been tax exempt, but recently these governments 

have increasingly used tax-exempt bonds to finance private investments. 

The investment tax credit greatly reduces the effective 

tax rate on income generated by business equipment, and accelerated 

depreciation and the deduction for interest expense combine to 

eliminate most taxes on income from debt-financed investments in real 

estate. In extreme cases these and other features of the tax law 

create losses for tax purposes that can be used to shelter other 

income. Exclusions, itemized deductions, and the deduction value of 

credits offset about 34 percent of personal income in 1982, as opposed 

to only 18 percent in 1954. 

Economic Distortions 

The lack of a comprehensive income tax base has two obvious and 

important adverse effects on the ability of the marketplace to 

allocate capital and labor to their most productive uses. First, the 

smaller the tax base, the higher tax rates must be to raise a given 

amount of revenue. High tax rates discourage saving and investment, 

stifle work effort, retard invention and innovation, encourage 

unproductive investment in tax shelters, and needlessly reduce the 

Nation's standard of living and growth rate. 

Second, tax-preferred activities are favored relative to others, 

and tax law, rather than the market, becomes the primary force in 

determining how economic resources are used. Over the years, the tax 

system has come to exert a pervasive influence on the behavior of 

private decision-makers. The resulting tax-induced distortions in the 

use of labor and capital and in consumer choices have severe costs in 

terms of lower productivity, lost production, and reduced consumer 

satisfaction.

The existing taxation of capital and business income is 

particularly non-neutral. It favors capital-intensive industries over 

others, such as services. The tax system favors industries that are 

unusually dependent on equipment over those -- such as wholesale and 

retail trade -- that rely more heavily on other forms of capital, 

including inventories and structures. High technology companies are 

put at a particular disadvantage. Since they do not require large 

capital investments that benefit from preferential tax treatment they 

bear the full brunt of high tax rates. A tax system that interferes 

less with market forces in the determination of what business should 

produce -- and how -- would be more conducive to productive investment 

and economic growth. 

Inequities 

Erosion of the tax base also creates inequities. Most obviously, 

it is unfair that two households with equal incomes should pay 

different amounts of tax, simply because one receives or spends its 

income in ways that are tax-preferred. There is, for example, no 

reason that employees should be allowed to escape tax on fringe 

benefits and entertainment provided by their employers, while others 

must buy the same benefits and entertainment with after-tax dollars. 

Even at moderate income levels, taxpayers with similar incomes can 

incur tax liabilities that differ by thousands of dollars. Moreover, 

gaps in the tax base create inequities across income classes, as well 

as within income classes. Some of the most important tax preferences 

-- those that give rise to tax shelters -- benefit primarily those 

with high incomes. 

Unfair Treatment of the Family 

Thirty years ago the personal exemption for the taxpayer, spouse, 

and each dependent was $600, and there was a standard deduction of 10 

percent of adjusted gross income, up to $1,000. Thus a family of four 

would pay no tax until income exceeded $2,675. Even though the personal 

exemption is now $1,000 and a larger "zero-bracket amount" has 

replaced the standard deduction, inflation has resulted in a substantial 

decline in the real value of the "tax-free amount," the level 

of income at which tax is first paid. Some families with incomes 

below the poverty level have become subject to tax. Tax burdens have 

increased relatively more for large families with many dependents than 

for other taxpayers. 

The tax law was designed for a society in which dependents are 

generally present as part of a family with both parents present. Some 

groups with greater-than-average proportions of poor families, such as 

the elderly and the disabled, receive special tax treatment, but this 

treatment is often arbitrary and random, and depends on the source of 

the income, not on the need of the family. Until recently, the 

working poor have almost always been excluded from such special 

treatment. The special burdens faced by many single heads of 

households -- especially those caring for dependents and trying to 

work at the same time -- have been addressed inadequately. 

459-370 0 - 84 - 2

Inflation and the Income Tax 

- 6 - 

The U.S. income tax was not designed to be immune from inflation. 

Thus when inflation accelerated in the 1970s, taxpayers with constant 

real incomes were pushed into progressively higher tax brackets. The 

proportion of income paid to the government increased, even when real 

income did not, and higher tax rates created serious disincentives. 

Historically, "bracket creep,'' as this effect is called, could only be 

offset by periodic congressional action to increase the personal 

exeqption, zero-bracket amount (ZBA), and bracket limits. But bracket 

creep sensitized the public to the problem of high and rising tax 

rates, and the Economic Recovery Tax Act of 1981 made a major step in 

tax reform by reducing tax rates and curing bracket creep. Even 

though many taxpayers are still subject to needlessly high marginal 

tax rates, the personal exemption, ZBA, and bracket limits will be 

indexed, starting in 1985. However, another important cause of 

inflation-induced tax increases remains uncorrected. 

During inflationary times, taxes are collected on totally 

fictitious income. Capital gains taxes are paid when the prices of 

assets merely rise with inflation. Business firms are not allowed 

tax-free recovery of their real capital investments in inventories and 

depreciable assets. Moreover, high interest rates that merely reflect 

expected inflation overstate the real income of recipients of interest 

and inflate deductions for real interest expense. 

The interaction of inflation and taxes creates further inequities 

and distortions. The overstatement of real interest income and 

deductions arbitrarily increases the tax burden on savers and rewards 

borrowers. Resource allocation is distorted by effective tax rates on 

some types of capital income that can easily exceed 100 percent. 

During the 1970s, the combination of high rates of inflation and a tax 

system that was not inflation-proof caused an increase in the taxinduced 

bias in favor of investment in owner-occupied housing; this 

probably aggravated the shortage of funds for business capital 

formation. 

The combination of lower rates of inflation, the Accelerated Cost 

Recovery System of depreciation, and the lower tax rates on long-term 

capital gains have relieved some of the problem. Even so, the present 

tax system does not accurately measure real income from business or 

capital under most circumstances. Moreover, the tax treatment of 

business inventories and of debtors and creditors remains dependent on 

the rate of inflation. 

The Rise of Tax Shelters 

The well-advertised boom in the tax shelter industry in recent 

years has had particularly adverse effects. Some shelters involve 

little more than thinly veiled, if sophisticated, tax fraud, But even 

perfectly legal tax shelters distort the allocation of scarce capital 

because they produce highly visible inequities in taxation. Perhaps 

most importantly of all, they undermine taxpayer confidence in the

- 7 - 

integrity and fairness of the tax system. Tax shelter losses 

typically result from a combination of current deductions for future 

expenses, deferral of taxable income, and conversion of ordinary 

income to preferentially taxed long-term capital gains. Thus, 

shelters allow taxpayers to defer tax liability far into the future. 

Tax deferral is equivalent to an interest-free loan from the Federal 

Government. 

Recent data on tax returns of partnerships, a commonly used 

vehicle for tax shelters, indicate the nature and magnitude of the 

problem. In 1981 partnerships operating in the United States reported 

aggregate losses in excess of aggregate profits. This is not a 

cyclical phenomenon; partnership losses have increased steadily, 

relative to profits, for two decades. (See Figure 1-1.) Yet there is 

no reason to believe that Americans are losing more and more money 

each year by investing in these enterprises. Rather, many partnership 

investments are profitable on an after-tax basis, becausq they 

generate accounting losses that can be used to reduce or eliminate tax 

on other income (that is, to shelter other income from tax). But many 

shelter activities that offer attractive after-tax yields have little 

social value, as evidenced by before-tax yields that are low and 

sometimes even negative. 

Partnerships in two industries that are favorites with tax shelter 

investors -- oil and gas and real estate -- are a case in point. In 

1982, of the $60 billion in aggregate losses reported by all partnerships, 

$31.6 billion were attributable to losses reported by oil and 

gas and real estate partnerships, even though partnerships reporting 

losses in these two industries had a positive net cash flow of $1.6 

bi 11ion. 

Between 1963 and 1982, the number of taxpayers who claimed 

partnership losses on their individual returns increased by 400 

percent, from 412,000 to 2.1 million, even though the total number of 

individual tax returns filed during the same period increased by only 

50 percent. As a result of this growth in tax shelter activity, there 

has been a significant erosion in the base of the Federal income tax, 

particularly among taxpayers with the highest incomes. In 1983, partnership 

losses claimed by individual taxpayers may have sheltered as 

much as $35 billion of individual income from taxation. An estimated 

82 percent of this total ($28.6 billion in partnership losses) was 

reported by taxpayers whose gross income before losses was $100,000 or 

more, and 60 percent ($21.0 billion) was reported by taxpayers with 

gross income before losses in excess of $250,000. By comparison, 

these groups reported 9 percent and 4 percent, respectively, of all 

gross income before losses reported by individuals. 

A sample of taxpayer returns illustrates quite strikingly the way 

in which tax shelter accounting losses can be used to shelter 

substantial amounts of income from tax. A group of 88 taxpayers who 

held interests in certain non-abusive tax shelters -- shelters whose 

legitimacy was not being questioned by the Internal Revenue Service -- 

were chosen for statistical analysis. Though this sample was not

--a -

- 9 - 

selected scientifically, there is no reason to believe it is not 

representative; certainly it indicates the nature of the problem. 

Taxpayers in this sample reported positive income that is gross 

income before losses -- of $17 million, or an average of $193,000. On 

average, each of these taxpayers owned interests in 6 partnerships, 

and a total of $6.4 million in net partnership losses was reported on 

the 88 returns. When these losses are added to other business and 

investment-related losses of almost $8.7 million, the taxpayers in the 

sample reported gross income of only $1.9 million. Thus, accounting 

losses from tax shelter partnerships reduced the gross income of 

taxpayers in the sample by almost 40 percent, and other losses reduced 

income by an additional 49 percent. (See Table 1-1.) The taxable 

income of these individuals was further reduced by adjustments to 

gross income and by itemized deductions. 

Of the 08 returns sampled, 19 returns, with an average gross 

income before loss (positive income) of $243,710, reported a total 

income tax payment of $500 or less; 37 returns, with an average gross 

income before loss of $172,113 reported a total tax payment of $6,000 

or less. By comparison, a typical family of four, with positive 

income of $45,000, but no tax shelter losses, would pay $6,272 in 

taxes. The extent to which tax shelter losses can be used to 

dramatically reduce tax liabilities is further documented by estimates 

from the 1983 Treasury tax model which show that 9,000 taxpayers with 

gross incomes before losses of $250,000 or more paid no tax as a 

direct result of partnership losses, while 59,000 taxpayers with that 

much positive income were able to reduce their tax payments by at 

least one-half. 

The Decline in Taxpayer morale 

The United States has long been proud of the “taxpayer morale” of 

its citizens -- the willingness to pay voluntarily the income taxes 

necessary to finance government activities. Taxpayer morale ulti-. 

mately depends, however, on the belief that taxes are fair. If the 

basis for this belief comes under suspicion, voluntary compliance with 

the tax laws is jeopardized. Thus, the perceived lack of fairness of 

the income tax may be as important as actual complexities, economic 

distortions, and inequities. Taxpayers resent paying substantially 

more tax than their neighbors who have equal or higher incomes. This 

is true even if the neighbor reduces taxes through commonly available 

and perfectly legal exclusions, adjustments, deductions, and credits, 

rather than by questionable or illegal means. Nany witnesses at tax 

reform hearings the Treasury Department held throughout the country 

during June 1984 enphasized that tax should be collected on virtually 

all income, with little regard to how the income is earned or spent. 

Taxation can be thought to be unfair because the basic tax structure 

is defective, as well as because taxpayers who do not comply with the 

law are not penalized. The proliferation and publicity of tax 

shelters has a particularly pernicious effect on taxpayer morale. 

--

- 10 - 

.. 

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- 11 - 

Taxes That are Broad-Based, Simple, and Fair 

Fundamental reform of the tax system is required to correct the 

problems just described. The tax system must be made simpler, more 

economically neutral, fairer, and more conducive to economic growth. 

These objectives are described more fully in the next chapter. The 

key to their achievement is to define real taxable income comprehensively, 

to exempt families with poverty-level incomes from tax, and 

to subject taxable income to a rate structure thtit, while mildly 

progressive, avoids rates so high that they stifle incentives and 

prevent economic growth. In short, the income tax should be broadbased, 

simple, and fair.

- 13 - 

Chapter 2 

GOALS OF FUNDAMENTAL TAX REFORM 

In undertaking fundamental reform and simplification of the tax 

system of the United States, it is important to specify clearly and 

explicitly the goals or criteria that should guide such an undertaking. 

The criteria underlying the Treasury Department's study of 

fundamental tax reform are described here. Though some are framed in 

the familiar context of an income tax, in general they are equally 

applicable in the context of the less familiar tax on consumed income. 

Economic Neutrality 

One of the primary advantages of a free market economy is its 

tendency to allocate economic resources to their most productive uses. 

For example, market forces lead business firms to produce what 

consumers want in ways that are relatively efficient and economical. 

Any tax inevitably discourages the type of activity that is taxed. An 

ideal tax system would, however, interfere with private decisions as 

little as possible. That is, it would not unnecessarily distort 

choices about how income is earned and how it is spent. It would not 

unduly favor leisure over work, or consumption over saving and investment. 

It would not needlessly cause business firms to modify their 

production techniques or their decisions on how to finance their 

activities. A neutral tax policy would not induce businesses to 

acquire other firms or to be acquired by them merely for tax 

considerations. It would not discourage risk-taking or the formation 

of new businesses. It would not discourage competition by granting 

special preferences only to one industry or one type of financial 

institution. In short, an ideal tax system would be as neutral as 

possible toward private decisions. Any deviation from this principle 

represents implicit endorsement of governmental intervention in the 

economy -- an insidious form of industrial policy based on the belief 

that those responsible for tax policy can judge better than the 

marketplace what consumers want, how goods and services should be 

produced, and how business should be organized and financed. 

Economic neutrality is furthered by a few simple rilles of tax 

design. Perhaps most importantly, income from all sources should be 

taxed equally; otherwise, too many resources will be devoted to 

activities subject to the lowest taxes. For the same reason, tax 

liability should not depend on how income is spent. Uniform treatment 

of all sources and uses of income requires a comprehensive definition 

of income for tax purposes. 

Lower Tax Rates 

The higher tax rates are, the more taxes interfere with economic 

choices -- choices about working, about saving and investing, about 

production techniques and business finance, and about invention and

innovation. Moreover, any omission from the tax base is more valuable 

at high tax rates than at low rates. As a consequence, there is more 

political pressure for preferential treatment of selected activities 

at high rates, and tax shelters are more important at high rates. 

Thus an important goal of tax policy is to keep tax rates as low as 

possible, given other objectives. Of course, the tax rates needed to 

raise a given amount of revenue can be lower, the more income is 

subject to tax. This is a second important reason for adopting a 

comprehensive definition of taxable income. It is far better -- more 

neutral, as well as simpler and more equitable -- to levy low tax 

rates on all income than to impose high tax rates on only part of 

income. 

Revenue Neutrality 

Most Americans probably agree that those with high incomes should 

pay a greater percentage of their income in tax than those with intermediate 

levels of income. But the proper pattern of effective tax 

rates -- the percentage of income paid in taxes at various income 

levels is a matter on which opinions differ. 

-- 

- 14 - 

The Treasury Department study of fundamental tax reform has 

concentrated 011 questions of tax structure and has not considered any 

2roposals to increase the level of tax revenues that will result from 

current law. Thus the Treasury Department proposes tax reforms that 

are revenue neutral, that is, reforms that would leave revenues 

essentially unchanged from what they would be under current law. 

Equal Treatment of Equals 

A tax that places significantly different burdens on taxpayers in 

similar economic circumstances is not fair. For example, if two 

similar families have the same income, they should ordinarily pay 

roughly the same amount of income tax, regardless of the sources or 

uses of that income. A fair tax system does not allow some taxpayers 

to avoid taxes by legal means or to evade them by illegal means. 

The only way to achieve equal treatment of equals is to define the 

tax base comprehensively. If some items of income are omitted from 

the tax base, or if particular expenditures are treated preferentially, 

then taxpayers who are otherwise in equal positions will not 

be treated equally. 

Fairness for Families 

It is commonly agreed that households with incomes below the 

poverty level should pay little or no tax. Otherwise, they will be 

paying taxes with income that is needed to maintain a minimal standard 

of living. In a real sense, families with poverty-level incomes do 

not have taxpaying ability. Taxpaying capacity exists only once 

income exceeds the poverty level. 

Fairness Across Income Classes

- 15 - 

In its study of fundamental tax reform the Treasury Department has 

adopted the simple working assumption that the existing distribution 

of tax payments across income classes should not be significantly 

changed b4 tax reform. If any change in the existing distribution of 

tax burdens is desired, it can and should be implemented by adjusting 

the proposed personal exemptions and rate schedules. It should not be 

achieved by taxing some sources or uses of income more or less heavily 

than others, since that would violate both economic neutrality and the 

principle that those with equal incomes should pay approximately equal 

taxes. 

Defining the tax base comprehensively is necessary for the 

achievement of equity across income classes. Any exclusion or deduction 

is worth more, the higher the marginal tax bracket of the taxpayer. 

Moreover, wealthy taxpayers make relatively greater use of 

many provisions of the tax law that reduce the tax base, especially 

those yielding business deductions that result in the mismeasurement 

of economic income and produce tax shelters. As long as these tax 

preferences exist, the tax system will be less progressive than the 

rate structure suggests, and high marginal rates will be advocated as 

a means of achieving progressive taxation. Conversely, if income is 

defined comprehensively, the existing pattern of progressivity can be 

maintained with markedly lower marginal tax rates on upper income 

groups, as well as other taxpayers. 

Tax reform that does not alter the distribution of tax burdens 

across income groups will, of course, involve redistribution of tax 

burdens -- winners and losers -- within income classes. This is only 

natural in the context of reform that attempts to replace the 

inequities of the present tax system with equal treatment of 

households with a given income. Those who gain from any such reform 

will be those who, at a given level of income, have been paying more 

than average amounts of tax, and those who lose will have been paying 

less than their fair share of taxes. But many of the losers will not 

lose permanently; they will simply divert funds from uneconomic 

investments to more productive investments and pay lower tax rates on 

the higher income that results. 

Simplicity 

An important goal of the Treasury Department study of fundamental 

tax reform is simplification. During June of 1984, the Treasury 

Department held hearings on fundamental tax reform in seven U.S. 

cities. One of the themes repeated most frequently by citizens 

appearing at those hearings was the need for simplification of the 

income tax. 

Though simplicity in taxation may be difficult to define, everyone 

knows what it is not. Simplicity is not reflected in a tax system 

that requires extensive recordkeeping by ordinary citizens. A simpler 

system would require fewer taxpayers to collect and retain receipts or 

cancelled checks in order to calculate and document tax deductions,

- 16 - 

adjustments, and credits. Simpliciky is not wondering which receipts 

and checks to save because the tax law is too complex and is 

constantly changing. Simplicity is not computing dozens of deductions 

and credits, and wondering all the while whether other means of saving 

tax might have been missed through ignorance of the laws. Nor. is 

simplicity being forced to wade through long and complicated 

instruction booklets or resort to professional assistance, in order to 

meet the civic responsibility to pay taxes. A simple tax system would 

not require 41 percent of all taxpayers -- and about 60 percent of 

those who itemize deductions -- to engage professional assistance in 

preparing their tax returns. Under a simple system, most responsible 

taxpayers would be more certain of their tax liabilities. 

Reduced costs and greater ease of administration for the 

government are the mirror image of simplicity or the taxpayer. Many 

provisions of the tax code could be administered effectively only by 

devoting exorbitant resources to their enforcement. About 90 percent 

of taxpayers who itemize deductions make at least one error in 

claiming their deductions, but the Internal Revenue Service simply 

does not have the capacity to audit all returns and either collect the 

tax due or make refunds to these taxpayers. The current tax structure 

creates a dilemma for tax administrators. Effective enforcement of 

complicated laws generally creates complexity for the taxpayer and 

fosters apprehension and resentment against the fiscal authorities. 

On the other hand, ineffective enforcement loses revenue, it creates 

uncertainty for taxpayers, it converts the tax system into an unfair 

tax on honesty, and it may also generate hostility toward the tax 

system. A primary focus of the tax reform study has been to eliminate 

and avoid provisions that would unduly complicate tax administration 

and compliance for most taxpayers. 

Perceived Fafmess 

The perception of fairness may be as important as fairness itself 

as a goal of tax policy. The United States was once justly proud of 

the taxpayer morale of its citizens. With media coverage of tax 

shelters now commonplace and talk of "beating the system" prevalent in 

conversation, taxpayers increasingly view the tax system as unfair and 

wonder why they should pay taxes. One of the primary goals of the 

Treasury Department study of fundamental tax reform is the reversal of 

this threatening trend. 

The growing use of the income tax to subsidize various forms of 

economic activity is a major source of the increase in the perceived 

lack of fairness of the tax system. The U.S. Government has long 

spent public funds in ways that many taxpayers question. While this 

may cause many to believe that their tax dollars are being wasted, it 

does not raise doubts about the equity of the tax system itself. The 

situation is very different when the tax system, rather than direct 

spending, is used to provide subsidies. Similarly situated taxpayers 

can pay considerably different amounts of tax, depending on how they 

earn and spend their income, and high-income families may pay tax on a 

smaller portion of their income than do poorer families. The result

- 17 - 

is a perception that the income tax itself is unfair, both with n and 

across income classes. 

Reforms of many types are needed to improve the image of the U.S. 

income tax. Families below the poverty line should pay little or no 

tax. Income tax compliance should be easier and less expensive. Most 

forms of economic income should be subject to tax, but fictitious 

income representing nothing but inflation should not be taxed. The 

tax system generally should not be used to implement subsidy programs. 

Opportunities for tax shelters should be sharply curtailed, if not 

eliminated. Tax evasion should be made more difficult. Adoption of 

fairer tax rules would h aw a multiplier effect, as increased fairness 

would lead to an improved perception of fairness and, in turn, to 

better compliance. 

An Inflation-proof Tax Law 

Starting in 1985 personal exemptions, the zero bracket amount, and 

the tax brackets in the individual income tax will be adjusted for 

inflation. This important innovation, commonly called indexing, will 

prevent taxpayers with a given real income from being forced by 

inflation to pay higher taxes. It should remain an inviolate part of 

the tax system. Indexing of this kind, important as it is, meets only 

part of the need to protect taxpayers from inflation. Inflation 

adjustment in the calculation of taxable income is perhaps more 

important, because it cannot be achieved by periodic adjustments of 

personal exemptions and the rate structure. Without it inflation 

causes mismeasurement of business and capital income. 

Inflation currently causes income to be overstated in at least 

four ways. First, depreciation allowances based on historical costs 

are generally not adequate to allow tax-free recovery of investment in 

a time of inflation. Second, deductions for the cost of goods sold 

from inventories are inadequate if based on historical costs. Third, 

capital gains include nominal appreciation that merely reflects the 

general rise in prices, rather than an increase in the real value of 

assets. Fourth, nominal interest receipts include an inflation 

premium that should not be taxed. By the same token, full deduction 

for nominal interest expenses during inflationary times results in the 

understatement of real economic income. 

Congress has made some ad hoc adjustments in depreciation 

allowances and the taxation of capital gains in response to inflation. 

‘In most cases these measures do not accurately adjust for inflation, 

and they are too inflexible to deal adequately with changes in the 

rate of inflation. 

An ideal income tax system would provide inflation adjustments in 

the ceasurement of taxable income in order to prevent the taxation of 

fictitious income and the deduction of fictitious interest expenses. 

Such adjustments would prevent the effective tax rates imposed on 

business and capital income from varying dramatically and arbitrarily 

every time the inflation rate changes.

Neutrality Toward Business Form 

- 10 - 

Corporate income that is distributed as dividends is subject to 

tax twice, first at the corporate level and again when received by 

individuals. Many observers -- among them economists and lawyers, 

businessmen, and public officials -- have argued that a separate 

unintegrated tax on corporate profits has adverse economic effects and 

makes no sense. Yet the corporate and individual income taxes cannot 

be fully integrated, for technical reasons, and the corporate tax 

cannot simply be eliminated without creating a large loophole. It is, 

however, possible to relieve double taxation of dividends, keeping 

full taxation at the corporate level only for income that is retained. 

The Treasury Department study of tax simplification and reform has 

been guided by the need for balance in the treatment of corporations 

and individual taxpayers. The corporate tax rate shoulg be no higher 

than -- and, as has been the case historically, perhaps somewhat below 

-- the top rate applied to income of individuals. If the corporate 

rate and the top individual rate differ significantly, there would be 

an artificial inducement either for or against use of the corporate 

form. 

Economic Growth 

The U.S. economy has long been hampered by a combination of 

defects in its tax system. High marginal tax rates discourage work, 

saving and investment, and invention and innovation. Heavy reliance 

on income taxation, rather than taxes on consumption, has produced a 

further disincentive for saving. Preferential tax treatment of 

particular industries -- industrial policy implemented through tax 

policy -- causes too much labor and capital to flow into the favored 

industries, and too little into other sectors. In many instances, it 

is difficult to establish new businesses simply because the tax system 

places them at a severe competitive disadvantage. In extreme cases 

tax-preferred investments that lose money on a before-tax basis are 

profitable once tax savings are considered. The result of all this 

tax-induced interference with market forces is lost opportunities for 

productive investment and needless sacrifice of national output. Economic 

growth, a primary goal of the study of fundamental tax reform, 

depends on a neutral tax system -- one that would not hinder the 

potential for growth inherent in a free market economy. 

Trade-offs 

In many cases the objectives of tax policy discussed above are 

quite consistent. Elimination of deductions not required for the 

accurate measurement of income would generally simplify the tax 

system, promote horizontal equity, allow lower tax rates, and reduce 

existing distortions of economic decisions. Sometimes, however, it is 

necessary to strike a balance among competing objectives of sound tax 

policy. In some cases -- extraordinary medical expenses or the 

presence of dependents, for example -- deductions are justified 

because they affect ability to pay even if they do not affect income.

- 19 - 

#any of the deductions and credits that complicate the tax system 

were enacted -- and are defended -- as necessary to avoid inequities. 

For example, almost everyone agrees that taxpayers should be allowed 

to claim-exemptions for dependents, but implementing the dependency 

test can be complicated in certain cases. Deductions for extraordinary 

medical expenses are necessary for the measurement of the 

ability to pay taxes; but documenting them can be very time-consuming. 

Low-income individuals may not realize that they are eligible for the 

earned income tax credit; they are also least able to deal with the 

complexity it entails and may not realize that the IRS will compute 

the credit if a return is filed. The two-earner deduction involves 

complicated conflicts between equal treatment of equals, incentive 

effects, fairness to families, and fairness across income classes, as 

well a: trade-offs between these effects and simplicity. 

Measuring income accurately or implementing a tax on consumed 

income, either of which would be desirable on grounds of fairness and 

neutrality, may involve difficult problems of compliance and administration, 

for example, in the valuation of certain fringe benefits. 

Measurement of income as it accrues on infrequently traded or unique 

assets would present insurmountablv administrative problems. On the 

other hand, taxing capital gains on realizations allows tax to be 

postponed indefinitely. Calculation of business income is complicated, 

but legitimate business expenses, including estimated 

depreciation allowances, must be allowed on both equity and neutrality 

grounds. Implementing an inflation-proof income tax is complicated, 

but the alternative is to allow inflation to play havoc with effective 

tax rates, creating distortions and inequities. And any tax on 

consumption, whether a sales tax or a progressive personal tax on 

consumed income, raises troublesome issues of distributional equity. 

The Treasury Department has carefully weighed these competing 

objectives in appraising the strengths and weaknesses of the four 

options it considered in its study of fundamental tax simplification 

and reform. Nost individuals will face a dramatically simpl.er tax 

system under the Treasury Department proposals. But in some cases 

praposed reforms that are necessary to improve the equity and 

neutrality of the tax law do conflict with the important goal of 

simplification. 

Fair and Ordorlj! Transition i_ 

The present income tax is complex, it is inequitable, it causes 

economic distortions, and it impedes economic growth. But movement to 

a comprehensive tax on all income or consumption, while desirable in 

the long run, would involve substantial short-run shifts in resource 

allocation and tax burdens. Even here there are conflicts and tradeoffs 

-- between the advantages of rationalizing tax policy and the 

disruptions caused by doing so too suddenly or too rapidly. 

-- -- 

Tax reform has often and long been held hostage by failure 

to deal with transition issues; those who would be hurt by tax reform

- 20 - 

have successfully resisted change. An important objective of the 

Treasury Department's study of fundamental tax reform is the 

specification of transition rules that will allow tax reform to become 

a reality. Transition steps are necessary both to ease the impact of 

tax changes and to make tax reform a political reality. Without them, 

reform will not occur, and this generation will leave to the next a 

tax system that remains deeply flawed. 

Rather than being introduced suddenly, with little or no time for 

adjustment, some components of fundamental tax reform should be 

introduced gradually, in order to avoid windfall gains and losses and 

economic dislocations. Gradual introduction of fiscal measures can 

take a number of forms, depending on circumstances. Effective dates 

can be postponed and implementation can be phased in, starting either 

at once or at a subsequent effective date. Grandfathering of income 

from certain assets or of groups benefitting from certain provisions 

(for example, applying new provisions only to new purchasers of 

assets, and not to income from old assets) is appropriate in some 

cases. These mechanisms are among those proposed to meet the final 

criterion of a fair and orderly transition t o a simpler, fairer, and 

more neutral tax system. 

__ Addendum: 

Implications for Spending 

Most of the exclusions, adjustments, itemized deductions, and 

credits currently found in the income tau are not required for the 

accurate measurement of income or ability to pay taxes. Rather, they 

are simply subsidies for private activities that are administered 

through the tax system. 

Administering subsidies through the tax system creates complexity 

for taxpayers. By allowing taxpayers in similar circumstances to pay 

greatly different amounts of tax, it undermines taxpayer morale in a 

way that direct spending does not. The Treasury Department thus 

recommends that most of the exclusions, adjustments, deductions, tax 

deferral provisions, and credits that are inconsistent with a 

comprehensive definition of income for tax purposes be repealed or 

sharply curtailed. 

This recommendation should not be construed to imply that none of 

the currently tax-preferred activities is worthy of direct public 

support. Such a judgment would go beyond the mandate from the 

President to propose reforms that will make the tax system broadbased, 

simple, and fair. Except in a few cases this study makes no 

recommendations about the need to enact spending proposals to replace 

subsidies currently administered through the tax system. Of course, 

to the extent that direct spending replaces tax subsidies, tax rates 

could not be reduced as much as proposed.

- 21 - 

Chapter 3 

THE FOUR OPTIONS 

In its study of fundamental tax reform, the Treasury Department 

focused on four basic options: a pure flat tax; a "modified" flat 

tax; a consumed income tax; and a general sales tax, such as a valueadded 

tax or a Federal retail sales tax. These four options are 

described and analyzed briefly in this chapter. Chapters 4 to 8 

describe the Treasury Department proposal for a modified flat tax in 

greater detail and compare it with similar proposals that have been 

advanced recently by several members of Congress. Chapters 9 and 10 

provide further analysis of the consumed income tax and value-added 

tax, two options which are not being proposed. (Volume I1 contains 

details of the Treasury Department proposal for a modified flat tax 

and Volume 111 analyzes a value-added tax in greater detail.) 

I. The Pure Flat Tax 

Most pure "flat tax" proposals share two characteristics: a much 

more comprehensive tax base than under current law and a single low 

tax rate. In some flat tax proposals the tax base is consumption, 

rather than income. In the most extreme proposals there are virtually 

no deviations from a comprehensive definition of income or 

consumption, except for personal exemptions. 

A. Advantages of the Flat Tax 

A pure flat tax would have major advantages over current law, 

because of the breadth of the tax base and the low tax rate made 

possible by the comprehensive base. Such a tax would reduce the 

inequality of tax treatment of families with equal incomes, the 

distortions of economic decisions, the disincentives to growth, and 

some of the complexities that plague the current tax system. Because 

the present system contains many exclusions, exemptions, deductions, 

and credits not required for the accurate measurement of income, it 

requires higher tax rates than would be necessary under a pure flat 

tax. In addition, a uniform tax rate lessens problems inherent in 

steeply graduated rates, such as the bunching of income, 

discrimination between single persons and married couples, and 

incentives to shift income artificially to family members subject to 

lower tax rates. 

B. Distributional Inequity of the Pure Flat Tax 

These important advantages must be compared to the troublesome 

distributional implications of a pure flat rate tax. A single, 

totally flat rate, whether imposed on income or on consumption, would 

involve a substantial shift of tax burden from those in the highest 

income brackets to low- or middle-income taxpayers. Under current law 

families with less than $20,000 of income pay 5.5 percent of the

_I 

~ 

- 22 - 

Table 3-1 

Percentage Distributions of Individual Income Tax Liability 

Under Current Law, a Pure Flat Tax and 

the Treasury Department Proposal, 

by Economic Income Class of Families 

(1983 Levels of Income) 

Share of Tax 1/ 

: Share of : Current : Pure : Treasury 

Family Economic Income Class: income : law flat : Department 

: tax l-/ : tax &/ : proposal A/ 

(. ................... percent .................... ) 

Less than $20,000 ......... 13.7 5.5 9.5 5.1 

$20,000 to $50,000 ........ 41.6 34.6 41.6 34.3 

$50,000 to $100,000 ....... 30.4 32.7 32.6 33.1 

$100,000 or more .......... 14.3 27.2 16.3 27.5 

- - - 

Total ............. 100.0 100.0 100.0 100.0 

Office of the Secretary OE the Treasury 

Office of Tax Policy 

-1/ Current law applicable in 1986. 

-2/ A single rate of 16.8 percent applied t o taxable income under the Treasury 

Department proposal, which essentially exempts from tax those in poverty. 

-3/ A three-rate graduated structure applied to taxable income under the 

Treasury Department proposal, which essentially exempts from tax those in 

poverty .

individual income tax, although they receive 13.7 percent of the 

income. (See Table 3-1.) A pure flat tax even one with 

liberalized personal exemptions and zero-bracket amounts designed to 

eliminate tax for families at or below the poverty level -- would 

raise the share of taxes paid by families with less than $20,000 of 

income to 9.5 percent of the total. This pure flat tax would sharply 

reduce the share of individual taxes paid by those with incomes over 

$50,000, from 59.9 percent under current law to 48.9 percent. Stated 

differently, taxpayers with incomes above $50,000 would pay about 18 

percent less under a revenue-neutral flat-rate tax than under current 

law. (See Table 3-2.) Conversely, those with incomes between $20,000 

and $50,000 would pay one-fifth more tax than under current law. 

Because of the massive redistribution of tax burdens a pure flat tax 

would produce, the Treasury Department recommends against its 

enactment. 

11. Reconciliation: The Modified Flat Tax 

In order to simplify and reform the existing income tax, but avoid 

the massive redistribution of tax liabilities of a pure flat tax, the 

Treasury Department proposes that a modified flat tax on income be 

enacted. The proposal is broadly consistent with several modified 

flat tax proposals advanced by members of Congress, but it goes beyond 

them in the scope of its recommendations for simplification and 

reform. 

Many believe that conflict between the goal of distributional 

equity, on the one hand, and the goals of simplicity, economic 

neutrality, encouragement of growth, and equal tax treatment of equals 

(horizontal equity), on the other, is inherent in any flat tax 

proposal, whether pure or modified. In fact, this conflict is more 

apparent than real. Most of the advantages commonly attributed to 

pure flat tax proposals result primarily from the inclusion of all 

income (or consumption) in the tax base and have relatively little to 

do with whether tax rates are flat or graduated. Conversely, the 

redistribution of the tax burden from high- to middle-income taxpayers 

that would result from application of a flat rate cannot be traced to 

implementation of a comprehensive definition of the tax base. It 

results entirely from the substitution of a flat rate for graduated 

rates. 

Because the effects produced by a totally flat rate are quite 

distinct from those resulting from base-broadening, it is possible to 

achieve most of the base-broadening advantages of a pure flat tax 

without the shift in tax burdens among income classes a pure flat rate 

would entail. This is, in effect, the approach taken in proposals for 

a modified flat tax. By combining a more comprehensive definition of 

income than under current law with modestly graduated low rates, 

modified flat tax proposals are able to achieve gains in simplicity, 

economic neutrality, equal tax treatment of families with equal 

incomes, and economic growth, without sacrificing distributional 

equity.

- 24 - 

Table 3-2 

Changes in Tax Resulting from a Pure Flat Tax 

and the Treasury Department Proposal 

Distributed by Family Economic Income Class 

Family Economic 

Income Class 

(1983 Levels of Income) 

- - 

: Pure Flat Tax 2/ : Treasury Proposal 3/ 

:Current: : Chanae from : : Chanse trom 

: law :Amount: current law :Amount: current law 

: tax L/: 

:Amount:Percent: :?mount:Percent 

(.... $ billions .....) (. 8 .)( $ billions )( . % .) 

Less than $20,000 ..... 14.6 25.0 10.5 72.1 12.3 -2.3 -15.7 

$20,000 - $50,000 ..... 91.2 109.6 18.4 20.2 82.8 -8.4 -9.2 

$50,000 - $100,000 .... 86.4 86.1 -0.3 -0.4 80.0 -6.4 -7.4 

$100,000 or more ...... 71.6 43.1 -28.6 -39.9 66.4 -5.2 -7.2 

- - 

~-I_______ 

Total ................. 263.8 263.8 0 0 241.5 -22.3 -8.5 

Office of the Secretary of the Treasury 


I 1/ Current 

law applicable in 1986. 

-2/ A single rate of 16.8 percent applied to taxable income under the Treasury 

Department proposal, which essentially exempts from tax those i n poverty. 

-3/ A three-rate graduated structure applied to taxable income under the 

Treasury Department proposal, which essentially exempts from tax those in 

poverty.

- 25 - 

A modified flat tax that imcludes only two or three tax rates 

covering a wide range of low to middle income would be indistinguishable 

from a pure flat tax for most taxpayers. (Of course, low-income 

taxpayers would pay lower rates under a modified flat tax than under a 

pure flat tax.) The use of flat rates over wide ranges of incomes 

minimizes marriage penalties and bonuses, as well as problems caused 

by bunching of income in one year. 

A. Questions Common to income and Consumed incorne Taxes 

The term "modified flat tax" could be applied to an expanded 

income tax base or to a consumption tax base. The only inherent 

difference between these two tax bases involves the treatment of 

saving. Under a tax on consumed income, a deduction is allowed for 

net saving, whereas under an ordinary income tax it is not. This 

distinction is explained briefly in part B of this section and at 

greater length in chapter 9. Under either approach many of the issues 

that must be answered in defining the tax base are the same. Should 

fringe benefits provided by employers be taxed, or should they be 

exempt? HOW are business assets to be distinguished from private 

assets? Should housing receive preferential treatment? Should 

charitable contributions be favored? Should activities of state and 

local governments be subsidized through the tax system? Should a tax 

continue to be Levied on corporations? The remainder of this section 

focuses on questions such as these, on suggested modifications of the 

present taxation of capital and business income, and on proposed 

deviations from the pure income tax model. 

B. Advantages of a Comprehensive Measure of income 

A comprehensive definition of taxable income or consumption is 

generally conducive to simplicity and to equal treatment of equally 

situated taxpayers, while retreat from a comprehensive base generally 

involves complexity and horizontal inequity. A comprehensive tax base 

is also necessary for economic neutrality, since high tax rates and 

discrimination between various ways of earning and spending income 

distort economic decisions. 

Omissions from the tax base generally also result in a 

distribution of tax liability between families with different income 

levels that is at least somewhat different -- and frequently markedly 

different -- from what the schedule of marginal tax rates suggests. 

Finally, any deviations from a comprehensive definition of income, 

unless based on widely-held views of tax equity and other generally 

accepted economic objectives, are likely to reduce the perceived 

fairness of the tax system and therefore undermine taxpayer morale. 

Erosion of the tax base also has a heavy political cost. If one 

special interest group is allowed a deduction or credit not required 

for the accurate measurement of income, it becomes more difficult to 

resist others. Ultimately, the only way to maintain a fair tax base 

-- one without the many loopholes in the present tax code -- 

is to

- 26 - 

resist requests for special treatment. For all those reasons, the tax 

base should be defined as broadly as possible. 

C. Distributional Neutrality 

Modification of the uniform rate contained in flat-tax proposals 

also involves difficult trade-offs. Fairness suggests that a single 

flat tax rate should not be levied at all income levels. And yet tax 

equity and due regard for the disincentive effects of high marginal 

tax rates dictate that the top marginal tax rates should not be 

excessive. By-and-large, the rate structure proposed by the Treasury 

Department, when applied to an expanded definition of taxable income, 

is designed to approximate the distribution of tax liabilities that 

prevails under current law. The primary exception is at the bottom of 

the income scale. Increased personal exemptions and zero-bracket 

amounts will ensure that most taxpayers with incomes below the poverty 

line will be exempt from income tax altogether. 

An important feature of modified flat tax proposals is a reduction 

in the number of tax rates. Because rates would be constant over much 

wider ranges of incomes than under current law, a modified flat tax 

system would resemble a flat-rate system for most taxpayers. Of 

course, for marginal tax rates to be reduced significantly, without 

sacrificing revenue, it would be necessary to define the tax base much 

more comprehensively than under current law. 

D. Issues in Income Measurement 

At a conceptual level, the proper tax treatment of many currently 

untaxed sources and uses of income is clear. Fringe benefits provided 

by employers and payments that represent wage replacement should be 

included in income subject to tax. Only in a few cases do problems of 

valuation make this ideal unattainable, as in the case of small 

hard-to-value fringe benefits recently determined to be tax-exempt in 

the 1984 Deficit Reduction Act. Taxpayers should not be allowed 

business deductions for what are really personal expenses, and they 

should not be allowed artificially to shift income between family 

members to reduce taxes. Preferential treatment of above-average 

amounts of charitable contributions is desirable, in order to maintain 

incentives for contributions; moreover, taxpayers making extraordinary 

contributions may be considered to have less taxpaying ability than 

others with similar incomes. The deduction of state and local taxes 

should be phased out, both because it is unnecessary for the 

measurement of income and because there is no compelling reason for 

the deduction. The Federal Government, through the tax system, in 

effect pays part of the cost of expenditures by state and local 

governments. Only real income should be taxed; capital gains and 

nominal profits that only represent inflation should not be taxed. 

Special credits and deductions that are not required to measure 

income accurately should be repealed. These include depreciation 

allowances that are greater than real economic depreciation, 

percentage depletion allowances in excess of cost depletion,

- 27 - 

intangible drilling expenses, and various forms of preferential 

treatment currently accorded certain financial institutions. 

particularly important is the need to deal with inconsistencies in the 

tax law that give rise to tax shelters. Tax shelters and the 

complexities, inequities, and distortions they create can be 

eliminated only by repealing the tax preferences that make them 

possible. The disparate tax treatment of corporations and 

partnerships should be rationalized by reducing the double taxation of 

dividends and by treating large limited partnerships like corporations 

for tax purposes. 

E. Disparities in Effective Tax Rates 

A simple example illustrates the lack of fairness and neutrality 

of the present income tax. The first column of Table 3-3 shows how 

the current tax system treats two different types of labor income, 

wages and salaries and fringe benefits, and two forms of capital 

income, interest and capital gains. Under present law, a taxpayer 

subject to the top statutory rate of 50 percent would actually pay 

effective tax rates on various forms of real income ranging from zero 

to 125 percent. The disparities in effective rates are less dramatic 

for taxpayers with lower incomes, but they are qualitatively the same. 

Whereas wages and salaries are taxed at an effective rate equal to 

the statutory rate, certain fringe benefits are not taxed under 

current law. The inequity and non-neutrality of this tax treatment 

are obvious. Recipients of fringe benefits are treated more favorably 

than those who receive labor income as wages and salaries. Besides 

being unfair, this provides an artificial incentive for greater 

consumption of goods and services that can be provided as tax-free 

fringe benefits. Under a comprehensive definition of income, wages 

and fringe benefits would be taxed identically, that is, at the same 

effective rates. 

The story is somewhat more complicated for capital income, since 

the effective tax rate depends crucially on the rate of inflation. 

The example in Table 3-3 assumes that the interest rate is 4 percent 

if there is no inflation, but 10 percent if the inflation rate is 6 

percent. It also assumes that capital assets that have no current 

yield are appreciating at the rate of interest, either 4 percent or 10 

percent. In the absence of inflation, interest and long-term capital 

gains are taxed at rates of 50 percent and 20 percent, respectively. 

But if the inflation rate is 10 percent, tax on nominal interest 

income is 125 percent of real interest income, and real long-term 

capital gains are taxed at an effective rate of 50 percent, despite 

the apparent top rate on long-term capital gains of 20 percent. At 

higher rates of inflation, effective tax rates on real interest income 

and real capital gains are even higher. 

The statutory tax rate collected on interest income equals the 

effective rate only if there is no inflation. At inflation rates 

within recent experience, the effective tax rates on real interest 

income are much higher than the statutory rates suggest. Besides

eing unfair, this penalizes saving and encourages borrowing, with 

adverse effects on capital formation and growth. This problem can be 

overcome in the context of an income tax only by providing an 

inflation adjustment for debt. 

Long-term capital gains nominally benefit from preferential tax 

treatment. Thus in the absence of inflation, they are taxed less 

heavily than wages and salaries and interest income, as shown in Tabie 

3-3, creating both inequities and misallocations of capital. A 

comprehensive definition of income would not apply different tax rates 

to capital gains and other income. But if inflation is high and 

illusory capital gains are taxed, as under the current system, effective 

tax rates on real gains are high; inequities and distortions are 

magnified and invention and innovation suffer. A comprehensive 

definition of income that included indexing (inflation adjustment) of 

the basis (cost) of assets used in calculating capital gains and 

losses would ensure that fictitious gains are not taxed. 

The second column of Table 3-3 illustrates the advantage of a 

comprehensive definition of taxable income. The current top statutory 

rate of 50 percent is used for illustrative purposes; of course, with 

a more comprehensive definition of income, a lower rate would be 

possible. For taxpayers subject to the highest marginal tax rate 

under current law, income from all sources would be taxed at a rate of 

50 percent, regardless of the rate of inflation. Subjecting all real 

income to tax treats equally situated families equally and reduces 

tax-induced distortions of economic decisions. 

F. Simplification 

Simplifying the income tax for most individual taxpayers has been 

an important objective of the Treasury Department study. Simplification 

would result from several general approaches. First, increasing 

the personal exemptions and zero-bracket amounts will eliminate many 

poor Americans from the income tax rolls. Second, several itemized 

deductions will be eliminated or subjected to floors. Like the floor 

under the current deduction for medical expenses, these floors will 

reduce the need for so many to keep records of deductible expenditures 

for extended periods of time. With the expanded zero-bracket amount 

and fewer deductions, about one-third fewer taxpayers will find it 

advantageous to itemize deductions. Third, most tax credits would 

simply be eliminated. The Treasury Department believes that most 

Americans would rather pay low taxes on all of their income than pay 

high taxes on part of it; doing so is simpler, as well as fairer and 

more neutral toward economic behavior.

- 29 - 

Table 3-3 

Illustration of Disparities in Effective Tax Rates 

Effective Tax Rate on 

Taxpayer in 50% Bracket 

Type of Income Current Comprehensive 

Law 

Definition of 

Real Income 

Taxable wages and salaries 

Tax-free fringe benefits 

Interest: 

No inflation 

6 percent inflation 

Long-term capital gains: 

NO inflation 

6 percent inflation 

50 50 

0 50 

50 50 

125 50 

20 50 

50 50 

Office of the Secretary of Treasury November 25, 1984 

Office of Tax Analysis

111. consumed Income Tax 

Consumption provides an alternative to income as the basis for 

personal taxation. A personal tax on consumption, or consumed income, 

would be levied by exempting all saving from tax, allowing a deduction 

for repayment of debt, taxing all borrowing and withdrawals from 

savings. Consumed income would be reported on a form much like the 

present form 1040. Deductions would be allowed for deposits in 

"qualified accounts" similar to existing individual retirement 

accounts (IRAs); withdrawals from such accounts would be subject to 

tax. (Further details of such a tax are described in Chapter 9.) 

Though a flat rate could be applied to the consumption base 

calculated in this way, most proposals for a consumed income tax 

postulate personal exemptions and graduated rate schedules. Thus, a 

consumed income tax could be progressive, if that were desired. 

Itemized deductions could also be allowed, as under the existing 

income tax. 

A. Administrative AavantaE 

The current income tax is based on the principle that income 

should be taxed annually as it is realized. It represents a practical 

compromise between administrative feasibility and the objective of 

taxing income as it accrues. Conceptually, accrued income can be 

defined as the amount a taxpayer could consume without reducing his OK 

her net wealth, that is, as the total of what the taxpayer actually 

consumes plus the change in his or her net wealth. Many practical 

difficulties plague application of this conceptual ideal as the basis 

of an income tax. Compromise between achieving the ideal, on the one 

hand, and avoiding complexity, on the other, produces a system that 

departs significantly from the conceptual ideal. Examples of compromise 

include taxation of capital gaitis only when they are realized, 

commonly by sale of an asset, rather than as they accrue. Compromises 

such as this can allow tax on large amounts of income to be postponed 

indefinitely, or even avoided altogether, as when appreciated property 

is transferred at death. On the other hand, efforts to administer the 

tax on an accrual basis, by levying tax before realization occurs, can 

introduce significant complexity an6 hardship. For example, if tax 

were levied on unrealized gains on closeiy-held business, valuation 

would be difficult; payment of tax, moreover, could frequently be 

required even though there is no cash flow with which to pay the tax. 

Because it avoids the problems inherent in accrual taxation, a tax 

on personal consumption is simpler i n many respects than an income 

tax. The consumed income tax is simpler because all costs of investment 

are deducted immediately ("expensed"), rather than 

depreciated over the life of assets; because all costs of creating 

inventories are expensed, rather than being recognized only as goods 

are sold; and because capital gains are not taxed, as such. A corporate 

income tax is not an essential part of an ideal tax system based 

on consumption; if retained, it woulc? serve only as a withholding 

device.

- 31 - 

The consumed income tax has another major administrat ve advantage 

over the income tax. Under the present income tax, the m asurement of 

income is commonly distorted by inflation. Because consumption 

inherently occurs in dollars of the current year, the measurement of 

the base of the consumed income tax cannot be distorted by inflation. 

Since depreciable assets and inventory investments are expensed, 

inflation cannot erode the value of future deductions because there 

are none. Interest is not taxed, unless spent on consumption, and 

thus the inflation premium is not taxed. Purely inflationary capital 

gains are not taxed, because there is no tax on capital gains, per se 

5. Economic Advantages 

Advocates of a consumed income tax argue that it is preferable to 

the ordinary income tax on conceptual and economic grounds, as well as 

on administrative grounds. First, an income tax penalizes saving by 

inducing taxpayers to consume rather than save for future consumption. 

By comparison, under certain circumstances, a tax on consumption does 

not distort the choice between consuming now and saving for future 

consumption. This is a major attraction of any tax on consumption. 

Second, seen from a lifetime perspective, a tax on consumed income 

is said to be more equitable than an income tax. A taxpayer's total 

tax burden under a tax on consumed income does not depend on when 

income is earned or spent, at least under fairly restrictive 

simplifying assumptions. By comparison, an income tax imposes a 

heavier burden on those who earn income relatively early in life or 

spend it relatively late. 

Despite the manifest attractions of the tax on consumed income, 

the Treasury Department does not propose it as either a replacement 

for, or a supplement to, the income tax. Several defects and 

difficulties of a consumed income tax lead to this conclusion. 

C. Transition Problems 

First, the current existence of substantial wealth, much of which 

has been accumulated from after-tax income, poses difficult transition 

problems. Taxing all consumption financed from such wealth would 

constitute a cruel trick on those who did not expect it -- especially 

those who have saved after-tax dollars for retirement. Nor would 

complete exemption of consumption financed from existing wealth be 

satisfactory. Such an exemption would either be enormously expensive 

in terms of lost revsnue or entail extremely high tax rates during the 

transition period. Worse, it would allow wealthy taxpayers to escape 

taxation for many generations if they consumed only old wealth and 

saved all current income. 

On equity grounds, a compromise between complete exemption and 

full taxation of consumption from existing wealth would be necessary. 

Such a compromise might allow each taxpayer above a given aye to enjoy 

a given amount of tax-free consumption during his or her lifetime.

- 32 - 

But phasing in a consumed income tax in this way would involve 

transition rules that could complicate the tax system for ordinary 

taxpayers for a generation. 

A different type of transition problem would result from the 

possibility of avoiding taxes by hoarding money before the effective 

date of the new tax. Arter the effective date the taxpayer could 

either deposit the hoarded funds in a qualified account in order to 

get a tax deduction for saving or use them to meet living expenses 

without paying tax. Alternatively, pre-effective date investments in 

foreign banks could be liquidated after the effective date and 

reinvested as tax-deductible saving. Even though this would be a 

temporary problem of transition, it would undermine both the revenue 

yield and fairness of the tax during that period. 

D. Perception Problems 

Even though a taxpayer’s standard of living, as reflected by his 

level of consumption, may be considered by many to be an appropriate 

base for taxation, the consumed income tax suffers from an important 

perception problem. Taxpayers presumably would welcome the 

opportunity to postpone taxes on amounts saved, paying tax only when 

dissaving and consumption occurs; such is the tax treatment currently 

accorded saving in qualified pension accounts. But to be consistent, 

it would also be necessary to tax amounts borrowed and allow a 

deduction for repayment of loans. This treatment of saving and 

dissaving would create a pattern of tax liabilities over the lifetime 

of the taxpayer that might be perceived to be unfair. Relative to 

experience under current law, tax liability would be greater during 

early adulthood and during retirement -- periods when financial 

resources are commonly strained. Tax would be relatively lower during 

middle age, the tine when many taxpayers receive most of their income. 

The fairness of including amounts borrowed in taxable consumption 

might be questioned, and this tax treatment might even require a 

constitutional arnendment. 

E. Complexity for Individuals 

A consumed income tax would be more complicated than the existing 

income tax for many individual taxpayers. Under the present income 

tax, amounts withheld on wages and salaries roughly offset tax 

liabilities for many taxpayers who have only modest amounts of income 

from capital. Relatively few taxpayers must worry about estimating 

liabilities and paying significant amounts of tax in addition to 

amounts withheld. Under the consumed income tax the situation could 

be quite different. Withholding might be required on borrowing and 

withdrawals from savings; if so, “reverse withholding” would be 

appropriate when a loan is paid off. Even then, far more taxpayers 

might need to file estimated returns than now, because it would be 

difficult to adjust withholding rates on financial transactions to the 

personal circumstances of taxpayers. Moreover, many young adults and

- 33 - 

retired individuals are not required to file or pay -tax under an 

income tax, but would be required to file and pay tax under a consumed 

income tax. 

Owner-occupied housing would not be treated as an item of 

consumption, to be taxed in full in the year of purchase. Rather, 

inclusion of the purchase price in taxable consumption would be spread 

over the lifetime of the home, in effect, by requiring taxpayers to 

pay tax as their mortgages were paid off. This could be accomplished 

through special treatment of mortgages outside of qualified accounts. 

But purchases of homes from amounts saved in qualified accounts could 

require special averaging features that would complicate compliance 

for taxpayers. Ironically, individual taxpayers would, in a sense, be 

aslted to keep accounts resembling depreciation accounts at the same 

time that such accounts were eliminated for businesses. 

F. The Dilemma of G ifts and Bequests 

The proper treatment of gifts and bequests under a tax on consumed 

income is a fundamental issue. Under one view such transfers would 

not be taxed to the person making the gift or bequest; they would only 

be taxed when consumed by the recipient. Under a very different view, 

transfers would be taxed to the donor, as well as when consumed by the 

recipient. Advocates of this second approach argue that taxing gifts 

and bequests is necessary in order to realize fully the beneficial 

equity and efficiency effects of a consumption-based tax. They refer 

to this type of tax 7s a tax on lifetime income, to distinguish it 

from the conventiondl tax on annual income. The distributional 

differences in the two ways of treating gifts and bequests are, of 

course, substantial. The first approach would allow great fortunes to 

be passed from generation to generation without tax, whereas the 

second would subject transfers to tax. 

G. International Aspects 

No country has a tax on consumed income, although Sweden and the 

United Kingdom have considered it, and India and Sri Lanlta (then 

Ceylon) attempted to impose the tax for a brief period following World 

War 11. Any country imposing a consumed income tax would be very much 

out of step with its trading partners, all of which employ income 

taxes, and would face the task of renegotiating its foreign tax 

treaties. 

IV. 

Sales Tax 

The fourth option considered by the Treasury Department in its 

study of fundamental tax reform was a general sales tax, such as a 

value-added tax or retail sales tax. Chapter 10 of this volume 

examines sales taxes in greater detail, and Volume 111 contains an 

even more detailed analysis, especially of the value-added tax. 

Serious consideration was given to only two forms of sales tax: a 

single-stage retail sales tax and a value-added tax extending through

- 34 - 

the retail level. Alternatives such as a gross receipts or turnover 

tax, a general manufacturer's tax, and a value-added tax that excludes 

the retail level contain fundamental defects that render them 

inappropriate for use by a developed country such as the United 

States. These defects are described in greater detail in Chapter 10. 

Though the value-added tax (VAT) is now familiar throughout Europe 

and much of the rest of the world, it is new and unfamiliar in the 

United States. Americans therefore are likely to have difficulty 

appraising its economic effects. The kind of VAT most likely to be 

considered seriously in the United States is best seen as a particular 

way to administer a sales tax with economic effects very similar to 

those of a retail sales tax. Thus, in what follows, the discussion of 

the effects of a "sales tax" applies to both a VAT and a retail sales 

tax. 

General sales taxes have the advantages of not penalizing saving 

and investment, as income taxes do, and of being fairly neutral 

between ways of earning and spending money. Because their base is 

very large and they are collected in small increments on billions of 

transactions, they can efficiently and relatively painlessly raise 

large amounts of revenue to finance federal spending or to take 

pressure off the income tax. Some advocates of a national sales tax 

believe this to be a disadvantage and propose that any tax of this 

kind should be accompanied by constitutional limits on the tax rate or 

on Federal spending, as a percent of GNP. 

The following points also argue against use of a sales tax: it 

would involve some shift of tax liability to low-income groups; it 

would probably cause a one-time increase in prices; its implementation 

would require substantial administrative resources; and it would 

involve Federal intrusion on a revenue base long thought to be the 

fiscal preserve of state and local governments. Of these, the 

regressivity problem is probably the greatest. 

Regressivity could be eliminated, or at least reduced, by 

exempting from tax sales of certain goods such as food, housing, and 

medical care, or by taxing them at reduced rates. However, exemptions 

and differential rates increase complexity and require higher general 

rates of tax. Alternatively, regressivity could be redressed by 

establishing a comprehensive system of refundable credits under the 

income tax, or by adjusting transfer payments and providing nonrefundable 

credits. The slight tendency toward regressivity higher up 

the income scale should not be addressed by application of 

differential rates to "luxury" consumption. European experience 

indicates clearly that administrative costs far outweigh any benefits 

of such an approach. 

A value-added tax would be preferable to a retail sales tax, 

despite the greater familiarity of the latter. A Federal retail sales 

tax, when combined with the retail sales taxes levied by most states, 

would provide irresistable inducement to tax evasion at the retail 

level. By comparison, the VAT would involve collection of about

- 35 - 

two-thirds of revenue before the retail stage. Moreover, a VAT would 

contain self-enforcement features that, while easily overstated, are 

quite important. 

An additional reason for preferring the VAT over a retail sales 

tax is its treatment of capital goods and intermediate products and of 

goods in international trade. Under a VAT, exports, capital goods, 

and other intermediate inputs are automatically freed of tax. By 

comparison, under a retail sales tax this desired result is only 

approximately achieved; under many state sales taxes it is not even 

sought. 

Total substitution of a sales tax for the ciirrent income tax was 

rejected because of the distributional inequity of such a policy. In 

a revenue-neutral reform package, revenues from a sales tax could be 

used to reduce the income tax. This would have the advantage of 

shifting some of the burden of taxation from income to consumption and 

of allowing lower income tax rates, taking pressure off the definition 

and measurement of taxable income. It would have the disadvantage of 

reducing the progressivity of the tax system. Given the considerable 

administrative costs implementing a sales tax would entail, however, 

it probably should not be imposed merely as a replacement for part of 

the income tax.

- 37 - 

Chapter 4 

SUMMARY OF TREASURY DEPARTMENT PROPOSALS AND THEIR EFFECTS 

I. The Proposals in Brief 

This chapter summarizes the Treasury DepaKi"nt proposals for 

reform and simplification of the income tax and their effects on 

revenues and the distribution of tax burdens. Chapter 5 provides a 

detailed discussion of proposals that would affect most individual 

taxpayers. For the most part, it deals with taxation of income from 

labor and self-employment. Details of proposals for reform of the 

taxation of corporations and of income from business and capital are 

presented and discussed in chapters 6 and 7. The Treasury Department 

proposals that affect these features of the tax law are of little 

direct significance for most individual taxpayers. However, the most 

important reforms affecting retirement saving, the tax treatment of 

interest income and expense, and the taxation of capital gains are 

summarized briefly in chapter 5. 

It is worth repeating here the watchwords (described further in 

chapter 2) that guided development of these reforms: simplicity; 

fairness; lower rates; economic neutrality; economic growth; and fair 

and orderly transition. 

A. Individuals 

The financial affairs of most American taxpayers are not very 

complicated -- certainly, they are not as complicated as the income 

tax law makes them appear. Exclusions, adjustments, itemized 

deductions, and tax credits create much of the complexity in the 

individual income tax. If not required for the fair and accurate 

measurement of income or taxpaying ability, these provisions violate 

basic notions of fairness and distort economic choices. By reducing 

the tax base, they make necessary the high tax rates that stifle 

incentives and retard economic growth. 

1. Fairness for families. The personal exemptions will be 

increased to $2,000, and the zero-bracket amounts will be raised to 

$3,800 for a coup1e.filing a joint return, to $3,500 for a head of 

household, and to $2,800 for a single person. This will eliminate 

income tax for virtually all families with incomes below the poverty 

level. The dollar limits on the earned income tax credit will be 

indexed for inflation. The tax-exempt level for the elderly will be 

increased slightly, even though the extra exemption for the aged will 

be eliminated. The special exemption for the blind will be folded 

into an expanded credit for the elderly, blind, and disabled. 

2. Lower tax rates. The present 14 tax rates (15 for single 

returns) will be collapsed into 3 rates, 15, 25, and 35 percent. (See 

Table 4-1.) The first of these will apply only to income above the 

459-370 0 - 84 - 3

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- 39 - 

tax threshold, which will be $11,800 for a family of four. The 

personal exemption, zero bracket amount, and other bracket limits will 

be indexed, as under current law. 

A couple filing a joint return will not reach the 25 and 35 

percent rates until taxable income exceeds $31,800 and $63,800, 

respectively. By comparison, in 1986 under current law and expected 

1985 inflation, the 25 percent rate will apply to income in excess of 

$26,850, and rates of 38 to 50 percent will be levied on incomes in 

excess of $49,980. 

On average, the marginal. tax rates that will be paid on economic 

income under the Treasury Department proposals are 20 percent lower 

than under current law. Individual tax liabilities will be reduced an 

average of 8.5 percent. Of course, the percentage reduccion in taxes 

is greater at the bottom of the income scale, due to the increase in 

the tax threshold. Tax liabilities of families with incomes below 

$10,000 will fall by an average of 32.5 percent and the reduction in 

taxes for families with income of $10,000 to $15,000 will be 16.6 

percent. These changes are discussed further in section 111. 

3. Fair and Neutral Taxation. In order to achieve fair and 

neutral taxation and to allow rates to be reduced, it is necessary to 

define the tax base more accurately and more comprehensively thanunder 

current law. Certain fringe benefits -- most notably the cost 

of medical insurance in excess of $175 per month for a family and $70 

per month for a single person and group term life insurance -- will be 

subject to tax. Payments that replace lost wages will also be taxed. 

Since several forms of wage replacement will be eligible for the 

expanded credit for elderly, blind, and disabled, subjecting these 

forms of income to tax generally will not affect families with incomes 

below the poverty line. Real capital gains will be taxed as ordinary 

income, but interest income and capital gains that only reflect 

inflation will not be taxeC at all. 

Deductions for expenditures that are presently tax-preferred will 

be eliminated or curtailed. The deduction for State and local taxes 

will be phased out, and itemized deductions will be allowed for charitable 

contributions only to the extent that they exceed 2 percent of 

adjusted gross income. The deduction for charitable contributions by 

nonitemizers will be repealed. Deductions will be al.lowed for 

interest expense in excess of investment income only up to the amount 

of mortgage interest on the principal residence of the taxpayer, plus 

$5,000. The existing deductions for medical expenses and casualty and 

theft losses will be retained unchanged. The complicated credit for 

child and dependent care will be converted to a simpler deduction, 

available to nonitemizers as well as itemizers, in recognition that 

child and dependent care is an expense of earning income. Other 

expenses of earning income will be combined into one adjustment, or 

above-the-line deduction, subject to a minimis floor of one percent 

of adjusted gross income. The two-earner deduction will be repealed.

- 40 - 

Under the Treasury Department proposals it will not be possible to use 

gifts to children or trusts to circumvent the graduated rate 

structure. 

4. Retirement Savinq Incentives. Present law refrains from fully 

taxing economic income by providing tax-preferred treatment of saving 

for retirement. The Treasury Department-proposals will retain this 

treatment and, indeed, will liberalize the present tax treatment of 

Individual Retirement Accounts (IRAs). Spouses who work in the home 

will be eligible to make tax-deferred contributions to an IRA on equal 

terms with those who are employed in the marketplace. The Treasury 

Department proposes that the limits on tax-deferred contributions to 

IRAs be raised to $2,500 ($5,000 for a husband and wife). This 

proposal will, in effect, allow the vast majority of taxpayers to 

defer tax on most of their financial saving. 

5. Simplification. The increased personal exemptions and zerobracket 

amounts and the curtailment of itemized deductions and credits 

will bring considerable simplification. Of the 97 million tax returns 

filed currently, 16 percent involve no tax liability. This figure 

will rise to 22 percent. Roughly 35 percent of all returns now report 

itemized deductions. This figure will drop by about a third under the 

Treasury Department proposals, relieving an additional 10 to 11 

percent of all taxpayers of the need to record expenses and itemize 

deductions. 

In order to simplify tax compliance further, the Internal Revenue 

Service (IRS) will examine the possibility of implementing a system 

under which many taxpayers would no longer be required to prepare and 

file tax returns. Under such a "return-free" system, the IRS would, 

at the election of each eligible taxpayer, compute their tax 

liability, based on withholding and information reports provided to 

the IRS currently and send the taxpayer a report on the calculation of 

tax liability. The taxpayer would, of course, be allowed to question 

the IRS calculation of tax. Institution of the "return-free" system, 

together with the increases in zero-bracket amount and the personal 

exemptions, would substantially reduce the number of returns that 

taxpayers need to file with the IRS each year. This, in turn, would 

eliminate burdensome recordkeeping and cost requirements incurred by 

taxpayers in preparing returns. 

B. Taxation of Capital and Business Income 

The taxation of capital and business income in the United States 

is deeply flawed. It is best characterized as irrational and 

internally inconsistent. Effective tax rates on investment income are 

unpredictable, as they vary tremendously with inflation. The tax law 

provides subsidies to particular forms of investment that are unfair 

and that seriously distort choices in the use of the Nation's scarce 

capital. The interaction of various provisions results in opportunities 

for tax shelters that allow wealthy individuals to pay little 

tax, create the perception of a fundamentally unfair tax system, and 

further distort economic choices. The double taxation of dividends

discourages equity investment in the corporate sector, and needlessly 

high marginal tax rates create disincentives for saving, investment, 

invention, and innovation. Moreover, high marginal rates encourage 

efforts to obtain additional special tax benefits which, if 

successful, further erode the tax base and necessitate even higher 

rates in a vicious cycle. The international allocation of IJ.S. 

capital is also distorted. 

The tax reforms proposed by the Treasury Department will 

rationalize the taxation of income from business and capital. The 

primary objective of reform is to subject real economic income from 

all sources to consistent tax treatment. IJniform taxation of all 

income is necessary in order to minimize interference of the tax 

system with the market-determined allocation of economic resources 

among competing uses. A comprehensive and consistent definition of 

the tax base is also needed to restore both the fairness of the tax 

system and the public perception of fairness. Finally, the tax base 

must be broadened in order to allow the reduction of both individual 

and corporate income tax rates. 

1. Taxing Real Economic Income. Real economic income should be 

measured accurately during periods of inflation. The Treasury 

Department proposes that inflation adjustments be made in the 

calculation of depreciation allowances, capital gains, the cost of 

goods sold from inventories, certain charitable contributions, and 

interest income and expense. This reform will eliminate the need for 

the arbitrary ad hoc adjustments for inflation currently incorporated 

in the investment tax credit, the accelerated write-off of depreciable 

property, and the partial exclusion of long-term capital gains. 

Replacing the investment tax credit (ITC) and the Accelerated Cost 

Recovery System (ACRS) with real economic depreciation and taxing real 

capital gains as ordinary income will eliminate the great disparities 

in the taxation of various industries under current law. Inflation 

adjustment will prevent effective tax rates on investment income from 

depending on the rate of inflation in ways that vary across asset 

types and industries. The taxation of real economic income at lower 

rates, coupled with several additional reforms, will reduce the 

opportunities and incentives for tax shelter activities and, thus, 

allow investment decisions to be motivated by economic realities 

rather than by tax considerations. 

2. Retirement Savings Incentives. The tax treatment of retirement 

savings, a major source of funds for capital formation in the IJnited 

States, should be expanded and rationalized. The Treasury Department 

believes that the basic elements of the current tax structure which 

favor retirement savings should be retained and that the tax 

incentives encouraging such saving should be expanded. Accordingly, 

the Treasury Department proposes that the limits on contributions to 

individual retirement accounts (IRAs) be increased and that 

availability of IRAs be extended on an equal basis to spouses not 

employed in the marketplace. Under the Treasury Department proposals 

much of the financial saving of families will be accorded favorable 

tax treatment. According to one survey, only 39 percent of all

- 42 - 

American families have accumulated total financial assets of more than 

$5000. An even smaller percentage would save as much as $5000 in any 

one year As a result, individuals will experience much of the tax 

preference for saving associated with a consumed income tax, but the 

many problems involved in implementing such a personal tax on 

consumption (discussed in chapter 9) will be avoided. The Treasury 

Department also proposes that the tax treatment of retirement savings 

be rationalized by subjecting all pre-retirement distributions to 

uniform rules, and by simplifying the contribution limits applied to 

various tax-preferred plans. 

3. Neutrality Toward Business Form. Corporations and partnerships 

should be taxed in more nearly the same way. The Treasury Department 

proposes that corporations be-given a partial deduction for dividends 

paid in order to reduce the double taxation of dividends, and that 

certain large partnerships be taxed as corporations. 

4. Industry-Specific Subsidies arid Tax Shelters. Highly 

preferential tax treatment that benefits only a few selected 

industries should be eliminated. This special treatment is 

undesirable both because it is inequitable and because it violates the 

principle of economic neutrality. A consistent definition of taxable 

income would allow market forces, rather than the tax system, to 

determine the allocation of the Nation's scarce economic resources. 

c. Economic Effects 

Implementation of the tax reforms proposed by the Treasury 

Department will cause a substantial reallocation of economic 

resources. The lower tax rates made possible by base-broadening and 

the more accurate rules for the measurement of income and calculation 

of tax liabilities will stimulate investment in industries that are 

burdened by the current unfair and distortionary tax regime. The 

proposed reforms will thus benefit both some established industries as 

well as new "high-tech" industries. 

However, the primary beneficiaries of the Treasury Department's 

proposals will be the American public. No longer will the allocation 

of the Nation's scarce economic resources -- its labor, its capital, 

its land, and its inventive genius -- be distorted by the biases of 

the current tax system. Instead, under the economically neutral tax 

system proposed by the Treasury Department, market forces will direct 

resources to those activities where returns are greatest. The result 

will be more productive investment and thus greater output. A more 

effectively utilized capital stock will result in a more productive, 

and thus more highly paid, labor force. Output prices in currently 

tax-favored industries will increase, while output prices in currently 

tax-disadvantaged industries will fall. As a result, a more useful 

mix of goods will be produced, since consumer prices will adjust to 

reflect these changes in costs, and consumer demand will no longer be 

artificially distorted.

- 43 - 

In addition, the biases under current law against emerging firms, 

especially those with relatively low demands for physical capital, 

will be eliminated. The current bias toward firms with relatively 

la?ge investments in depreciable assets, especially short-lived 

equipment, will be eliminated under a capital recovery system that 

approximates economic depreciation. Economic depreciation will reduce 

the current bias toward established firms that can fully utilize 

special deductions and credits by replacing the present "front-loaded" 

capital recovery system of ACRS and the ITC. MOKeOVeK, the current 

bias toward established firms with retained earnings will be reduced 

by decreasing the marginal tax rate on corporate income paid out as 

dividends. Since retained earnings would not have as large a tax 

advantage over new equity, firms in need of new equity financing will 

find it more readily available. Since many firms in the "high 

technology" industries are emerging and relatively low capital 

intensity, the proposed reforms will foster invention and innovation 

by benefitting such firms. The reform proposal thus would promote 

faster economic growth, in addition to improving the allocation of the 

Nation's resources at any single point in time. 

The Treasury Department prOpOSalS will affect different industries 

in different ways; in particular, not all industries would benefit 

from tax reform. That is the nature of the tax reform problem. The 

only way to reduce the burden of taxes on industries that pay aboveaverage 

taxes under current law is to shift part of that burden to 

industries where taxes are now artificially reduced by special provisions. 

Taxpayers that would lose special tax preferences under the 

proposed reforms include the oil and gas industry; banks, life 

insurance companies, and other financial institutions; and industries 

in which production extends over several years. 

Although it is possible to identify the industries that would lose 

special tax preferences, it is impossible to predict the precise 

economic effects of the entire package of Treasury Department 

proposals on all industries and individuals in the economy. Although 

many mathematical models of the economy exist, economic science simply 

is not sufficiently precise to allow accurate prediction of the 

effects of reforms as fundamental and pervasive as those proposed by 

the Treasury Department; accordingly, this Report contains no such 

attempt at precise quantification of economic effects. 

D. Transition 

Enactment of the Treasury Department proposals would undoubtedly 

result in a sizable reallocation of resources. Costly dislocations 

and unanticipated losses caused by tax reform can -- and should -- be 

mitigated through provisions for fair and orderly transition. This 

Report contains many recommendations (see Volume 2) for delayed or 

phased-in enactment dates. MOKeOVeK, "grandfathering" provisions 

designed to maintain current tax treatment for commitments made under 

present law would mitigate the dislocations and windfall losses 

associated with implementing reform. Nevertheless, transition to a 

more equitable and more neutral system must OCCUK. To resist

- 44 - 

permanently the need to tax all real economic income consistently and 

uniformly would be to perpetuate the high tax rates, inequities, and 

tax-induced distortions of resource allocation that currently plaque 

the economy. It would also threaten the viability of our voluntary 

income tax system by allowing these defects to continue to undermine 

taxpayer morale. 

11. Effects on Revenues 

The Treasury Department proposals are designed to be revenue 

neutral. That is, they raise roughly the same amount of revenue as 

current law, when fully phased in, and during each of the transition 

years, FY 1986-90. Table 4-2 shows projected tax receipts under both 

current law and the Treasury Department proposals, plus receipts under 

the proposals as a percent of current law receipts, for fiscal years 

1986-90. 

During FY 1986, receipts under the proposals exceed those under 

current law by $0.5 billion. In FY 1987, they fall short of current 

receipts by $5.8 billion. During the FY 1988-90 period, receipts 

under the proposal exceed those under current law by an average of 

$6.0 billion, or 0.9 percent of current law receipts. These 

deviations from receipts under current law are small enough, compared 

to potential errors in estimates, that the proposals should be 

characterized as revenue neutral. 

It would not be helpful to show actual dollar receipts beyond the 

transition period, given the vagaries of forecasting so far into the 

future. But, when fully phased in, the proposal raises about 1 to 3 

percent less revenue than current law. In other words, if receipts 

under current law would have otherwise been $1 trillion, they will be 

$10 to $30 billion less under the Treasury Department proposal when 

fully phased in. Thus, even when fully phased in, the proposals are 

revenue neutral. 

The estimates of receipts for 1986-90 are based on the economic 

forecast in the 1984 Mid-session Review. The estimates reflect the 

assumption that the level of economic output is not affected by the 

tax reforms being proposed. In fact, the dramatic reductions in 

marginal tax rates that are being proposed can be expected to generate 

additional work effort, saving, investment and innovation. As a 

result, economic output -- and with it tax receipts -- will probably 

be higher than projected. Predicting how much higher is, however, 

inevitably a difficult task. Any estimates of the effects of 

increased incentives would be far outside the range of recent 

experience. 

Table 4-2 also shows the breakdown of annual receipts between 

individual and corporate taxpayers. Over the period FY 1986-1990, 

individual receipts will be reduced by some 6 to 9 percent per year 

relative to current law, while corporate receipts will be 25 to 37 

percent higher. Fully phased in individual receipts will be 8.5 

percent lower; corporate receipts will be about 24 percent higher.

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111. Effects on Income Distribution and Incentives 

The Treasury Department has designed its proposals to be basically 

neutral from a distributional point of view, as well as revenue 

neutral, once fully phased in. That is, the distribution of 

individual income tax burdens across income classes does not differ 

significantly from that under current law, except in one important 

respect. An explicit goal of the study is the elimination of income 

tax liability from families with incomes below the poverty level. To 

achieve the increase in the tax threshold required to meet this 

objective, the personal exemptions and zero-bracket amounts will be 

increased, thus increasing slightly the relative burdens of all 

taxpayers above the new tax-exempt levels of income. 

One way to see the distributional neutrality of the proposed 

package of tax reforms and simplification is to examine the percentage 

distribution of tax liabilities under present law and proposed law. A 

comparison of lines 5 and 6 of Table 4-3 reveals that the percentage 

distribution of tax liabilities would not be changed significantly, 

except at the bottom of the income scale, where burdens would clearly 

be reduced. 

Although the proposed tax reforms reduce total revenues from the 

individual income tax by 8.5 percent, the increase in the tax 

threshold is reflected in substantially greater reductions in taxes 

paid in the bottom two income classes. Liabilities of families with 

incomes below $10,000 fall by 32.5 percent and those of families with 

incomes between $10,000 and $15,000 fall by 16.6 percent. Above 

average, but smaller reductions are also experienced in the next three 

income classes. In the three income classes above $50,000 the 

reduction in taxes is slightly less than average, at 6.4 to 8.0 

percent. (See line 9 of Table 4-3 and Figure 4-2.) 

The distributional neutrality of the proposed reforms is also 

shown by the pattern of average tax rates paid at each income level, 

under present law and the proposed law. (See lines 10 and 11 of Table 

4-3 and Figure 4-1.) Under current law, the average rates increase 

steadily from about 1-1/2 percent for those with incomes below $10,000 

to roughly 21 percent for taxpayers with income in excess of $200,000. 

Under proposed law the range of average rates is from about 1 percent 

to just above 19 percent. 

The pattern of average tax rates, that is, the percentage of total 

income taken by taxes at various income levels, is relevant for 

judging the distributional fairness of the tax system. The figures 

just presented show that the reforms proposed do not significantly 

redistribute tax burdens across income classes except insofar as tax 

burdens at the very bottom of the income scale are reduced 

dramatically; that is, the proposals are basically distributionally 

neutral. 

Average tax rates do not indicate the extent to which taxation 

creates disincentives for productive economic activities. To appraise

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- 47 - 

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incentive effects it is necessary to know marqinal tax rates, that is, 

the percentage of an additional dollar of income that will be taken by 

taxes. 

Lines 12 to 14 of Table 4-3 and Figure 4-3 present data on 

marginal tax rates paid, on the average, at various income levels. In 

the aggregate the proposed reforms reduce marginal tax rates by 19.9 

percent, from 23.6 percent to 18.9 percent. The fact that marginal 

tax rates can be cut this much while average tax rates fall by only 

8.5 percent shows clearly the advantage of defining taxable income 

comprehensively. By levying lower marginal tax rates on a broader tax 

base, it is possible to avoid the disincentive effects of higher 

rates. 

Marginal tax rates paid by families in the three income classes 

between $30,000 and $200,000 fall, on average, by about 20 percent. 

The marginal tax rates paid, on the average, by families with income 

below $30,000 fall by 10 to 13 percent. Even though marginal income 

tax rates do not fall as much at this income level as at others, they 

are low, on average, ranging from only 4 to 14 percent under the 

proposed law. 

In the very highest income bracket, that above $200,000, the 

marginal tax rate falls by 23 percent, from 46 percent to 33 percent. 

It bears repeating that this relatively greater cut in marqinal rates 

in the top income classes does not imply that high-income taxpayers 

will experience a relatively greater tax cut than taxpayers with lower 

incomes. As line 9 of Table 4-3 indicates, all income groups above 

the $50,000 income level experience smaller than average tax 

reductions. Rather, marginal rates fall furthest at the top of the 

income distribution because that is where the tax base is increased by 

the largest fraction. The proposed tax reforms increase adjusted 

gross income (AGT) for all families by only 2.8 percent. (See line 7 

of Table 4-3.) But for families with income in excess of $200,000, 

AGI increases by 10.1 percent, as a result of eliminating many 

provisions that allow income to be sheltered from tax. 

The total of taxable income for all families is virtually 

unchanged under the Treasury Department proposals. (See line 8 of 

Table 4-3.) But for those with incomes below $15,000, taxable income 

falls dramatically -- by 14 to 16 percent, due primarily to the 

increase in the personal exemptions. Smaller reductions in taxable 

income extend through the $30,000 to $50,000 income class. Above that 

point, taxable income increases, with taxable income of those with 

incomes of more than $200,000 rising by 24.9 percent. (See Figure 

4-4 1 ) 

The dramatic reduction in marginal tax rates that base-broadening 

makes possible at the top of the income scale emphasizes the 

importance of taxing all income in a consistent manner. Simply by 

defining the tax base comprehensively, it is possible to achieve a 

percentage reduction of marginal tax rates paid by high-income 

individuals that is larger than that provided in the Economic Recovery

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- 53 - 

Tax Act of 1981, and to do so while cutting taxes for them by less 

than they are cut for lower income classes. A reduction of marginal 

tax rates of this magnitude will open wide the doors of opportunity to 

those who are willing to work, to save and invest, and to innovate. 

The advantage of base-broadening can also be seen from Table 4-4 

and from Figure 4-5. Of the 91.4 million families in the country, 

fewer than 20 million, or about 22 percent, will experience any tax 

increase as a result of the Treasury Department proposals. By 

comparison, 56 percent will have their taxes reduced. At the lower 

income levels the fraction of families with tax increases is even 

smaller, ranging from less than 5 percent in the zero to $10,000 

income class to about 20 percent in the $15-20,000 income class. 

In every income class far more families will benefit from the 

Treasury Department's proposals than will lose. Moreover, there are 

far more families whose average tax rate will fall by a given.amount 

(for example, less than one percentage point or more than two 

percentage points) than there are families whose average rates will 

rise by that amount. (See Table 4-4.)

- 54 - 

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- 57 - 

Appendix 4-A 

Explanation of Concept of Economic Income Used 

in Distributional Tables 

The tables in this Report showing the distribution of current and 

proposed tax liabilities by family income class represent an important 

improvement over the kinds of comparisons the Treasury Department has 

been able to display in the past. They differ from the usual tables 

in two ways: (1) taxes and the effects of changes in tax policy are 

distributed over all families in the population, rather than over taxfiling 

units; and (2) the definition of income is a broad measure of 

economic income, rather than adjusted gross income. 

Families 

For many people, the tax unit and the family are the same. A 

family can, however, consist of several tax filing units if dependents 

have incomes of their own. For instance, if the children in a family 

have jobs or have investment funds in their names, they may have to 

file returns to pay taxes OK to receive a refund of taxes that were 

withheld. For judging the fairness of the distributional burden of 

the tax system, the incomes and the taxes of those dependents should 

be included with the incomes and taxes of the taxpayers (usually 

parents) who support them. 

Another difference between the tax return unit and the family is 

that many families and individuals have too little income for them to 

be required to file a tax return under current law. These "nonfilers" 

should be recognized in surveying the tax system's impact on people at 

different income levels. Tables based on tax returns cannot show how 

many people at a given income class are not even in the tax system, 

whereas the tables in this Report do reflect the families and 

indivfduals who do not file tax returns. 

Income Definition 

The definition of income used in this Report for classifying 

families and for comparing tax burdens differs from adjusted gross 

income and other tax system concepts of income in a number of ways. 

(The income classifier does not serve as the basis for actual 

taxation.) Economic income is a comprehensive measure of income that 

is intended to approximate as closely as possible the standard 

definition of income, consumption plus change in net worth. It 

includes forms of income that are not subject to tax, such as interest 

from tax-exempt state and local bonds and government transfer 

payments. It also measures more accurately certain other forms of 

income that are subject to tax, such as real interest income. This 

broader measure of income, therefore, provides a better yardstick for 

comparing families -- that is, for determining their abilities to pay 

taxes and comparing tax burdens by income class.

- 58 - 

"Economic income" starts from adjusted gross income as reported on 

tax returns and adds in unreported or underreported income. It adds 

back certain "adjustments to income," principally IRA and Keogh 

contributions and the second earner deduction. Since economic income 

aims to measure income in the current year, it adds back net operating 

losses carried over from previous years. It includes cash and nearcash 

transfers that are not subject to tax, principally social 

security benefits, welfare payments, unemployment and workers' 

compensation, veterans' compensation, and food stamps. It adds in the 

untaxed portion of compensation such as employer contributions for 

pensions and health and life insurance and other fringe benefits. So 

that pension income not be double counted, it excludes pension income 

as received but includes the accrual of earnings on pension and life 

insurance plans, and on IRA and Keogh accounts. It includes taxexempt 

interest. Since home owners receive implicit income from their 

houses, economic income includes an estimate of the real imputed net 

rent on owner-occupied housing. 

"Economic income" reflects the view that corporations are not 

separate from their stockholders, but that: the income of corporations 

is income of its stockholders; therefore, economic income allocates 

pre-tax corporate profits both to individuals who own stock directly 

and to those who own stock indirectly, for example, through shares of 

pension or Life insurance funds. Economic income attempts to measure 

capital income correctly: by indexing interest receipts and expenses, 

by indexing capital gains and losses, by replacing tax depreciation 

with real economic depreciation, and by including the tax-preference 

component of intangible drilling costs and percentage depletion 

allowances. 

The derivation of economic income from adjusted gross income is 

described in greater detail in Table 4A-1. Figure 4A-1 compares the 

distribution of tax returns classified by AGI with the distribution of 

families classified by economic income. The most striking difference 

is that twice as large a percentage of tax returns fall in the 

smallest class -- below $lG,OOO -- than do families. Conversely, a 

much higher percentage of the families appear in the higher income 

classes of economic income. The chart shows clearly how poorly the 

distribution of tax returns by AGI approximates the distribution of 

families by economic income, which is a more appropriate way of 

viewing the population for most analytical purposes.

-' 59 - 

Table 4A-1 

Economic Income Equals 

Adjusted gross income: 

reported on tax returns 

unreported or underreported 

plus net operating losses carried over from previous years 

plus adjustments to income: 

IRA and Keogh contributions 

two-earner deduction 

other adjustments 

plus untaxed employer contributions for: 

pensions 

health and life insurance 

profit sharing 

other benefits 

plus certain fringe benefits 

plus certain military benefits 

plus untaxed cash benefits for: 

unemployment compensation 

workers' compensation 

AFDC 

SSI 

veterans' compensation 

social security 

railroad retirement 

plus food stamps benefits 

plus non-corporate earnings on pension and 1 fe insurance pl ns 

less taxable pension income 

plus earnings on IRA and Keogh plans 

plus tax-exempt interest 

plus real net imputed rent on owner-occupied homes 

less realized conorate income 

plus accrued pre-tax real corporate income 

plus adjustment for indexing of non-corporate capital gains and losses 

plus adjustment for indexing of interest income and expense 

plus replacement of tax depreciation with economic depreciation 

plus tax preference for intangible drilling costs, and percentage 

depletion

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Chapter 5 

INCOME TAX REFORM AND SIMPLIFICATION FOR INDIVIDUALS & FAMILIES 

I. Summary 

The Treasury Department proposals will lower tax rates and reduce 

the current number of rate brackets from 15 to three: 15, 25, and 35 

percent. The amount of income that can be earned tax-free will also 

be increased by raising to $2,000 the personal exemptions for the 

taxpayer, spouse, and dependents and by increasing the zero bracket 

amounts. Very few families below the poverty level will be subject to 

income tax. 

The tax base will be broadened to make this rate reduction 

possible, simplify the system, and make it fairer by eliminating 

special preferences and abuses. The definition of individual taxable 

income will be expanded to include certain fringe benefits and other 

items. Deductions for tax shelter investments and business expenses 

that involve personal consumption will be curtailed. The itemized 

deduction for State and local taxes will be phased out, and charitable 

contributions will be deductible only to the extent that they exceed 2 

percent of adjusted gross income. Left intact will be the current 

itemized deductions for interest on the principal residence of the 

taxpayer, medical expenses, and casualty losses. 

Elimination of several tax credits and other items will 

substantially simplify the tax forms. The Internal Revenue Service 

will consider the possibility of initiating a new system under which 

it calculates tax liability for many taxpayers. 

The deductions for contributions to Individual Retirement Accounts 

will be increased to $2,500 per employee and from $250 to $2,500 for 

spouses working in the home. Other proposed changes that involve the 

taxation of business and capital income, including the corporation 

income tax, are of less concern to most individuals and are discussed 

in chapters 6 and 7. (The appendix to the present chapter contains a 

detailed listing of all proposals primarily affecting individuals and 

families.) 

11. Rate Reduction 

The reforms proposed by the Treasury Department will expand the 

income tax base enough to allow substantial rate reductions for 

individuals. On incomes above the tax threshold ($11,800 for a family 

of four) three rates -- 15, 25, and 35 percent -- will apply. Under 

current law, marginal rates range from I1 percent to 50 percent. Thus 

the top marginal rate will be cut by 30 percent under the Treasury 

Department proposals. The proposed rate schedules for single returns, 

head of household returns, and joint returns are compared with those

- 64 - 

under current law in Table 5-1. On average, marginal tax rates will 

be 20 percent lower under these proposals than under current law. The 

effects on marginal rates paid at various points in the income 

distribution were discussed further in Chapter 4. 

Individual income taxes in 34 States rely on the Federal income 

tax base. Taxpayers will experience further rate reductions if States 

cut rates to hold their revenues constant in the face of an increased 

tax base. 

As noted in previous chapters, rate reduction will encourage 

saving, investment, work effort, innovation, and other productive 

behavior. It will reduce the attraction of both tax avoidance through 

legitimate tax shelters and illegal underreporting of income. Even 

without elimination of tax preferences, credits, and deductions, rate 

reduction will lessen the disparities in the tax treatment of various 

sources and uses of income. When combined with some of the other 

proposals described below, rate reduction should also help to reduce 

interest rates and lead to a more robust and efficient economy. 

While lower marginal rates tend to increase work incentives for 

everyone, beneficial incentive effects will be especially pronounced 

for secondary workers, persons who often have considerable discretion 

over their labor market activity. Lower marginal rates will also 

reduce the extent to which the tax system influences choices of 

occupation and the amount of personal investment in education. 

Rate reduction will provide significant benefits to those who 

receive little or no income in preferred forms. Thus, rate reduction 

will be particularly helpful to persons who now receive the bulk of 

their labor income in the form of cash wages. This group includes 

secondary workers, workers in retail and certain service industries, 

and other workers who generally do not benefit from large fringe 

benefit packages. By the same token, those employers who now pay 

their employees in cash, rather than fringe benefits, will find that 

the after-tax wages of their employees will rise slightly relative to 

those of other employers, without any added cost to the employer. 

These employers will find that any competitive disadvantage they 

experience in attracting workers because of the current tax Law will 

be diminished. 

On the other hand, rate reduction will have a less favorable 

impact on the sectors of the economy that benefit most from preferen 

tial treatment under current law. Rate reduction will reduce the 

attraction of tax-exempt bonds relative to taxable investments. 

Since charitable contributions are encouraged by high marginal tax 

rates that reduce the after-tax cost of giving, reducing marginal 

rates may reduce contributions. Deductions or exclusions for the cost 

of health insurance (whether provided by employers or by individuals) 

will becomes less valuable, thus leading to a reduction in the demand 

for such insurance and for health services.

- 65 - 

Table 5-1 

Proposed Tax Rate Schedule 

Single Returns 

Taxable : Marqinal . 

income : tax rate 

( percent ) 

Less than $2,800 0 

$2,800 to 19,300 15 

$19,300 to 38,100 25 

$38,100 or more 35 

:Head of Household Returns: 

Joint Returns 

- - 

: Taxable : Marqinal : Taxable : Marqinal 

: income : tax rate income : tax rate 

( percent ) ( percent ) 

Less than $3,500 0 Less than $3,800 0 

$3,500 to 25,000 15 $3,800 to 31,800 15 

$25,000 to 48,000 25 $31,800 to 63,800 25 

$48,000 or more 35 $63,800 or more 35 

1986 Current Law Tax Rate Schedules 

Single Returns :Head of Household Returns: Joint Returns 

Taxable : Marginal : Taxable : Marginal : Taxable : Marginal 

income 1/: tax rate : income 1/: tax rate : income 1/: tax rate 

( percent ) ( percent ) ( percent )- 

Less than $2,5 10 0 

2,510- 3,710 11 

3,710- 4,800 12 

4,800- 7,090 14 

7,090- 9,280 15 

9,280-1 1,790 16 

11,790-14,080 18 

14,080-1 6,370 20 

16,370-1 9,860 23 

19,860-25,650 26 

25,650-31,430 30 

31,430-37,210 34 

37,210-45,290 38 

45,290-60,350 42 

60,350-89,270 48 

89,270 or more 50 

Less than $2,510 0 Less than $3,710 0 

2,510- 4,800 11 3,710- 6,000 11 

4,800- 7,090 12 6,000- 8,290 12 

7,090- 9,490 14 8,290- 12,990 14 

9,490- 12,880 17 12,990- 17,460 16 

12,880- 16,370 18 17,460- 22,040 18 

16,370- 19,860 20 22,040- 26,850 22 

19,860- 25,650 24 26,850- 32,630 25 

25,650- 31,430 28 32,630- 38,410 28 

31,430- 37,210 32 38,410- 49,980 33 

37,210- 48,780 35 49,980- 65,480 38 

48,780- 66,130 42 65,480- 93,420 42 

66,130- 89,270 45 93,420-119,390 45 

89,270-118,190 

48 119,390-117,230 49 

118,190 or more 50 177,230 or more 50 

Office of the Secretary 


of the Treasury 

-1/ Estimated.

- 66 - 

The impact on currently favored sectors can, of course, easily be 

exaggerated. All tax rate reductions can be opposed on the grounds 

that high tax rates increase the value of exemptions and deductions 

for favored activities. But imposing high tax rates on most income, 

in order to accord favorable treatment to some sources and uses of 

income, is hardly an efficient way to provide subsidies, even if that 

is desired. A more efficient and productive economy in the end helps 

participants in all sectors. For example, though rate reductions 

would initially raise the after-tax cost of health insurance, the 

overall cost of health care should eventually be less than in the 

absence of tax reform. Costs will respond to the reduced demand for 

such care and to the greater attention that would be focused on the 

cost of both health care and insurance. 

111. Fairness for Families 

Families with incomes at or below the poverty level should not be 

subject to income tax. Thus, the tax threshold -- the level of income 

at which tax is first paid -- will be raised so that for most 

taxpayers it approximates the poverty level, as determined by the 

Bureau of the Census. The proposed tax threshold will be increased 

relatively more for returns filed by heads of household (those single 

persons who maintain households for dependents), in recognition of the 

particular economic difficulties of such households. 

After considering various means of setting the tax threshold, the 

Treasury Department proposes to retain the basic structural features 

of the present income tax: the personal exemption and the zero- 

bracket amount. The personal exemption for taxpayers, spouses, and 

dependents for 1986 will be increased to $2,000, compared with a 

projected $1,090 under current law (after indexing for inflation 

expected to occur during 1985). The zero-bracket amounts for single 

persons, heads of household, and married couples filing jointly will 

be increased, as shown in Table 5-2. The personal exemptions, zero- 

bracket amounts, and tax brackets will continue to be indexed to 

prevent their value from being eroded by inflation. These proposed 

changes are designed to reflect differences in ability to pay taxes 

that result from differences in family size and composition. The 

increase in the personal exemption recognizes the greater financial 

responsibilities and lesser ability to pay of those taking care of 

dependents. 

The proposed changes in the personal exemptions and zero-bracket 

amount would raise the 1986 tax threshold for a married couple filing 

jointly with no dependents from $5,890 to $7,800. A couple with two 

children would pay no income tax unless its income exceeded $11,800. 

Under current law, the same family will pay tax on income above 

$9,613, assuming full use of the earned income credit. (See Table 5-2 

and Figure 5-1.)

- 67 - 

Table 5-2 

Comparison of Personal Exemptions, and ZBA 

Under Current Law and Treasury Department Proposals 

1986 Levels 

: Current Law -1/: Treasury 

: Proposal 

Personal Exemption $1,090 $2,000 

Zero-Bracket Amount 

Single persons 2,510 2,800 

Heads of househ o1ds 2,510 3,500 

Married couples 3,710 3,800 

-1/ Includes indexation for expected inflation in 1985.

- 68 - 

 

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- 69 - 

This increase in the tax threshold will exempt all families in 

poverty from Federal income tax. Table 5-3 shows the relationship 

between the poverty level of income and the tax threshold for 

households of different sizes and compositions under both current law 

and the Treasury Department proposals. For single persons without 

dependents, where the tax threshold will still be $1,000 less than the 

poverty level. If the tax-free income level for single taxpayers were 

raised further, in order to benefit those single persons whose tax 

threshold is below the poverty level, it would be too high relative to 

the levels for heads of household and married couples. An increase in 

tax -- or marriage penalty -- would be imposed on single persons who 

decide to marry. 

For single taxpayers without dependents who live with relatives or 

unrelated persons, the comparison of the tax-free income level with 

the poverty income level may be misleading. When the tax-free income 

level for these individuals is combined with the tax-free income 

levels for other members of the household, the total generally exceeds 

a poverty income level. For example, the tax-free income levels for 

taxpayers who are under age 21, who account for over one-quarter of 

all single persons with income subject to tax, often should be 

combined with the tax-free income levels of parents and other 

household members. Similarly, the combined poverty level for two 

single persons who share living quarters might, if appropriately 

measured, be close to that of a married couple. Their combined taxexempt 

income level might exceed that poverty level. 

The existing tax treatment of the blind, disabled, and elderly has 

evolved with little rationale. The Treasury Department proposes that 

all special treatment provided these groups under current law, 

including the additional personal exemptions, be replaced with a 

single tax credit for the elderly, blind, and disabled. Under the 

proposal, persons receiving workers' compensation, black lung 

payments, and certain veterans' disability pay would be treated 

similarly to persons who are permanently and totally disabled and 

receive disability pay from employers. Once the tax benefits of this 

expanded credit are taken into account, the tax-exempt level of income 

for a single person who is disabled for an entire year, and whose 

income is composed mainly of such disability payments, would be 

$9,700. For a family of four, the level would be $17,200. These taxexempt 

levels substantially exceed of those applying to other 

taxpayers ($4,800 for single persons; $11,800 for families of four). 

In about 80 percent of States, a family of four solely dependent upon 

workers' compensation would pay no Federal income tax even if it 

received the maximum payment under that State's program. 

llnder the Treasury Department proposal, as under current law, tax- 

exempt levels for the elderly will be substantially higher than those 

for the non-elderly. When both the increased personal exemption and 

459-370 0 - 84 - 4

- 70 - 

Table 5-3 

Comparison of the Poverty Threshold and the Tax-Free Income 

Level Under Current Law and the Treasury Proposal 

I./ 

(1986 Levels) 

:Tax-free Income Levels 

: Poverty : Current : Treasury 

Status : Threshold : Law 2/: Proposal 2/ 

single persons without dependents $5,800 $3,600 $4,800 

Heads of households with 

one dependent 7,900 7,979 9,303 

Married couples 3/ 7,400 5,890 7,800 

Married couples with 

two dependents 3/ 11,600 9,613 11,800 

-1/ Includes expected indexation for inflation in 1985. 

-2/ Assumes full use of the earned income tax credit where applicable. 

3/ Assumes one earner. 

-

- 71 - 

the new expanded credit for the elderly, blind and disabled are taken 

into account, the tax-exempt level for elderly couples receiving no 

social security income, at $14,533, will be essentially unchanged from 

current law. It will be $16,800 for a couple receiving the average 

amount of social security income, virtually the same as under current 

law. BY comparison, a non-elderly couple will have a tax-exempt 

amount of only $7,800. (See also Figure 5-2.) 

The benefits of the existing two-earner deduction are not 

well-focused for families where marriage increases tax burdens. While 

marriage penalties are reduced in some cases, marriage bonuses are 

created in others. With the proposed increase in personal exemptions 

and flatter rate structure, the two-earner deduction will be 

unnecessary. For most taxpayers the work incentive of second earners 

will be greater under the proposed lower and flatter rate structure 

than under existing law, with its two-earner deduction. The Treasury 

Department therefore proposes that the two-earner deduction be 

eliminated in favor of tax rate reduction. 

The earned income tax credit (EITC) adds considerable complexity 

to the system, especially for those least able to understand it. If 

simplicity were the primary goal of tax reform, the EITC would be 

eliminated, and with it a large number of tax returns filed only to 

claim the refundable credit. Given the equity objectives of reform, 

however, the EITC is retained, and it is indexed to prevent its 

erosion by inflation. 

The complicated child and dependent care credit should be replaced 

by a simpler deduction. A deduction is more appropriate than a 

credit, because child and dependent care is an expense related to 

earning income. Accordingly, the true net income of those who incur 

child care expenses in order to be employed will be better measured if 

they are allowed to deduct such costs, up to a limit. Failure to 

allow a deduction, besides being unfair, would adversely affect work 

incentives. Of course, a deduction is relatively less favorable to 

low-income taxpayers than is a credit. The choice of a deduction in 

this case reflects the view that progressivity should be provided 

directly, through changes in the rate structure, rather than through 

individual provisions that lack logic and add to complexity. 

Recognition of the cost of raising dependents, the cost of main 

taining a household, and the cost of child care will be especially 

beneficial to low-income single heads of household, a group that has 

grown from 2.6 percent of total income tax returns in 1963 to 8.9 per- 

cent in 1982. In combination the Treasury Department proposals should 

have an especially positive effect on the amount of labor supplied by 

members of this group.

- 72 - 

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IV. 

Fair and Neutral Taxation 

- 73 - 

Equity and neutrality require that all income be subject to tax 

regardless of its source or use. Otherwise, families in similar 

circumstances will pay different amounts of tax, depending on how they 

earn or spend their income. 

A. Excluded Sources of Income 

1. Fringe benefits. Many fringe benefits are not subject to tax 

under current law; among the most important fringe benefits presently 

excluded from tax are contributions to qualified retirement plans, and 

accident, health, and group term life insurance provided by employers. 

It is unfair that one taxpayer is excused from paying income tax on 

the value of a fringe benefit, while another who wants to enjoy the 

same good or service, but does not receive it as a fringe benefit, 

must purchase it with after-tax dollars. Nor is the solution to 

extend the exemption of fringe benefits even further, as some have 

suggested. Health care is made much more expensive for all because it 

is effectively subsidized through the tax system for some. The tax 

advantage now accorded some fringe benefits causes more of them to be 

consumed than if, like most goods and services, they could only be 

bought with after-tax income. This distortion of consumer choices 

would only be accentuated by widening the exemption of fringe 

benefits. Moreover, extending the scope of the exclusion of fringe 

benefits would exacerbate inequities in the treatment of employees 

receiving fringe benefits and those who receive income in other forms. 

Finally, the growing tendency to pay compensation in tax-exempt forms 

reduces the base for the social security taxes and thus weakens the 

social security system, These inequities and distortions can be 

reduced only if statutory fringe benefits are taxed more nearly like 

other income. 

The Treasury Department supports the proposal contained in the 

Administration's Budget for fiscal year 1985 to place a limit on the 

amount of health and accident insurance provided by an employer that 

can be obtained tax-free by an employee. The Treasury Department 

proposes to repeal the exclusion of such premiums, to the extent that 

they exceed $70 per month for a single person and $175 per month for a 

family. The proposed limits would have no effect on approximately 70 

percent of all employees, because the limits exceed their employers' 

contributions. For example, for 1985 the maximum monthly contribution 

by the Federal Government to plans for its non-postal employees will 

be $52 for a single person and $116 for a family. The Treasury 

Department also proposes to repeal the current exclusions for 

employer-provided group life insurance, death benefits, dependent-care 

services, housing and housing allowances for ministers, and certain 

military cash compensation and proposes to permit provisions dealing 

with educational assistance plans and group legal services to expire. 

The value of taxable fringe benefits will be reported by the employer, 

and tax will be withheld on it. No revenue gain is projected from

- 74 - 

repealing the exclusion of military compensation, because it is 

expected that compensation will be increased to offset the loss of 

this tax benefit. 

Presently the exclusion of fringe benefits from taxable income has 

gone so far that it has become necessary to offset the distorting 

effects of some tax provisions by allowing employers to offer a choice 

of tax-free benefits. On the one hand, current law encourages the use 

of tax-free forms of compensation, but on the other it attempts to 

counteract these incentives by allowing employers to offer employees 

the choice that is normally associated with payment of wages in cash. 

Under the Treasury Department proposals, it will not be necessary to 

restrict so-called cafeteria plans, plans that allow employees to 

choose among tax-exempt fringe benefits. Since premiums for medical 

insurance below the proposed cap will be the only major statutory 

fringe benefit that will remain exempt, the provisions authorizing 

tax-free cafeteria plans will be largely redundant and should be 

repealed. Of course, employers -- and their employees -- may find 

nontax reasons, such as lower insurance rates for groups and the 

accommodation of different preferences, for allowing employees to 

select from a menu of taxable fringe benefits. Cafeteria plans might 

continue for this purpose. 

Taxing most statutory fringe benefits will greatly simplify the 

administration of the tax laws by relieving the pressure to pay 

compensation in non-taxable forms. Employers can continue, in effect, 

to offer certain goods and services for sale through salary deduc 

tions, but in the absence of tax inducements for paying wages as 

fringe benefits, most compensation will be in cash. 

Employees will compare the full market prices of formerly 

subsidized consumption with other uses of their after-tax dollars. As 

a result, it is expected that employers will provide less life 

insurance and legal insurance, and that employees will purchase more 

directly. Purchases of insurance for marginal amounts of health 

coverage will also decline. These purchases are often quite 

inefficient because administrative costs, while small relative to 

large health bills, can be quite large relative to the cost of 

moderate or small amounts of health care. The rapidly rising cost of 

health care in the United States can be attributed in part to the 

large subsidy inherent in the current tax laws. The proposal to cap 

these health insurance benefits will help contain future increases in 

costs of health care. 

Repeal of the current exemption of fringe benefits will require 

both employees and employers to reconsider the mix of fringe benefits 

offered and accepted. To allow time for adjustment, taxation of 

fringe benefits will be phased in gradually, as existing employment 

contracts expire. 

2. Retirement savinqs. Current law allows saving for retirement 

to be sheltered from tax until retirement. Tax-preferred vehicles for 

retirement saving include qualified retirement plans established by 

corporate employers, individual retirement accounts (IRAs), and H.R.

- 75 - 

10 plans for the self-employed (Keogh plans). The Treasury Department 

proposes that eligibility for IRAs be extended on equal terms to those 

who work in the home without pay and to those who work in the labor 

market. Moreover, the limit on tax-deferred contributions to an IRA 

will be raised to $2,500 ($5,000 for a husband and wife). This 

proposal will allow most American families to pay no tax on the income 

they save, as under a tax on consumed income, and will stimulate 

saving. 

3. Wage replacements. Under the Treasury Department proposals, 

unemployment compensation will be made fully subject to taxation. 

There is no reason to tax moderate-income workers more heavily than 

unemployed persons with the same incomes. Employees in many seasonal 

industries are employed, then laid off, and then rehired on a 

predictable annual cycie. For them, unemployment compensation is more 

accurately seen as a part of annual earnings than as insurance against 

lost wages. Beyond that, many recipients of unemployment compensation 

have income from other sources or are married to working spouses. Tax 

equity is not served by exempting from tax the unemployment 

compensation they receive, while fully taxing other families with the 

same amount of income received from other sources. 

The failure to tax wage replacement programs under current law is 

quite unfair. If a program is designed to replace 70 percent of 

before-tax wages for all employees, tax exemption results in a 70 

percent wage replacement for low-income employees who have no other 

source of income. By comparison, it produces total wage replacement 

for a taxpayer in the 30 percent tax bracket, and lost wages are more 

than fully replaced for taxpayers in higher tax brackets. 

The current tax law provides quite inconsistent treatment of 

persons who are elderly, blind, and disabled. The proposed new credit 

for these groups will ensure greater equality of treatment of various 

sources of income that they receive. Tax-exempt levels of income will 

continue to exceed substantially the levels applying to other 

taxpayers. Families with large amounts of income from other sources, 

however, will no longer be allowed a complete exclusion for workers' 

compensation or for black lung or certain veterans' disability 

payments. Instead, such income will be taxable, but made eligible for 

the credit. The proposed taxation of wage replacement programs will 

apply only to amounts received as a result of future settlements. 

The taxation of wage replacements will have little effect on 

families with low or moderate incomes; these families generally will 

not be taxable because of the increase in exemptions and zero-bracket 

amounts proposed in this package. Many moderate income disabled 

workers will also receive additional benefit from the credit for the 

elderly and the disabled. For example, a family of four that receives 

$9,000 or more of workers' compensation will not owe tax until its 

income exceeds $17,200. Further, workers in 80 percent of States who 

are totally disabled for the entire year will be exempt from tax if 

they had no other income. For persons with high incomes -- including 

both those with generous rates of wage replacement and those with

- 16 - 

substantial income from other sources -- taxation of wage replacement 

payments will have a positive work incentive effect. Under current 

law, some individuals receive nontaxable wage replacement in excess of 

the after-tax wages they would receive if they continued work. Under 

the proposal, these individuals will again be given a positive 

incentive to work. 

4. Scholarships and fellowships. Scholarships and fellowships 

should be taxable, to the extent that they exceed tuition, because the 

stipends are used largely for consumption; such as food and lodging. 

For most students, the higher tax threshold provided by the personal 

exemptions and zero-bracket amount will prevent the taxation of these 

benefits. Students with substantial other sources of income, however, 

will be treated like other individuals with the same income. 

5. Capital qains. Only 40 percent of long-term capital gains -- 

appreciation on assets held for more than 6 months -- are currently 

subject to tax. On the other hand, capital gains and losses are 

measured without regard to inflation during the time the taxpayer 

holds an asset. In other words, tax is applied to fictitious gains 

that only reflect inflation, as well as to real increases in the value 

of capital assets. Thus real (inflation-adjusted) gains are taxed at 

effective rates that can far exceed the nominal tax rate, and in some 

cases tax is collected even when assets decline in real value. 

The Treasury Department proposes to eliminate the taxation of 

fictitious gains by allowing taxpayers to index (adjust for inflation) 

the basis (usually the cost) of assets in computing capital gains. 

Moreover, real capital gains should be fully taxed as ordinary income. 

By equalizing the tax treatment of real capital gains and other 

sources of income, these reforms will improve the equity and 

neutrality of the tax system. 

Given recent rates of inflation, taxing real capital gains as 

ordinary income would be no less generous, on average, than current 

law. Thus, the Treasury Department proposals should have no negative 

effect on capital formation and the supply of venture capital. This 

is discussed further in chapter 6. 

Elimination of the distinction between capital gains and ordinary 

income will allow substantial simplification of the tax law and 

facilitate taxpayer compliance and tax administration. Each year the 

courts hear literally hundreds of tax cases involving capital gain 

versus ordinary income issues. Moreover, some of the most technical 

and complicated provisions of the Internal Revenue Code are necessary 

to deal with ramifications of the distinction between ordinary income 

and capital gains. These include the provisions dealing with 

depreciation recapture, collapsible partnerships and corporations, 

dealer versus investor determinations, and so-called section 1244 

(small business corporation) stock. Finally, taxpayers and their 

advisors spend enormous resources or tax planning designed to achieve 

capital gain characterization.

6. Interest indexing. During an inflationary period, interest 

payments include an element that is neither income to the lender, nor 

an expense for the borrower, but merely compensates the lender for the 

reduction in the purchasing power of principal that results from 

inflation. Under current law this so-called "inflation premium" is 

subject to tax as interest income to the lender and is allowed as an 

interest expense to the borrower. 

At even moderate rates of inflation, tax liability can exceed the 

amount of interest earned, once adjustment is made for inflation. 

Suppose, for example, that the interest rate is 12 percent at a time 

when the inflation rate is 8 percent; the real (inflation-adjusted) 

interest rate is thus 4 percent. A taxpayer in the 20 percent tax 

bracket who holds a $1,000 bond that pays interest of $120 per year 

pays $24 in tax. Since the real component of interest, after 

adjustment for inflation, is only $40, the taxpayer pays an effective 

tax rate of 60 percent, not the statutory rate of 20 percent. For a 

taxpayer in the 40 percent bracket the situation is even worse; tax 

liability is $48, or 120 percent of real interest income. 

The Treasury Department proposes that a portion of interest 

receipts be excluded from tax in order to avoid this taxation of the 

inflation premium. An equal reduction is proposed for the deduction 

of non-mortgage interest expense in excess of $5,000 per year. The 

proposal for interest indexing is discussed briefly below and in 

greater detail in chapter 6. 

7. Dividends-received exclusion. Current law provides an 

exclusion from gross income for the first $100 ($200 for married 

taxpayers filing a joint return) of dividend income received from a 

domestic corporation. Because the exclusion provides little, if any, 

investment incentive and contributes to complexity in the tax system, 

it should be repealed. The proposed partial deduction for dividends 

paid (described in Chapter 6) can be expected to have far more 

favorable benefits to the owners of corporate stock. 

8. Preferred Uses of Income 

Deductions for certain personal expenditures should be curtailed, 

in order to broaden the tax base, simplify compliance and administra 

tion, reduce government interference with private decision-making, and 

allow rates to be reduced for all. Two of the most important itemized 

deductions represent substantial Federal subsidies to State and local 

governments and to charities. 

The deduction for State and local taxes, other than the deductions 

for State and local taxes constituting expenses of earning income, 

will be phased out. Therefore, no itemized deductions for State and 

local taxes will be allowed. The above-the-line deduction of 

charitable contributions by nonitemizers will be repealed a year 

before its current expiration date, and the itemized deduction for 

contributions will be limited to the excess over 2 percent of adjusted 

gross income. On the other hand, the existing deductions for medical

expenses and casualty losses, which are allowed only to the extent 

that expenses and losses exceed 5 percent and 10 percent, respectively, 

of adjusted gross income, will be retained. Table 5-4 

indicates floors applied to various itemized deductions under both 

current law and the Treasury Department proposal. 

Itemized deductions for State and local taxes and charitable 

contributions together totalled some $122 billion in 1982, and they 

reduced individual income tax collections by roughly $30 billion. Had 

the policies proposed by the Treasury been in effect in that year, 

individual income tax rates could have been cut by about 10 percent, 

on average, without sacrificing revenue. Federal support of this 

magnitude can be defended only if there is reason to believe that the 

subsidized activities would otherwise be carried on at too low a level 

and if the present tax deduction is an efficient form of subsidy. 

1. State and local taxes. Itemized deduction for State and local 

taxes are not required for the accurate measurement of income. Many 

years ago, with top rates in the neighborhood of 90 percent, the 

deduction was perceived to be necessary to prevent the sum of the 

marginal tax rates for Federal and State income taxes from exceeding 

100 percent. Given the present levels of tax rates, such an argument 

is no longer relevant. The deduction is sometimes defended as a 

subsidy that is required to reduce the taxpayer's net cost of paying 

State and local taxes. Some would argue that the deduction has the 

advantage of encouraging greater expenditures by State and local 

governments. 

Expenditures by State and local governments provide benefits 

primarily for residents of the taxing jurisdiction. To the extent 

that State and local taxes merely reflect the benefits of services 

provided to taxpayers, there is no more reason for a Federal subsidy 

for spending by State and local governments than for private spending. 

Both equity and neutrality dictate that State and local services 

should be financed by taxes levied on residents or on businesses 

operating in the jurisdiction, in the absence of evidence that 

substantial benefits of such expenditures spill over into other 

jurisdictions. 

There is no reason to believe that most expenditures 

of State and local governments have such strong spillover effects that 

they would be greatly under-provided in the absence of the deduction 

for State and local taxes. There is no reason to have high Federal 

tax rates and provide implicit Federal subsidies to spending of State 

and local governments by allowing deduction for their taxes. It would 

be better -- fairer, simpler, and more neutral -- to have lower 

Federal tax rates and have State and local government services -- like 

private purchases -- funded from after-tax dollars. 

Moreover, the deduction for State and local taxes is not an 

efficient subsidy. Because itemized deductions are claimed by 

approximately one-third of all families (or 35.1 percent of total 

returns in 1982), it is doubtful that they increase significantly the

- I9 - 

Table 5-4 

Floors for Deductions on Individual Income Tax Returns* 

Item 

Medical expenses 

Casualty expenses 

Charitable contributions 

Itemized deductions for 

miscellaneous expenses 

Employee business 

expenses 

Floor 

: Current Law :Proposal 

5% Of AGI 

10% of AGI 

No floor 

AIO floor 

( Available only 

t:o itemizers) 

No floor 

(Available to all 

taxpayers ) 

5% Of AGI 

10% of AGI 

2% Of AGI 

1% Of AGI 

(Combined 

and made 

available 

to all 

taxpayers ) 

*Deductions generally would be allowed only to extent they exceed the 

floor.

- 80 - 

level of State and local government services. The benefits of the 

subsidy thus accrue primarily to high-income individuals and high- 

income communities. To the extent that such subsidies are warranted, 

they could be provided in a much more efficient and cost-effective way 

through direct Federal outlays. 

The three most important sources of State and local tax revenue in 

the United States are the general sales tax, the personal income tax, 

and the property tax. There may be a tendency to believe that 

itemized deductions should be eliminated for some of these taxes, but 

retained for others. The Treasury Department rejects this view, 

because the degree of reliance on these three tax bases varies widely 

from state to state. Five States have no general sales tax, and six 

have no personal income tax. Moreover, local governments in various 

States make widely different use of the property tax; in 1982 the tax 

represented from below 40 percent to almost 100 percent of total local 

tax collections in various states. To allow itemized deductions for 

some of these revenue sources, but not others, would unfairly benefit 

residents of the States levying the deductible taxes, relative to 

those who live elsewhere. Moreover, it would distort tax policy at 

the State and local level away from the non-deductible cevenue source. 

Current law does this by allowing deductions for certain taxes but not 

for many fees and other taxes. 

Moreover, because the deduction for State and local taxes leads to 

higher Federal tax rates for all, there is a net benefit only for 

States (and localities) that levy above-average taxes. Residents of 

states (and localities) with below-average taxes are worse off than if 

there were no deduction. 

Finally, because income levels vary across the country, taxpayers 

in various States make differing use of itemized deductions and pay 

different marginal tax rates, on average. That is, residents of highincome 

States make more use of itemized deductions arid pay higher 

marginal tax rates, on average, than do residents of low-income 

States. Under current law, the Federal Government pays part of State 

and local taxes only for those who itemize, and it pays a higher 

percentage of State and local taxes the higher the average income of 

those who do itemize deductions. Thus, under present law, the Federal 

Government underwrites a greater share of State and local expenditures 

in high-income States than in low-income States. In order to be evenhanded 

and avoid this distributionally perverse pattern of subsidies, 

no itemized deductions should be allowed for taxes and fees paid to 

State and local governments. In order to minimize dislocations and 

inequities, the Treasury Department proposes that these deductions be 

phased out over a two-year period. 

Elimination of this itemized deduction will probably have little 

direct effect on the revenues of State and Local jurisdictions, unlike 

direct reductions in revenue sharing or similar cutbacks in Federal 

grants. It may make citizens more conscious of the actual social cost 

of services provided by State and local governments. Governments will

- 81 - 

have incentives to rely more heavily on user charges when appropriate. 

Under current law, the use of such charges is discouraged, since they 

are not deductible. Finally, these proposed changes will reduce the 

extent to which low-tax and low-income jurisdictions indirectly 

subsidize high-tax and high-income jurisdictions. 

In considering the effect of the Treasury Department proposals on 

State and local governments, it should be noted that 34 State income 

tax systems piggyback on the Federal individual income tax base, and 

many of the 46 States with corporate income taxes rely on income 

measurement rules of the Federal corporate tax. The base broadening 

contained in the Treasury Department proposals will produce large 

increases in individual and corporate tax revenue for these States, 

with little or no effort on their part. Therefore, if State revenues 

are not to increase, rate reduction will also be necessary at the 

State level. 

2. Charitable contributions. Many organizations that benefit from 

the deduction for charitable contributions provide services that have 

important social benefits. Services of this kind may not be provided 

at optimal levels if left to the marketplace. In the absence of 

charitable organizations, these services might have to be provided or 

funded directly by government. Instead, in our pluralistic society 

they have been subsidized through the tax system by the allowanc'e 

itemized deductions for charitable contributions. Some would argue 

that a deduction is especially appropriate when charitable 

contributions of a high percentage of current income substantially 

reduce the taxpayer's true ability to pay, as measured by income 

available for private use. The important question is whether it is 

necessary or efficient to allow a deduction for all contributions -- 

and thereby force tax rates to be higher -- in order to achieve the 

desired stimulus to charitable giving. To the extent that 

contributions would have been made in the absence of the tax benefit, 

the deduction only reduces revenues and causes all tax rates to be 

higher, without stimulating giving. For example, little incentive is 

provided by a deduction for the first dollars of contributions -- 

those that are most likely to be made in any case. 

The Treasury Department proposes to allow a tax deduction for 

charitable contributions only to the extent that they exceed 2. percent 

of adjusted gross income. For example, a taxpayer with $25,000 of 

income and $1,200 of contributions, would be allowed to deduct only 

$700; the first $500 would be nondeductible. 

Under present law, charitable donations of appreciated property 

can result i n substantial tax saving. The full value of certain 

donated property can be deducted against ordinary income, without any 

requirement that gain on the property be recognized for tax purposes. 

Such treatment conflicts with basic principles governing the 

measurement of income, produces an artificial incentive to donate 

appreciated property rather than cash, and also leads to abuse and 

administrative problems for the Internal Revenue Service when 

taxpayers overvalue donated property. The Treasury Department 

of

- 82 - 

proposes that the deduction for a charitable contribution of 

appreciated property be limited to the smaller of the indexed basis of 

the asset or its fair market value. This reform would increase tax 

equity and eliminate the attraction of fraudulent schemes based on 

donation of property with overstated values. It is consistent with 

tax law in circumstances where appreciated property is used to pay a 

deductible expense, or where such property is the subject of a 

deductible loss; a taxpayer generally is not allowed a tax deduction 

in respect of untaxed appreciation in property. 

Under current law, the deduction for charitable contributions is 

generally limited to 50 percent of adjusted gross income. Thus, those 

who contribute more than 50 percent of their income to charity are 

taxed on the amount contributed in excess of 50 percent of income. 

Individuals who contribute all of their income to charity, such as 

those who have taken a vow of poverty, must therefore pay tax on 

one-half of their contribution. By repealing the limits on the 

deductible charitable contributions, the Treasury propo;jal will 

benefit those who contribute all or most of their income to charity. 

Before 1982, only itemizers were allowed a deduction for charitable 

contributions. Extension of this deduction to nonitemizers 

taxpayers who on average have only small amounts of deductions -- 

creates unnecessary complexity, while probably stimulating little 

additional giving and presenting the IRS with a difficult enforcement 

problem. In 1983, 33 percent of those who did not itemize claimed the 

"above-the-line" deduction for charitable contributions. Of these, 70 

percent claimed $25, the maximum amount allowed. In appraising this 

deduction, it would be useful to know whether taxpayers actually made 

these contributions or only claimed them. If the donations were made, 

one must ask whether they would have been made in the absence of the 

deduction. If they would have been made, the deduction provides no 

incentive for increased giving and is equivalent to an increase in the 

zero-bracket amount. The above-the-line deduction is scheduled to be 

increased in 1986, then eliminated thereafter. Since there is some 

lag in taxpayers' response to incentives, eliminating the incentive in 

1986 is unlikely to have a significant effect on the level of 

charitable contributions. 

In recent years, a little more than half of all tax returns with 

itemized deductions reported contributions of less than 2 percent of 

adjusted gross income (AGI). Even so, these proposed changes in the 

tax treatment of charitable contributions will have only a modest 

effect on the amount of charitable giving. It is doubtful that the 

first dollars of giving, or the giving of those who give only modest 

amounts, are affected much by tax considerations. Rather they 

probably depend more on factors such as financial ability to give, 

membership in charitable or philanthropic organizations, arid a general 

donative desire. As potential giving becomes large relative to 

income, however, taxes are more likely to affect the actual level of 

donations. Under the Treasury Department proposal, incentives are 

maintained for the most sensitive group, taxpayers who give aboveaverage 

amounts.

- 83 - 

By removing tax deductions for small charitable gifts, the 

Treasury Department proposal simplifies recordkeeping requirements for 

taxpayers and eliminates the need for IRS to spend resources auditing 

these small transactions. 

3. Interest expense. Under current law all interest expense is 

deductible, either as a business or investment expense or as an 

itemized deduction. As a result, taxpayers are allowed deductions for 

interest expense that does not produce currently taxable income. Home 

mortgages, automobile loans, and other consumer credit are examples of 

debt incurred to finance personal consumption, rather than business 

investments. Debt may also be used to finance investments that yield 

income that is tax-preferred, either because it is taxed at preferential 

rates or because tax liability is postponed to a later year. 

Under a comprehensive definition of income, full interest deductions 

would not be allowed for debt of either type. 

The Treasury Department proposes that the deductions individuals 

can claim for interest expense be limited to the sum of mortgage 

interest on the principal residence of the taxpayer, passive 

investment income (including interest income), and $5,000 per return. 

This limitation would permit a taxpayer to deduct mortgage interest on 

his or her home, interest for the purchase of a car, and interest on a 

considerable amount of consumption and investment-related debt. It 

would, however, curtail the subsidy implicit in the current law 

deduction for interest on debt to finance large amounts of passive, 

tax-preferred, investment assets (such as corporate stock) or 

extraordinary consumption expenditures (such as second homes). 

Interest expense, like interest income, is overstated during a 

period of inflation. Thus, the Treasury Department proposes that 

deductions for interest expense also be adjusted for inflation. The 

adjustment would apply only to the extent that interest deductions 

exceeded the interest on the taxpayer's principal mortgage, plus 

$5,000 per return ($2,500 per return for a married couple filing 

separately). Again, inflation adjustment of interest expense would 

not affect the current ability to deduct both mortgage interest on the 

taxpayer's home and on a considerable amount of consumer debt. 

Neither the indexing of net interest expense nor the limit on interest 

deduction would affect the vast majority of taxpayers. In 1981, only 

3.3 percent of individual tax returns claimed itemized deductions for 

non-mortgage interest in excess of $5,000. 

4. Simplification benefits. Eliminating the deduction for State 

and local taxes and limitinq those for charitable contributions will 

simplify compliance and administration. It will no longer be 

necessary for taxpayers to wonder which taxes are deductible and which 

are not. The table used to calculate deductions for sales tax, a 

major nuisance and the source of numerous errors and much inaccuracy, 

can be eliminated. So also can the significant recordkeeping requirements 

for taxpayers who choose to claim sales tax deductions based on 

actual receipts rather than the table.

- 84 - 

Those who can confidently predict that their charitable contributions 

will not exceed 2 percent of AGI will not nee6 to worry about 

either writing checks or obtaining and keeping receipts for contributions. 

Moreover, disputes over valuation of donated property will be 

reduced, since deductions will be limited to indexed basis, and 

disputes over basis can occur only if contributions exceed the two 

percent threshold. 

With itemized deductions limited in this way and the zero-bracket 

amount increased, the number of returns with itemized deductions will 

fall by about one-third. Virtually the only taxpayers who would 

choose to itemize would be those who could claim a deduction for 

mortgage or other allowable interest, those with large charitable 

gifts, and those with large medical expenses or casualty losses. 

As in the case of taxation of fringe benefits, wage replacements, 

and other sources of presently excluded income, the increase in the 

personal exemption and zero-bracket amounts will prevent the few low- 

income households who itemize from being adversely affected by the 

proposed reductions in itemized deductions. 

C. Abuses 

1. Mixed personal and business expenses. Some expenditures 

combine business expenses with personal consumption. Amonq obvious 

examples are expense-account meals and entertainment, travel that has 

little or no business purpose, and automobiles used for both personal 

and business transportation. Some of these expenditures are legally 

deductible under current law as business expenses. Others are 

improperly claimed as deductions, both by unscrupulous taxpayers and 

by generally honest taxpayers who give themselves the benefit of the 

doubt in marginal or uncertain cases. When the expenses are deducted, 

the government effectively pays part of the cost of personal 

consumption that others must purchase with after-tax dollars. 

As long ago as 1962, this abuse of the tax system was recognized 

and criticized by President Kennedy: '' ... (Tloo many firms and 

individuals have devised means of deducting too many personal living 

expenses as business expenses, thereby charging a large part of their 

cost to the Federal Government. Indeed, expense account living has 

become a byword in the American scene. This is a matter of national 

concern, affecting not only our public revenues, OUL sense of 

fairness, and our respect for the tax system, but our moral and 

business practice as well." 

The 1984 tax reforms addressed the issue of unjustified business 

deductions for expensive automobiles, aircraft, personal computers and 

other mixed-use property. To reduce abuse in this area further, 

several reforms are proposed. No deduction will be allowed for most 

entertainment expenses; allowable deductions for meals and lodging 

will be limited; and deductions for travel involving a substantial 

personal element will be curtailed in order to avoid government

- 05 - 

subsidies to thinly disguised vacation trips. The Treasury Department 

proposal also establishes bright line rules for determining deductible 

travel expenses in areas that have generated large numbers of audits 

and substantial amounts of litigation in the past. These reforms will 

improve the image of the income tax by preventing its abuse by those 

who take tax deductions for personal. expenses. It will also simplify 

tax administration by providing sharp guidelines as to deductibility. 

These proposals would increase the price of purchasing travel and 

entertainment indirectly through a business to the same price paid by 

the typical taxpayer, who does not have access to business perks. The 

demand by businesses and certain executives for expensive meals and 

various forms of entertainment would decline. As a result, the price 

of such services and goods would also tend to decline, benefitting the 

typical citizen who is unable to obtain a subsidy for consumption 

expenditures by characterizing them as business expenses. Because the 

providers of these high-priced meals and entertainment would face 

reduced demand, the production of these goods and services would also 

tend to fall. At the same time, providers of nonsubsidized consump 

tion goods and services, such as moderately-priced meals, would face 

an increased demand. 

It is doubtful that aggregate employment in food services will 

decline at all as a result of the Treasury Department proposals. For 

most taxpayers, consumption of restaurant meals is not subsidized. 

Elimination of many other preferences throughout the tax law will 

increase the relative demand for unsubsidized consumption such as 

this. In assessing the impact on this industry, as well as others, it 

would be a mistake to look only at the elimination of one type of 

preference in attempting to assess the overall impact of the tax 

reform package. 

2. Income shifting. Progressive tax rates make it attractive for 

parents to shift taxable income to their children in order to reduce 

taxes. Income can be shifted by giving income-earning assets to the 

children or by establishing trusts that pay income to the children. 

Though such arrangements clearly can have valid non-tax motivations, 

their tax consequences violate both the principle that families with 

equal incomes should pay equal taxes and the notions of vertical 

equity embodied in the schedule of tax rates, regardless of their 

motivation in a particular case. Moreover, they contribute to the 

perception that the tax system is unfair. Although income shifting 

would be less attractive under the less highly graduated rate 

structure proposed, it would continue to occur. 

The Treasury Department proposes several steps to prevent income 

shifting. First, under most circumstances unearned income of children 

under 14 derived from property given to the child by the parents, to 

the extent it exceeds the child's personal exemption, would be taxed 

at the parent's marginal tax rate. With a personal exemption of 

$2,000 and an interest rate of 10 percent, a child with investments of 

less than $20,000 would not be affected by this proposal. This 

provision would affect very few taxpayers. In recent years, only

- 86 - 

about 250,000 children under age 14 claimed as dependents on another’s 

tax return reported unearned income in excess of the personal 

exemption. 

Second, in both the case of a trust that reverts to the creator of 

the trust and of trust income that i s not required to be distributed 

to beneficiaries or set aside for them, the income of the trust would 

be taxed to its creator, rather than to the trust or its beneficiaries. 

This reform, though intended primarily to preserve the fairness 

of the tax system, also would have substantial advantages in 

terms of simplification. It would reduce the incentive to create 

elaborate trusts or engage in other complicated transactions designed 

to shift income to others. 

IV. 

Simplification 

Many of the proposals described in this chapter, though intended 

primarily to increase the neutrality and fairness of the tax system, 

would allow simplification of the tax system for most individuals. 

Yet others, described in this section, are proposed with the primary 

objective of further simplifying taxpayer compliance. 

A. A Return-Free System, 

To simplify taxpayer compliance, the Internal Revenue Service will 

consider initiation of a system under which many individual taxpayers 

would no longer be required to prepare and file tax returns. Instead, 

the IRS, at the election of eligible taxpayers, would calculate tax 

liability, based on withholding and information returns currently 

submitted by employers and third parties. The IRS will not need any 

information for this purpose that it would not receive from third 

parties under current law. All taxpayers included in the return-free 

system would be provided copies of the calculation of tax liability 

prepared for them by the IRS and would be allowed to question the 

computation of their taxes. 

The return-free system would initially be limited to single wage 

earners with uncomplicated financial transactions, the population of 

roughly 15 million taxpayers now filing the simplified form 1040EZ. 

After a pilot program, the system could be extended to other indi 

vidual taxpayers, and by 1990, roughly 66 percent of all taxpayers 

could be covered by the return-free system. It is estimated that at 

this level of participation this system would save taxpayers annually 

approximately 97 million hours and $1.9 billion in fees paid to 

professional tax preparers. 

B. Other Simplification for Individuals 

Movement toward a broad-base tax requires that better measures of 

income be obtained and that currently excluded items be counted in 

income subject t o tax. 111 some cases, additional calculations would 

be needed, but on balance a broad-base income tax would reduce the 

complexity caused by current law. Many of the most important sources

- 87 - 

of complexity under current law arise from tax-induced changes in the 

economic affairs of millions of individuals. For example, the 

Treasury Department proposals will reduce the incentive to invest in 

tax shelters. Thus, many fewer individuals will need to appraise 

calculations of the after-tax benefits of complicated tax-shelter 

investments, much less shift assets in search of such shelters. 

similarly, if employers insist on providing free in-kind benefits to 

employees, then the calculation of taxable compensation may be made 

more difficult. But if they pay wages in cash, or charge appropriately 

for other goods they want to provide, then their wage and 

fringe benefit structure, as well as the calculations they make for 

tax purposes, will actually be simpler than before. 

Additional proposals will both simplify the income tax and make it 

more comprehensive. These include elimination of the preference for 

capital gains; imposition of a uniform tax on compensation income in 

whatever form derived (with few exceptions); repeal of the $100/$200 

partial dividends received deduction; elimination of provisions such 

as the credit for political contributions and the presidential 

campaign checkoff; and restricting eligibility for income averaging. 

Itemized deductions for expenses of earning income and certain other 

deductions will be combined into one adjustment (an above-the-line 

deduction) subject to a floor of one percent of AGI. Because of the 

floor, taxpayers with only minimal expenses of this kind willnot need 

to bother with recording the expenses and claiming a deduction. 

V. Reducing Noncompliance 

A. The Tax Gap 

During recent years considerable attention has been focused on the 

existence and size of the "underground economy." That term has 

multiple definitions but in the minds of many the focus is on illegal 

activities or clandestine economic operations. Those engaged in 

totally legal activities may, nonetheless, improperly fail to comply 

with the tax laws. This report employs the term "tax gap," in lieu of 

"underground economy," to encompass the revenues lost from all 

failures to comply with the tax law. 

The tax gap is, thus, a broad concept which represents the 

difference between total payments received through voluntary 

compliance and the total amount of tax that would be collected if 

there were full compliance with the tax law. Thus, the tax gap 

includes not only the tax due on all unreported income, regardless of 

whether the underlying activities are legal or illegal, but also the 

tax that is not paid because of overstated business expenses and 

personal deductions. 

Largely on the basis of studies of taxpayer compliance, the IRS 

estimated that in 1981 the tax gap was $90.5 billion. (See Table 

5-5.) Nine billion dollars of the gap represents a minimal estimate 

of the lost income tax revenue from illegal activities, primarily 

illegal drugs, gambling, and prostitution. The remaining $81.5

- 88 - 

Table 5-5 

Income Tax Gap - 1981 

(in billions of dollars) 

Legal Sector Tax Gap, Total 

Corporation tax gap, Total 

Individual tax gap, Total 

Individual income tax lii 

lity reporting gap,Total 

Nonfilers' income tax liability 

(Net of prepayments and credits) 

Filer's income tax liability 

Unreported income 

Overstated business expenses 

Overstated personal deductions -1/ 

Net calculation errors 

Individual income tax remittance gap, Total 

Employer underdeposit of withholding 

Individual balances due after remittance 

Illegal sector tax gap (partial) 2/ 

Total legal and illegal tax gap 

$81.5 

6.2 

75.3 

68.5 

2.9 

65.6 

52.2 

6.3 

6.6 

0.5 

6.8 

2.4 

4.4 

$9.0 

$90.5 

Office of the Secretary of the Treasury November 19, 1984 

Office of Tax Analysis 

-1/ Includes itemized deductions, personal exemptions, and 

statutory adjustments. 

-2/ Income from illegal drugs, gambling, and prostitution only. 

Source: Internal Revenue Service. Income Tax Compliance 

Research, Estimates for 1973-1981. (July, 1983)

- 89 - 

billion of the gap was from omitted income or overstated deductions in 

activities that are otherwise completely legal. Of the $81.5 billion, 

$6.2 billion is attributable to corporations, $6.8 billion results 

from acknowledged but unpaid liabilities (essentially collection 

problems), and $2.9 billion is due to those who improperly fail to 

file tax returns. The remaining $65.6 billion gap is on returns of 

individuals who file income tax returns but who omit or understate 

income or overstate expenses: $52.2 billion is attributable to 

unreported or underreported income; $12.9 billion is due to overstated 

deductions; and $0.5 billion is due to net calculation errors in the 

taxpayer's favor. 

The total unreported income for individuals (both filers and non- 

filers) in 1981 was $250 billion. The eight largest areas of omission 

were: wages and salaries ($94.6 billion) with a 94 percent compliance 

rate; non-farm proprietorships (including partnership and small 

business corporations) ($58.4 billion) with a 79 percent compliance 

rate; interest income ($20.5 billion) with a compliance rate of 86 

percent; capital gains ($17.7 billion) with a 59 percent compliance 

rate; "informal supplier" income ($17.1 billion) with a 21 percent 

compliance rate; farm income ($9.5 billion) with an 88 percent 

compliance rate; pension and annuities ($8.8 billion) with an 85 

percent compliance rate; and dividends ($8.8 billion) with an 84 

percent compliance rate. The causes of these underpayments vary, and 

resolution will require a number of actions. Fundamental tax reform 

will help to stem the growth of the tax gap. Although the Treasury 

Department study was directed primarily toward restoring simplicity 

and equity to the tax system, its proposals will have some impact on 

the tax gap. 

The breakdown in tax compliance and taxpayer morale during the 

last 20 years seems to be attributable, at least in part, to growing 

perceptions of unfairness in the current tax system. For example, a 

public opinion survey conducted for the IRS during the summer of 1984 

supports the view that many taxpayers fail to comply because they 

believe inequities in the tax structure inherently favor others. 

Loopholes such as tax shelters, personal use of business assets, 

deductions for what are essentially personal expenses (e.g., disguised 

vacations), and nontaxable fringe benefits contribute to this 

perception. By sharply curtailing these avenues of tax avoidance and 

evasion, the proposa1.s will diminish this form of rationalization for 

failure to comply with the tax laws. 

Enactment of the reforms described above will reduce the number of 

taxpayers claiming itemized deductions by about one-third. AS the 

list of deductible expenses is curtailed, the opportunities to inflate 

itemized deductions will disappear. Also, lower tax rates reduce the 

benefits of cheating. Hence, though broadening the tax base to allow 

a reduction in tax rates is the primary objective of these proposals, 

an important by-product of base-broadening is a reduction in the tax 

gap.

- 90 - 

The tax gap is not entirely a consequence of cheating by taxpayers. 

In many cases it is a result of oversight or carelessness. 

This may explain much of the underreporting of interest and wages. 

IRS statistics indicate that 81 percent of the approximately 25 

million taxpayers who make errors in the reporting of interest do so 

in amounts of $200 or less. In other cases individuals admit to owing 

tax, but do not have the resources to pay the tax. If the amount of 

tax owed is small, the cost of collection may exceed the outstanding 

liability. 

The proposal to eliminate filing of returns for a majority of 

individual taxpayers is motivated primarily by the objective of 

simplification. However, coincident with this change, the IRS 

contemplates continued development and expanded use of information 

returns. Accordingly, in the return-free system, the unreported income 

from wages, dividends, interest, capital gains and all other form of 

income on which third-party reports are made to IRS will be subject to 

greater scrutiny. As a result, it is reasonably anticipated that a 

significantly greater part of the currently unreported income will be 

included in the computation of tax liabilities. 

While a simpler and fairer tax system reduces both the 

opportunities and the incentives for tax evasion, some opportunities 

will remain, and determined taxpayers will continue to use them. 

There will always be a trade-off between the types and Levels of 

enforcement activities and the amounts of tax evasion. The balance 

between the two must be determined by public policy, consistent with 

the traditions and institutions of our free and democratic society. 

From the point of view of tax policy and tax administration in a 

free society, we must recognize that eliminating the tax gap 

attributable to illegal sector activities is essentially hopeless. 

If, despite our best attempts, we cannot stop the underlying illegal 

activity, we should not delude ourselves into believing that we can 

actually collect taxes on that activity. Thus, tax reform by itself 

will not help to convert the illegal sector tax gap into tax receipts. 

The $81.5 billion tax gap previously estimated for 1981 may 

substantially overstate the actual gap under current law. The 23 

percent rate reduction enacted in the Economic Recovery Tax Act of 

1981 (ERTA) substantially lowered the tax consequences of omitted 

incomes. The 1981, 1982, and 1983 enactments of expanded information 

reporting for certain income such as tips, capital gains, and mortgage 

interest payments, and the backup withholding requirements for 

dividend and interest permanently improved compliance in these areas. 

The lower tax rates and doubled personal exemptions that The Treasury 

Department is proposing will further lower the tax gap. 

While tax reform and lower tax rates may reduce the benefits of 

evasion, some benefits would remain. In the so-called "informal" 

sector and in both farm and non-farm small businesses where business 

is transacted in cash or where there is a mixing of business and

- 91 - 

personal activit es, many of the problems that lead to the current tax 

gap will remain. 

B. Amnesties 

Several states have recently enacted amnesties for past failures 

to comply with their tax laws, and the possibility of a Federal 

amnesty has been discussed. Advocates of amnesties view them as a 

means of encouraging future compliance. They reason that amnesties 

will improve compliance by those who may be otherwise less than 

forthright with the tax authorities. Some even see amnesties as a 

source of substantial short-run revenue as delinquent taxpayers 

discharge past liabilities. In a well-documented study on tax amnesty 

titled "Tax Amnesty: State and European Experience," the 

Congressional Research Service elaborates on many of the difficulties 

associated with amnesty programs. 

The Treasury Department rejects the idea of forgiving past tax 

liabilities, civil penalties, and interest. To include tax, civil 

penalties, and interest in an amnesty would further undermine taxpayer 

morale by sending a clear signal to the American public concerning 

non-compliance and tax fraud: "Don't bother to pay now. We may 

forget you owe anything. Even if you have to pay tax, we won't charge 

interest." Even a limited amnesty that applied only to criminal 

prosecution, without affecting liabilities for tax, penalties, and 

interest, would have very much the same effect. 

Amnesties can only reinforce the growing impression that the tax 

system is unfair and encourage taxpayer non-compliance. After 

reviewing state and foreign experience with amnesties, the Treasury 

Department rejects their use by the Federal Government.

- 93 - 

APPENDIX 5-A 

LIST OF PROPOSED REFORMS 

INCOME TAX REFORM AND SIMPLIFICATION FOR INDIVIDUALS 

A. Rate Reauction 

1. Reduce rates and collapse present 15 tax rates for single 

taxpayers and 14 tax rates for married taxpayers and heads of 

households into 3 rates. 

8. Fairness for Families 

1. Increase the zero-bracket amount from $2,510 t o $2,800 for 

single filers, from $2,510 to $3,500 for heads of households, 

and from $3,710 to $3,800 for joint filers. 

2. Increase personal exemptions from $1,090 to $2,000. 

3. Fold additional exemptions for the blind and elderly into an 

expanded credit for the elderly and disabled, and make all 

taxable disability income eligible for the credit. 

4. Repeal deduction for two-earner married couples. 

5. Index earned income tax credit. 

6. Replace child and dependent care credit with a deduction from 

gross income with same cap ($2,400 if one child, $4,800 if 

two or more). 

C. Fair and Neutral Taxation 

1. Excluded Sources of Income 

a. Fringe Benefits 

1. Repeal exclusion of health insurance above a cap 

($175 per month for family coverage, $70 per month 

for individual coverage). 

2. Repeal exclusion of group-term life insurance. 

3. Repeal exclusion of employer-provided death benefits. 

4. Repeal exclusion of dependent care services or reim 

bursement. 

5. Repeal special treatment of cafeteria plans. 

6. Repeal exemption of voluntary employee's beneficiary 

associations and trusts for supplemental unemployment 

compensation and black lung disability. 

7. Repeal special treatment of incentive stock options. 

8. Repeal exclusion of employee awards. 

9. Repeal exclusion of certain military compensation, 

with offsetting adjustments in military pay 

schedules. 

459-370 0 - 84 - 5

- 94 - 

10. Repeal exclusion of rental allowances or rental value 

of a minister's home. 

b. Wage Replacement Payments 

1. Repeal tax-exempt threshold for unemployment insurance 

compensation. 

2. Repeal tax exemption of workers' compensation, black 

lung, and certain veterans' disability payments, but 

make all such income eligible for the credit for the 

elderly, blind, and disabled. 

c. Other Excluded Sources of Income 

1. Repeal exclusion of scholarships and fellowships in 

excess of tuition. 

2. Repeal exclusion of awards and prizes. 

2. preferred Uses of Income 

D. Tax Abuses 

a. Repeal the itemized deduction for state and local taxes. 

b. Repeal the above-the-line deduction for charitable con 

tributions. 

c. Limit itemized deductions for charitable contributions to 

those in excess of 2% of gross income. 

d. Limit deduction for charitable contributions of appre 

ciated property to indexed basis. 

e. Repeal 50% and 30% limits on individual contributions. 

f. Repeal 10% limit on corporate contributions (but retain 

5% limit in certain cases). 

1. Business Deductions for Personal Expenses 

a. Deny all entertainment expenses including club dues and 

tickets to public events, except for business meals furnished 

in a clear business setting. Limit deduction for 

business meals on a per meal per person basis. 

b. Limit deductions for meals and lodging away from home in 

excess of 200% of the Federal per diem. When travel 

lasts longer than 30 days in one city, limit deductions 

to 150% of the Federal per diem. 

c. Establish bright-line rules to separate indefinite and 

temporary assignments at one year. 

d. Deny any deduction for travel as a form of education. 

e. Deny deductions for seminars held aboard cruise ships. 

f. Deny any deduction for travel by ocean liner, cruise 

ship, or other form of luxury water transportation 

above the cost of otherwise available business 

transportation with medical exception.

2. Income Shifting 

- 95 - 

a. Revise grantor trust rules to eliminate shifting of in- 

come to lower rate beneficiaries through trusts in which 

the creator retains an interest. 

b. During creator's lifetime, tax trusts at the creator's 

tax rate and allow deductions only for non-discretionary 

distributions and set-asides. After creator's death, tax 

all undistributed trust or estate income at the top mar 

ginal rate. 

c. Tax unearned income of children under 14 at the 

parents' rate ( to the extent such income exceeds the 

child's personal exemption). 

d. Revise income taxation of trusts. 

E. Further Simplification 

1. Non-filing system, in which IRS would compute taxes for many 

taxpayers. 

2. Repeal individual minimum taxes (only if basic reforms are 

fully implemented). 

3. Move miscellaneous deductions above the line, combine with 

employee business expenses, and make subject to a floor. 

4. Repeal preferential treatment of capital gains.l/ - 

5. Repeal political contribution credit. 

6. Repeal presidential campaign checkoff. 

7. Repeal deduction of adoption expenses for children with 

special needs, and replace with a direct expenditure program. 

8. Disallow income averaging for taxpayers who were full-time 

students during the base period. 

9. Repeal $100/$200 exclusion for dividend income. -1/ 

F. Other Miscellaneous Reforms 

1. Increase limits on moving expenses. 

2. Special rule for allowing deduction of some commuting expenses 

by workers (-, construction workers) who have no 

regular place of work. 

-1/ Discussed at greater length in Chapter 6.

- 97 - 

Chapter 6 

BASIC TAXATXON OF CAPITAL AND BUSINESS 2NCOPlE 

I. Summary 

The Treasury Department proposals for fundamental reform of the 

taxation of capital and business income are described in this chapter. 

Reforms directed at specific industries and at tax shelters are 

covPred in chapter 7. 

General reforms of three basic types are proposed. First, in 

order to measure real economic income more accurately, the Treasury 

Department proposes that inflation adjustments be made in the 

calculation of depreciation allowances, capital gains, the cost of 

goods sold from inventories, and interest income and expense. This 

will eliminate the need for the current arbitrary ad hoc adjustments 

for inflation incorporated in the investment tax credit, the 

accelerated write-off of depreciable property, and the partial 

exclusion of long-term capital gains. 

Second, the Treasury Department proposes that current incentives 

for retirement savings be expanded by increasing the limits on 

contributions to individual retirement accounts (IRAs) and extending 

the availability of IRAs to spouses not employed in the marketplace. 

Also, the treatment of all tax-favored retirement plans will be 

rationalized by subjecting all pre-retirement distributions to uniform 

rules and simplifying the contribution limits applied to various 

plans. 

Third, the Treasury Department proposes that corporations and 

partnerships be taxed in more nearly the same way by granting 

corporations a partial deduction for dividends paid and by taxing 

certain partnerships as corporations. 

11. Lower Corporate Tax Rates 

The Treasury Department's proposals to define the corporate tax 

base more comprehensively and eliminate most tax credits would allow 

the corporate tax rate to be reduced to 33 percent. All corporate 

income, except income of S corporations, which is accorded passthrough 

treatment, will be subject to this single rate. With a flat 

corporate rate only 2 percentage points below the proposed top 

individual rate, the personal holding company tax can be repealed. 

The current preferential rates for small corporations will be 

unnecessary once the corporate tax rate is reduced, especially since 

the reform package will substantially improve the competitiveness of 

small businesses.

111. Taxing Real Economic Income 

- 98 - 

The U.S. tax law takes a schizophrenic view toward the taxation of 

business income. On the one hand, some forms of income zre treated 

quite favorably. Capital gains are taxed only when they are realized, 

60 percent of long-term gains are excluded from the tax base, and 

gains on appreciated property transferred at death escape tax 

completely. On the other hand, nominal gains are subject to tax 

without an adjustment for inflation. Whether, on balance, real 

capital gains are taxed more or less heavily than ordinary real income 

depends on complicated interactions between the rate of inflation, the 

rate of appreciation, and the holding period of the particular asset. 

Much the same is true of income from depreciable assets. On the 

one hand, the investment tax credit (ITC) lowers equipment costs, and 

asset lives under the Accelerated Cost Recovery System (ACRS) are 

shorter than economic lives. On the other hand, depreciation 

allowances are based on historic costs without adjustment for 

inflation. 

The combination of the ITC and ACRS may be more or less generous 

than real economic depreciation, depending on the particular asset and 

the rate of inflation. At current rates of inflation, the ITC and 

ACRS generally provide capital recovery allowances that exceed the 

present value of the real economic depreciation which is required for 

the accurate measurement of income. Indeed, for short-lived machinery 

and equipment, the present value of capital recovery allowances under 

XRS and the ITC is roughly equivalent to expensing (and in some 

instances is even more favorable); that is, at current inflation 

rates, there is no tax on (or even a subsidy to) the income earned by 

such assets. 

The present tax treatment of depreciable assets is inappropriate 

in the context of an income tax. It gives rise to a form of tax 

arbitrage; taxpayers can borrow, receive a full deduction for interest 

paid, and invest in assets where the return is not fully subject to 

income tax. (Lenders are generally in lower rate brackets than 

borrowers, due to the "clientele effect;" that is, high-bracket 

taxpayers tend to be borrowers while low-bracket taxpayers tend to be 

lenders under a progressive income tax). Moreover, capital recovery 

allowances under ACRS and the ITC are "front-loaded,'' in that they 

greatly exceed the value of economic depreciation in the early years 

of an investment; this feature has been an important contributing 

factor to both the stockpiling of unused tax deductions and credits by 

some firms and the recent dramatic growth of tax shelters. 

The tax treatment of inventories is also rather schizophrenic. 

Firms are allowed to use last-in, first-out (LIFO) accounting, which 

provides an approximate adjustment for inflation in the calculation of 

goods sold from inventory. However, due to the "LIFO conformity 

requirement," firms using LIFO for tax purposes must use the same 

accounting method for financial reporting purposes. This requirement 

discourages the adoption of LIFO, since many firms apparently think

that the use of LIFO for financial reports would put them at a 

competitive disadvantage in attracting investment funds relative to 

firms that report profits using first-in, first-out (FIFO) accounting. 

The Treasury Department proposes that the taxation and measurement 

of capital income be rationalized. The most critical element of a 

rational system is the accurate measurement of real economic income in 

an inflationary environment. To this end, the present system, with 

its ad hoc adjustments for inflation, such as the partial exclusion of 

long-term capital gains and the combination of accelerated depreciation 

and the ITC, will be replaced with explicit inflation adjustments 

for the basis used in calculating both depreciation allowances and 

capital gains. Since depreciation will no longer need to be 

accelerated to compensate for the effects of inflation, ACRS will be 

replaced with economic depreciation. With taxation based on real 

capital gains and real economic depreciation, the partial exclusion of 

long-term capital gains and the investment tax credit will be 

repealed. To prevent inflation-induced tax discrimination against 

industries that invest heavily in inventories, the availability of 

LIFO inventory accounting will be expanded by eliminating the LIFO 

conformity requirement. Indexed first-in, first-out (FIFO) accounting, 

a more accurate method of accounting for the effects of inflation 

on the cost of goods sold from inventory, will be made available, but 

not required. 

Allowing inflation adjustment for capital gains, depreciation, and 

inventories, without also adjusting interest income and expense, would 

be neither fair nor neutral. Nominal interest rates include an 

inflationary component which merely compensates the lender for the 

reduction in real value of principal resulting from inflation. 

Without indexing of interest, the income of lenders would be 

overstated, since they would continue to pay tax on the inflationary 

component of nominal interest that represents a return of capital, 

rather than real income. Conversely, the income of borrowers would be 

understated, since they would continue to take a deduction for the 

full amount of nominal interest paid including the inflationary 

component. This problem is particularly serious in an indexed world, 

since borrowers can invest in assets that benefit from inflation 

adjustment. In order to mitigate this problem of income measurement, 

the Treasury Department proposes that both interest expense (in excess 

of home mortgage interest plus $5,000) and interest income be indexed 

for inflation, using the fractional exclusion method described below. 

The proposed inflation adjustments will assure that taxpayers no 

longer pay tax on fictitious income from capital that merely reflects 

inflation; similarly interest deductions subject to the inflation 

adjustment will not be bloated by inflation premiums that do not 

represent real costs. For all adjustments, inflation will be measured 

by the change in the consumer price index for urban households 

(CPI-U); this index was chosen because it is familiar, readily 

available, and not subject to revision after it is published.

- 100 - 

Allowing deductions for real economic depreciation and for the 

real cost of goods sold from inventories will improve the measurement 

of real income from business and capital. This, in turn, will 

increase tax equity and reduce tax-induced distortions in investment 

decisions. Many tax shelters are motivated by the combination of the 

up-front benefits of the investment tax credit and accelerated 

depreciation, the deductibility of nominal interest expense, and the 

preferential taxation of capital gains. Eliminating the ITC, indexing 

capital gains and taxing them as ordinary income, indexing interest 

expense, and gearing depreciation allowances for tax purposes more 

clearly to real economic depreciation will substantially reduce the 

benefits of investments in tax shelters. These measures will 

simultaneously increase the return to investments in industries that 

are currently disadvantaged by the tax system, including established 

industries with disproportionately large inventories or use of 

structures, as well as new, emerging industries such as those in the 

"high technology ' area. Also, decreased use of tax shelters and the 

taxation of real corporate income will increase the perceived fairness 

of the income tax. 

Inflation adjustment inherently involves complexity. Nonetheless, 

the Treasury Department believes that the economic advantages flowing 

from improvement in the measurement of real economic income during 

inflation more than offset the cost of increased complexity. 

Indexing for inflation may give the impression that inflation is 

expected; indeed, some will argue that indexation weakens the private 

sector's resistance to inflation and therefore makes inflation more 

likely. The proposal for inflation adjustment should not be interpreted 

as a prediction that high inflation will resume. Prudent 

monetary policy would keep the inflation rate at the low level 

forecast by the Administration. Nor does inflation adjustment in the 

measurement of taxable income necessarily produce higher inflation. 

While indexing may reduce private resistance to inflation, it also 

eliminates the possibility of using inflation to raise taxes on real 

capital and business income. 

Inflation adjustment is best seen as insurance against inflation 

for taxpayers and for the nation. High rates of inflation are not 

expected, but if they occur, Americans will not be forced, as they 

were during the 1970s, to suffer the inequities, distortions, and 

adverse impacts on capital formation that result from an unindexed tax 

system. Increased complexity is part of the price for that insurance. 

A. Capital Gains 

Capital gains on assets held for at least a prescribed period have 

long benefitted from preferential tax treatment. In particular, tax 

on accrued gains is postponed until gains are realized (usually 

through the sale of an asset), 60 percent of long-term nominal capital 

gains are excluded from the tax base, and gains on assets transferred 

at death completely escape income taxation. Nevertheless, during an 

inflationary period, capital gains may be subject to very high

- 101 - 

effective tax rates because purely inflationary gains are included in 

the tax base; for example, during the high inflation years of the 

1970s, effective tax rates on real capital gains frequently exceeded 

100 percent, despite the 50 percent exclusion then in force. 

Similarly, despite the current 60 percent exclusion, real capital 

gains can be taxed at rates greater than those applied to ordinary 

income if the rate of inflation is sufficiently high. Moreover, under 

current law the effective tax rate on capital gains varies 

tremendously with the inflation rate. 

In addition to compensating poorly for the effects of inflation, 

the current exclusion of 60 percent of long-term nominal capital gains 

effectively overtaxes taxpayers who have little or no investment 

success (since sufficiently small nominal gains are actually capital 

losses), and it undertaxes very successful investors (since the 

exclusion overcompensates for inflation for sufficiently large gains). 

This treatment is clearly inequitable. 

The Treasury Department proposes that the tax treatment of capital 

gains be rationalized by making a precise adjustment for inflation 

through indexing the basis of capital assets for the inflation which 

has occurred since purchase of the asset or January 1, 1965, whichever 

is later. Since roughly 84 percent of the inflation during the 

postwar period has occurred since 1964, this will result in nearly 

complete inflation adjustment for almost all assets, while limiting 

the size of the table of inflation adjustment factors. Inflationadjusted 

gains will be taxed as ordinary income at the proposed 

reduced individual rates; that is, the current 60 percent exclusion 

would be repealed. 

In order to limit the transition problems associated with an 

unexpected change to the new system of taxing indexed capital gains as 

ordinary income, indexing of assets held as of the date of enactment 

will be delayed until 1989 and the current approach to taxing capital 

gains on those assets will be maintained through 1988. (That is, 

nominal gains will be taxed at a maximum rate of roughly 20 percent 

through 1988). Assets acquired after enactment, however, will be 

subject to indexing under the new tax rules as of the date of 

acquisition. 

The existing preferential tax treatment of capital gains has been 

justified by the need to avoid taxing fictitious gains that merely 

reflect inflation, to stimulate investments in risky undertakings, to 

avoid applying highly progressive rates to gains bunched in one year, 

and to prevent investors from having investments in appreciated assets 

"locked in" by the tax system. The effects of the Treasury Department 

proposal in each of these problem areas will be examined in turn. 

Inflation adjustment. The current exclusion of 60 percent of 

long-term capital gains is a very rough way of allowing for the 

effects of inflation. At high rates of inflation it is inadequate, 

but at low rates it is too generous.

- 102 -' 

In contrast with the current ad hoc adjustment for inflation, the 

proposed adjustment will be precise. At current cates of inflation 

(4.0 percent in 1983 and 1984), most taxpayers will be subject to 

roughly the same effective tax rate on long-term capital gains as 

under current law (preferential taxation of nominal capital gains at a 

maximum 20 percent rate). At rates of inflation experienced in recent 

years (an average annual rate of 7.9 percent between 1972 and 1982), 

the proposal will significantly reduce the effective tax rate on real 

capital gains. This is shown by Table 6-1, which provides maximum 

effective tax rates on real capital gains under current law for 

various combinations of inflation rates, rates of real appreciation, 

and holding periods. In each part of the table, effective rates below 

the broken line are higher than the 35 percent maximum rate on 

ordinary income proposed in this Report; only the current law effective 

rates above the broken line are less than this proposed rate. 

Only for assets held for very long periods is current law likely 

to be preferred to the proposed 35 percent rate on real gains. If, 

for example, the real rate of appreciation is 4 percent and the inflation 

rate is 4 percent or more, a tax rate of 20 percent applied to 

nominal gains produces an effective rate in excess of 35 percent, 

except for assets held 10 years or longer. The story is only slightly 

different if the real rate of appreciation is a rather high 7 percent 

per year. At an inflation rate of 5 to 7 percent, current law 

produces effective tax rates on gains on assets held for less than 5 

years that do not differ greatly from 35 percent. 

Although current inflation rates are relatively low, the 

"insurance" benefits of a tax system which guarantees an explicit 

inflation adjustment should not be minimized, For example, inflation 

averaged I percent per year between 1971 and 1975. Over that period, 

nominal capital gains on sales of corporate stock totaled $24.6 

billion. However, once adjusted for inflation, these sales actually 

represented a loss of $0.4 billion. Similarly, reported nominal gains 

on sales of real estate over the same period totaled $13.2 billion, 

while the inflation-adjusted gain was only $5.3 billion. The 50 

percent exclusion rate in effect during that period clearly was far 

from adequate in terms of allowing for inflation. Indeed, no 

exclusion rate can make up for a negative real rate of appreciation. 

By comparison, under the Treasury Department proposal, the 

inflationary component of nominal capital gains will always be 

excluded from the tax base. The associated reduction in variation in 

effective tax rates caused by inflation should stimulate investment in 

capital assets. Thus, the Treasury Department believes that with 

inflation indexing, reduced tax rates, and a rate structure with only 

a few wide income brackets there is no need for preferential tax 

treatment of realized capital gains, beyond that provided by the 

substantial benefits of deferral of tax until gains are realized and 

the exemption of gains on assets transferred at death. 

Effect on risk-taking. The effect of capital gains taxation on 

private risk-taking in the economy is of critical importance. Venture 

capital and associated high-technology industries seem particularly

- 103 - 

Table 6-1 

Effective Tax Rates on Realized Capital Gains 

Under Current Law for 50 Percent Bracket Taxpayer 

With Different Real Rate of Return Assumptions 

Inflation 

Rate 

APercent) 

: Nominal 

:Appreciation : Holding Period in Years : 

Rate 

: (Percent) : 1 : 3 : 5 : 10 : 20 : 

CONSTANT 4 

PERCENT REAL RATE OF RETURN 

0 

2 

3 

4 

6 

8 

10 

12 

0 

2 

4 

5 

6 

7 

8 

10 

12 

4 

6 

7 

8 

10 

12 

14 

16 

CONSTANT 7 

7 

9 

11 

12 

13 

14 

15 

17 

19 

20.0 

30.0 

--_-I 

35.01 

I 

40.0 

50.0 

60.0 

70.0 

80.0 

20.0 20.0 20.0 20.0 

29.4 28.9 27.7 25.6 

34.0 33.1 31.0 27.8 

-I_-_------ 

38.5 37.1 

47.3 44.9 

55.9 52.0 

64.0 58.8 

71.9 65.1 

34.1 29.6 

----_ I 

39.71 32.5 

I 

44.5) 34.7 

-------- 

48.6 36.3 

52.1 37.6 

PERCENT REAL RATE OF RETURN 

20.0 20.0 20.0 20.0 20.0 

25.7 25.2 24.9 23.8 22.4 

31.4 30.3 29.1 27.1 24.1 

34.3 32.8 31.4 28.5 24.7 

--______-I 

37.1 35.21 I 33.4 29.9 25.3 

I ----_I 

40.0 37.5 35.41 31.1 25.8 

42.9 39.9 37.31 I 32.2 26.3 

I 

48.6 44.5 41.0) I 

34.4 

I 

27.0 

54.3 48.9 44.4 36.31 27.6 

Note: Figures in bold face type below the broken line indicate 

combinations of inflation rates and holding periods for which the 

proposed treatment is more favorable than current law.

- 104 - 

sensitive to changes in effective tax rates. The supply of venture 

capital largely dried up during the 1970s when effective tax rates on 

real gains were high due to inflation and other provisions in the 

Code, but revived dramatically after the 1978 and 1981 tax changes 

reduced the maximum tax rate on realized long-term capital gains to 20 

percent and inflation rates fell significantly from earlier levels. 

In light of this experience, the likely effects of the proposed 

treatment of capital gains m the supply of venture capital and "high 

technology" industries are of particular interest. Taxing real 

(indexed) capital gains at a maximum ordinary income rate of 35 

percent will result in a greater tax burden on the most successful 

investments made by venture capitalists. If one assumes safficiently 

high rates of return and moderate rates of inflation, indexing for 

inflation, even over the approximately 7 to 10-year life of the 

average venture capital investment, will not be as generous as the 60 

percent exclusion. Some argue that this treatment, even if desirable 

on equity grounds, will unduly inhibit investment in the high 

technology industries typically funded by venture capitalists. 

The basic principle underlying the Treasury Department proposals 

-- that all income should be taxed equally -- suggests that the 

taxation of real capital gains as ordinary income is the appropriate 

policy for all industries, including the venture capital industry. 

Perhaps more importantly, the Treasury Department believes the 

proposed treatment of capital gains is unlikely to have significantly 

negative effects on these industries. Several arguments can be made 

to support this position. More accurate measurement of economic 

losses and reduced variation in effective tax rates resulting from 

inflation will stimulate all investment, including investment in the 

venture capital and high technology industries. 

Moreover, a maximum marginal tax rate of 35 percent on indexed 

capital gains will produce effective rates that are not substantially 

above those experienced during the last two venture capital booms. 

(Rates of 25 percent during the 1960s and 28 percent from 1978-81 on 

nominal gains were actually higher effective rates due to inflation.) 

Such an environment should be favorable to risky venture capital 

investments. 

Also, the increase in saving stimulated by reductions in individual 

marginal rates and expansion of IRAs, as well as the elimination 

of many industry-specific tax preferences coupled with the 

enactment of measures to reduce the advantages of investment in 

unproductive tax shelters, should increase the supply of capital 

available to high technology industries. Finally, roughly one-half of 

the funds committed to so-called venture capital firms come from taxexempt 

entities, such as pension funds, endowments, and foundations, 

or from foreign investors. To the extent that these are equity funds, 

their supply will not be affected by changes in the tax treatment of 

capital gains. For these reasons, the Treasury Department believes

- 105 - 

that taxation of indexed capital gains as ordinary income is unlikely 

to have significantly negative effects on the supply of venture 

capital to high-technology industries. 

Other issues. Implementation of the Treasury Department proposal 

will. have little effect on effective capital gains tax rates at 

moderate rates of inflation, and will significantly reduce effective 

rates at high rates of inflation. While the proposed treatment will 

have little effect on lock-in and bunching problems at moderate rates 

of inflation, it will mitigate them considerably at high rates of 

inflation, when they are most serious. 

Simplification. Taxing real (inflation-adjusted) capital gains as 

ordinary income will complicate the tax system in some respects but, 

on balance, should result in simplification. Adjusting the basis of 

assets for inflation will result in some complexity, but taxpayers 

will not need to perform overly complex calculations since they will 

derive the applicable adjustment from a table. On the other hand, 

significant simplification will result from eliminating the distinction 

between capital gains and ordinary income, including repeal of 

recapture rules as well as the extremely complicated collapsible 

partnership and corporation provisions. Real gains from the sale of 

most assets will simply be taxed in the same way as all other income. 

Many elaborate schemes designed to obtain capital gains treatment for 

ordinary income will lose much of their attraction; as a result, fewer 

resources will be wasted in tax planning activities as well as in 

auditing returns with questionab1,e conversion schemes. Once the 

proposed new tax treatment of business income is fully phased-in and 

a11 (or most) grandfathered assets are out of the system, the 

corporate minimum tax could be repealed. 

6. Capital Consumption Allowances 

The investment tax credit (ITC) and the accelerated cost recovery 

system (ACRS) were introduced during a period of rapid inflation to 

stimulate investment by preventing capital consumption allowances 

based on historical cost from being eroded by inflation. Without 

explicit indexing of depreciation allowances, the effects of rapid 

inflation on the return to investment in depreciable assets are so 

deleterious that something like ACRS and the ITC was essential to 

prevent confiscatory taxation of income from capital. Under the 

Treasury Department proposal, ad hoc accelerated capital recovery 

allowances like the combination of ITC and ACRS would be unnecessary; 

explicit indexing for inflation would ensure that future depreciation 

allowances would maintain their real value, regardless of the rate of 

inflation. 

Since current rates of inflation are significantly lower than 

those prevailing when the ITC and ACRS were enacted, current law 

allows investment in depreciable assets to be recovered far more 

rapidly than under a neutral system of income taxation. Table 6-2 

indicates the effective tax rates applied to income from various types

- 106 - 

of assets under current law; the figures apply to equity-financed 

investments by corporate taxpayers subject to the 46 percent statutory 

rate, for inflation rates between 0 and 10 percent. 

As shown dramatically in Table 6-2, the combination of ACRS and 

the ITC results in a system where, at the rates of inflation covered 

by the table, effective tax rates are lower than statutory rates but 

vary, often significantly, with the rate of inflation. For example, 

at an inflation rate of 5 percent, the effective tax rates paid by a 

taxpayer subject to a 46 percent statutory rate vary from -8 percent 

for equipment with a 3 year ACRS life to 40 percent for a structure 

with an 18 year ACiiS life. (A negative tax rate is the equivalent of 

the Federal Government paying a business to buy the asset and earn 

income tax-free.) Effective tax rates are lower, (that is, even more 

negative), for short-lived assets with lower inflation rates. At 

higher inflation rates such as those prevailing at the time of 

enactment of ACRS, effective tax rates are somewhat closer to the 

statutory tax rate, especially for longer-lived asset. (See Table 6-2 

for effective tax rates under an inflation rate of 10 percent.) 

The current system is obviously deeply flawed, since effective tax 

rates vary tremendously among asset types and with inflation. 

Moreover, by reducing effective tax rates below the statutory rate, 

the tax system favors investment in depreciable assets such as 

equipment and real estate over investments in labor and in inventories. 

This results in effective tax rates which vary widely among 

industries, as demonstrated in Table 6-3. 

Nevertheless, returning to the non-indexed economic depreciation 

of the pre-ACRS period is clearly unacceptable; the high effective tax 

rates on business plant and equipment during the 1970s that resulted 

from the failure to allow tax-free recovery of the real cost of 

capital reduced investment and economic growth. Instead, the Treasury 

Department proposes that the investment tax credit be repealed, that 

the basis of depreciable assets be indexed for inflation, and that 

depreciation allowances for tax purposes be set to approximate real 

economic depreciation. A combination of indexing for inflation and 

economic depreciation -- a Real Cost Recovery System, or RCRS -- will 

retain, and even reduce, the effective tax rates for depreciable 

assets that are present in the ACRS system, reduce the uncertainty 

about future changes in effective tax rates that occur without indexed 

depreciation, and eliminate the current tax bias toward investment in 

depreciable assets. 

The enactment of the Treasury Department proposal will have four 

very significant advantages over current law. First, the benefits of 

economic neutrality will be realized. Effective tax rates on 

depreciable as-ets will no longer vary according to asset life, as 

depreciation a lowarices will be approximately equal to the real 

economic depreciation of assets. Effective tax rates will also no 

longer vary actoss industries, as investment in all industries will 

face the same reduced corporate tax rate. As a result of tax 

treatment which is economically neutral, the allocation of the 

nation's scarce resources will be greatly improved.

- 107 - 

Table 6-2 

Effective Tax Rates on Equity-Financed Investments 

with various Rates of Inflation for a 46 Percent Taxpayer 

Under Current Law -1/ 

Asset class 

(years) 0 

Inflation 

5 

Rate 

3 -90 -0 22 

5 Equipment -51 -3 19 

10 -5 20 32 

15 9 35 45 

Structures 

18 28 40 45 

10 

Cpercent) 

-1/ Assumptions: Real return after tax is 4 percent. The investment 

credit rate selected is the maximum allowable (6 percent on 3-year 

equipment and 10 percent on 5-, lo-, and 15-year equipment). 

Effective tax rates are the difference between the real before tax 

rate of return and the real after-tax rate of return divided by 

the before-tax rate of return.

- 108 - 

Table 6-3 

Effective Tax aates on Equity Financed Investments in Equipment 

and Structures by Industry with Various Rates of Inflation 

for a 46 Percent Taxpayer Under Current Law 

Industry 

Agriculture 

Mining 

Logging 

Wood products and furniture 

Glass, cement and clay 

Primary metals 

Fabricated metals 

Machinery and instruments 

Electrical equipment 

Motor vehicles 

Transportation equipment 

Food 

Tobacco 

Textiles 

Appa r e 1 

Pulp and paper 

Printing and publishing 

Chemicals 

Petroleum refining 

Rubber 

Leather 

Transport services 

Utilities 

Communications 

Service and trade 

Inflation Rate (percent) 

5 10 

29 37 

13 31 

21 34 

28 38 

20 31 

16 28 

28 38 

26 36 

26 38 

8 26 

25 36 

25 35 

18 30 

19 32 

28 38 

12 26 

22 34 

19 32 

12 26 

18 30 

30 40 

9 26 

2e 38 

19 33 

31 40 

Office of the Secretary of Treasury 

Office of Tax Analysis 

November 24, 1984

- 109 - 

Second, effective tax rates will no longer vary with the rate of 

inflation. Businesses planning investments will be assured that the 

value of future depreciation allowances will be automatically 

corrected for inflation; they will not have to depend on Congress for 

periodic ad hoc and imperfect adjustments in tax laws to accomplish 

this correction. The reduced uncertainty implied by enactment of the 

Treasury Department proposals should stimulate investment in all 

industries. 

Third, capital recovery allowances will no longer be "frontloaded," 

or accelerated to the early years of the productive life of 

an investment. Because the advantages of the ITC and ACRS are frontloaded, 

these provisions are of relatively little value to new and 

rapidly growing firms or to firms i n ailing industries, neither of 

which can fully utilize their benefits. The Treasury Department 

proposal would thus eliminate a tax penalty faced by new firms and 

would eliminate incentives for tax-motivated mergers. @he result will 

be increased competitiveness and more incentive for innovation. Also, 

elimination of front-loading of tax benefits will reduce the 

advantages of tax shelters, many of which are abusive and create 

severe administrative burdens for the Internal Revenue Service. 

Fourth, these reforms will broaden the corporate tax base, just as 

many reforms in the individual income taxation area broaden the 

individual tax base. The most important effect in the corporate area 

is that the maximum corporate tax rate will be reduced from 46 to 33 

percent. 

The new method for taxing business income proposed by the Treasury 

Department is best appraised by examining the combined tax burden at 

the corporate and individual levels, in order to reflect the benefits 

of the dividend-paid deduction. Table 6-4 presents combined effective 

tax rates for a variety of alternative ways of taxing income from 

depreciable assets and inventories. Under the Treasury Department 

proposal the combined effective tax rate is 44 percent, regardless of 

the rate of inflation. This is substantially more generous than the 

tax treatment under ACRS, without the ITC or dividend relief, which at 

an inflation rate of 5 percent, produces a combined effective tax rate 

of about 58 percent. At an inflation rate of 10 percent the Treasury 

Department proposal is more generous than ACRS, even with the ITC. 

Even at an inflation rate of 5 percent, it is more favorable than 

current law, except for investment i n equipment. 

Table 6-5 shows effective tax rates at only the corporate level. 

The Treasury Department proposal for a Real Cost Recovery System 

produces approximately the same effective tax rate on income from all 

forms of investment, while the alternative approaches produce widely 

varying effective rates that depend on the rate of inflation. 

C. Inventories 

Under current law, taxpayers are allowed two basic options in 

calculating the cost of goods sold from inventories. They can either

Pre1981 b y 

- 110 - 

Table 6-4 

Effective Caprate and Rrsanal In- Tax btes cn Wey F-4 Invesbrents 

-R2hirns to Capital D i s t r W m l y -been Dividerds ad capital Gzim-l/ 

Wmt 

an3 

RU capital stmtures Structures Invrntories 

at 10 p-t inflation 63 63 51 66 61 

i m ?/ 

With invffibrent tax credit 

at 10 pr-t inflation 58 57 43 61 61 

at 5 p rmt inRation 53 50 26 56 61 

Withwt invffihrerit tax credit 

at 5 p-t inflation 58 57 57 56 61 

Redl emnonic ckpreiation 6/ 

Withwt divided relief z/ 49 49 49 49 49 

With divii3?& relief %/ 44 44 44 44 44 

Office of tk -kretary of t2E Reasury W&r 21, 1984 

Mfice of Tax nnalysis 

-1/ Assures a 4 prmt real retum efter mwrate tax. Assures tm-thirds of capital gains 

deferred idefinitely, an3 the rerJiniw third tax& at th saw effective tax rate (35%) 

m 4 gain in order to eliminate any prssible bias against current law, tfcause the 

effective tax rate on capital gains der current Lw d e w M tk interrelaticwhip 

te- Wion, real appreciaticn, and t2E blding pricd. 

-2/ Nl capital inclui2s equipmiit, structures an3 inventories. 

-3/ Ass- LI170 amwntjlq with M reduction in inventories aid inventory prim rising with 

t t ~Wral price level. 

-4/ Assures 46 pr-t mprate statutory tax rate an3 45 pmt personal tax rate 

urder current law. Fssuns sun of years digits ckpreciatiwi mer 9 yevs and 10 praent 

invsbt credit for quiprent an3 150 pxoent asll- Mane over a 34.4 year average 

life for structUrE5. 

-5/ Assures 46 praent mprate tax rate an3 45 prcent prsonal tax rate. Ass- 5ys% 

depreciatim schaule with half-basis aijusbrent for equi-t an3 18- &de for 

sttuzbres. 

-6/ Assirrej 33 p rmt mprate rate and 35 pmt prsaral rate m?er reform. Tax 

depreci3tion rates assured epzd to econcmic &prpCgiaticn rats. Bviations m y slightly 

alter tax rates. 

-l/ Effective tax rates are overstated. In a revenw wutml props&, 

relief muld inply lcwer statutory tax rats. 

-8/ pss- 50 pmnt mrprate deduction for fet divided pia. 

elhhticn of divided

- 111 - 

assume that the first goods put into inventory are the first ones out 

(FIFO), or they can assume that the last goods in are the first ones 

out ( LIFO). Roughly 95 percent of firms with inventories use FIFO 

accounting for tax purposes. In an inflationary period the use of 

FiFO overstates current taxable i,ncome,because the deduction for cost 

of goods sold is based on lower prices that prevailed earlier. Nonetheless, 

many firms are dissuaded from switching to LIFO by, among 

other considerations, the "LIFO conformity requirement," which 

specifies that if LIFO is used for tax purposes it also must also be 

used for financial accounting. The overstatement of'taxable income 

that results from the use of FIFO under inflationary conditions 

implies t.hat the tax system imposes a penalty on inventory-intensive 

activities. 

The important role of inventories in the economy is often overlooked. 

Inventories account for approximately one-fifth of corporate 

non-financial assets, and more than one-third of corporate depreciable 

assets. For many types of industries, particularly the wholesale and 

retail trade and service industries, inventories are more important 

than depreciable assets. (See Table 6-6.) Thus, in a system which 

indexes depreciation allowances and capital gains, indexing inventories 

is essential for economic neutrality across types of business 

assets and across industries. 

The Treasury Department suggests repeal of the LIFO conformity 

requirement since it induces many firms to use accounting practices in 

calcuiating taxable income that seriously mismeasure income during 

inflationary periods; it is an anachronism that has no counterpart in 

other parts of the tax law. 

In addition, the Treasury Department proposes that firms be given 

the option of employing indexed FIFO, instead of either LIFO or 

unindexed FIFO. Under indexed FIFO, the value of all goods in 

inventory will be adjusted (written up or down) for the amount of 

inflation that has occurred since their acquisition. Thus, since 

inflationary gains are permanently removed from the tax base, indexed 

FIFO measures income more accurately than does LIFO, where 

inflationary gains are only deferred until the firm reduces its 

inventory or liquidates. Also, indexed FIFO is thought to be somewhat 

simpler than LIFO. Adoption of indexed FIFO will not be mandatory, 

however . 

D. Indexing Interest 

Nominal interest rates include an inflation premium that 

compensates lenders for the loss of principal. Under current law, 

interest income and expense are overstated during a time of inflation, 

since nominal interest receipts are fully taxable and nominal interest 

payments are fully deductible. As a result, interest income is overtaxed 

during an inflationary period, and saving is discouraged; similarly, 

borrowing and debt finance are encouraged. A completely 

inflation-adjusted tax system wouid exclude the inflationary component 

of nominal interest rates from taxation.

- 112 - 

W 

-3 

m 

v) 

7.- 

m 

m 

P'

- 113 - 

--- 

Wle 6-6 

Inventories as Percent of 'Ibtal Physical &sets ad Cepreciable Assets 

: Inventories as Percent of Total: 

. pfivsical : Net Dwreciable 

&piculture 

Mining 

Construction 

Manufacturing 

Transportation 

Wholesale Trade 

Retail Trade 

Finance, Real 

Estate 

Srvies 

14.3 % 31.7% 

9.1 18.1 

34.8 87.5 

29.2 54.3 

5.1 5.6 

61.2 216.5 

50.9 135.3 

3.8 11.7 

10.1 14.5 

motdl 

22.4% 39.3% 

Office of the Secretarv of the Treasury November 21, 1984 

IJ 

Physical assets include inventories, net depreciable, depletable, and intangible 

assets, land and other non-financial assets. 

Source: 1981 Statistics of Incane Corporate Incane Tax Returns.

- 114 - 

Perfect adjustment of debt or interest for inflation would require 

that lenders receive an annual deduction for each outstanding loan 

equal to the product of the inflation rate and the principal of the 

loan; borrowers would report an offsetting amount of taxable income on 

each loan. Such an approach would be extremely complicated, and thus 

is not recommended. The Treasury Department does, however, propose a 

rough surrogate for an exact inflation adjustment. Under this 

proposal a given fraction of interest income will be excluded from 

tax, and the deduction of interest expense (in excess of the sum of 

mortgage interest attributable to the principal residence of an 

individual taxpayer and $5,000) will be reduced by the same fraction. 

Corporations will also exclude this fraction of interest income or 

expense. 

The fraction of interest income and expense to be excluded will be 

set to reflect the approximate relationship between the current inflation 

rate and the long-run real interest rate. In an ideal world, the 

exclusion rate that would result in accurate measurement of real 

interest income and expense would equal the ratio of the inflation 

rate to the nominal rate. This relationship was used in calculating 

Table 6-7, which provides the proposed relationship between inflation 

and the exclusion rate; these results are based on the conservative 

assumption of a 6 percent real interest rate (a lower real interest 

rate would result in higher exclusion rates). The exclusion rate to 

be used in calculating interest income and expense will be announced 

each year. Inflation will be measured by the percentage increase in 

the consumer price index (CPr) over the previous twelve months. ~ f , 

for example, the CPI increases by 4 percent, 40 percent of nominal net 

interest income will not be taxed. 

The proposed approach provides only a rough adjustment for 

inflation. Although the inflation adjustment will not be exact most 

of the time, it will clearly be more appropriate than the zeroinflation 

assumption implicit in the current law's treatment of all 

nominal interest as taxable income or deductible expense. 

As long as neither interest receipts nor interest payments are 

indexed, lenders will be taxed too heavily and borrowers too lightly. 

This tax treatment accentuates the incentive under the current 

progressive rate structure for low-bracket taxpayers to acquire 

interest-bearing assets and avoid borrowing, while high-bracket taxpayers 

borrow and avoid interest-bearing assets. Moreover, these 

undesirable distortions of behavior would be accentuated if 

depreciation deductions and capital gains are indexed but interest 

receipts and payments are not. Investors in high tax brackets would 

have a strong incentive to out-bid other investors for borrowed funds 

in order to finance the acquisition of depreciable assets and assets 

expected to yield indexed capital gains. These incentives will be 

mitigated under a system with fractional exclusion of interest 

receipts and expenses. As a result, high-bracket investors will have 

less incentive to borrow and a stronger incentive to equity-finance 

their acquisition of assets. In addition, interest indexing will

- 115 - 

Tabla 6-1 

Fractional Exclusion Rate Table 

Constant Reel Before Tax Rata of Return of 6 Percent 

Inflation : Isominal : opt inal 

Rate : Interest : Exclusion 

.(pi).. : Rate (%) Rate (%) 

0 G 0 

a 7 14 

2 8 25 

3 9 33 

4 IO 00 

5 11 45 

6 12 50 

7 13 54 

8 14 57 

9 15 60 

10 16 62 

11 17 65 

12 18 67 

Office of the Secretary November 21, 1904 

of the Treasury 


- 116 - 

reduce the tax disadvantage of taxable debt relative to tax-exempt 

bonds. This in turn will make it easier and cheaper for other 

investors to obtain borrowed funds. 

IV. Retirement Savings 

By encouraging taxpayers to save for retirement, the tax-preferred 

treatment of retirement plans serves two important public purposes. 

It helps retirees accumulate funds so they can live out their lives in 

dignity without becoming wards of society, and it produces saving that 

can be made available for capital formation. In the latter sense, 

tax-preferred retirement plans have much the same benefits as a 

consumed income tax, but without its other disadvantages (discussed 

more fully in chapter 9 ). The Treasury Department believes that the 

present tax incentives for such retirement plans should be retained 

but made more consistent. The retirement saving proposals should 

increase saving, provide greater protection for spouses, and simplify 

compliance and administration. 

Under current law, individual retirement plans (IRAs) are fully 

available only to those who are employed. Whereas an employee can 

contribute up to $2,000 per year tax-free on his or her own behalf, 

only an additional $250 can be contributed to a "spousal" IRA. The 

Treasury Department supports the Administration's proposal that IRAs 

be available on equal terms to spouses working in the home and in the 

market. Further, the Treasury Department proposes that the limits on 

an IRA be raised to $2,500 for both employees and those working at 

home, that is, to $5,000 for husband and wife. With the present 

limits, over one-half of tax returns with payments to IRAs showed 

maximum contributions; thus the availability of IRAS provided little 

incentive at the margin for additional saving. Increasing the limits 

will make this general saving incentive more effective. 

Employees of employers that maintain qualified cash or deferred 

arrangements (401(k) plans) effectively can avoid the IRA limitations 

of current law by making additional deductible contributions to these 

plans. The Treasury Department believes that this disparity among 

individuals is inappropriate and thus, coupled with increasing the 

limits on IRAs, proposes to repeal the current provisons that accord 

cash or deferred arrangements preferential tax treatment. Employers 

will be able to set up IRA plans for their employees, as under current 

law. 

I Other revisions are required to provide consistent treatment of 

various types of retirement plans. Under current law the tax 

treatment of both contributions to retirement plans and subsequent 

distributions may be different, depending upon the particular type of 

plan. The Treasury Department proposes to establish a consistent and 

uniform policy that will apply to all retirement plans. Certain early 

distributions to finance first-time purchases of homes and college 

education will be subject to a 10 percent tax; the tax will be raised 

to 20 percent for other early distributions.

- 117 - 

Current law contains annual limits on contributions and benefits 

that may be provided to an individual under an employer's tax-favored 

retirement plans. There are separate rules limiting contributions to 

two types of pension plans, those where a fixed contribution is 

required (defined contribution plans) and those that promise a fixed 

benefit (defined benefit plans). The defined contribution plan dollar 

limit, at $30,000 per year, is much more generous than the defined 

benefit limit, which allows deductions to finance future benefits of 

up to $90,000 per year. In addition, complex rules are required to 

limit contributions and benefits on behalf of employees who 

participate in both types of plans. 

The Treasury Department proposes to eliminate the overall limit 

for individuals participating in both defined contribution and defined 

benefit plans that provide significant benefits to rank-and-file 

employees. To replace the overall limit, and to limit the ability of 

an individual to accrue excessive benefits by working for separate 

employers, the Treasury Department proposes to apply an excise tax on 

extraordinary withdrawals made in any year from either type of plan. 

This and more specific reforms will both simplify considerably the 

task of employers who must deal with the present complex rules and 

provide greater rationality and consistency in this area. 

V. Neutrality Toward the Form of Bu6inees Organization 

Under present law, equity income originating in the corporate 

sector is taxed twice -- first as corporate profits and then as 

dividends. This double taxation of dividends, coupled with the 

deductibility of interest payments, discourages the use of equity 

finance and favors debt finance. Double taxation of dividends also 

discourages saving and discriminates against investment in the 

corporate sector. By comparison, opportunities for tax shelters, the 

benefits of which are usually most easily available through partnerships, 

artificially encourage the use of that form of business 

organization. 

Between 1963 and 1982 the value of all partnership assets 

increased almost twelve-fold, from an estimated $71.8 billion in 1963 

to $845 billion in 1982. Assets owned by partnerships in the two most 

important and popular tax shelter industries, oil and gas drilling and 

real estate, grew even more rapidly, increasing roughly sixteen-fold 

during the same period. By comparison, between 1963 and 1982 the 

value of corporate assets increased slightly more than six-fold, from 

$1.48 trillion to $9.1 trillion. 

The Treasury Department proposes several fundamental changes that 

will foster neutrality in the selection of organizational form, and in 

the choice among alternative methods of finance. Without these 

changes, both corporations and partnerships would continue to rely too 

heavily on debt finance, the recent tax-induced shift of assets away 

from the corporate sector would continue, and tax administration would 

be needlessly difficult.

- iia - 

A. Relief for Double Taxation of Dividends 

With a comprehensive corporate income tax base, income derived 

from equity investment in the corporate sector would be taxed twice -- 

once when earned by a corporation and again when distributed to 

shareholders. The double taxation o f dividends has several 

undesirable effects. It encourages corporations to rely too heavily 

on debt rather than equity finance. By increasing the risk of 

bankruptcy, this artificial inducement for debt finance increases the 

incidence of bankruptcies during business downturns. 

The double taxation of dividends also creates an inducement for 

firms to retain earnings, rather than pay them out as dividends. 

There is, however, no reason to believe that firms with retained 

earnings are necessarily those with the best investment opportunities. 

Instead, they may have more funds than they can invest productively, 

while new enterprises lack capital. If retained earnings are used to 

finance relatively low productivity investments, including uneconomic 

acquisitions of other firms, the quality of investment suffers. In 

addition, both corporate investment and aggregate saving are 

discouraged, because the double taxation of dividends increases the 

cost of capital to corporations and reduces the return to individual 

irivesto rs. 

These problems cannot be solved by simply eliminating the 

corporate income tax. If there were no corporate tax, dividends would 

be taxed properly, at the tax rates of the shareholders who receive 

them, but earnings retained by corporations would not be taxed until 

distributed, and thus would be allowed to accumulate tax-free. As a 

result, there would be a substantial incentive to conduct business in 

corporate form, in order to take advantage of these benefits of tax 

exemption and deferral. 

Nor can the corporate and individual income taxes be fully 

integrated by treating the corporation as a partnership for tax 

purposes. Technical difficulties such as those described below 

preclude adoption of this approach. The Treasury Department thus 

proposes that the United States, following the practice of many other 

developed countries, continue to levy the corporate incom- tax on 

earnings that are retained, but provide partial relief from double 

taxation of dividends. 

There are two alternative ways to provide dividend relief. The 

approach more commonly employed in other countries is to allow 

shareholders a credit for a portion of the corporate tax attributable 

to the dividends they receive. The credit is generally available only 

to residents, although it is sometimes extended to foreigners by 

treaty. The credit can be denied tax-exempt organizations, if that is 

desired. 

The simpler method, an2 the one proposed by the Treasury 

Department, will allow corporations a deduction for dividends paid 

similar to the deduction or interest expense. Dividends paid to

- 119 - 

nonresident shareholders will be subject to a compensatory withholding 

tax, equivalent to the reduction in tax at the corporate level. The 

proposal will not impose such a compensatory tax where it would be 

contrary to a tJ.S. tax treaty; nor will the compensatory tax apply to 

dividends paid to U.S. tax-exempt organizations. However, the initial 

decision to extend the benefits of dividend relief to these two groups 

of shareholders will be subject to continuing review. 

Despite the advantages of full relief from double taxation of 

dividends, the Treasury Department proposal would provide a deduction 

cjf only one-half of dividends paid from income taxed to the 

corporation. This decision is based primarily on considerations of 

revenue loss, and can be reconsidered once the proposal is fully 

phased in. 

The deduction will not be allowed for dividenls paid from income 

that had not been subject to corporate tax; firms wishing to pay out 

tax-preferred income will not receive a deduction, but dividends will 

be presumed to be paid first from fully taxed income. For this 

purpose, income that did not bear a corporate tax because of allowable 

credits, including foreign tax credits, will not be eligible for the 

deduction. 

Reduction of the double taxation of corporate equity income will 

tend to increase initially the market value of existing corporate 

shares of companies that distribute an above-average proportion-of 

current earnings as dividends. It will reduce the current tax bias 

against equity finance in the corporate sector and make equity 

securities more competitive with debt. Because dividend relief will 

also reduce the tax bias against distributing earnings, corporations 

will be likely to pay greater dividends and to seek new funds in 

financial markets. Corporations will therefore, be more subject to 

the discipline of the marketplace and less likely to make relatively 

unproductive investments simply because they have available funds. 

Similarly, the pool of funds available to new firms with relatively 

high productivity investment opportunities will be larger. As a 

result, the productivity of investment should be improved 

substantially. 

Dividend relief will be phased in gradually in order to match the 

phase-in of the correct rules for measurement of corporate income and 

to minimize unjusti.fied windfaLl profits to current shareholders. 

Moreover, phasing.in dividend relief will prevent a large loss of tax 

revenue and any associated reduction in the tax burden of high-income 

shareholders. 

The current exclusion from individual income taxation of $100 of 

dividends received serves no useful purpose and will be repealed 

immediately. It loses considerable revenue without stimulating 

significant investment in corporate equities. It would have no 

justification i n a system that allows dividend relief.

- 120 - 

8. Tax Treatment of Large Partnerships 

Large modern partnerships have many of the attributes commonly 

associated with corporations, especially when there is limited 

liability for most partners in the enterprise. The interests in some 

large partnerships are even traded on organized stock exchanges. Yet 

partnerships still benefit from preferential tax treatment that was 

more fitting in a simpler world in which partnerships were typically 

comprised of small groups of individuals, each of whom was responsible 

for the liabilities of the business. 

The main tax advantage of the partnership form is that gains, 

losses and tax credits pass through to partners, rather than being 

taxed to the entity. Thus, unlike corporations who cannot benefit 

fully from tax credits, deductions for recovery of capital costs , and 

interest expense if taxable income becomes negative, partnerships are 

able to pass any net operating losses through to partnet-s, who can use 

the losses to shelter other income from tax. AS a result, partnerships 

are an attractive vehicle for investment in tax shelter 

activities that initially may produce positive cash flow but result in 

losses for tax purposes; once the venture begins to show a profit for 

tax purposes, it is converted to corporate form or is sold so that 

deferred income is realized as tax-preferred 1.ong-term capital gains. 

Moreover, since debt finance magnifies the benefits of tax 

preferences, the tax Code encourages partnerships, as well as 

corporations, to rely too heavily on debt finance. 

Until the mid-l960s, the corporate form of ownership was often 

considered the optimal way in which to hold large aggregations of 

assets. The corporation presented the advantages of both limited 

liabil-ity and a simple administrative vehicle for business transactions 

when large numbers of owners were involved. Because of the 

recent shift to the use of partnerships as tax shelters, however, 

ownership of more and more assets has been switched to partnership 

form. In many cases, the assets are actually transferred from 

corporations, while in other cases, new businesses that normally would 

be formed as corporations are now established as partnerships. 

Pass-through treatment of large limited partnerships creates 

enormous administrative and compliance burdens for the Internal 

Revenue Service. Any time a partnership is audited and an adjustment 

is made, the tax liability of each partner must be adjusted. This 

process can be time consuming and expensive, as collection of additional 

tax can be required from hundreds of individual taxpayers, many 

of whom may have moved, died, or suffered substantial declines in 

income since the original partnership return was filed. Administrative 

problems such as these are among the reasons why the corporate 

and individual income taxes cannot be fully integrated by according 

corporations the pass-through treatment used for partnerships. In 

view of the problems encountered in .applying pass-through treatment to 

large partnerships with many partners, it is especially appropriate to 

tax large partnerships as corporations where they possess important 

characteristics of corporations, particularly the limited liability of

partners. *The recent proliferation of many such large partnerships 

suggests that the implications for tax administration of not doing so 

could be serious indeed. 

In order to restore competitive balance between the corporate and 

partnership forms of business organization, and to avoid these 

administrative problems, the Treasury Department proposes that large 

limited liability partnerships be subject to taxation as corporations. 

Losses of such entities will not pass through to partners, earnings 

retained by the partnership will be subject to tax at the entity 

level, and distributions of partnership earnings will qualify for 

dividend relief. This proposal will reduce the interference of the 

tax law in the decision of whether to use the partnership or corporate 

form for ventures in which many owners are involved. Current passthrough 

treatment is appropriate for those corporations and 

partnerships that are truly mere economic extensions of their owners. 

Accordingly, so-called S corporations, limited partnerships with 35 or 

fewer limited partners, and general partnerships, including those with 

more than 35 partners, will continue to be accorded pass-through 

treatment. 

The Treasury Department’s proposals would promote greater 

neutrality in the choice of business organizational form. Additional 

study should be devoted to the continuing differences in the taxation 

of corporations and partnerships of all sizes, and of ways to make the 

taxation of both forms of business organization as consistent as 

possible. Such study also should consider the tax treatment of the 

trust entity and how to ensure that the use of trusts is limited to 

their traditional non-business functions.

- 123 - 

APPENDIX 6-A 

LIST OF PROPQSED REFORNS 

5ASIC TAXATION OF CAPITAL AND BUSINESS INCOME 

A. Lower Corporate Tax Rates 

1. Reduce maximum corporate rate to 33%. 

2. Repeal graduated corporate rate structure. 

3. Repeal personal holding company tax. 

5. Taxing Real Economic Income 

1. Index basis (cost) of assets and tax real gains as ordinary 

income. 

2. Index depreciation for inflation and set depreciation allowances 

to approximate economic depreciation. 

3. Repeal investment tax credit. 

4. Repeal collapsible corporation rules. 

5. Allow expensing of the first $5,000 of depreciable business 

property, but repeal currently scheduled increases in that 

dollar limit. 

6. Allow indexed FIFO and repeal LIFO conformity requirement. 

7. Index interest receipts and payments in excess of mortgage 

interest plus $5,000. 

C. Retirement Savings 

1. Raise IRA limits to $2,500. 

2. Make IRA’S available to both employees and spouses working in 

the home. 

3. Subject all tax-favored retirement plans to uniform distribution 

rules. 

a. Subject all pre-retirement distributions from tax-favored 

retirement plans to a 20 percent premature distributions 

tax generally, (but 10 percent if used for tuition or 

first-home purchase). 

b. Subject all tax-favored retirement plans to uniform minimum 

distribution rules. 

c. Repeal 10-year averaging for lump-sum distributions. 

d. Eliminate special - recovery rules for qualified plan dis 

~ 

tributions. 

e. Repeal special treatment for distributions of employer 

sekuritiGs.

-124- 

4. Simplify the deduction, contribution, and benefit limits for 

tax-favored retirement plans. 

a. Repeal aggregate-based deduction limit for profit-sharing 

and stock bonus plans. 

b. Subject excess contributions to a 6 percent excise tax 

to recapture excessive tax benefits. 

c. Repeal combined plan limit for non-top-heavy plans. 

d. Subject all distributions in excess of $112,500 per year 

to a 10 percent excise tax. 

5. Miscellaneous changes. 

a. Extend deduction limits for tax-favored retirement plans 

to employee stock ownership plan and repeal the employee 

stock ownership plan credit. 

b. Repeal "cash or deferred arrangements." 

c. Subject reversions of funds from tax-favored retirement 

plans to employers to a 10 percent excise tax. 

D. Neutrality Toward the Form of Business Organization 

1. Reduce double taxation of distributed corporate earnings by 

allowing 50% dividends paid deduction. (Allow 50% dividendsceceived 

deduction for intercorporate dividends). 

2. Repeal $l00/$200 exclusion of dividend income. 

3. Require that all limited partnerships with more than 35 

limited partners be taxed as corporations.

- 125 - 

Chapter 7 

INDUSTRY-SPECIFIC SUBSIDIES, TAX SHELTERS, AND OTHER TAX ISSUES 

I. Introduction 

Over the course of the last 70 years, the income tax has been 

riddled by special tax preferences and subsidies for certain 

industries and activities. These special rules have no place in a 

comprehensive income tax. This chapter discusses the Treasury 

Department's proposals to modify or eliminate most of these subsidies. 

In addition, this chapter discusses proposals that will improve the 

rules for measuring income, require more consistent accounting of 

receipts and expenses, and further reduce the opportunities for tax 

she1ters. 

Two large sectors of the economy -- natural resources and 

financial institutions -- have special tax rules that are inconsistent 

with both a comprehensive income tax and the goal of increased 

reliance on the market allocation of investment and saving. TO ensure 

that saving and investment in the economy are channeled to their most 

productive uses, these sectors should be accorded tax treatment 

similar to that of other businesses. 

The tax exemption of interest on debt of state and local governments 

is inconsistent with a comprehensive income tax. Nonetheless, 

to the extent that the exemption is confined to governmental activity, 

it has come to be an accepted part of the fiscal landscape. In recent 

years, however, state and local governments have expanded the use of 

tax-exempt bonds in ways which are often abusive and which compete 

directly with both government purpose issues of State and local 

governments and private financial intermediation. The proposal will 

repeal the use of tax-exempt bonds for nongovernmental purposes and 

tighten restrictions that prevent state and local governments from 

earning arbitrage profits. 

The general income measurement rules proposed will greatly reduce 

the attractiveness of existing tax shelters. Yet opportunities for 

tax shelters may remain, and the Treasury Department proposes 

tightening provisions designed to prevent taxpayers from borrowing to 

invest in tax-preferred assets or from taking deductions that exceed 

the amount of funds "at risk." 

The Treasury Department proposals will retain the basic system of 

U.S. taxation of international transactions. The reduction in the 

corporate tax rate necessitates changing the foreign tax credit to 

apply on a country-by-country basis. Source rules should be modified 

to reflect more closely the economic substance of transactions. The 

possessions tax credit will be revised to direct the credit to 

employment-producing investment by U.S. corporations. 

453-370 0 - 84 - G

- 126 - 

Finally, the Treasury Department proposals will unify and simplify 

the taxation of estates and gifts, simplify the adminstration of 

penalty provisions, and allow certain provisions to expire. In 

addition, the proposals would have beneficial indirect effects on the 

financial solvency of the social security system. 

19. General Issues of Income Measurement 

The current tax law does not account satisfactorily for the timing 

of many receipts and expenses. Too frequently, taxable receipts can 

be deferred until later years and deductible expenses can be 

accelerated. This mismatching of receipts and expenses results in tax 

deferral, and the Federal Government effectively provides to the 

taxpayer an interest-free loan equal to the deferred tax liability. 

The value of tax deferral is greater, the longer the deferral and the 

higher the taxpayer's marginal tax rate. Table 7-1 indicates how much 

tax deferral reduces effective tax rates. For example, at an 8 

percent after-tax interest rate, a 10-year tax deferral. effectively 

reduces a 50 percent marginal tax rate to only 23 percent. 

Several general income measurement rules in current law require 

modification in order to eliminate opportunities for tax deferral. 

The matching of receipts and expenses for activities extending over 

several years (multiperiod production) requires more comprehensive and 

more uniform cost capitalization rules. The use of the cash method of 

accounting should be available only to businesses that do not use the 

accrual method for financial accounting purposes, carry no 

inventories, and are too smali to have access to professional accounting 

expertise. Vendors should not be permitted to report sales income 

on the installment method when their receivables are effectively 

converted into cash. The deduction for bad debt losses should be 

restricted to the actual losses experienced in the current year. Once 

these an2 other income measurement changes have been fully 

implemented, the retention of the corporate minimum tax will be 

unnecessary because the underlying tax preferences will have been 

eliminated. 

A. aultiperiod Production 

Activities that involve multiperiod production, or sales that 

occur in years after expenses are incurred, often benefit from the 

mismatching of expenses and receipts. For instance, most of the 

expenses involved in growing timber are deducted long before the 

timber is sold and payments are received. Any acceleration of 

deductions effectively shelters other income from current taxation. 

$latching of receipts and expenses is achieved if the costs of 

producing long-lived assets are capitalized, that is, included in the 

basis of the asset, and recovered when the asset is sold or 

depreciated. 

under current law, certain indirect costs, such as fringe benefits 

and the cost of borrowing to carry multiperiod production to 

completion, generally are not capitalized. In addition, the

- 127 - 

Table 7-1 

Effective Tax Rate Per Dollar of Income Deferred by a 

50 Percent Taxpayer 

for Different Deferral Periods and Interest Rates 

Interest rate : 

Deferral period 

1 : 3 : 5 

(in years) 

: 1 0 : 2 0 : 3 0 

4 percent 48.1 44.4 41.1 33.8 22.8 15.4 

6 percent 47.2 41.0 37.4 27.9 15.6 0.7 

8 percent 46.3 39.7 34.0 23.2 10.7 5.0 

10 percent 45.4 37.6 31.0 19.3 1.4 2.9 

12 percent 44.6 35.6 28.4 16.1 5.2 1.7 

Office of the Secretary of the Treasury November 25, 1984 


- 128 - 

capitalization rules do not apply uniformly to all activities, and 

they vary depending on whether the output is sold or used in the 

producer's own business. Long-term contracts, self-constructed 

assets, inventories, minerals, and timber all have different cost 

capitalization rules. The Treasury Department proposals will make the 

cost capitalization rules more comprehensive and apply a uniform rule 

to all multiperiod production act'ivities. 

Making cost capitalization rules more uniform would ensure 

neutrality across types of businesses, reduce tax shelters, and 

improve equity. Uniform rules would eliminate the current tax 

incentive for businesses to construct their own plant and equipment, 

even when they are not the most efficient producers. 

In addition, due 

to the incomplete capitalization rules, industries with long 

production processes -- the so-called "natural deferral" industries, 

such as timber and minerals -- are dominated by tax shelter investors. 

Thus, current law results in serious dislocations and inequities. 

Among the many consequences, shelter investors bid up land prices and 

drive down product prices in these tax-favored industries; as a 

result, low-bracket individuals and businesses with little taxable 

income to shelter can no longer earn a sufficient after-tax rate of 

return from investments in these activities. 

B. Use of Cash Nethod of Accounting 

Allowing taxpayers to choose between cash and accrual accounting 

methods results in significant mismatching of taxable receipts and 

deductions. For instance, mismatching occurs in the case of 

prepayments of expenses when the buyer uses the cash method and 

deducts payments currently, but the seller uses a method of accounting 

that defers income until a later period. 

The use of the cash method of accounting is not in accord with 

generally accepted accounting principles and, therefore, is not 

permissible for financial accounting purposes. Yet, many taxpayers 

that use an accrual method for financial accounting purposes choose to 

use the cash method for tax purposes solely because this method defers 

taxable income by accelerating deductions. The proposal will restrict 

the use of the cash method to businesses that do not use the accrual 

method for financial accounting purposes, carry no inventories, and 

have gross receipts of less than $5 million. 

The restriction on the use of the cash method would only affect 

businesses that are already using accrual accounting in some part of 

their business or are sufficiently large to have access to 

professional accounting expertise. The taxpayers that would be most 

affected by the proposal would be banks that use accrual accounting 

for financial reporting purposes, but the cash method for tax 

purposes, and large cash-method service organizations, such as 

accounting, engineering, law, and advertising firms.

C. Bad Debt Deductions 

- 129 - 

Taxpayers generally are not allowed to deduct the cost of future 

liabilities or losses. The deduction for bad debt reserves is an 

exception from the general realization principle that losses on an 

asset are not deducted until the sale or sxchange of the asset. The 

current reserve deduction accelerates the timing of the deduction for 

bad debts, and thus allows businesses to defer tax on a portion of 

their income. 

The current bad debt reserve rule allows taxpayers a deduction for 

actual bad debt losses in the current year plus any increase in the 

reserve. For example, a beginning firm with $150 of loan losses might 

deduct $250 in the first year: $150 for the actual loan losses plus 

$100 for an increase in the allowable reserve for future losses. AS 

long as the firm's total loan losses never fell below $100, the excess 

deductions would never be recaptured. Because firms effectively 

deduct their current loan losses, the accumulated reserve for a 

growing firm is never brought into taxable income. Indefinite tax 

deferral is virtually equivalent to tax exemption. Only firms that 

have declining loan losses are taxed on their deferred income. Thus, 

the current rule mismeasures the timing of taxable income, and 

provides differential tax treatment across types of firms. In 

addition, the current treatment of bad debt losses encourages debt 

financing for risky projects by reducing the risk premium that lenders 

charge. 

The proposal will restrict the deduction for bad debts to the 

actual loan losses i n the current year. This will eliminate the 

preferential tax treatment of risky loans and treat bad debt losses 

consistently with other types of losses. 

D. Installment Sales 

The tax system is not neutral with respect to the form of 

financing of property sales. The current rules for taxation of 

installment sales allow taxpayers that can afford to provide seller 

financing to defer tax liability on the sale of property. In 

contrast, sellers that receive cash directly, or whose sales are 

financed by a third party, pay tax on the giiin currently. Charging 

interest on the amount of the deferred tax liability for taxpayers 

electing the installment method would make the tax law neutral as to 

the financing of property sales and would end use of installment sales 

as a vehicle for tax deferral. 

The Treasury Department does not propose charging interest on 

installment sales, however, because of the increased complexity and 

taxpayer perception problems that such an approach would create. Most 

taxpayers would not readily comprehend why they should pay interest on 

the deferred taxes when the taxes are only paid as installment 

payments are received.

- 130 - 

The installment sale method originally was intended to alleviate 

the seller's liquidity problems. The method is now commonly used to 

defer tax liability on gain from sales by individuals and businesses 

that have no liquidity problems. For example, sales income may be 

reported on the installment method, even though the installment notes 

received are immediately pledged as collateral for loans. In such 

cases, the seller has received cash immediately, has no liquidity 

problem, and is simply using the installment method for tax deferral. 

The Treasury Department proposes to deny use of the installment sale 

method in such circumstances. 

E. Coruorate Minimum Tax 

Minimum taxes reflect an attempt to maintain the equity and 

neutrality of a tax system that is riddled with special preferences. 

The corporate minimum tax would be necessary only if the underlying 

special preferences were retained. Because the Treasury Department's 

comprehensive tax reform package repeals almost all special 

preferences directly, eventual repeal of the corporate minimum tax 

would be possible. However, the minimum tax should not be repealed 

unless and until the basic reforms are fully implemented. 

If, after enactment of tax reform, individuals and corporations 

with significant economic income still find mechanisms by which to pay 

little or no income tax, the Treasury Department would support the 

enactment of appropriate minimum taxes on the economic income of 

individuals and corporations. 

II3. 

Subsidies for Specific Industries 

A, Energy and Bthes Minerals 

Proper measurement of income in natural resource industries 

requires that costs of exploration and development be capitalized. 

Such expenses should then be recovered over the productive life of a 

natural resource property as resources are extracted and income is 

earned. The proper recovery of exploration and development costs is 

achieved through cost depletion; it is analogous to economic 

depreciation. Where only "dry holes" occur and an entire property is 

abandoned, the related costs should be written off at the time of 

abandonment. 

Taxation of natural resources in general, and of oil and gas in 

particular, has long deviated from principles required for the 

accurate measurement of income. The energy industry is currently 

favored over other business activities through the tax system in two 

unique ways. First, "intangible drilling costs" -- the expenses of 

drilling, other than for the purchase of physical assets -- can be 

deducted currently even if drilling is fruitful. This acceleration of 

cost recovery produces several adverse effects. Investment in oil 

production is favored relative to other investments with higher pretax 

returns. Drilling is favored relative to less expensive means of 

exploration that are not tax-preferred. Investment in energy sources

- 131 - 

where capital costs are a relatively high share of total costs are 

favored relative to others. Tax burdens on energy corporations and on 

individuals investing in the energy sector are reduced, interfering 

significantly with tax equity. As a result, the perception of 

fairness of the tax system i.s tarnished. 

Second, except for major integrated oi,l companies and certain 

large independent producers, cost depletion is not required for those 

costs of exploration and development that are not written off 

immediately. Instead, qualified producars of petroleum and all 

producers of certain other natural resources are allowed to deduct 

from taxable income a flat percentage of gross income (ranging from 5 

to 22 percent, depending on the mineral), subject to a limitation that 

the deduction cannot exceed 50 percent of net income from the 

property. Deductions based on percentage depletion, plus previously 

deducted investment costs, generally exceed 100 percent of actual 

costs of exploration and development. Thus, percentage depletion is 

not merely an accelerated alternative to cost depletion' as a means of 

recovering investments in natural resources; rather it is a subsidy to 

the exploitation of natural resources that is administered through the 

tax system. This subsidy increases with the prices of natural 

resources. Percentage depletion encourages over-production of scarce 

domestic resources, adds complexity to the tax system, unfairly 

benefits owners of thosz resources, and erodes the perception of 

fairness of the tax system. 

The oil industry is also subject to the windfall profit tax, a 

special excise tax on revenues from crude o il produced domestically. 

Taxable crud- oil i s classified in three tiers. Generally, oil in 

tier one is oil that has been subject to price controls; oil in tier 

two consists of stripper well oil; and oil in tier three is newly 

discovered oil, incremental o il and heavey oil. The tax base is the 

difference between a statutory base price and the amount for which the 

oil is sold, less a severance tax adjustment. The tax rate is highest 

for tier one oil and is progressively reduced for tiers two and three 

(with a greater reduction for newly discovered oil). 

The windfall profit tax was enacted in 1980 at a time when crude 

oil prices were rising rapidly. Its enactment was associated with 

decontrol of crude oil prices. Since that time crude oil prices have 

moderated and, in fact, have significantly declined from record high 

levels. Consequently, the perceived "windfall" for producers has 

generally vanished. Furthermore, ?he tax offset some of the 

additional stimulus to domestic production provided by oil decontrol. 

The goal. of increased reliance on free-market forces underlies 

this Administration's energy policy, as well as the Treasury 

Department study of fundamental tax reform. As stated i n the Budget 

for Fiscal. Year 1985: 

The Nation needs adequate supplies of economical 

energy. The most promising way to meet this 

need is to let market forces work ... The

primary role of the Federal Government with 

respect to energy is to establish and maintain 

sound policies based on economic principles that 

promote efficient energy production and use. 

This strategy ... emphasizes the importance of 

allowing our market economy to function to 

ensute that these decisions are as productive 

and efficient as possible. 

The Treasury Department therefore proposes that the windfall 

profit tax be repealed ana that the option of expensing intangible 

drilling costs and percentage depletion be replaced by cost depletion. 

Repeal of expensing on intangible drilling costs and percentage 

depletion should not be viewed as penalizing or singling out the 

energy industry. The proposed rules are identical to proposed changes 

in the general rules for income measurement for all multiperiod 

production, which require cost capitalization in order to match deductions 

with taxable receipts. 

Some will argue that these subsidies for the production of 

minerals provided by special tax treatment cannot be eliminated, 

because doing so would reduce domestic production and increase 

American dependence on foreign sources of oil and other minerals. 

Further, they will argue that enactment of the Treasury Department 

proposals would raise prices of minerals, even though the magnitude of 

this effect would probably be small bocaiise the prices of most 

minerals are set in international markets. While these effects may 

occur and might be burdensome in the short run, the proposed reforms 

would be beneficial in the long run because the capital and labor 

released from the energy and minerals sector as a result of a more 

neutral tax policy would be employed more productively in other 

industries. Higher prices for oil and gas, lower marginal tax rates, 

indexation of the basis against which depletion allowances are taken, 

and repeal of the windfall profit tax would partially offset the 

elimination of the subsidy, cushion any drop in domestic production, 

and encourage the development of alternative domestic energy sources. 

AS the Administration's announced policy on energy makes clear, the 

public would gain froin a more rational allocation of resources among 

competing energy modes, Prices more reflective of the actual 

replacement costs of energy would encourage greater conservation, and 

that, plus less rapid depletion of domestic resources, would, over the 

long run, reduce vulnerability to foreign supply disruptions. 

13. Financial Institutions 

Most types of financial institutions presently benefit from 

preferential tax treatment. Besides being unfair and distortionary 

relative to the taxation of the rest of the economy, these tax 

preferences create distortions within the financial sector that are 

inconsistent with the Administration's efforts to deregulate financial 

markets. Equity and neutrality demand that all financial institutions 

be taxed uniformly on all of their net income. These special

- 133 - 

preferences are especially inappropriate in a world in which the 

corporate tax rate is lowered and both individuals and other 

corporations are taxed on their economic income. 

Banks and thrift institutions are allowed to deduct an arbitrary 

fraction of outstanding loans or otherwise taxable income as an 

addition to a reserve against bad debts, without regard to the actual 

losses they experience on bad debts. In theory, reserve accounting is 

consistent with accrual accounting; but in practice reserve accounting 

for banks and thrift institutions has borne little relation to 

expected losses, and therefore little relation to proper accrual 

accounting. The special bad debt deduction for thrift institutions is 

tied to specialization in residential mortgage lending, and only 

benefits profitable thrift institutions. The special rules are at 

variance with the general rules that are applied to non-depository 

institutions and the correct income measurement rule. This arbitrary 

deduction involves a tax subsidy for financial institutions that has 

no place in an income tax system; it should be repealed. 

Taxpayers generally are prohibited from deducting interest on debt 

incurred to finance holdings of tax-exempt bonds. Banks benefit from 

an exception to this rule; they are able to deduct 80 percent of 

interest incurred to carry tax-exempt securities, and thus offset 

taxable income from other sources, in many cases totally eliminating 

income tax liability. Because of the special rule that allows banks 

to earn arbitrage profits, borrowing costs of state and local 

governments are subject to greater volatility because of the excessive 

demand created for their tax-preferred bonds. The Treasury Department 

proposes extending to banks the general rule that fully disallows 

interest deductions on debt incurred to carry tax-exempt securities. 

Credit unions, which compete with banks and thrift institutions, 

currently are tax exempt. This exemption allows deferral of tax on 

members' interest income that is retained in the credit union. This 

tax break for their members gives credit unions a competitive 

advantage in attracting deposits from other financial institutions. 

The exemption should be repealed. 

Life insurance companies traditionally have been allowed a 

deduction for increases in policy reserves that exceed the amount of 

policyholders' savings and interest income represented by the actual 

increase in the cash value of the policies they underwrite. In 

addition, they are allowed a special deduction for 20 percent of 

otherwise taxable income (60 percent for small companies). This extra 

deduction is equivalent to applying a lower tax rate to the income of 

life insurance companies. Deductions for increases in reserves should 

be limited to increases in cash value, and the special deduction 

should be repealed. 

Amounts earned by policyholders on the cash value of life 

insurance (the "inside buildup") generally escape income tax under 

present law. As a result, income earned on investments i n life 

insurance policies is treated substantially more favorably than

interest on deposits in banks and thrift institutions, which is taxed 

currently. In addition, tax-deferred income from annuities can be 

earned in unlimited amounts. rn order to make the taxation of income 

flowing through financial institutions more neutral, the Treasury 

Department proposes that the exclusion of the inside buildup in life 

insurance be repealed and that annuity interest income be subject to 

current taxation. Taxpayers will be allowed to treat the savings 

portion of life insurance premiums as deposits in an individual 

retirement account (IRA), subject to the overall IRA limitations. 

Income earned on these savings will be tax exempt until withdrawn from 

the IRA. 

Property and casualty (P&C) insurance companies are allowed a 

deduction for additions to accounts for protection against losses that 

bears no relation to actual losses. In addition, P&C companies are 

allowed current deductions for losses expected to be incurred in the 

future, with no recognition that the future losses are worth 

substantially less, in present value terms, than the deductions being 

allowed currently. (Another way of saying this is that to meet future 

losses a much smaller amount can be set aside today because of the 

interest earned before the loss is incurred.) Both of these excessive 

deductions are inconsistent with a comprehensive income tax; the first 

should be repealed, and the second should be altered to reflect the 

value of an early deduction for Euture losses. 

The proposed tax changes at both the individual and corporate 

levels would make the "playing field" for financial institutions more 

level and more comparable to that of nonfinancial institutions. These 

changes are consistent with and necessary for the deregulation of the 

financial sector. All financial institutions would be affected, but 

they would generally be compensated by the reduction in the corporate 

tax rate. 

Banks would no longer find it advantageous to eliminate Federal 

tax liability by investing in tax-exempt bonds; the lower tax rate 

would make their after-tax return on taxable investments generally 

higher than the current tax-exempt yields. Eliminating the special 

rule that enables many banks to pay little, or no, Federal income tax 

would improve the perception of fairness of the tax system. Repeal of 

the special deductions of thrift institutions and life insurance 

companies will be offset by the lower tax rate. Credit unions will be 

taxed on the same basis as banks and other thrift institutions. 

Individuals would buy life insurance and annuity policies for the 

primary purpose of protecting against premature death or longevity, 

rather than as a tax shelter. And P&C insurance companies would have 

no tax advantage in selling casualty insurance coinpared with companies 

willing to self-insure against the risk of property loss. 

The total amount of saving flowing through financial institutions 

would increase as rate reductions increase the after-tax return to 

saving. The proposed changes would remove the tax distortions that 

encourage saving to flow through life insurance companies at the

- 135 - 

expense of other financial institutions. The change in the bad debt 

deduction would remove the tax incentive for banks and thrift 

institutions to make risky loans. 

C. Debt of State and Local Governments 

Interest on debt issued by State and local governments for governmental 

purposes, such as schools, roads, and sewers ("governmental 

bonds"), has long been exempt from tax. The exemption of this 

interest is inconsistent with a comprehensive income tax. Moreover, 

the subsidy it provides to the borrowing of State and local governments 

is an inefficient one because much of its benefits are received 

by high-income bondholders, rather than producing cost savings for 

state and local governments. The exemption of interest on 

governmental bonds originated in earlier views about the fiscal 

relationship between the Federal and State and local governments under 

the Constitution. However outmoded that understanding of federalism 

may appear today, this exemption appears to be an accepted part of the 

fiscal landscape. 

State and local governments have recently expanded the use of taxexempt 

bonds in ways that should not be accepted. Proceeds from taxexempt 

bonds have been used for non-governmental purposes: for 

economic development (via industrial development bonds or IDBs), for 

low-interest mortgages on owner-occupied housing, for student loans, 

and for private hospital and educational facilities. In addition, 

State and local governments have invested proceeds of tax-exempt bonds 

in higher-yielding taxable securities to earn arbitrage profits. 

The use of State and local governments' tax-exempt borrowing 

privilege for the direct benefit of private businesses, nonprofit 

organizations, and individuals has increased rapidly in recent years. 

Non-governmental bonds issued in 1975 totaled only $9 billion, 

accounting for 30 percent of long-term tax-exempt bond volume. In 

1983, non-governmental tax-exempt bonds totaled $58 billion and 

accounted for 62 percent all new long-term tax-exempt bond issues. 

(See Figure 7-1.) Despite recently enacted volume limitations on 

certain non-governmental bonds, their share of the total tax-exempt 

bond market will continue to increase in the future in the absence of 

further restrictions. This will bid up the interest rates that must 

be paid on debt of State and local governments issued for governmental 

purposes. 

Seen from the perspective of any one State or local government, 

issuance of such non-governmental tax-exempt bonds appears attractive; 

a local business or resident obtains a Federal subsidy at no cost to 

the local government. In many cases the local government would not 

provide a direct subsidy to the same business or resident. From a 

national perspective, however, the subsidies provided through taxexempt 

financing to private businesses and individuals are 

inefficient, costly and distortionary. If all of the States compete 

for economic development by issuing industrial development bonds, 

economic activity will not be significantly greater than in the

- 136 - 

0 

-0 

(1: 

0 

a 

C 

cu 

0 

-I 

c 

C 

e, 

-0 

3 

5

absence of the bonds and it will probably not be located very 

differently. Firms not benefitting from IDBs are placed at a 

competitive disadvantage. Moreover, the loans are not allocated to 

their best use, but rather to those who best know how to manipulate an 

administrative or political process. 

The primary effects of non-governmental tax-exempt bonds are a 

lower interest rate for the private business or individual benefitting 

from tax-exempt financing, tax savings for wealthy bondholders, higher 

borrowing costs on tax-exempt bonds issued for governmental purposes, 

less Federal revenues as a result of tax exemption of interest on the 

bonds, and correspondingly higher tax rates on wages and salaries and 

other forms of taxable income. If below-market mortgages or student 

loans benefitting local residents are thought to be worthy of local 

support, they should be financed locally, not through inefficient 

Federal subsidies to local borrowing that drive up tax rates 

throughout the country. The Treasury Department proposals will 

eliminate the future issuance of all tax-exempt bonds resulting in 

proceeds used by persons or organizations which are not governments, 

tighten the restrictions on arbitrage, rely on market forces to di.rect 

private investment to its most efficient use, expand the tax base, and 

lower tax rates. 

The proposed elimination of: non-governmental bonds should be of 

financial benefit to State and local governments. Reducing the volume 

of tax-exempt bonds will improve the market for bonds issued for 

government purposes, thus reducing interest costs to governments. 

v. -special Rules 

In addition to the industry-specific subsidies previously 

described, the tax law is littered with credits, exclusions, and 

special exceptions to general rules. These implicit subsidies should 

be repealed as part of tax reform designed to free markets from the 

intrusions of government via the tax system. 

band is not depreciable because its productive capacity is not 

expected to decline measurably over time. Yet certain capital 

expenditures have special recovery rules, even though some of these 

expenditures are for assets siinilar to land. For instance, companies 

are allowed to recover the cost of railroad grading and tunnel bores 

over 50 years, even though such improvements may have undiminished 

economic value for hundreds of years or even indefinitely. 

Other special rules were intended to encourage a particular 

activity by allowing accelerated write-offs and the advantages of tax 

deferral. The current law allows 5-year write-off of certified 

pollution control facilities. This provision was intended to reduce 

the cost of businesses complying with regulatory requirements. Since 

the enactment of ACRS in 1981, this provision has not been used, 

because accelerated cost recovery over 5 years is more generous than 

straight-line recovery over the same period. However, compared with 

the indexing and recovery over economic lives proposed for all other

- 138 - 

assets, this special provision would be extremely advantageous. As 

part of comprehensive tax reform, these special rules that mismeasure 

economic income and benefit specific industries should be repealed. 

The Merchant Marine Capital Construction Fund is an example of a 

tax subsidy program that has become outdated and distorted from its 

original purpose. In 1936, special tax treatment, along with direct 

appropriations programs, were provided for U.S. citizens owning or 

leasing U.S.-flag vessels to assure an adequate shipping capacity in 

the event of war. The direct appropriations programs have heen phased 

out because an adequate number of vessels are owned or controlled by 

U.S. citizens, though perhaps registered elsewhere. The tax subsidy, 

on the other hand, has been expanded to fishing vessels and ships 

plying the inland waterways -- a result inconsistent even with the 

original, but antiquated, purpose for the Fund. This tax subsidy 

program should be repealed. 

The R&E credit, which is designed to encourage businesses to 

undertake additional private research activities, will be extended. 

To improve the effectiveness of the credit, however, the scope of 

qualifying expenses will be focused so that the credit is available 

only for private research activities that are likely to lead to 

technological innovations. A revised definition of eligible expenses 

will target the credit more narrowly and provide a greater incentive 

for business to undertake research efforts which will lead to 

productivity-enhancing innovations. 

The tax Code also contains a number of credits that should be 

repealed. Rehabilitation tax credits provide Federal subsidies for 

the renovation of older buildings and historic property. These tax 

credits were intended to match the favorable tax treatment of new 

buildings resulting from accelerated depreciation and investment tax 

credits. With repeal of the investment tax credit and the use of 

indexed, economic depreciation, the rehabilitation tax credits should 

be repealed. The subsidization of historic preservation expenditures, 

if believed to be desirable, should be provided through direct 

appropriations, rather than through the tax system. 

ISr. 

Further Curtailment of Tax Shelters 

Participation in a variety of tax shelter investments has 

increased steadily since the 1960s. One indication is the growth in 

the number of individual tax returns claiming partnership losses, as 

partnerships are the most common vehicle for investing in tax 

shelters. Between 1963 and 1982 the number of taxpayers claiming 

partnership losses increased almost five-fold to 2.1 million. By 

comparison, the total number of tax returns filed during the same 

period increased by only 50 percent. 

In 1981 and 1982, U.S. partnerships actually reported aggregate 

net losses for tax purposes. Over one-half of all partnership losses 

were concentrated in three broad areas: farming, mining and other 

extractive industries, and real estate. These industries benefit

- 139 

especi,ally from opportunities for shelte.ring created by the 

combination of deferral of taxes, preferential treatment of long-term 

capital gains, and the deductibility of interest. 

Tax deferral arises whenever investors are able to accelerate 

deductions or defer reporting of taxable receipts. Opportunities for 

such deferral are created by a variety of tax rules. In the case of 

farms, current deductions are allowed for costs incurred to earn 

income which is not reported until a later taxable year; in the case 

of oil and gas drilling, intangible drilling costs may be expensed in 

the current taxable year, rather than capit.alized and recovered over a 

number of years; in the case of real estate, deferral is made possible 

by tax depreciation rules which permit deductions in excess of true 

economic depreciation to be taken in the early years of the 

investment. 

A second aspect of tax shelters is the conversion of ordinary 

income to tax-preferred capital gains. Tax deferral and conversion of 

ordinary income to capital gains occur together when accelerated 

depreciation deductions are used to offset ordinary wage and salary 

income, while a significant portion of the annual return on the 

investment is realized as preferentially taxed Long-term capital gain 

at some future date. 

Moreover, when taxation of income from an asset can be deferred or 

converted into tax-preferred income, investors will often have a 

strong incentive to finance the acquisition of the asset by means of 

borrowing, as this allows the investor to engage in interest-related 

tax arbitrage. Interest-related tax arbitrage transactions occur when 

an investor borrows funds, fully deducts the interest expenses 

incurred to borrow those funds, and then uses the funds to purchase 

investments which earn either partially or entirely tax-exempt or taxdeferred 

income. 

It is the combination of tax deferral and leveraged financing 

which is the principal cause of the substantial losses reported by tax 

shelter partnerships in the aforementioned three industries -- some 

$33 billion in 1982. Yet for reasons just mentioned, these "losses" 

overstate true economic losses incurred by those partnerships. A 

substantial portion of the accounting losses simply reflect preferential 

tax treatment of certain sources and uses of income. 

As a consequence of these tax accounting losses, affluent investors 

are able to shelter other income from tax. This is undesirable 

primarily because preferential treatment of particular activities 

interferes with the market-determined allocation of resources and 

unfairly benefits investors in tax shelters. 

The proliferation of tax shelters has other undesirable consequences. 

Auditing tax shelters absorbs valuable resources of the 

Internal Revenue Service that could better be devoted to other tasks. 

Beyond that, the widespread existence of legitimate shelters makes it 

far more difficult for the Internal Revenue Service to identify and

- 140 - 

control. abusive shelters involving tax fraud. Perhaps worse, 

unsophisticated taxpayers who cannot afford legal advice also cannot 

distinguish between legitimate and abusive shelters and thus 

increasingly invest in the latter with disastrous results. To lower 

and middle-income taxpayers who cannot benefit from tax shelters, the 

distinction between legal tax avoidance and illegal evasion may be too 

subtle to prevent a widespread impression that the tax system is 

unfair because high-income taxpayers are escaping taxation. This impression 

of unfairness lies at the root of many complaints about the 

tax system and undermines voluntary compliance with the tax law. Of 

course, this perception is accentuated by widely publicized stories 

about abusive shelters. 

Growth in tax shelter activity has also played a significant role 

in the erosion of the Federal income tax base, particularly among 

affluent taxpayers. Estimates from the 1983 Treasury individual tax 

model indicated that total partnership losses (losses claimed by 

individuals -- as distinct from corporations, who also own partnership 

interests) may have sheltered as much as $35 billion of all individual 

income from taxation. Roughly $28.6 billion or 82 percent of total 

partnership losses claimed on individual tax returns were reported by 

taxpayers with gross incomes (before losses) of $100,000 or more, and 

60 percent, or $21.0 billion, were reported by taxpayers with gross 

income (before losses) in excess of $250,000. By comparison, these 

groups reported considerably smaller shares of all gross income before 

losses -- 9 percent and 4 percent, respprtively. 

Several of the Treasury Department's proposals for example, 

lower tax rates, taxation of real capital gains as ordinary income, 

capital consumption allowances that approximate economic depreciation, 

indexing of interest expense, matching expenses and receipts from 

multiperiod production, and tax treatment of certain large 

partnerships as corporations -- will greatly reduce the attractiveness 

of tax shelters. Yet opportunities for tax shelters will remain. The 

proposals in this sect.ion will further reduce these opportunities. 

A. Limiting Interest Deductions 

Under the present income tax, certain forms of investment income 

are not fully taxed. Notable examples include interest from State and 

local securities, long-term capital gains, and the earnings on many 

insurance and retirement accounts. Moreover, certain expenditures 

give rise to deductions and credits that can be used to offset tax 

that would otherwise be due on other income. The most important of 

these are accelerated depreciation, the investment tax credit, and the 

immediate deduction for intangible drilling costs. 

When investments benefitting from tax preferences are debtfinanced, 

the preferences generally are magnified. This problem has 

long been recognized, and since 1921 deduction of interest incurred to 

carry tax-exempt securities has been disallowed. Because it is 

difficult for the Internal Revenue Service to associate a particular 

debt with investment in tax-exempt securities or other tax-preferred 

--

investments, this type of restriction is not fully effective. More 

recently, the deduction for investment interest expense was limited to 

the sum of investment income plus $l0,000, in order to prevent 

taxpayers from taking large deductions for interest expense incurred 

to earn tax-preferred income. However, the limitation does not 

adequately take into account interest incurred to finance investments 

in many tax-preferred activities. 

The Treasury Department proposes tightening the interest 

limitation rules. Individuals would be allowed no current deduction 

for investment interest expense in excess of the sum of passive 

investment income, mortgage interest on the taxpayer's principal 

residence, and $5,000, For this purpose, passive investment income 

will not include business and investment income from general partnerships 

interests, sole proprietorships, S corporations actively managed 

by the taxpayer, and farms, but will include dividends, interast, and 

income from limited partnership interests, Similarly, investment 

interest subject to the limitation will include all interest now 

deducted as an itemized deduction (other than interest on the 

taxpayer's principal residence) plus the taxpayer's allocable share of 

interest incurred through any limited partnership interest and any S 

corporation in which the taxpayer is a passive investor. This 

limitation will not prevent the deduction of mortgage interest on the 

principal residence of the taxpayer, nor the deduction of interest 

incurred in the conduct of a trade or business. The $5,000 allowance 

would prevent the limitation from affecting most taxpayers. 

As long as high-income investors are able to borrow funds to 

acquire investments which pay tax-preferred income, and deduct 

currently the interest expenses incurred to borrow those funds, tax 

equity will suffer and the marginal tax rate needed to raise a given 

amount of tax revenue will be higher than would otherwise be required. 

Moreover, the arbitrage availability encourages high-income investors 

to compete aggressively for borrowed funds in capital markets, 

reducing the supply of capital available for low-income borrowers, 

including prospective homeowners and new businesses. The proposed 

limitation on interest expense would reduce the extent to which highincome 

investors engage in tax-motivated borrowing, but would not 

discourage borrowing for active business pursuits. Tfiis would both 

lower marginal tax rates, and make it easier for moderate-income 

investors to compete for borrowed funds with high-income investors. 

8. At-Bisk Rules 

Current law contains rules to prevent a taxpayer from taking 

deductions that exceed the amount he or she has "at risk" in a given 

investment. The at-risk rules apply primarily when the taxpayer is 

taking deductions related to assets that are heavily financed by nonrecourse 

debt -- debt for which the taxpayer is not personally liable. 

Non-recourse debt often plays an important role in tax shelters, as it 

permits taxpayers to report deductions in excess of the amount of the 

taxpayer's actual investment. The tax losses that these deductions 

produce for the investor are clearly artificial, since an investor

- 142 - 

cannot possibly lose more than he or she has at risk in an investment. 

Because the at-risk rules are complicated, it is tempting to 

propose that they be eliminated in the interest of simplification. 

But the at-risk rules could not be repealed without replacing them 

with an equally effective solution, such as a reduction in the basis 

used in calculating depreciation allowances by the amount of nonrecourse 

debt. Such a radical departure from current law would have 

an uncertain and perhaps severe economic impact. Thus despite t,he 

logic of such an approach, the Treasury Department does not propose 

it. Rather, the at-risk rules should be retained and applied to all 

investments. 

In the case of activities to which the at-risk rules do not 

currently apply, such as real estate and leasing, the tax benefits of 

the investment are so magnified that the true economic return of the 

inzrestment property is often a minor consideration in the ultimate 

decision of whether to invest. As a result, resources are allocated 

without due regard to the true (pre-tax) profit.ability of such 

ventures. Since pre-tax profitability can generally be trusted to 

guide the nation‘s resources to their best uses, this emphasis on 

after-tax profits, to the neglect of pre-tax profits, interferes with 

the market allocation of resources ,to their most productive uses. 

Extending the at-risk rules to cover all activities would allow 

deductions only to the extent of the investor‘s actual liability for 

potential losses in that activity. As a result, investors in tax 

shelter activities could still claim sizable depreciation and interest 

deductions, provided that they were accountable for a commensurate 

share of the business risk associated with the investment. This would 

cause investors to pay more attention to the potential economic gain 

or loss from investments, rather than focusing on their tax 

consequences, and thereby promote greater efficiency in the allocation 

of the nation’s capital among competing activities. With investments 

based on economic realities, there would be less tendency for real 

estate prices to spiral upwards, driven by investors in tax shelters. 

v. Lnternational Issues .- 

In taxing the foreign income of U.S. taxpayers, the United States 

has sought a balanced treatment of foreign and domestic investment, 

tempered by concern for international competitiveness. U.S. taxpayers 

are subject to tax on their worldwide income. However, in order to 

avoid double taxation of foreign income also taxed by host countries, 

a credit is allowed for foreign income taxes paid. In the interest of 

competitiveness, U.S. tax on income earned by foreign subsidiary 

corporations is generally deferred until that income is remitted to 

U.S. shareholders. (This tax deferral is not available with respect 

to tax haven income.) In addition, the Foreign Sales Corporation 

(“FSC”)provisions and the exclusion of individuals‘ foreign earned 

income provide special rules to promote exports. Other special rules 

are designed to promote investment in the U.S. possessions.

- 143 - 

The Treasury Department proposals will retain this basic system of 

1J.S. taxation of international transactions. For example, the foreign 

tax credit, the deferral of tax on undistributed foreign subsidiary 

earnings, the FSC provisions, and the foreign earned income exclusion 

would be retained. The present system of current taxation of certain 

tax haven earnings of foreign subsidiaries also would be continued, 

but consideration should be given to coordinating the various rules. 

Changes would be made in the foreign tax credit limitation and in 

certain source provisions to make those rules work more efficiently 

and equitably. The taxation of income from the possessions and 

territories would be revised. Other more technical changes would 

rationalize the taxation of U.S. branches of foreign corporations and 

the translation of certain foreign exchange transactions. 

The foreign tax credit is intended to prevent the U.S. tax from 

resulting in double taxation of foreign income. It is not intended to 

reduce the U.S. tax on U.S. income. To prevent credits for high 

foreign taxes from offsetting the U.S. tax on domestic income, a limit 

is placed on the amount of foreign tax credit which may be used in any 

given year (with provision for carryover of excess credits). Current 

law generally limits the allowable foreign tax credit to the U.S. tax 

on the taxpayer's aggregate foreign source income. Under this 

"overall" limitation, foreign income taxes paid to different countries 

are zveraged together; high foreign taxes paid to one country may be 

used by the taxpayer to offset the U.S. tax on income earned in a low 

tax country. 

Such an approach distorts investment decisions. A taxpayer has an 

incentive to generate low-taxed foreign income to utilize excess 

foreign tax credits. As a consequence, investments may be shifted 

from the United States to low tax countries. The U.S. tax base is 

eroded and capital may be allocated to less productive uses for tax 

reasons. Low-taxed foreign income also may be generated by using the 

existing source rules simply to shift income to low-tax jurisdictions. 

For example, income from certain sales may be sourced in any country 

by having the title pass there. 

The proposed reduction in the U.S. corporate tax rate will greatly 

increase excess foreign tax credits. This will correspondingly 

increase the incentives to divert investment and income to low-tax 

countries, if the overall limitation is left intact. It is therefore 

proposed that the foreign tax credit limitation be changed to apply 

country by country, and that certain source rules be modified to 

reflect more closely the economic substance of the transaction. 

There are those who will argue that the Treasury Department 

proposal will only aggravate the problem of excess foreign tax 

credits. But this defense of the overall limit on the credit is based 

on a misunderstanding of the purpose of the credit. The purpose of 

the credit is to avoid double taxation of foreign source income. The 

per-country limit achieves that. Relief from taxes in excess of U.S. 

taxes on the same income must be sought elsewhere.

-- 144 - 

A "per country" limitation is used by most other countries that 

allow a foreign tax credit, and it was long used in the United States, 

either with the overall limitation or alone. It was repealed in 1976 

because large tax acc0untir.g losses in certain countries were 

offsetting U.S. income and reducing revenues. Proposed changes in 

accounting for depreciation and for multiperiod production will 

largely eliminate the reasons for repealing the per country 

limitation. The treatment of economic losses will be addressed 

directly by allowing them to offset the pool of profits from all other 

countries, with an appropriate provision for recapture. 

In combination with the reduced rate of corporate tax, the 

proposed changes in the foreign tax credit limitation and source rules 

will result in a substantial net reduction in the U.S. tax on foreign 

income. In effect, the combination will make the foreign tax credit 

operate more efficiently and equitably without penalizing foreign 

investment. 

Another proposed change in international taxation affects the 

credit or income from U.S. possessions. The tax benefit of the 

existing credit rewards the shifting of income to the possessions, 

whether or not the income generated creates real economic activity 

there. The revenue cost of the credit is very high, and the tax saved 

per worker employed greatly exceeds the cost of employing that 

individual. In the long run, with a low-rate, broad-based tax, and 

the deferral of U.S. tax on the earnings of foreign corporations, the 

special tax preference for income from the possessions should be 

phased out. In the meanwhile, the credit would be revised to relate 

it directly to the minimum wage for employees engaged in manufacturing 

activities in the possessions, and to allow the credit to be used 

against income from any source, not only possessions source income. 

These proposed changes are intended to bring the incentive more into 

line with its purpose, as stated by the Joint Committee on Taxation, 

to "assist the U.S. possessions in obtaining employment-producing 

investments by U.S. corporations." The existing systems of taxation 

in effect in the U.S. territories also would be modified to resolve 

the inconsistencies and problems which have developed. 

Finally, the taxation of income earned by foreign corporations 

through u.S. branches would be rationalized to bring it more into line 

with the taxation of income earned through U.S. subsidiaries, and 

certain rules concerning foreiqn currency transactions would be 

clarified. 

VI. 

Other Tax Issues 

A. Transfer Taxation 

Transfers of wealth are subject to tax at the Federal level under 

an estate tax, a gift tax and a generation-skipping transfer (GST) 

tax. Transfers of wealth at death are subject to the estate tax, 

which is imposed at slightly progressive rates (with a large exemption 

level). The gift tax and the GST tax are designed on the whole to

- 145 - 

ensure that taxpayers cannot easily avoid the estate tax through 

lifetime gifts, multigenerational trusts, and similar arrangements. 

Ideally, the Federal transfer tax system should have as little 

impact as possible on the ways that individuals hold and transfer 

their wealth. In order to achieve this goal, the transfer tax system 

must be designed so that the amount of wealth that can be transferred 

from one individual to another net of tax does not depend on the form 

or timing of the transfer. This requires close coordination among the 

three transfer taxes as well as attention to their interaction with 

the income tax. 

Major steps toward this goal were taken in 1976 with the unification 

of the estate and gift taxes and the enactment of the GST tax. 

Significant inequities and loopholes remain, however, leaving substantial 

opportunities for tax avoidance and, in some cases, resulting 

in double taxation. The principal thrust of the Treasury Department 

proposals for reform of the transfer tax system is to eliminate these 

inequities, thereby improving the fairness and neutrality of the 

system. 

Perhaps the most significant of these proposals is to complete the 

unification of the estate and gift tax systems by conforming the 

computation of the gift tax base to that of the estate tax. Also of 

major importance is the proposal to replace the present GST tax with a 

new GST tax along the lines of Treasury Department's proposal of April 

1983. Together, these changes will assure that the form of ownership 

and transfer of assets within a family will play a greatly reduced 

role in determining the transfer taxes paid by that family. 

These proposals are approximately revenue-neutral, even though 

they will result in a broader transfer tax base over the longer run. 

However, since transfer taxes are imposed on accumulations of wealth 

only once in each generation, the revenue effects of the base 

broadening will be felt only gradually. Hence, it is not possible to 

propose any reduction in transfer tax rates at the present time. Once 

the new rules are in place and the effects of the transition rules 

have been phased out, rate reductions may be possible. These will 

make the transfer tax system an even less obtrusive factor in taxpayers' 

decisions as to how to hold and transfer their wealth and will 

furher increase productivity and invention. 

These proposals also permit a number of simplifications in the 

transfer tax system. In particular, the rules relating to when a 

transfer is treated as complete, when a prior gift is included in the 

transferor's estate, and the power-of-appointment rules can be greatly 

simplified. Under the proposed rules, most transfers would be subject 

to the transfer tax system only once in each generation, and the 

number of occasions when a transfer would have to be valued on the 

basis of actuarial tables would be significantly reduced. 

One final major aspect of the transfer tax proposal relates to the 

timing of the payment of the estate tax. Under current law, many

- 146 - 

estates that have adequate cash to pay the Federal estate tax are 

nevertheless entitled to pay the tax in installments, with a preferred 

interest rate applicable to part of the deferred payment. On the 

other hand, some truly illiquid estates are denied the right to 

deferred payment. The proposal would alleviate this inequity by 

replacing the complex test of current law with a relatively simple 

test allowing an estate to pay its estate tax liability in 

installments based on its relative holding of liquid and illiquid 

assets. A market rate of interest on any deferred tax payments would 

be charged to ensure that the expanded liquidity relief provision is 

fair and revenue neutral. 

B. Penalties 

The numerous civil penalties imposed under current law for the 

violation of reporting and payment provisions are complex and often 

inconsistent in the treatment of similar violations. Moreover, 

because interest is not charged, current law provides,no incentive for 

the timely payment of penalties. The proposal consolidates many of 

the information-reporting penalties into one provision with uniform 

penalty amounts. This would simplify administration of the penalty 

provisions and ensure their fair application. The proposal also 

assesses interest on delinquent penalty amounts in order to encourage 

timely payment. 

C. Expiring Provisions 

The following special tax provisions are scheduled to expire by 

1988: residential and business energy credits, the targeted jobs 

credit, the credit for testing orphan drugs, the special expensing 

rule for expenditures to remove architectural barriers to the elderly 

and handicapped, the exclusions of employer-provided legal services, 

educational assistance, and van-pooling, and the special treatment of 

dividends reinvested in public utility stock. The Treasury Department 

proposes that these provisions be allowed to expire as scheduled. 

Several of these expiring provisions give preferred treatment to 

specific sectors, contrary to the spirit of neutrality. Others have 

outlived their usefulness. Most are believed to have had little 

effect on behavior or to provide only a weak incentive for the 

preferred activity. The credit for research and experimentation 

expenditures, however, would be extended for three years and targeted 

more effectively toward productivity-enhancing innovations. 

D. Social Security Issues 

Although the tax proposals presented by the Treasury Department 

deal primarily with the individual income tax, they would also have 

beneficial effects on the social security system. Within a few years 

after enactment, social security revenues would rise by about $5 

billion. The longer run impact, while harder to measure, will 

ultimately prove to be much more important. The increasing use of 

fringe benefits over the past few decades has led social security

forecasters to predict continual declines in the taxable wage base 

relative to total compensation paid to workers. The long-run impact 

on the Social Security and Disability Trust Funds (which are now 

nearly in long-run blance) will be minor since benefits, as well as 

revenues, will be increased. However, the long-run impact on the 

Medicare Trust Fund will be measurable, since revenues will be 

increased without creating additional liabilities. Moreover, the cap 

on the exclusion of employer-provided health insurance will help stop 

the upward spiral of the cost of health care. This, too, will help 

reduce the cost of Medicare and other government-provided health 

programs. 

E. Items Not Included in the Tax Reform Proposal 

Despite its comprehensi,venature, this study proposes no change in 

many sections of the tax Code. In some cases, this reflects the 

belief that current law is appropriate. In other cases, however, 

changes may be desirable, but specifying the appropriate changes will 

require more time for detailed analysis. Therefore, t!ie fqct- that no 

change is preposed in a particular area should not be interpi:eted as 

Treasury endorsement of current law. 

This Report proposes no change in the iil3mized deductions for 

mortgage interest on the taxpayer's principal residence, medjcal 

expenses, and casualty losses. In addition, extraordinary charitable 

contributions would remain deductible. No change is proposed in the 

current provisions which exclude all or part of each of the following 

from tax: soci,alsecurity benefits; income-conditioned transfers; inkind 

benefits; certain hard-to-value fringe benefits; employerprovided 

meals and lodging; personal injury awards; capital gains on 

appreciated assets transferred at death or by gift; capital gains on 

owner-occupied housing; earned income of U.S. citizens working abroad; 

and interest on state and local government bonds for "governmental" 

purposes. In addition, preferential tax treatment of IRAs and most 

retirement plans would be expanded, most employer-provided health 

insurance and most scholarships would remain untaxed, the earned 

income tax credit would be maintained and indexed, the credit for the 

elderly and disabled would be expanded and macle available to the 

blind, and income averaging would still be available for most 

taxpayers. 

Other provisions for which no changes are proposed include the 

following: subchapter S; corporate mergers, acquisitions, 

liquidations and reorganizations; export incentives (including FSC); 

deferral of tax on earnings of foreign corporations; rules for net 

operating losses; rules for pooled passive investment trusts; the 

accumulated earnings tax; rules for determining eligibility for the 

dependency exemption, marital status, and head-of-household status; 

related-party and attribution rules; rules governing the exemption of 

certain organizations from tax; and the tax treatment of cooperatives 

and their patrons and of partners and partnerships (except for limited 

partnerships irith more than 35 partners).

- 149 - 

APPENDIX 7 4 

LIST OF PROPOSED REFORPIS 

INDUSTRY--SPECIFIC SUBSIDIES, T.9x 

SHELTERS, AND OTHER TAX ISSUES 

A, General ISSU~Sof Income Heasuzement 

1. Match expenses and receipts from multiperiod production. 

2. Restrict use of cash accounting method. 

3. Limit bad debt deductions to actual loan losses. 

4. Disallow installment sales treatment when receivables are 

pledged. 

5. Repeal corporate minimum tax (only if basic reforms are fully 

implemented). 

___ Subsidies DL Specific Industries 

1. Energy and Natural Resource Subsidies 

a. Repeal windfall profits tax. 

b. Repeal percentage depletion; use cost depletion, adjusted 

for inflation. 

C. Repeal expensing of intangible drilling costs. 

d. Reoeal - exoensinq- - of qualified . 

tertiary injectant 

expenses. 

e. Reoeal expensinq- of hard mineral exploration and developmekt 

cost;. 

f. Repeal special treatment of royalty income. 

9. Repeal special rules for mining reclamation reserves. 

h. Repeal non-conventional fuel production tax credit, alco 

hol fuels credit and excise tax exemption. 

2. Special Rules of Financial Institutions 

a. Commercial banks and thrift institutions 

1. Repeal special bad debt deductions for banks and 

thrift institutions. 

2. Disallow 100% of interest incurred to carry taxexempt 

bonds by depository institutions. 

3. Repeal tax exemption of credit unions. 

4. Repeal special carryover rules, and repeal special 

merger rules for thrift institutions. 

b. Life Insurance Companies 

1. Limit life insurance reserve deductions to the in- 

crease in policyholders' cash surrender value. 

2. Repeal special deduction of percentage of taxable 

income of life insurance companies.

~ 

- 150 - 

3. Repeal tax exemption for certain insurance companies. 

c. Property and Casualty (P&C) Insurance Companies 

1. Limit P&C reserves to the discounted present value of 

future liabilities. 

2. Repeal mutual P&C insurance companies' deduction for 

additions to protection against loss account. 

3. Limit deductibility of P&C policyholder dividends. 

4. Repeal special tax exemption, rate reductions, and 

deductions of small mutual P&C insurance companies. 

3. Insurance Investment Income 

a. Repeal exclusion of investment income on life insurance 

policies. 

b. Treat policyholder loans as coming first from any taxexempt 

inside buildup. 

c. Repeal exclusion of current annuity income. 

4. State and Local Government Debt and Investments 

a. Repeal the tax exemption of nongovernmental purpose 

tax-exempt bonds. 

b. Tighten restrictions on tax arbitrage and adbance refunding 

for tax-exempt bonds. 

5. Special Expensing and Amortization Rules 

a. Repeal expensing of soil and water conservation expend 

itures, expenditures by farmers for fertilizer and for 

clearing fields. 

b. Repeal 5-year amortization of expenditures for rehabili 

tation of low income rental housing. 

c. Repeal 5-year amortization of certified pollution control 

facilities. 

d. Repeal 50-year amortization of railroad grading and 

tunnel bores. 

e. Repeal 5-year amortization of trademark expenses. 

f. Repeal 84-month amortization of reforestation expenditures 

and 10% tax credit for such expenditures. 

6. Other Specific Subsidies 

a. Repeal rehabilitation tax credits. 

b. Repeal special rules for returns of magazines and paper- 

back books and for qualified discount coupons. 

c. Repeal exclusion relating to Nerchant Marine Capital Constuction 

Fund. 

d. Rationalize credit for research and experimentation.

- 151 - 

C. Further Curtailment of Tax Shelters 

1. Disallow most current interest deductions (with carryforward) 

in excess of the sum of mortgage interest on the taxpayer's 

principal residence, invest,mentincome, income from limited 

partnerships and S corporations, and $5,000. 

2. Extend at risk limitations to real estate and equipment 

leasing. 

I). International Issues 

1. Change foreign tax credit limitation to a separate per coun-. 

try limitation. 

2. Modify rules defining source of income derived from sales of 

inventory-type property and intangible property. 

3. Repeal the secondary dividend rule and replace with a branch 

profits tax. 

4. Repeal special preference for 80/20 corporations. 

5. Repeal possessions tax credit and replace with phased out 

wage credit. 

6. Clarify treatment of certain transactions in foreign 

currency. 

E. Other Tax Issues 

1. Transfer Taxation 

a 

b 

C 

d 

Unify estate and gift tax structure by grossing up the 

tax on gifts, and simplify rules for determining when a 

transfer is complete for gift tax purposes. 

Simplify taxation of generation-skipping transfers, and 

modify credit for tax on prior transfers to a lower generation. 

Impose a rule to prevent abuse of minority discounts. 

Replace the rules governing payment of estate tax in 

installments with simplified rules based on estate li 

quidity, but make interest incurred by an estate non- 

deductible for estate tax purposes. 

e. Reduce estate tax deduction for claims against an estate 

by the amount of income tax savings from payment of the 

expense. 

f. Simplify state death tax credit by making it a flat per 

centage of fedetal estate tax collected. 

g. Repeal special tax rules for redemption of stock to pay 

death taxes. 

h. Tighten rules regarding powers of appointment.

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2. Penalties 

a. simplify information return penalties. 

b. Repeal maximum limits on penalties. 

c. Replace failure-to-pay penalty with a cost-of-collection 

charges. 

3. Expiring Provisions 

a. Residential and certain business energy tax credits. 

b. Targeted jobs tax credit. 

C. Expensing of expenditures to remove architectural 

barriers to the elderly and handicapped. 

d. Credit for testing orphan drugs. 

e. Speciai treatment for dividend reinvestment in public 

utility stock. 

f. Exclusion of employer-provided legal servic?. 

g. Exclusion of employer-provided educational assistance. 

h. Exclusion of employer-provided van-pooling.

- 153 - 

Chapter 8 

COMPARISON WITH OTHER TAX REFORM PLANS 

Over the past several years many proposals for tax reform have 

been advanced by members of the U.S. Congress. These include 

proposals for a pure flat tax, a modified flat tax, a tax on consumed 

income, and a value-added tax. All of these plans share common 

objectives: to broaden the tax base and lower rates and thereby make 

the tax system fairer, simpler, and more neutral in its impact on the 

private economy. The same objectives motivated the Treasury 

Department study. 

The Treasury Department proposals for tax simplification and 

reform combine many of the best features of these Congressional plans 

for tax reform. They go further in measuring taxable income 

comprehensively and consistently at both the corporate and individual 

levels. They deal more completely with problems of tax shelters and 

abuses -- a growing threat to the tax system -- and address in greater 

detail the need to simplify the income tax. In short, though the 

Treasury Department plan draws heavily on the pioneering efforts by 

many members of Congress and by others, it goes further in achieving 

the mandate to design a tax system that is broad-based, simple, and 

fair. 

Two of the earliest and most detailed of the congressional 

proposals are those by Representative Jack Kemp and Senator Robert 

Kasten for a "Fair and Simple Tax" (S. 2948; H.R. 6165) and by Senator 

Bill Bradley and Representative Richard Gephardt for a "Fair Tax" 

(S. 1472; H.R. 3271). These bills include most of the specific 

proposals for reform contained in the other bills offered by members 

of Congress. This chapter compares the most important features of the 

Treasury Department proposals with those of the Kemp-Kasten and 

Bradley-Gephardt plans. More detailed and more comprehensive 

comparisons with these and other congressional plans are provided in 

the appendices to this chapter. 

Like the discussion of tax reform proposals in chapters 5, 6, and 

7, the comparison of the Treasury Department, Bradley-Gephardt, and 

Kemp-Kasten proposals is divided into provisions that affect virtually 

all individuals, regardless of whether they have important amounts of 

capital. or business income (section I), those that pertain almost 

exclusively to the basic taxation of capital and business income, 

including the tax treatment of retirement savings and the taxation of 

corporations and partnerships (section II), and those that pertain to 

specific industries and tax shelters (section 111), and those that 

pertain to other tax issues, including the taxation of transfers and 

provisions that are currently planned to expire (section IV).

I. Individual Income Tax 

A. Income Tax Rates 

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One of the primary objectives of the Treasury Department study of 

tax simplification and reform has been to broaden the income tax base 

enough that a given amount of revenue can be raised with substantially 

lower tax rates than under current law. This important objective is 

shared by the Kemp-Kasten and Bradley-Gephardt proposals, and, indeed, 

by all of the proposals for fundamental tax reform that have been 

introduced in the Congress. 

Under the Treasury Department proposals all income of individuals 

above the tax-free amount will be taxed at three rates, 15 percent, 25 

percent, and 35 percent. Real capital gains -- that is, gains after 

adjustment for inflation -- will be taxed as ordinary income. By 

comparison, the Bradley-Gephardt proposal will impose three tax rates, 

14 percent, 26 percent, and 30 percent. This rate graduation will be 

achieved by levying the 14 percent rate on all income and surtaxes of 

12 and 16 percent on incomes above certain levels. Nominal capital 

gains will be taxed as ordinary income, without adjustment for 

inflation. 

The Kemp-Kasten proposal contains only one statutory rate, 25 

percent. However, 20 percent of "earned income" -- wage and salary 

income and income from sole proprietorships and farms -- up to the 

social security ceiling ($39,600 in 1985), will be exempt from tax. 

(For this purpose the first $10,000 of income of single taxpayers and 

$15,000 of income of a married couple with income below those levels 

is assumed to be earned income, even if it is from capital or business. 

These amounts are indexed for inflation.) That exemption is 

then phased out (at an income level of $102,960). Because this 

exemption is phased out, there is, in effect, a 20 percent rate on 

earned income up to the social security ceiling, a 28 percent rate 

over the phase-out range of income, and then a flat rate of 25 percent 

on income above the phase-out range. 

8. Fairness for Families 

Under current law, the personal exemption for taxpayers and 

dependents for 1985 will be $1,040 per person (allowing for 

indexation, which begins January, 1985); the elderly and the blind 

receive an additional $1,040 exemption. Under the Treasury Department 

proposals the taxpayer and dependent exemptions will be increased to 

$2,000 per person in 1986. The extra exemptions for the elderly and 

the blind will be folded into an expanded credit for the elderly, 

blind, and disabled, so that the tax-free amount for the elderly will 

be increased slightly. The Kemp-Kasten proposal follows a similar 

approach, raising the taxpayer and dependent exemptions to $2,000; it 

will also increase the additional exemptions for the elderly and the 

blind to $2,000. The Bradley-Gephardt proposal distinguishes between 

personal exemptions for the taxpayer and spouse, which it sets at 

$1,600 (or $1,800 for a head of household), and those for dependents,

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the elderly, and the blind; the latter are set at $1,000. The 

Bradley-Gephardt plan allows personal exemptions to be deducted in 

computing income taxed at the 14 percent rate, but not for computing 

income subject to the 12 percent and 16 percent surtaxes. 

Under current law the zero-bracket amount in 1986 is estimated to 

be $2,510 for individuals, $2,510 for heads of households, and $3,710 

for joint returns. Under the Treasury Department proposals these 

amounts will be increased to $2,800, $3,500, and $3,800, respectively. 

By comparison, the Kemp-Kasten proposal (after indexing to 1986 

levels) increases them to $2,950, $2,950, and $3,820, respectively, 

and the Bradley-Gephardt proposal increases them to $3,000, $3,000, 

and $6,000. For a family of four filing a joint return and receiving 

only income from employment, the tax-free amount -- the level of 

income at which tax liability begins (including the earned income 

credit) -- would be $11,800 under the Treasury proposal, $11,200 under 

the Bradley-Gephardt proposal, and $15,675 under the Kemp-Kasten 

approach. Under current law a family of four will incur no income tax 

liability until adjusted gross income exceeds $9,613 (after indexing 

for the increase in prices projected for 1985). 

The Treasury Department proposals retain the indexati.on of the 

zero.-bracket amount, personal exemptions, and rate brackets that 

becomes effective on January 1, 1985. Without indexation inflation 

will continue to give rise to "bracket creep" that causes taxpayers 

with unchanged real incomes to pay increasingly higher rates of tax. 

Lack of indexation also allows inflation to lower real tax-exempt 

levels of income and impose taxes on persons in poverty. Whereas the 

Kemp-Kasten proposal also retains indexation, the Bradley-Gephardt 

proposal will repeal it. The Treasury Department and Kemp-Kasten 

proposals will also extend indexation to the dollar limits of the 

earned income tax credit. 

The choice of personal exemptions and zero-bracket amounts 

involves conflict between several competing goals. First are revenue 

considerations. Higher tax-exempt levels reduce revenues and require 

higher tax rates to reach a given revenue goal. In some proposals 

there is a tendency to raise taxes more E3r middle-income taxpayers to 

accomplish greltter reduction at lower income levels. 

Second, if personal exemptions and the ZBA are set in such a way 

that the tax threshold closely resembles the poverty level of income 

for taxpaying units of various types, a marriage penalty is produced. 

The marriage penalty occurs because at any level of income two persons 

living together have lower expenses than two single persons living 

alone. Thus two single persons living alone at the poverty level have 

an aggregate tax-free amount greater than a married couple at the 

poverty level, if the tax-free amount tracks the poverty level. If, 

on the other hand, the tax threshold for a married couple is set equal 

to the poverty line, a tax threshold for single persons of only half 

that amount will fall short of the poverty level of income for a 

sinole person.

- 156 - 

A third objective is to make adjustments according to family size 

for ability to pay. Personal and dependent exemptions are the primary 

means of accomplishing this goal. The Treasury Department plan, as 

well as the Kemp-Kasten proposal, recognizes the need to adjust 

personal exemptions for inflation. The Bradley-Gephardt proposal 

makes no adjustment in the dependent's exemption and, in fact, through 

lack of indexing allows the real value of current dependent's 

exemption to decrease. 

In its proposals the Treasury Department has attempted to balance 

the competing objectives of eliminating the marriage penalty, tracking 

poverty levels of income, not raising the tax on single persons too 

high relative to that on one-earner married couples, and adjusting 

appropriately for family size. The Treasury Department proposal, the 

Bradley-Gephardt proposal, and the Kemp-Kasten proposal will all 

repeal the two-earner deduction, which is needed less, once the rate 

structure is less steeply graduated. 

C. Fair and Neutral Taxation 

If the U.S. tax system is to be made fair and more neutral, the 

tax base must be defined comprehensively. Base broadening under the 

Treasury Department proposals comes from three major sources: taxing 

currently excluded forms of income, curtailment of existing tax 

subsidies to particular uses of income via itemized deductions, and 

limitations on existing abuses of the tax system. 

1. Excluded sources of income. Fringe benefits provided by 

employers represent substantial amounts of real income that are 

excluded from the tax base. These are commonly divided into two 

groups, statutory and non-statutory, to reflect the fact that the 

former are explicitly excluded from taxation by law, whereas the 

latter have only been excluded by custom. This terminology is still 

useful, even though the Deficit Reduction Act of 1984 extended 

statutory exemption to certain of the non-statutory fringe benefits. 

The most important statutory fringe benefit excluded from the tax 

base is premiums on accident and health insurance provided by 

employers. Other statutorily excluded fringe benefits include groupterm 

life insurance, dependent care services, and certain living 

allowances. Under the Treasury Department proposals, most statutory 

fringe benefits will be taxed, with exceptions or limitations when 

amounts are small and valuation is difficult. Employer contributions 

to health plans will be taxed only to the extent that they exceed $70 

per month for an individual employee and $175 per month for family 

coverage; these floors will be indexed to protect their real value 

from inflation. The Bradley-Gephardt proposals and, to some extent, 

the Kemp-Kasten proposals also include many major statutory fringe 

benefits in taxable income. Non-statutory fringe benefits (including 

those recently excluded by law) would not be taxed under any of the 

proposals.

- 157 - 

All three proposals will tax unemployment compensation; the 

Treasury Department and Kemp-Kasten proposals will generally tax 

workers' compensation, because it also serves as a wage replacement 

program. All three proposals will tax income received in the form of 

scholarships and fellowships, but only to the extent that it exceeds 

tuition expenses. The increased tax thresholds provided by the higher 

personal exemptions and ZBA in the Treasury Department proposals will 

prevent the taxation of most low-income recipients of any of these 

benefits. 

2. Preferred uses of income. Major itemized deductions allowed 

under current law are for state and local taxes, charitable 

contributions, and interest expense. Deductions also are allowed for 

medical expenses in excess of 5 percent of adjusted gross income 

(AGI), casualty losses in excess of 10 percent of AGI, and for 

miscellaneous other expenditures, including costs of earning income 

not deducted elsewhere. The Treasury Department proposal will phase 

out completely the deduction for all state and local taxes. 

Charitable contributions will be deductible only to the extent they 

exceeded 2 percent of adjusted gross income; the deduction of 

charitable contributions by non-itemizers will be eliminated. The 

deduction for a charitable donation of appreciated property will be 

limited to the indexed basis. The existing deduction for medical expenses 

in excess of 5 percent of AGI and casualty losses in excess of 

10 percent of AGI will be left intact. The deduction for mortgage 

interest on the taxpayer's principal residence will be unchanged, but 

the deductibility of other personal interest expense will be reduced 

and limited for taxpayers with substantial interest expense in excess 

of realized capital income. Miscellaneous expenses of earning income 

will be combined with employee business expenses and made an "abovethe-line'' 

adjustment, rather than an itemized deduction; this combined 

deduction will be limited to the excess of such expenses over 1 

percent of adjusted gross income. Placing this floor under itemized 

deductions for employee expenses will simplify compliance for many 

taxpayers and allow rates to be lowered further than if all expenses 

could be deducted. 

The Bradley-Gephardt proposals will retain the deduction for state 

and local taxes on income and real property, but eliminate itemized 

deductions for all other state and local taxes. The proposals will 

retain the itemized deductions for interest on home mortgages, but 

will substantially limit deductions for other personal interest. The 

itemized deductions for charitable contributions and for casualty and 

theft losses will be retained, but that for medical expenses will be 

limited to expenditures in excess of 10 percent of adjusted gross 

income. 

Under the Bradley-Gephardt approach itemized deductions could be 

used only in calculating tax under the 14 percent rate; they will not 

be deductible against the 12 percent and 16 percent surtaxes that 

raise marginal rates to 26 percent and 30 percent. By allowing 

itemized deductions only for purposes of computing income taxed at the 

14 percent rate, the Bradley-Gephardt plan effectively converts 

459-370 0 - 84 - 7

- 158 - 

itemized deductions into 14 percent tax credits. This approach limits 

the tax value of deductible expenses to the same dollar amount for all 

taxpayers. If the purpose of the deduction is to provide a subsidy 

through the tax system, this approach is satisfactory. However, to 

the extent that itemized deductions help define economic income 

properly subject to tax, the full deduction should be allowed in 

computing income for purposes of the surtaxes as well. 

Under the Kemp-Kasten approach itemized deductions will be 

retained for interest on home mortgages and on educational loans, but 

not on other consumer debt, for state and local property and general 

sales taxes, for charitable contributions, and for medical expenses in 

excess of 10 percent of adjusted gross income and for casualty and 

theft losses. The deduction for state and local income taxes will be 

eliminated. 

D. Tax Abuses 

Some taxpayers improperly take business deductions for expenses 

that most Americans would view as personal expenses. In addition, 

various techniques are used by some taxpayers to shift income from 

themselves to their children, who are in lower tax brackets. For 

example, parents can transfer income-earning assets to their children 

or they can establish trusts that enable income to be subject to tax 

rates lower than those of the parents. Provisions in the Treasury 

Department proposal will prevent the claiming of business deductions 

for personal expenses and will limit the benefits of income shifting. 

Neither the Bradley-Gephardt proposal nor the Kemp-Kasten plan 

addresses these issues. 

E. Simplification 

The increases in the personal exemptions and zero-bracket amounts 

and the limitations on the availability of itemized deductions will 

simplify tax compliance for many Americans. With lower tax rates 

taxpayers will have less incentive to find deductible expenditures and 

because fewer deductions are available, they will have less need for 

recordkeeping. 

1. The return-free system. Because of its increased capability of 

processing withholding and information returns, the Internal Revenue 

Service will soon have improved capability of calculating tax 

liabilities for many Americans. As a result, the Treasury Department 

is proposing that the United States begin to test a "return-free 

system," under which many individual taxpayers will be relieved of the 

obligation of filing an income tax return. Instead, for taxpayers who 

certify that they only had certain sources of income and deductions, 

the Internal Revenue Service will send the taxpayer a report of tax 

calculation based on information at its disposal. The taxpayer will 

then either accept the IRS report or indicate that additional 

information will require filing of a regular return. Initially, 

eligibility for the return-free system will be limited to taxpayers 

who had only wages subject to withholding and interest income subject

- 159 - 

to information reporting. Thus, an estimated 20 percent of returns to 

be filed by non-itemizers in 1988 might rely completely on returns 

originally prepared by the Internal Revenue Service. None of the 

other proposals for tax reform and simplification include a returnfree 

system. 

2. Other simplification. The Bradley-Gephardt and Kemp-Kasten 

proposals share some of the simplification advantages of the Treasury 

proposals, but they leave intact many provisions that involve 

complexities for taxpayers. The Treasury Department proposals will 

repeal the credit for political contributions, the Presidential 

campaign checkoff, special 10-year averaging for lump-sum distributions, 

and the 3-year rule for recovery of retirement contributions. 

It will eliminate (or allow to expire) all existing tax credits, other 

than the foreign tax credit, the credit for research and 

experimentation, and the earned income tax credit. It will simplify 

the tax treatment of pensions, it will unify and simplify existing 

penalties, and it will unify the substantive rules for the taxation of 

gifts and estates. The Bradley-Gephardt and Kemp-Kasten proposals 

would also eliminate most tax credits and the special 10-year 

averaging for lump-sum distributions. These plans generally do not 

address the tax treatment of pensions or the substantive rules for the 

taxation of gifts and estates, or alter tax penalties. The Treasury 

Department proposal will retain income averaging, except for those who 

have been students during the base period. Both the Bradley-Gephardt 

and Kemp-Kasten plans will repeal income averaging in its entirety. 

11. Basic Taxation of Capital and Business Income 

Under current law capital and business income is subject to vastly 

different tax treatment, depending on its source. An important 

objective of the Treasury Department proposals is to make the tax 

treatment of business and capital income more uniform. This will 

allow business decisions to be based more on economic reality, and 

less on tax implications. Cutting corporate rates will further reduce 

the distortion of business decisions caused by the tax system. 

A. Corporate Tax Rates 

Under current law the marginal rate of tax paid on corporate 

income increases with the amount of income, reaching a maximum of 46 

percent at an income of $100,000. The Treasury Department proposals 

will replace this graduated rate structure with a flat rate of 33 

percent applied to all corporate income, including real capital gains 

of corporations. The Treasury Department proposals will retain the 

corporate minimum tax through 1992 and then phase it out over a threeyear 

period, if most tax preferences are eliminated as proposed. The 

Bradley-Gephardt proposals will levy a 30 percent corporate rate and 

eliminate the corporate minimum tax. The Kemp-Kasten proposals will 

also subject most corporate income to a rate of 30 percent, but it 

will retain the corporate minimum tax, limit the tax rate on the first 

$50,000 of corporate income to 15 percent, and apply a 20 percent rate 

to capital gains of corporations.

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B. Investment Tax Credit 

The Treasury Department, as well as Bradley-Gephardt and Kemp- 

Kasten, proposes that the investment tax credit (ITC) be eliminated. 

The Treasury Department proposes repeal of the ITC because 1) the 

proposed system of capital recovery will compensate for inflation 

directly; 2) the current ITC discriminates against new businesses and 

companies with losses; 3 ) the ITC is a major source of tax shelter 

formation; and 4) administration of recapture rules with respect to 

the ITC i s quite difficult and subject to abuse. At current low rates 

of inflation, moreover, the investment tax credit distorts resource 

allocation and it will continue to do so if retained in the proposed 

system. Rate reduction provides a uniform incentive for all 

corporations, and is therefore preferable to devices such as the 

investment tax credit, which is targeted to industries that are heavy 

producers or users of only the certain types of capital that benefit 

from the credit. Both the Bradley-Gephardt and Kemp-Kasten proposals 

will eliminate the credit for research and experimentation. The 

Treasury Department proposals will retain this credit, but restructure 

it to make it more effective. 

C. Income Measurement: Inflation Adjustment 

During periods of high inflation the current income tax causes 

capital income to be overstated and it causes interest deductions to 

be exaggerated. The result is misallocation of the nation's capital 

and undesirable incentives for borrowing and disincentives for saving. 

Current law reflects efforts to avoid these distortions and inequities 

by allowing recovery of capital more rapidly than it actually 

depreciates and by excluding part of nominal capital gains. These ad 

hoc adjustments are appropriate only for given rates of inflation. On 

the other hand, no adjustment is made for the effect of inflation in 

the calculation o f costs of goods sold from inventories or for 

overstatement of interest income and expense resulting from inflation. 

The Treasury Department proposes to ameliorate these problems by 

allowing explicit inflation adjustment for depreciable assets, 

inventories, interest income and expense, and the calculation of 

capital gains. With the measurement of income improved by these 

adjustments for inflation, the ad hoc adjustments for depreciable 

assets and capital gains will no longer be needed. Thus, depreciation 

deductions can be made to correspond more closely to economic 

depreciation arid capital gains can be taxed as ordinary income. 

Expensing would, however, be allowed for the first $5,000 of 

depreciable business property. The deduction of capital losses will 

continue to be limited. The Treasury Department proposal will exclude 

from taxation a portion of interest income and disallow deduction of 

part of interest expense in excess of that on business indebtedness 

and mortgages on the taxpayer's principal residence, plus $5,000. The 

fraction of interest income and expense to be ignored in calculating 

taxable income will depend on the rate of inflation.

- 161 - 

The Kemp-Kasten proposal also includes indexation of the basis of 

capital gains and taxation of all capital gains of individuals as 

ordinary income, but it does not include inflation adjustment of 

depreciable assets. (It will continue the present Accelerated Cost 

Recovery System and the presently suspended ability of firms to 

expense up to $10,000 of assets each year.) The combination of 

inflation adjustment for capital gains and continued ad hoc adjustment 

of depreciation allowances could create technical difficulties and 

unforseen misallocation of economic resources. Moreover, the failure 

to index the cost of goods taken from inventories will continue the 

present tax discrimination against inventory-intensive industries. 

The Kemp-Kasten proposal will allow unlimited capital losses. It 

attempts to deal with the artificial minimization of taxes that is 

possible when losses on some assets may be recognized even though 

gains on other assets need not be recognized by treating capital 

losses as a preference item to be subject to the alternative minimum 

tax. 

The Bradley-Gephardt proposal eliminates the distinction between 

long-run and short-run capital gains by subjecting all nominal gains 

to taxation as ordinary income. This approach leaves the effective 

rate of taxation of real capital gains dependent upon the rate of 

inflation. As during the 1970s, effective rates could far exceed the 

statutory rate; they could go above 100 percent, and tax could be 

collected on real losses. Taxing nominal gains as ordinary income 

could create substantial disincentives for investment, invention and 

innovation, particularly in periods of high inflation. The 

Bradley-Gephardt proposal will apply 250 percent declining balance 

depreciation to assets classified under the Asset Depreciation Range 

System of depreciation, with no adjustment for inflation. As a 

result, it will be much too yenerous at low inflation rates, but not 

generous enough at high inflation rates. The Bradley-Gephardt 

approach will not index inventories or adjust the amount of interest 

to be included in income or allowed as an expense. 

All three proposals retain the rollover of capital gains on a 

principal residence: the Treasury Department and Kemp-Kasten 

proposals retain the $125,000 one-time exclusion of gains on the 

principal residence; the Bradley-Gephardt proposal does so only for 

the purpose of computing income subject to tax at the 14 percent rate. 

D. Retirement Savings 

All three proposals leave intact the present tax treatment of 

individual retirement accounts (IRAs) and Keogh plans (retirement 

accounts for the self-employed). The Treasury Department proposal 

will make IRAs of spouses working in the home without pay subject to 

the same limits as those of employed taxpayers and raise the limit on 

tax-free contributions to IRAs. 

Al.1 three proposals essentially leave intact the present tax 

treatment of qualified pension plans and profit-sharing plans. To 

achieve administrative simplicity, the Treasury Department proposals

- 162 - 

will eliminate the combined limits on amounts contributed to defined 

benefit and defined contribution plans which are not top-heavy, but 

will impose an excise tax on the receipt of extraordinarily large 

benefits after retirement. The Bradley-Gephardt proposal, by 

comparison, nearly halves the limits under present law. Under the 

Kemp-Kasten proposal, the current limits will be retained. The 

Treasury Department proposals will unify various other provisions, 

including penalties for premature withdrawals by employees. 

E. Neutrality Toward the Form of Business Organization 

Under present law corporations and partnerships are subject to 

substantially different tax treatment. Partnerships, regardless of 

their size or other features, are taxed as pass-through entities; that 

is, there is no tax at the partnership level, and allvincome or losses 

are simply passed on to individual partners for inclusion in their tax 

returns. As a result, partnerships are used as important vehicles for 

tax shelters, since they allow individuals to take deductions for 

partnership losses against income earned from other sources. In the 

case of large partnerships, pass-through treatment can create severe 

collection and other administrative costs. In the event of a 

partnership audit, collection notices must be sent to the hundreds or 

thousands of individual taxpayers who were owners of the partnership 

at the time the original, erroneous return was filed. Some of these 

taxpayers may have moved, some may be in substantially different 

circumstances, some may have died, and some may have sold their 

interests to others. Income earned by corporations, on the other 

hand, is subject to double taxation; corporate profits are taxed as 

earned and then dividends paid from after-tax income are taxed again 

when received by shareholders. One objective of the Treasury 

Department's study has been to make more consistent the treatment of 

partnerships and corporations which closely resemble one another. 

The Treasury Department proposals will provide a more consistent 

treatment of similarly situated corporations and partnerships through 

1) the reclassification of certain partnerships as corporations for 

tax purposes, and 2 ) the reduction of the double tax on dividends 

paid. The reclassification proposal involves treating as a 

corporation any limited partnership that includes 35 or more limited 

partners. In addition, corporations will be allowed a deduction for 

part of dividends paid. The dividends paid deduction will eliminate 

part of the double taxation of dividends, since the part of dividends 

allowed as a deduction to the corporation will be taxed only at the 

shareholder level. 

Neither the Bradley-Gephardt nor the Kemp-Kasten proposals deal 

with the important issue of unification of the tax treatment of 

partnerships and corporations. The Treasury Department and Bradley- 

Gephardt proposals will repeal both the personal holding company tax 

and the rules for collapsible corporations. The Bradley-Gephardt 

proposal repeals the accumulated earnings tax; the Treasury Department

- 163 - 

proposes to retain it. All three proposals will repeal the small 

exclusion for dividends received by shareholders ($100 for single and 

separate returns; $200 for joint returns). 

111, Industry-Specific Subsidies, Tax Shelters, and Other Tax Issues 

A. General Issues of Income Measurement 

Because certain provisions of current law do not take adequate 

account of the timing of income receipts and payments, taxation of 

income can be deferred until future years. This tax deferral lowers 

the effective tax rate on the tax-preferred activity, distorts the 

allocation of investment across industries, and causes similarlysituated 

taxpayers to be treated differently. 

Current tax rules do not match taxable receipts and deductions for 

activities that require several years to produce. Matching can be 

achieved if the costs of producing assets are capitalized, that is, 

includea in the basis of the asset and recovered (deducted) when the 

asset is sold or when the basis is depreciated. The rules requiring 

capitalization of expenses incurred in the construction of capital 

assets are incomplete and vary by type of activity. This treatment 

distorts the choice between purchased and self-constructed assets and 

encourages tax shelters in multiperiod production activities. 

Under the Treasury Department proposals the capitalization rules 

will be reasonably comprehensive of all expenses and will be uniform 

across activities. The other proposals will extend 10-year 

amortization of construction period interest and taxes to other 

business assets, but are not as comprehensive as the Treasury 

proposal. 

Under current law the gain on installment sales is not taxed until 

payments are received. Under the Treasury Department proposal, a 

taxpayer will not be entitled to use the installment sales method if 

the installment obligations are converted into cash by means of 

pledging or other arrangement, thereby eliminating the taxpayer's 

possible liquidity problem. The other two proposals do not change 

current law in this area. 

IJnder current law, taxpayers can generally elect to use either the 

cash or accrual methods of accounting. Although the accrual method of 

accounting is considered to be a more accurate measure of annual 

economic income, the cash method is administratively simpler for 

certain taxpayers. The option to use different accounting methods 

allows taxpayers to reduce taxes artificially by mismatching 

recognition of taxable income and deductions. The Treasury Department 

proposal will require the use of the accrual method by all large 

firms, by all firms using the accrual method for financial reporting, 

and by firms holding inventories. The other two proposals do not 

address this issue. The other two proposals will require accrual 

accounting for farming and timber where the taxpayer has gross 

receipts greater than $1 million.

- 164 - 

The preferential tax treatment of bad debt losses encourages 

lenders to make risky loans and favors debt over equity financing. 

The Treasury Department proposal will remove these distortions by 

repealing the deduction for additions to reserves for bad debt loan 

losses and limiting the bad debt lass deduction to the amount of the 

current loan losses. The Treasury Department proposal will apply to 

both financial and non-financial institutions. The other two 

proposals will change allowances for bad debt loan losses only for 

financial institutions. 

With these modifications of tax law, taxable income will resemble 

much more closely economic income. Ultimately, the present corporate 

minimum tax will be unnecessary and evenutally it should be 

eliminated. It should be retained, however, over an interim period 

during which previously made investments continue to benefit from 

preferences allowed under current law. Whereas the Bradley-Gephardt 

proposal will also eliminate the corporate minimum tax, the 

Kemp-Kasten proposal will retain it. 

E. Subsidies for Specific Industries 

The Treasury Department proposals will repeal numerous preferential 

cost recovery provisions designed to favor one form of investment 

over another, or one industry over another. These special provisions 

operate as subsidies, altering economic decisions. Such subsidies are 

justified only if the subsidy corrects appropriately an otherwise 

incorrect market evaluation of costs and benefits. None of the 

subsidies to be repealed can be justified on these grounds. Moreover, 

since the subsidy they provide is in the form of exclusion of income 

from tax, OK as tax deferral, these provisions unfairly benefit 

higher-income investors more than lower-income ones. 

1. Energy and Natural Resources. Under the Treasury Department 

vroposals expensinq of intanqible drilling costs in the oil and gas 

industry will be replaced by-depreciation-allowances,and percentage 

depletion will be replaced by cost depreciation. Indexing of the 

basis of non-depleted resources will be allowed. The Treasury 

Department proposal will also accelerate the phase-out of the windfall 

profit tax to 1988. The Bradley-Gephardt and Kemp-Kasten proposals 

will also eliminate percentage depletion, expensing of exploration and 

development costs, and the deduction for intangible drilling costs, 

replacing them with ordinary depreciation. The Bradley-Gephardt and 

Kemp-Kasten proposals, however, wil retain the windfall profit tax. 

I 

Under current law additions to reserves for strip mining 

reclamation can be deducted currently even though no expenditure has 

occurred. This tax treatment accelerates deductions for future 

expenses and lowers strip mining operators' effective tax rates 

through tax deferral. The Treasury Department proposal will require 

reclamation expenses to be deductible when the expenses have been paid 

OK economic performance has occurred. The other two proposals do not 

change current law.

- 165 - 

2. Financial institutions. Under current law various types of 

financial institutions (banks, thrift institutions, life insurance 

companies, and casualty insurance companies) are accorded a wide 

variety of preferential tax treatment. In effect, they are regulated 

through tax provisions that discourage competition. Besides 

discriminating in favor of investment in these institutions, relative 

to other investment alternatives, this patchwork treatment of 

preferences prevents the achievement of fair and neutral taxation, 

even within the financial sector. The Treasury Department proposals 

will make uniform the tax treatment of various types of financial 

institutions and generally subject income earned in the financial 

sector to the same tax law applied elsewhere in the economy. The 

Treasury Department proposals will repeal special exclusions, 

deductions and tax rates for the different financial institutions, 

require discounting of banks' bad debt loss reserves and casualty 

insurance company reserves, and restrict life insurance company 

reserves to the increase in policyholders' cash surrender value. The 

other two proposals will only change the special bad debt deductions 

of commercial banks and thrift institutions. 

3. Insurance investment income. The exclusion of investment 

income ("inside" buildup) on life insurance policies and annuities is 

one of the major excluded sources of income. Interest income on 

savings held with other financial institutions is subject to tax 

whether or not the interest is currently distributed to the taxpayer. 

The tax-preferred treatment of the inside buildup encourages 

individuals to save through life insurance companies and perhaps to 

purchase life insurance that they would not buy except to gain access 

to the favorable tax treatment. All three proposals will tax the 

annual investment income earned on life insurance policies and 

annuities. 

4. State and local debt and investments. Interest on debt issued 

by state and local governments (often called municipal bonds) has long 

been exempt from Federal income tax. In recent years the generally 

accepted exemption for general obligation bonds has been extended by 

state and local governments to "private purpose" activities -- 

activities such as home mortgages, educational institutions, 

hospitals, and industrial development projects -- that might more 

appropriately be financed entirely from local funds, or through 

private credit markets without Federal exemption for interest. In an 

attempt to limit these abuses, the Deficit Reduction Act of 1984 

includes a limit of $150 per capita on issuance of private purpose 

obligations by any state and its subdivisions. Even worse, some state 

and local governments have used proceeds from their securities to 

engage in tax arbitrage, by investing them in private or Federal debt 

obligations that pay rates of interest in excess of the municipal bond 

rate because they are subject to Federal tax. Each state and locality 

is encouraged to engage in as much of these activities as possible, 

since the cost is borne primarily by taxpayers in other states and 

localities. The result is an unproductive increase in Federal tax 

rates and shift in burdens of taxation between states. Residents of

- 166 -- 

jurisdictions with cautious or conservative borrowing habits are 

e specia11y peria 1ized. 

The Treasury Department proposals will repeal the tax exemption of 

interest on private purpose bonds issued by state and local 

governments and tighten the restrictions on tax arbitrage and advance 

refunding related to tax-exempt bonds. Both the Bradley-Gephardt 

proposal and the Kemp-Kasten proposal will repeal the exemption of 

interest on private purpose obligations. 

5. Other specific subsidies. Among the subsidies the Treasury 

Department proposals and both congressional bills will repeal are: 

the business energy production and alcohol fuel credits; the complex 

Capital Construction Fund mechanism to subsidize investment in fishing 

vessels and inland waterway and ocean going ships; expensing of 

capital expenditures for farmland conditioning and soil and water 

conservation; and 7-year amortization of capital outlays for 

forestation and reforestation. 

The Treasury Department and Bradley-Gephardt proposals, but not 

the Kemp-Kasten proposal, will repeal provisions allowing 5-year 

amortization of investment in the rehabilitation of low-income housing 

and certified pollution control facilities installed in pre-I976 

plants. 

The Treasury proposals, but neither the Bradley-Gephardt nor the 

Kemp-Kasten propsoals, will repeal the special favorable rule for 

deducting costs of future mine reclamation expenditures, the 5-year 

amortization of costs of registering trademarks and tradenames, and 

the 50-year amortization of investment in, and sunk costs of, railroad 

grading and tunnel bores. 

C. Further Curtailment of Tax Shelters 

Many taxpayers use tax shelters to reduce their current tax 

liability. Even though many tax shelters are perfectly legal, they 

distort the allocation of economic resources and undermine both the 

equity of the tax system and the perception of fairness. Many of the 

Treasury Department, Bradley-Gephardt, and Kemp-Kasten proposals 

discussed above will make investing in tax shelters much less 

attractive. Important examples include reform of depreciation rules 

and changes in the tax treatment of capital gains. All three 

proposals will limit the deduction for interest expense. To further 

curtail the attraction of tax shelters, the Treasury Department 

proposal will extend the at-risk rules for loss deductions to real 

estate. Both the Treasury Department proposals and the Bradley-. 

Gephardt proposal will repeal the alternative minimum tax; the Kemp- 

Kasten proposal retains it. 

D. International Issues 

Income earned abroad by foreign subsidiaries of U.S. corporations 

is generally not subject to U.S. tax unless repatriated as dividends.

- 167 - 

U.S. tax imposed on such dividends and on the earnings of foreign 

branches can be offset by a credit for taxes paid to foreign 

governments. The foreign tax credit is limited to the effective rate 

of U.S. tax paid on the foreign source income in question. Under 

current law companies are allowed to pool income and credits from all 

countries (though not from all sources) in calculating the limit on 

the foreign tax credit. In order to encourage U.S. exports, U .S. 

firms are allowed to establish Foreign Sales Corporations, the income 

from which benefits from tax deferral, even if distributed. 

The Treasury Department and Kemp-Kasten proposals will continue 

the deferral of taxation of income from suhsidiaries of domestic 

corporations. By comparison, the Bradley-Gephardt proposal will 

eliminate deferral. The Treasury Department proposal will require 

calculation of the limitation of the foreign tax credit on a countryby-country 

basis, in order to prevent an artificial incentive for 

American firms operating in high tax countries to invest in low-tax 

countries, rather than in the United States. Neither the Bradley- 

Gephardt nor Kemp-Kasten proposals address this issue. The Treasury 

Department proposal will continue the preferential treament of Foreign 

Sales Corporations. The Treasury Department proposal also deals with 

certain problems in the measurement and determination of source of 

income; the Bradley-Gephardt and Kemp-Kasten proposals do not do so. 

The Treasury Department proposal will modify the possessions tax 

credit. The Bradley-Gephardt proposal will repeal the possesions tax 

credit, whereas the Kemp-Kasten proposal will retain it in its current 

form. The Treasury Department and Kemp-Kasten proposals will retain 

the exclusion for income of Americans working abroad; the Bradley- 

Gephardt proposal will repeal this exclusion. 

IV. 

Other Ta% Issues 

A. Taxation of Transfers 

Because the bases of the estate and gift taxes are calculated 

differently, current law favors those who can afford to make lifetime 

gifts over those who need or desire to retain their property until 

death. The preference given to lifetime gifts has also caused complex 

and arbitrary rules for including in the donor's estate certain 

previously transferred property. The Treasury Department proposal 

will treat transfers more uniformly by imposing the gift tax on the 

same basis as the estate tax. This change will simplify transfer 

taxation by eliminating the need for the rules that include certain 

gifts in an estate. The Treasury Department proposals will also 

simplify the rules for generation-skipping transfers and the rules 

that allow the estate tax to be made in installments where the estate 

has insufficient liquid assets to pay the tax. The other two 

proposals generally do not change the substantive rules for the 

taxation of transfers.

B. Expiring Provisions 

- 160 - 

The Treasury Department proposes elimination (or the allowance of 

currently planned expiration) of all major tax credits other than the 

earned income tax credit, the foreign tax credit, the credit for the 

elderly, blind, and disabled, and the credit for research and 

experimentation. The Kemp-Kasten proposals will reduce the earned 

income credit and retain the foreign tax credit and will repeal the 

credit for the elderly and the disabled, for research and 

experimentation credit, and all major tax credits. The Bradley- 

Gephardt proposal will retain the foreign tax credit and the earned 

income credit, but will repeal the credit for the elderly and the 

disabled, the credit for research and experimentation and all major 

tax credits. 

All three proposals will repeal or allow to expire the special 

treatment for dividend reinvestment in public utility stock. All 

three plans will repeal or allow to expire the exclusions for 

employer-provided legal services and transportation. The Treasury 

Department proposal and the Bradley-Gephardt proposals will also 

repeal or allow to expire the exclusion of employer-provided legal and 

educational assistance.

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Appendix 8-8 

SUMMARY OF TAX REFORM BILLS 

INTRODUCED DURING THE 98TH CONGRESS 

H.R. 170, the Tax Simplification Act, was introduced by Mr. 

Hansen. The bill would tax the income of individuals, estates, and 

trusts at the rate of 15 percent. The deduction for personal 

exemptions would be increased to $3,000. Most deductions and 

exclusions would be repealed, including those for medical expenses, 

capital gains, and IRAs. Itemized deductions would continue to be 

allowed for expenses attributable to the conduct of a trade or 

business and for the production of income, for charitable 

contributions to a church or a convention or association of churches, 

and for alimony payments. Tax credits would continue to be allowed. 

The bill would not amend the corporate income tax. 

H.R. 542, the Flat Rate Tax Act of 1983, was introduced by Mr. 

Philip M. Crane, The bill would tax the income of individuals, 

estates, and trusts in excess of the deduction for personal exemptions 

at the rate of 10 percent. The allowance for personal exemptions 

would be increased to $2,000 and would be indexed for inflation 

occuring after 1982. All exclusions, deductions, and credits would be 

repealed. The bill would not amend the corporate income tax. 


Paul. The bill would tax the income of individuals, estates, and 

trusts at the rate of 10 percent. The personal exemptions would be 

increased to $2,500. The bill would not amend the corporate income 

tax. 

H.R. L770, the Flat Tax Act of 1983, was introduced by Mr. Dreier. 

The bill would tax the gross income of individuals, estates, and 

trusts in excess of the deduction for personal exemptions at the rate 

of 14 percent. The allowance for personal exemptions would be 

increased to $2,000. All exclusions, deductions, and credits would be 



Paul. The bill would tax the gross income of individuals, estates, 

and trusts in excess of $10,000 at the rate of 10 percent. All 

exclusions, deductions, and credits for individual taxpayers would be 


H.R. 2520, the Income Tax Simplification Act of 1983, was 

introduced by Mr. Panetta. The bill would tax the income of 

individuals, corporations, estates, and trusts at the rate of 18 

percent. For individuals, the bill would replace the standard 

deduction and the deductions for personal, blind and elderly 

exemptions with a tax credit. The credit for personal exemptions 

would be $1,000 for a single return and $2,000 for a joint return.

- 186 - 

The credit for each dependent, the blind, and the elderly would be 

$200 each. Most credits (except the foreign tax credit), exclusions, 

and deductions would be repealed, except for those that are related to 

the conduct of a trade or business or the production of income. 

Individuals would continue to be allowed to deduct alimony payments. 

The bill would repeal special rules that apply to natural resources 

industries, including the deduction for depletion and for intangible 

drilling and development costs, and special rules relating to 

insurance companies and banking institutions. The bill would also 

repeal deductions for certain entertainment expenses, and employer 

contributions to pension, stock bonus, profit-sharing or annuity 

plans. The bill would repeal the special tax treatment afforded 

Domestic International Sales Corporations and the exclusion of income 

of Americans working abroad. The special tax treatment of capital 

gains would be repealed, including the provisions that allow the 

rollover of gain on the sale of a home. Income averaging would be 

repealed. 

H.R. 3271, the Fair Tax Act of 1983, was introduced by 

Mr. Gephardt. This bill is the same as S. 1421, introduced by Senator 

Bradley. The provisions of these bills are summarized in Appendix 8-A. 


Don Young. The bill would tax gross income over $10,000 at the rate 

of 15 percent. All exclusions, credits, and deductions would be 

repealed, except for the deductions for charitable contributions, home 

mortgage interest, and expenses incurred in carrying 011 a trade or 

business. The bill would not amend the corporate income tax. The 

bill would provide certain taxpayer protection standards that relate 

to the administration of the tax. 


Quillen. The bill would tax the income of individuals, estates, and 

trusts at the rate of 10 percent. Exclusions would be repealed, 

except for social security benefits, veterans benefits, and interest 

on tax-exempt bonds. The allowance for personal exemptions would be 

increased to $2,000. Other deductions would be repealed, except for 

charitable contributions, home mortgage interest and interest used to 

finance investment, state and local income and property taxes, and 

trade and business expenses. Tax credits would be repealed. The bill 

would not amend the corporate income tax. 

H.R. 4871, introduced by Mr. Dannemeyer, directs the Treasury 

Department to propose legislation and provides guidelines that would 

be used to develop the legislation. All income of businesses and 

individuals would be taxed only once at a 15 percent rate. The 

poorest households would not pay income tax. Individual taxpayers 

would be allowed a deduction for personal and dependency exemptions, 

charitable contributions, and home mortgage interest. Capital gains 

would be exempt from tax. For the business tax, the distinction 

between corporations, partnerships, farms, and professionals would be 

removed. Deductions would be allowed for capital expenses, for the 

cost of goods and services, and charitable contributions.

- 187 - 

H.R. 5432, the Ten Percent Flat Tax Rate Act, was introduced by 

Mr. Siljander. This bill is the same as S. 5432, introduced by 

Senator Nickles. The provisions of these bills are summarized in 

Appendix 8-A. 

H.R. 5484, the Ten Percent Tax Rate Act, was introduced by Mr. 

Paul. The bill would tax the income of individuals at the rate of 10 

percent. The personal exemptions would be increased to $2,000. 

Certain exclusions would continue to be allowed, including alimony 

payments, scholarship and fellowship grants, supplemental security 

income, disability payments, government employee retirement benefits, 

interest on certain tax-exempt bonds, and fringe benefits. Deductions 

would continue to be allowed for trade and business expenses, and for 

expenses related to the production of income. Most other deductions 

would be repealed, including the deductions for medical expenses, 

alimony payments, taxes, and for two-earner married couples. All tax 

credits for individuals would be repealed. The estate and gift tax 

provisions would be repealed. The bill would not amend the corporate 

income tax. 

H.R. 5711, introduced by Mr. Shelby, is the same as S. 551, 

introduced by Senator DeConcini. The provisions of these bills are 

summarized in Appendix 8-A. 

H.R. 5841, the Progressive Consumption Tax Act of 1984, was 

introduced by Mr. Heftel. The bill would tax consumption of 

individuals at graduated rates that range from 10 percent to 50 

percent. The consumption of corporations would be taxed at the rate 

of 30 percent. To compute taxable consumption, the taxpayer would add 

net income, any increase in debt, and any decrease in saving. From 

that total, the taxpayer would subtract any decrease in debt and any 

increase in savings. To compute net income the taxpayer would be 

allowed deductions for trade and business expenses, capital losses, 

certain expenses related to the production of income, moving expenses 

and alimony. Individuals could claim a standard deduction, equal to 

$3,400 for joint returns and $2,300 for single returns. A credit of 

$200 would be provided for each personal exemption. Most credits, 

exclusions and deductions allowed under current law would be repealed. 

The deduction for interest would be limited to home mortgage interest, 

interest on debt used to purchase investment assets, and interest 

incurred in the active conduct of a trade or business. The deduction 

for charitable contributions would be limited to 5 percent of adjusted 

gross consumption. The deduction for medical expenses would continue 

to be allowed. Capital losses would be fully deductible. Casualty 

and theft losses in excess of $500 would be deductible. The deduction 

for property taxes would be repealed. The gift tax would be repealed, 

but gifts would be includible in the recipient's gross income. 

H.R. 6165, the Fair and Simple Tax Act of 1984, was introduced by 

Mr. Kemp. The this bill is the same as S. 2948, introduced by Senator 

Kasten. The provisions of these bills are summarized in Appendix 8-A. 

H.R. 6165 and S. 2948 replace H.R. 5533 and S. 2600, respectively.

- 188 - 

H.R. 6364, the Broad-Based, Enhanced Savings Tax Act of 1984, was 

introduced by Mr. Moore. This bill is the same as S. 3042, introduced 

by Senator Roth. The provisions of these bills are summarized in 

Appendix 8-A. 

H.R. 6384, the SELF-Tax Plan Act of 1984, was introduced by Mr. 

Schulze. This bill is the same as S. 3050, introduced by Senator 

Quayle. S. 3050 replaces S. 1040. Taxable income in excess of $6,000 

for single returns and head of household returns, and $10,000 for 

joint returns would be subject to tax at graduated rates ranging from 

15 percent to 30 percent. The personal exemption would not be 

increased. All tax credits for individuals would be repealed. Many 

exclusions for individuals would be repealed, including interest 011 

certain state and local government bonds. The exclusion for 

scholarships and fellowships would be limited to tuition expenses. 

Many deductions for individuals would be repealed, including the 

deductions for casualty and theft losses, two-earner married couples, 

intangible drilling and development costs, and percentage depletion. 

Home mortgage interest would be deductible, but other consumer 

interest would not be deductible. Unemployment compensation and 

governmental welfare or assistance benefits would be taxable. Capital 

gains would be taxed like ordinary income. The bills would not amend 

the corporate income tax, but directs the Treasury Department to study 

certain corporate and individual income tax changes. 

6420, the Cash Flow Income Tax Act of 1985, was introduced by Mr. 

Heftel. The bill would tax the income of individuals at graduated 

rates ranging from 10 percent to 30 percent. Income of corporations 

would be taxed at the rate of 30 percent. Income of estates and 

trusts in excess of $3,000 would be taxed at the rate of 30 percent. 

Individuals would be allowed a standard deduction of $8,000 for joint 

returns, $6,000 for head of household returns, and $4,000 for single 

returns. A nonrefundable credit equal to $200 for each dependent 

would be permitted. Most other credits, exclusions, and deductions 

provided under current law would be repealed. To compute adjusted 

gross income, a taxpayer would add net income, any increase in debt, 

and any decrease in savings. From this total, the taxpayer would 

subtract any decrease in debt and any increase in savings. The 

taxpayer would be permitted to elect an exclusion of up to $20,000 in 

debt. To compute net income, the taxpayer would be permitted 

deductions for trade and business expenses, foreign taxes, capital 

losses, certain expenses related to the production of income and 

alimony payments. Interest expenses for the purchase of investment 

assests and home mortgage interest would continue to be deductible, 

but consumer interest would not be deductible. The deduction for 

charitable contributions would be limited to 5 percent of adjusted 

gross income. The deduction for property taxes would be repealed. 

Deductions would be permitted for medical expenses in excess of 10 

percent of adjusted gross income and for casualty and theft losses in 

excess of $500. Capital losses would be fully deductible. Gifts and 

bequests in excess of $5,000 per year would be includable in the 

recipient's gross income.

- 189 - 

S. 1767, the Personal Income Tax Reform Act of 1983, was 

introduced by Senator Mitchell. The income of individuals, estates, 

and trusts would be subject to a base tax equal to 12 percent and a 

surtax that ranges from 8 percent to 24 percent. Personal exemptions 

would be increased to $1,750 for a taxpayer who is the head of 

household, and $1,500 for any other taxpayer. The amount of dependency 

exemptions would be $1,000 each. The standard deduction would be 

increased to $4,600 for joint returns. For all other returns, the 

amount would be $2,300. Most of the exclusions, deductions, and 

credits contained in current law would be repealed. One-third of the 

employer's contribution to the employee's medical care plan would be 

included in the employee's income. Scholarship and fellowship grants 

in excess of tuition and related expenses would be included in income. 

The deductions for two-earner married couples and for adoption 

expenses would be repealed. For individual taxpayers, the capital 

gains exclusion and the distinction between short and long term 

capital gains are repealed. The deduction for interest would be 

allowed for home mortgage interest, interest on trade or business 

debt, and other interest subject to limitations. The credit for 

dependent care expenses would be replaced with an itemized deduction. 

The exclusion for the gain on the sale of a principal residence for a 

taxpayer who is 55 years old or older would be replaced with an 

itemized deduction. Individual retirement accounts, and qualified 

pension, profit-sharing, and stock bonus plans would be taxed at the 

rate of 12 percent. Income averaging would be repealed. The bill 

would not amend the taxatjon of corporations. 

s. 2158, the Simpliform Tax Act, was introduced by Senator 

Hatfield. The bill would tax the income of individuals at graduated 

rates ranging from 6 percent to 30 percent. Joint returns would be 

eliminated. The standard deduction would be repealed and the personal 

and dependency exemptions would be replaced by credits equal to $250 

each. Most credits, deductions, and exclusions provided under current 

law would be repealed. Deductions would continue to be allowed for 

expenses related to the production of income, and for alimony 

payments. Certain deductions allowed under current law would be 

replaced by tax credits. A credit would be provided for 20 percent of 

qualified medical expenses in excess of 10 percent of adjusted gross 

income (AGI). A credit would be provided for home mortgage interest 

equal to 15 percent of the interest paid in excess of one percent of 

AGI, up to a maximum credit of $1,000. A credit would also be 

provided for 20 percent of charitable contributions in excess of one 

percent of AGI, and for 15 percent of state and local taxes in excess 

of one percent of AGI, up to a maximum credit of $1,000. The bill 

would repeal the partial exclusion of capital gains and would index 

the basis of assets for determining capital gains and losses. The 

bill would not amend the corporate income tax, but directs the 

Treasury Department to conduct a study of amendments to the corporate 

income tax that would lower the rate of tax, eliminate tax 

preferences, and structure the corporate tax in a way that is similar 

to the individual income tax provided in the bill. 

459-3'70 0 - 84 - 8

- 191 - 

Chapter 9 

CONSUMED INCOME TAX 

A tax on consumed income, one of the four options considered by 

the Treasury Department in its study of fundamental tax reform, is a 

frequently mentioned alternative to the income tax. The base of a 

comprehensive personal tax on consumption, or consumed income, differs 

from that of a comprehensive income tax only in that a deduction is 

allowed for net saving. This effectively excludes capital income from 

the tax base because deferring the tax on saving until withdrawal is, 

on average and in present value terms, equivalent to exempting the 

return to saving from taxation. 

Apart from the deduction for net saving, the bases of the two 

types of taxes are identical. They are both direct personal taxes 

which can be structured to reflect the individual circumstances of 

taxpayers. Thus, like the income tax, a consumed income tax can 

contain personal exemptions, a zero-bracket amount, itemized deductions, 

and flat or graduated rates. Personalization of this type is 

not possible under a transaction-based sales tax on consumption, such 

as a value-added tax or a national retail sales tax (discussed in 

chapter 10). 

A comprehensive consumed income tax and a comprehensive income tax 

also share the advantages obtained from moving from the current, 

narrow base to a broad, uniform tax base. (These advantages are 

discussed in chapter 5.) Many of the issues covered in the discussion 

of the base of a modified income tax would also arise under a tax on 

consumed income. For example, except for contributions to retirement 

plans, most fringe benefits provided by employers represent a form of 

consumption; therefore, they should be subject to a tax on consumed 

income as well as on all income. Similarly, expenditures such as for 

moving expenses and medical care might not be viewed as taxable 

consumption, just as they may be viewed as reducing ability to pay 

income taxes. Other expenditures that qualify as itemized deductions 

under the current income tax, such as state and local taxes and charitable 

contributions, could either be granted or denied preferential 

treatment under the consumed income tax. Because these issues are, 

for the most part, no different under a consumed income tax and an 

income tax, they are not discussed further in this chapter. 

This chapter describes the main features of a consumed income tax, 

and then discusses its advantages and disadvantages. It is important 

to specify clearly whether a consumed income tax is being compared to 

the current income tax or to a broad-base income tax. Since a consumed 

income tax and a comprehensive income tax share many of the same 

advantages over current law, the more important comparision for 

judging the desirability of a consumed income tax is with a broad-base 

income tax.

- 192 - 

I. Consumed Income Tax Base, Rates, and Administration 

A tax on consumed income would not be administered by asking a 

taxpayer to add together all consumption expenditures during the year; 

that would clearly be an impossible task. Rather, the taxpayer would 

report total income and be allowed a deduction for net saving. Conversely, 

dissaving would be subject to tax. All saving and dissaving 

would have to occur through "qualified accounts" held with financial 

institutions so that annual saving and dissaving could be reliably 

reported and measured. 

A. The Tax Base. 

The principle of taxing consumption determines the treatment of 

loans under a consumed income tax. Since repayment of debt is equivalent 

to saving, a deduction would be granted for such repayment and 

for payments of interest; similarly, the proceeds of borrowing would 

be included in taxable consumption. If net loan proceeds were not 

included in the tax base, taxpayers could "game" the tax system simply 

by borrowing funds, depositing them in a qualified account, and taking 

a deduction for the increase in their "saving". Purchasing assets 

with borrowed funds does not add to net saving, and therefore would 

not qualify for a deduction under a consumed income tax. Although the 

present value of the taxes might not be affected, since the taxpayer 

could not deduct the repayments and interest on the loan, omitting 

borrowing from the base would enable the taxpayer to postpone the 

liability. This would disrupt the timing of government receipts and 

would seem unfair. More extreme tax avoidance would occur if borrowing 

were not in the base but deductions were allowed for loan 

repayments, or even just for interest payments. Under these circumstances 

taxpayers could actually reduce their future as well as 

present tax liability by borrowing. 

An exception to the rule on borrowing could be made to exclude the 

proceeds of home mortgages from the base of a consumed income tax, 

provided that no deductions were allowed for subsequent repayment of 

principal and interest. This treatment would avoid a huge consumption 

tax liability at the time of home purchase and would effectively 

spread out tax payments over the life of the loan (since deductions 

for loan repayment and interest are denied), without the complexity of 

actual averaging. Similarly, tax on withdrawels from a qualified 

account used for a down payment on a home could be spread out, too. 

Special treatment for owner-occupied housing might be acceptable 

because, under certain circumstances, it would not alter the present 

value of taxes, and because the possibilities for "gaming" would be 

limited. 

The tax treatment of business assets would also be based on the 

principle of taxing consumption. Accordingly, the purchase of 

business assets would be deducted immediately; that is, investment is 

expensed under a consumed income tax. The returns to the asset and 

the amount received upon sale would be included in the tax base,

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unless reinvested. Similarly, the purchase of corporate stock or 

other financial assets is deductible; dividends and interest received, 

as well as the receipts from selling the stock or bond, are included 

in the tax base unless they are saved. 

Under a consumed income tax, there is even less theoretical 

justification for a corporate income tax than under a comprehensive 

income tax. The rationale for eliminating the corporate income tax is 

easily seen by considering the uses to which net corporate income can 

be put. Earnings that are retained should not be taxed because they 

are a form of saving, and the consumed income tax explicitly excludes 

saving from the tax base. Corporations would not pay tax on income 

distributed to shareholders, because dividends would be taxable to 

shareholders, unless they saved them. At most, a corporate income tax 

might be retained for three reasons: (1) to prevent foreign investors 

in the United States from automatically benefitting from the elimination 

of the corporate income tax, ( 2) to assess an additional tax on 

extraordinary returns to investment in the corporate sector, or (3) to 

tax indirectly corporate expenditures which represent consumption on 

the part of employees by denying corporations deductions for such 

expenditures. 

There is general agreement that gifts and inheritances should be 

included in the taxable consumption of the recipient, unless saved. 

Some advocates of a tax on consumed income believe that gifts and 

bequests also represent consumption of the donor, and thus should be 

included in the tax base of the donor, as well as in the base of the 

recipient. This would make the base of the consumed income tax lifetime 

income. However, other advocates of a consumed income tax point 

out that this would amount to double taxation of the gift or bequest, 

and believe quite strongly that gifts and bequests should be taxed 

only to the recipient and not to the donor. The distributional 

implications of this issue are enormous. If bequests and gifts were 

excluded from the consumed income tax base of the donor, higher rates 

would be required to approximate the existing distribution of tax 

burdens by income class. Moreover, the "wealthy miser" would almost 

completely escape tax under such a tax on consumed income, and large 

fortunes could be passed on between generations tax-free. 

Thus, under a comprehensive consumed income tax, the tax base 

would include all forms of current monetary and in-kind income, the 

current consumption value of all fringe benefits supplied by 

employers, the proceeds of sales of capital assets and the returns to 

direct investment that are not reinvested, withdrawals in excess of 

deposits in saving accounts, the proceeds of all borrowing in excess 

of loan repayments, and gifts and inheritances received. Accrued 

interest, earnings from ownership of corporate shares, increases in 

the value of pension and life insurance reserves, and other increases 

in the value of asset holdings would not be subject to tax until paid 

out, borrowed, or otherwise withdrawn for consumption. 

This tax on consumed income then amounts to a tax on the sum of 

gifts, inheritances, and labor income received. For the economy as a

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whole and for most taxpayers, who receive only an insignificant amount 

of gifts and inheritances, a consumed income tax would, in fact, be 

virtually equivalent to a tax only on wages. Capital income would in 

effect be exempt. Although individuals would have to pay tax on 

capital income when it was used for consumption, the deduction of 

saving (out of wages) and the tax exemption of interest income results 

in a present value of the tax liability which, under certain circumstances, 

is the same as if the individual had been taxed only on total 

wages when paid. 

8. Tax Rates 

Because the household sector is a net lender in the economy, the 

base of a consumed income tax would be smaller than the base of an 

income tax with identical treatment of items other than capital 

income. Thus, to raise an equal amount of revenue as an income tax, a 

consumed income tax would have to have higher rates. The tax 

exemption of capital income must be weighed against higher marginal 

tax rates on labor income. The percentage difference in marginal tax 

rates between a consumed income tax and a broad-based income tax would 

depend on the difference in the tax base. The tax rates under a 

consumed income tax might still be lower than the rates on the narrow 

base of the current income tax. 

C. Administration 

In order to administer a consumed income tax and to minimize 

noncompliance, almost all financial transactions would have to be 

conducted through one or more IRA-type qualified accounts held through 

banks, brokerages, or other financial institutions to insure reliable 

information reporting. A useful way to think of qualified accounts 

under a tax on consumed income is to imagine extension of the present 

rules for individual retirement accounts (IRAs) and Keogh plans to 

cover all forms and amounts of saving and dissaving (including loans). 

Any amounts put into such accounts (including loan repayments of 

principal and interest) would be deductible. Investment income earned 

on the accounts would be currently tax exempt unless withdrawn, but 

any withdrawal from the accounts (including the proceeds of loans) 

would be taxable. 

Requiring virtually all financial transactions to be recorded 

through a qualified account is necessary to prevent abuses of the tax 

system. In some cases, the present value of the tax liability of 

transactions conducted outside of qualified accounts might be the same 

as transactions through qualified accounts, but the taxpayer would be 

able to time the tax payments to his or her advantage. Excluding the 

proceeds of borrowing from the tax base (which is equivalent to 

borrowing outside of qualified accounts) provides an example of this. 

In other instances, avoiding qualified accounts could actually reduce 

the present value of the tax liability. This could occur if the 

taxpayer expects unusually high returns on an investment. By not 

making an investment through a qualified account, and not getting a 

deduction for it, the taxpayer "prepays" the tax. But the value of

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the tax on the actual consumption from the high returns would have 

been greater than the prepayment amount. Allowing taxpayers to choose 

whether to use qualified accounts would provide only ex ante equity in 

taxation, whereas requiring qualified account treatment for all 

transactions provides ex post equity. 

The unit of taxation under a consumed income tax would probably be 

the family, rather than the present tax unit. The problems under an 

income tax caused by transfers of income to family members with low 

marginal rates would be magnified under a consumed income tax. Con 

sumption cannot be as clearly attributed to individual family members 

as income can. Distinctions between a "gift" and "shared consumption" 

would be meaningless within most families. Furthermore, the family is 

the more appropriate unit for taxing consumption, since in general a11 

family members (at least within the same household) share in a common 

standard of living. 

11. Advantages of a Consumed Income Tax 

One of the major advantages that a comprehensive consumed income 

tax would have over the present income tax would be a uniform tax 

base, which would eliminate many of the economic distortions and 

inequities of the present system. Of course, a comprehensive income 

tax would share this advantage over current law. Relative to a broadbase 

income tax, a comprehensive consumed income tax would still have 

several advantages i n terms of administration, economic effects, and 

equity. 

A. Administrative Advantages 

The main administrative advantages of e tax on consumed income are 

that it avoids most problems of measuring income from business and 

capital, it does not require complicated indexing adjustments to make 

it inflation-proof, and it provides a simple solution to the current 

problems of tax shelters and tax arbitrage. 

1. Income measurement issues. The measurement of income from 

business and capital is inherently difficult. Many of the most 

complicated provisions of the current income tax can be traced to 

problems of income measurement. A major advantage of a tax on 

consumed income would be that it avoids most of these problems. 

Business income measurement. A number of the complexities in 

measuring business income stem from issues of timing. For example, 

under current law taxpayers are allowed to choose whether to employ 

cash or accrual accounting. Under either accounting convention, there 

are important questions of interpretation. When, for example, shou1.d 

a cash-basis taxpayer record expenses incurred during one year for the 

purpose of earning income in a later year? When should an accrual 

basis taxpayer reflect income from projects that extend beyond one 

year? Taxpayers employing different accounting methods -- including 

affiliated or commonly owned taxpayers -- can engage in transactions 

that produce recognition of expenses (by the accrual basis taxpayer)

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but postponement of recognition of receipt (by the cash basis tax- 

payer), thereby reducing their aggregate tax liability. under most 

proposals, a consumed income tax would be based on cash flow; the 

taxpayer has or has not paid or received cash or its equivalent. None 

of the problems described above would exist under a consumed income 

tax of this type. 

Problems of depreciation accounting, depletion allowances, 

amortization, and accounting for inventories for tax purposes also 

would not arise under a consumed income tax. The cost of depreciable 

assets would simply be currently deducted (expensed) in the year of 

acquisition under the cash flow tax. Similarly, expenditures on goods 

placed in inventory would be automatically expensed. Various other 

types of cash expenditures are expensed, rather than capitalized and 

amortized over their useful life. In the case of natural resources, 

all costs of acquisition, exploration, and development would be 

expensed, rather than recognized over the lifetime of the resulting 

asset through cost depletion; the possibility of percentage depletion 

should never arise. By comparison, under the income tax it is 

necessary to determine the useful life of assets and the pattern of 

depreciation to employ for tax purposes. special and arbitrary rules 

are required under current law for property such as motion pictures, 

sound recordings, and trademarks. 

For certain purposes the characterization of an income flow can 

affect tax treatment under the income tax; for example, the distinction 

between dividends and interest is often important. Under an 

ideal tax on consumed income all such distinctions would be irrelevant. 

Perhaps more important, the distinction between income and 

return of capital would also be meaningless under a tax on consumed 

income since cash received would be taxable unless reinvested. 

Similarly, payment of cash would always produce deductions, whether 

the payments were for expenses or for repayment of capital. 

Capital gains would not be subject to tax under an ideal tax on 

consumed income. Rather, the taxpayer would be allowed a deduction 

for the full value of expenditures on capital assets. The entire 

proceeds of asset sales would be included in taxable consumption, 

unless reinvested. This treatment would have several administrative 

advantages. First, there would be no need to know the original basis 

(usually the cost) of capital assets, since basis would be irrelevant 

in calculating the consumed income tax; this would greatly simplify 

both taxpayer compliance and tax administration. Second, since 

capital gains would receive no special treatment, there would be no 

incentives to characterize income as capital gain. This would 

eliminate the complex distinctions between capital gains and ordinary 

income in current law, as well as the associated tax shelters. 

Averaginq. Current law includes some fairly complicated 

provisions for income averaging. Such provisions are necessary under 

a progressive income tax so that an individual with fluctuating income 

does not bear a heavier tax burden than an individual with the same

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average income received at a steady rate. Since annual consumption 

does not fluctuate as much as annual income, there would be less need 

for complex averaging provisions under a consumed income tax. 

Pensions. A primary administrative advantage of a tax on consumed 

income in the area of measurement of individual income lies in the 

simplification of the tax treatment of pensions. At present, contributions 

to certain qualified pension accounts are accorded consumption 

tax treatment; that is, contributions are fully deductible but receipt 

of both principal and interest is subject to tax. Contributions are, 

however, subject to limitations, and pre-retirement withdrawals are 

penalized. However, many pension plans and other vehicles for retirement 

saving are not covered by these rules. Under a tax on consumed 

income all saving for retirement -- indeed, all saving -- is accorded 

uniform treatment: deduction upon contribution and taxation of both 

the original contribution and subsequent earnings at the time of 

withdrawal. 

2. Inflation-proof tax base. During inflationary periods, the 

current income tax generally mismeasures income from capital and from 

business; real income is understated in some instances and overstated 

in others. This occurs for a number of reasons: depreciation is based 

on historical costs; tax is collected on nominal capital gains, rather 

than real (inflation-adjusted) gains; the deduction for the cost of 

goods sold from inventory is often based on the value of the oldest 

goods in stock at the beginning of the year; and interest income and 

expense are calculated without recognizing that nominal interest rates 

include an inflation premium that should neither be taxed nor 

deducted. During the 1970s the mismeasurement of business and capital 

income resulted in substantial overtaxation of these forms of income, 

which in addition to being inequitable, had a serious depressing 

effect on capital investment. Adjusting depreciation allowances, the 

cost of goods sold from inventories, capital gains, and interest 

income and expense for inflation is inevitably complicated. Because 

the tax on consumed income is based on cash flow, it requires no 

inflation adjustment to make it inflation-proof. Cash flow is 

inherently measured in dollars of the current period, so there is no 

occasion to combine current income and expenses with historical ones. 

3. Tax shelters and tax arbitrage. Tax shelters and tax arbitrage 

are a major source of inequity and distortion under the current income 

tax system. Any attempts-at >eforming the tax system must address 

their underlying causes; these include -- usually in combination -- 

acceleration of deductions for expenses, preferential treatment of 

capital gains or the return to saving (often through vehicles typical 

of a consumed income tax, such as pensions, IRAs, and life insurance 

policies with large saving components), and borrowing in order to 

realize deductions for interest expense. The relative advantage of 

the consumed income tax with respect to tax shelters is the simplicity 

of the solution. By addressing the underlying causes of tax avoidance, 

a well-structured income tax would certainly reduce the use of 

tax shelters. But it would require extensive and complex provisions, 

including "at risk rules" intended to prevent taxpayers from taking

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deductions in excess of their actual investment in the asset, limitations 

on the deduction of inflation-adjusted interest expenses, real 

economic depreciation with more complete cost capitalization rules, 

and full taxation of real capital gains. 

In contrast to the complex rules necessary to prevent tax shelters 

under an income tax, existing tax shelters would simply disappear with 

the tax exemption of capital income. The relative advantage of 

current tax shelters would be eliminated if all purchases of capital 

goods were expensed, if capital gains and the returns to saving were 

taxed only when consumed, and if borrowing were subject to tax unless 

offset by additional investment. 

Some caution must be exercised, however, in extolling the relative 

advantage of a consumed income tax with regard to tax shelters. Unless 

the family was the tax unit, and to some extent even if it were, 

attribution of consumption to related individuals subject to low 

marginal tax rates would be a new tax reduction technique under a 

graduated consumed income tax. This is just one example of how any 

tax preference or possible tax loophole would likely be exploited 

under a consumed income tax. The difficult measurement issues which 

gave rise to loopholes in the present income tax are fairly well known 

after 70 years of experience. Similar measurement difficulties in an 

actual consumed income tax would probably give rise to many new and 

different "tax shelters". 

8. Economic Advantages 

Advocates of a consumed income tax argue that it would have two 

important advantages over an income tax. First, it would not distort 

the consumer choice between present and future consumption. Second, 

it would probably increase saving, which in turn would increase 

investment, productivity and growth. Implementation of a consumed 

income tax would also affect individual behavior regarding gifts and 

bequests. 

1. Economic neutrality. An individual can consume income now or 

save it in order to consume it later. The cost or "price" of future 

consumption is inversely related to the net rate of return to saving 

obtained by the individual; a higher rate of return implies a lower 

price, since more future consumption can be purchased for any amount 

saved. A consumed income tax does not change the price of future 

consumption since it does not change the rate of return to saving. In 

contrast, by taxing the return to saving, the income tax raises the 

price of future consumption, thus distorting the choice between 

consuming now or saving for future consumption. In this sense, unlike 

the income tax, the consumed income t.ax does not discriminate against 

saving. 

However, eliminating the income tax discrimination against saving 

by enacting a consumed income tax would have some adverse effects as 

well. Although only the income tax discriminates against saving, both 

the income and consumed income taxes distort the individual decision

- 199 - 

to work more or take more leisure (broadly defined to include nonmarket 

production in the home). However, tax rates must be higher 

under a consumed income tax, as the base is smaller. As a result, the 

consumed income tax distorts the work-leisure choice more than the 

broad-based income tax does. Thus, in terms of overall economic 

neutrality, the relative merits of the two taxes are unclear on 

theoretical grounds. (The theoretical argument is unlikely to be 

resolved in the near future; for example, there is little empirical 

evidence and no consensus about the val.ue of an esoteric but critical 

parameter in the analysis -- the labor supply response to changes in 

the return to saving.) Under many assumptions about individual 

behavior, the consumed income tax results in a smaller total distortion 

of the two choices and thus is preferable in terms of economic 

neutrality. However, under other assumptions, the income tax can be 

shown to result in a smaller overall distortion. 

2. Effect on saving. The effect on saving of implementing a 

consumed income tax is also controversial. As described above, saving 

would be encouraged under the consumed income tax because the income 

tax discrimination against saving would be eliminated. However, 

because the net return to saving would be higher, any particular goal 

for future consumption could be attained with less current saving; 

this would reduce the need to save. The net effect of taxation on 

saving is a topic of much debate. Most economists believe that, 

relative to an income tax, a consumed income tax would result in more 

saving, and thus more investment, faster growth and eventually higher 

wages; some contend the effects would be very significant. However, 

many economists argue that little change in saving would result. 

Also, if the marginal tax rate at the time of dissaving were lower 

than the tax rate at the time the deductions were taken, the effective 

tax rate on the return to saving would be negative -- not only would 

the government collect no tax on the saving, it would actually pay 

people to save. Although this would further encourage saving, it 

would reduce total tax collections and require higher marginal tax 

rates on the remaining tax base. 

3. Effects on gifts and bequests. The tax treatment of gifts and 

bequests under the consumed income tax would affect individual 

decisions to give and to leave inheritances. Gifts and bequests would 

probably be stimulated if they were taxed only to the recipient. 

However, the opposite effect would occur if they were taxed to both 

the donor and recipient. Saving would also be stimulated in the 

former case but discouraged in the latter. 

C. Equity Advantages 

Many advocates of taxes on consumed income believe that 

consumption provides a better measure of ability to pay than does 

income. One argument for a tax on consumed income is that annual 

income, which is subject to considerable fluctuation, is a less

- 200 - 

satisfactory indicator of ability to pay than is permanent income, and 

that consumption is a better proxy for permanent income than is annual 

income. 

At another level of sophistication, some advocates of a particular 

form of consumed income tax argue that ability to pay should be 

measured in terms of lifetime income, rather than annual income. 

Lifetime income can, in turn, be measured in present value terms in 

either of two ways: as the sum of gifts and bequests received plus 

labor income, or as the sum of consumption plus amounts given or 

bequeathed to others. Under this rationale, the tax base of the tax 

on consumed income is appropriate because it is exactly a measure of 

lifetime income, but only if gifts and bequests are included in the 

tax base of the donor as well as the recipient. 

The consumed income tax can be viewed as more equitable than an 

income tax from the perspective of the lifetime. Under certain 

circumstances, including a constant tax rate over the lifetime of the 

taxpayer, the value of taxes paid under a consumed income tax does not 

depend on when a person consumes or receives earnings. By comparison, 

an income tax levies higher taxes on individuals who earn income at a 

relatively early age or spend it at a relatively older age. 

Finally, some advocates of a tax on consumed income believe it is 

more equitable because individuals should be taxed on "what they take 

out of the pot" (consumption) rather than "what they put into it" 

(income). Since this position basically involves philosophical 

judgments, it is inherently inconclusive. 

111. Disadvantages of a Consumed Income Tax 

Although the advantages of a tax on consumed income are numerous, 

the Treasury Department believes they are outweighed by a number of 

serious administrative, economic, and equity disadvantages. These 

include increased complexity for individual taxpayers, higher marginal 

tax rates, serious compliance problems, perceived unfairness, and a 

lengthy transition period with complicated treatment of existing 

wealth. Again, the relative advantages and disadvantages of a compre 

hensive consumed income tax must be compared to those of a broad-base 

income tax, not just to the current income tax system. 

A. Administrative Disadvantages 

A consumed income tax would be simpler for business and for 

taxpayers with much capital income. However, it would probably be 

more complicated for the average individual taxpayer. The elements of 

a consumed income tax required to separate saving from consumption 

would be unfamiliar and complex. In addition, increased compliance 

difficulties, troublesome international issues, and potential constitutional 

challenges are unique to a consumed income tax. 

1. Complexity for average taxpayers. under a consumed income tax, 

problems of measuring the tax base for individuals would be different,

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rather than eliminated. For the family of a typical wage earner, the 

problems of measuring capital income that a consumption tax avoids are 

of little concern. Such a family's tax picture would be complicated 

by the addition to the tax base of borrowing and savings account 

withdrawals. Also, taxpayers would confront a more elaborate tax 

administration system, with "qualified accounts" for all financial 

transactions, and the possibility of withholding on borrowing, on 

withdrawals of savings, as well as negative withholding on deposits in 

qualified accounts. 

Borrowing. Most families would have to keep track of their net 

borrowing under a consumed income tax. In addition to reporting their 

wage income, they would have to report any new borrowing and any 

repayments of prior borrowing. Taxpayers would find it hard to 

understand why all borrowing -- including consumer loans, credit card 

debt, and business loans -- would be part of the tax base, Unlike the 

present income tax, with its deduction of gross additions to Ims, a 

consumed income tax would allow a deduction only for net saving, that 

is, increases in saving in excess of increases in debt. Conversely, 

any increases in debt in excess of the increase in saving would be 

included in the tax base. 

Qualified financial accounts. The requirement that almost all 

financial transactions be conducted throuqh qualified accounts would 

reduce a taxpayer's financial flexibility-and ability to maintain the 

privacy of his or her financial affairs. Taxpayers would have to 

learn to think of amounts accumulated in a qualified account as pre- 

tax funds. The amount of consumption a given amount of saving could 

buy would be less than the amount accumulated, since taxes would have 

to be paid on any net withdrawal from an account. The same is true of 

existing state sales taxes, but not of the current income tax. 

Treatment of personal-use assets. The tax treatment of housing, 

autos, other consumer durables, and "collectibles" like art and 

antiques is an important and difficult issue under a consumed income 

tax. These items have both consumption and investment characteristics 

since they provide consumption services over a number of years. 

Treating them like ordinary consumer goods by including the full 

purchase price in the tax base overstates the taxpayer's consumption 

that year. However, there are no annual monetary payments, like lease 

payments paid by a renter, associated with these goods to indicate the 

amount of annual consumption services. 

Treating personal assets like ordinary investments, on the other 

hand, understates the taxpayer's consumption. Owner-occupied housing 

and pieces of art provide good examples of this. Suppose an indi 

vidual buys a house or painting for $100,000 and sells it for the same 

price three years later. If the purchase is treated as an investment, 

an individual would be able to deduct the purchase price of $100,000 

and then include the resale price of $100,000 in taxable income. In 

this example the taxpayer has no net tax liability (indeed he 

postpones tax for three years). Yet the house or art has provided 

consumption benefits while used by the taxpayer. If the purchase

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price were deductible, the ownership and use of a car that was bought 

for $10,000 and sold three years later for $4,000 would actually 

reduce tax liability, thus subsidizing the consumption services 

provided by the personal asset. 

One compromise way to treat personal use assets would require 

consumers to include the full purchase price of certain major consumer 

assets in the tax base but allow them to spread out the tax payments 

over a number of years. But averaging is notoriously complicated 

anytime there is a change in the taxpaying unit, such as through 

marriage, death, or divorce. Alternatively, purchases of a limited 

group of consumer durables, perhaps only housing, could be made out of 

non-qualified accounts; the proceeds of loans from such accounts would 

not be included in the tax base, and deposits and repayment of loan 

principal and interest would not be deductible. Under certain circumstances, 

this treatment would be equivalent to the qualified account 

approach in ternis of present value of tax liability. However, the 

simultaneous use of qualified accounts for certain transactions and 

non-qualified accounts for others increases complexity and the 

potential for tax avoidance. In addition, this treatment raises 

questions about the proper treatment of extraordinary gains realized 

upon disposition of the asset. 

Extended withholdinq. Under the present system of withholding, 

most taxpayers experience little net tax liability at the end of the 

year. Relatively few taxpayers are required to file statements of 

estimated tax and make quarterly payments of tax. Even with itemized 

deductions, most taxpayers can adjust withholding to achieve a satis 

factory degree of similarity between total amounts withheld and 

ultimate tax liability. Those who file estimated returns generally 

have substantial non-labor income that is not subject to withholding 

and are more able to cope with the complexities of filing an estimated 

return. 

The situation is potentially quite different under a tax on 

consumed income. Withholding applied only to income would frequently 

produce a poor approximation of ultimate tax liability if the tax base 

were consumption, rather than income. With withholding on consumed 

income, most taxpayers would have to become more actively and 

frequently involved in determining their withholding, guessing and 

revising their expected consumption several times a year. In the 

absence of a system of withholding on loans and withdrawals, any major 

purchase, such as that of a vacation or an automobile, could result in 

a substantial underpayment of tax. Consumer loans or withdrawals 

taken out near the end of a year might be particularly troublesome, 

since they could not easily be reflected in withholding, unless 

anticipated earlier. For example, loans taken out to finance 

Christmas presents might unexpectedly increase tax liability for many 

taxpayers. Year-end contributions to savings accounts may also not be 

reflected in withholding during the year. But these are likely to be 

welcome, because they result in reduced tax liability or even a 

refund, rather than increased tax.

- 203 - 

Both taxpayer convenience and protection of revenues might dictate 

that a system of universal withholding be applied to all loans, 

withdrawals, deposits, and repayments. This prospect raises several 

problems. Under a graduated tax schedule, the lender would not know 

the correct rate at which to withhold, so that withholding would have 

to be at a flat rate. With a simplified rate structure, this might 

not appear to be problematic, since most taxpayers would be subject to 

tax at the same marginal rate. However, it would overwithhold low 

consumption taxpayers and underwithhold large consumers. In addition, 

withholding on loans and repayments would logically be coupled with 

negative withholding on saving: for a $5,000 deposit, the bank would 

credit $6,000 (at a 20 percent withholding rate). At a minimum, this 

would be complex and confusing to taxpayers. 

2. Compliance. With consumption defined as income minus net 

saving, a tax on consumed income would entail many of the compliance 

problems of an income tax -- plus additional difficulties of monitoring 

saving and dissaving. While taxpayers would have an incentive 

to report all the deductions for saving and investment to which they 

are entitled, they would have an incentive for riot reporting withdrawals 

or borrowing. Consequently, qualified accounts could only be 

established in institutions that could provide reliable and accurate 

reporting. 

Tax evasion would be more rewarding and consequently more tempting 

with a tax on consumed income. In this case, evasion would involve 

not reporting or erroneously deducting the full principal plus 

earnings on capital transactions, rather than just the earnings. The 

IRS estimates that 40 percent of capital gain transactions are not 

reported. This is serious enough under current law, where only the 

gains are taxed, and at preferential rates. It would be much more 

serious under a tax on consumed income, where the entire proceeds of a 

sale, not just the gain, would be taxable (unless reinvested) and at 

ordinary rates. Compliance with a consumed income tax would therefore 

require a more extensive system of information reporting and monitoring 

than does an income tax. 

To prevent legal "gaming of the system" and illegal tax evasion, a 

number of comprehensive, and possibly complex enforcement procedures 

would be necessary. These would go beyond third-party information 

reporting that would be useful under an income tax. They might 

include a comprehensive inventory of all existing wealth upon enact 

ment of the tax, registration of private borrowing, and a far-reaching 

system of exchange controls to facilitate policing of foreign 

transactions. 

3. Constitutionality. The Sixteenth Amendment of the U.S. 

Constitution empowers the Federal Government ' I . . . to lay and collect 

taxes on incomes, from whatever source derived . . . . ' I Experience 

suggests that the Sixteenth Amendment would not prevent taxation from 

being limited to income that is consumed. After all, many forms of 

saving now effectively result in tax exemption. Nor does there appear 

to be any problem in taxing dissaving of amounts that have previously

- 204 - 

benefitted from tax exemption or deferral, such as qualified pension 

accounts, individual retirement accounts, or Keogh plans; this is also 

a feature of current law. But the tax on consumed income goes beyond 

the deduction for saving, deferral of tax on interest, and inclusion 

of dissaving in the tax base. It includes borrowing in the tax base, 

even for taxpayers who have no income. Although a consumed income tax 

is not likely to be found unconstitutional, there is little doubt that 

the constitutionality of a tax on consumed income would be challenged 

on the ground that the Sixteenth Amendment does not allow imposition 

of a direct tax on amourits borrowed. Such a challenge might impair 

administration of the tax pending resolution of the dispute in the 

courts. 

4. International issues. A shift by the U.S. to a consumed income 

tax would at best be disruptive of international relatipns, would 

increase the opportunities to use foreign transactions to avoid or 

evade U.S. taxes, and would provide tax incentives for immigration and 

emigration. 

The U.S. tax in the world economy, Under current law, U.S. citizens, 

residents, and corporations are taxed on their worldwide income, 

with credit for foreign income taxes paid. Nonresident aliens and 

foreign corporations are generally taxed on their U.S. source income. 

It would be impossible to require all international savings transactions 

to flow through U.S. qualified accounts. Therefore, a shift 

to a consumed income tax would apply only to U.S. residents; for them 

the tax base would be worldwide consumption. A deduction for foreign 

income taxes paid could be allowed; however, it would be difficult to 

devise a workable foreign tax credit. For nonresidents (citizens and 

noncitizens alike), the tax base would continue to be income -- income 

from U.S. sources (which would be a change for nonresident citizens). 

The corporate income tax could be eliminated for both domestic and 

foreign corporations, though retaining it during a transition period 

would help phase out the foreign tax credit. In order to tax the 

corporate income of nonresident investors, "withholding-at-source" 

taxes on their dividends and interest could be raised; taxing their 

share of earnings retained by U.S. corporations would be more 

problematical. 

Eliminating the corporate income tax and replacing the foreign tax 

credit with a deduction would increase the attraction of U.S. investment, 

relative to investments elsewhere, for domestic and some foreign 

businesses. Other nations might object to the resulting capital 

outflow. In addition, after the many years that the U.S. has had a 

foreign tax credit and advocated it as a mechanism for relieving 

double taxation and achieving "capital export neutrality," other 

nations might protest the replacement of the credit with a deduction 

as a breach of a longstanding commitment. In many cases, such a 

change would require overriding an existing U.S. tax treaty with the 

other country. 

Compliance. Detecting foreign borrowing and receipts from foreign 

corporations raises compliance problems for a consumed income tax that

- 205 - 

are more serious than under an income tax. U.S. residents could 

borrow abroad and then "save" the unreported foreign borrowing in a 

domestic qualified account, thereby lowering current year taxes by 

taking a deduction for the "saving". This would not necessarily 

reduce the present value of their tax liability, since they would not 

be able to deduct future repayments on the loan. (If such repayments 

were deductible at lower rates, taxes would be reduced.) It may, 

however, be viewed as inequitable to allow those taxpayers with access 

to foreign lenders to juggle the timing, if not the present value, of 

their tax liability. Futhermore, the proper timing of foreign loans 

and U.S. deposits would enable the taxpayer to reduce somewhat the 

present value of the tax liability, as long as there were no withholding 

on the loan. Allowing deductions for investments in foreign 

business that the U.S. could not monitor would enable taxpayers to 

consume the return and repayment of those investments tax free. 

Solutions could be devised to stop this type of abuse. They would 

require, however, a great deal of added complexity, either by tracing 

funds flowing into and out of the U.S., or disallowing deductions for 

investments in countries with which the U.S. does not have effective 

exchange of information arrangements. 

Emisration and immigration. A pioneering shift by the U.S. to a 

consumed income tax would also encourage individuals to emigrate to 

avoid 1J.S taxes in times of high consumption, such as retirement. 

Exit taxes and an expansive definition of residence could moderate 

this tendency, although again at the cost of increased complexity. 

Immigrants would also be required to include in their receipts assets 

brought into the country to prevent them from sheltering 1J.S. consumption. 

These twin issues of immigration and emigration have not 

weighed heavily in U.S. debates on the consumed income tax, but 

several European nations have considered them major obstacles. 

8. Economic Disadvantages 

All tax systems distort some form of economic behavior -- consumption 

choices, the work-leisure tradeoff, the consumption-saving tradeoff, 

financing decisions, production decisions, and the decision to 

comply with or evade taxes. The types of decisions affected depend on 

the transactions included in the tax base. Both a comprehensive 

consumed income tax and a broad-base income tax would reduce many of 

the economic distortions in current law by lowering marginal tax rates 

and treating all sources and uses of income more consistently. 

One of the advantages of a consumed income tax, under certain 

circumstances, is neutrality with respect to the consumption-saving 

tradeoff. However, in order to achieve this neutrality while 

financing a given level of Federal Government services, the exclusion 

of net savings from the tax base requires higher marginal tax rates on 

the remaining taxable items. Higher marginal tax rates increase the 

efficiency losses from the remaining distortions in the tax system. 

1. Higher marginal tax rates on wages. As noted above, marginal 

tax rates on wage income would be higher under a consumed income tax

- 206 - 

since capital income would effectively be excluded from the tax base, 

As a result, the consumed income tax would discourage work effort more 

than would a broad-base income tax applied to both capital and labor 

income. The work disincentive would fall hardest on second workers. 

The higher marginal tax rate might encourage more non-market activity 

or underground economy activity that is not subject to tax, further 

narrowing the base for a consumed income tax. 

2. Tax preferences under a consumed income tax. Much of the discussion 

of consumed income taxes has implicitly been overly optimistic 

about the possibilities of the repeal of all tax preferences and the 

complete neutrality toward saving that consumption tax treatment would 

imply. 

Under a consumed income tax, the effective tax rate applied to 

income from capital would be zero only if no form of capital income 

benefitted from preferential tax treatment. But historical experience 

in the united States suggests that zero would only be an upper bound 

on the taxation of capital income under a consumption tax. 

Under an ideal consumed income tax all interest income would be 

exempt until consumed. In such a system state and local securities 

would lose their tax advantage over other investments. If political 

forces succeeded in maintaining the existing differential between the 

treatment of interest from state and local bonds and other forms of 

investment income, it would be necessary to pay a Federal subsidy on 

interest from such bonds. Similarly, if it were desired to continue 

preferential tax treatment for housing, energy or other natural 

resources, research and developmenc, or any of the many other forms of 

investment that now benefit from preferential treatment, it would be 

necessary to extend to those activities a negative effective tax rate. 

To provide any preferential treatment of particular investments 

through the tax Code, legal tax shelters would have to be permitted, 

with the resulting economic distortions and perception of unfairness. 

Negative effective tax rates would perpetuate the type of distorting 

effect that the present tax system has on the allocation of resources. 

As under current law, the investment projects that were the most 

productive for the economy would not necessarily provide the most 

attractive after-tax yield. This differential would lead resources to 

flow to less productive uses, preventing the economy from reaching its 

maximum level of output and growth. 

Even if preferential tax treatment is not accorded to particular 

investments, a consumed income tax with graduated rates and a tax 

threshold may reduce the effective tax rate on some saving below zero. 

This is inherent in the typical pattern of lifetime saving and consumption. 

(See Figure 9-1.) Most saving occurs during middle age 

(during working and child-raising years) at the same time when family 

consumption is highest and thus marginal tax rates are highest. 

Dissaving and borrowing occur during periods when consumption is lower 

and thus when marginal tax rates are lower. Therefore, the present 

value of the tax deduction of savings (and repayment of debt) would 

possibly be greater than the present value of the tax liability on

- 207 - 

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- 208 - 

borrowing and dissaving for some taxpayers. The tax system would 

actually subsidize saving, paying people to save at the cost of higher 

taxes and tax rates on labor income. This problem might be reduced in 

a system with relatively wide tax brackets. 

3. Corporate taxes under a consumed income tax. One of the 

advantases of a consumed income tax is that reveal of the corvorate 

income fax would obviate the need for a complicated scheme ofintegrating 

the corporate and individual income tax systems. Because 

investment income would not be subject to tax until consumed, there is 

no theoretical justification for a corporate income tax under a 

consumed income tax. As discussed above, there are other reasons, 

however, why the corporate income tax might be retained with a 

consumed income tax. If the corporate income tax were retained, the 

mechanism by which capital income is exempted from tax would pose 

significant problems. 

Under a consumed income tax, all purchases of capital investments 

are deducted immediately (expensed). The large upfront deductions of 

investment would offset income earned, and in many cases would be 

larger than needed to simply offset all tax liability. Any business 

that grows fast enough or is less profitable than average would owe no 

Federal income tax liability. Only firms that grow relatively slowly 

or have above average profitability would pay corporate tax. This 

result would cause the fairness of the tax to be questioned. 

The tax system is not likely to allow for full benefit of tax 

deductions via refunds of excess deductions, due to serious perception 

problems. In order for firms to utilize excess deductions, there 

would need to be generous carryover rules with payment of interest by 

the Federal Government on such "losses". Otherwise -- and perhaps 

even then -- companies would find it attractive to merge with, or 

acquire other firms to create a new form of tax shelter. This tax 

incentive can be expected to distort managerial decisions on firm 

size, ownership, and product mix, as well as increase industrial 

concentration and reduce competition. 

4. Government as business partner. The deduction for saving and 

investment has the effect of making the government a "silent partner" 

in the investment. With a 20 percent tax rate, a person or corporation 

would only have to save $4,000 to invest $5,000; the government 

provides the other $1,000 through lower taxes. Only if the investment 

is successful will the government get its money back when the investor 

decides to use the profits to finance consumption. If the investment 

fails, the government would lose its investment. Having the government 

as a partner may influence investors' choices of risk. They may 

be less cautious in risking losses since some of the money at stake is 

not their own, but they may also be less adventuresome in seeking high 

returns since they have to share the proceeds with the government.

- 209 - 

Any tax system which is based on voluntary compliance must be 

perceived as fair and equitable. Although theoretical arguments can 

be made about the fairness of a consumed income tax over the lifetime 

of taxpayers (always subject to various assumptions), the public 

perception of fairness is likely to be judged annually at the time of 

payment of tax, rather than over the individual's entire lifetime. 

1. Perception of lifetime fairness. Many taxpayers borrow when 

they are young and establishing families and most draw down accumula 

ted-savings (dissave) during retirement. During middle age, peop1.e 

save to retire previous indebtedness and accumulate wealth with which 

to finance retirement. Under the current tax on annual income, most 

families pay relatively little tax when they are young and have low 

incomes and again when they are old and retired and drawing down 

accumulated wealth; by comparison, they pay relatively mor'e tax during 

middle age. Under the consumed income tax there would be a shift in 

tax liability toward periods of borrowing and dissaving and away from 

periods of saving and repayment of debt. Thus, although similar in 

present value terms, taxes would be higher during early adulthood and 

retirement than under the income tax; similarly, during middle age 

taxes would be lower than under the annual income tax. Though an 

economic argument can be made that this pattern of tax payments is 

more neutral and more equitable than that under the income tax, it 

seems unlikely that this would be the public perception. 

2. Perception of fairness between rich and poor. There is a 

general presumption that all taxes on consumption must be regressive, 

because consumption falls as a percentage of income as income rises. 

While this presumption is generally accurate for consumption taxes 

based on transactions, such as a value-added tax or retail sales tax, 

it need not be accurate for a personal tax on consumed income. A tax 

on consumed income can be made progressive by allowing personal 

exemptions, a zero-bracket amount, and graduated rates. 

The ultimate judgement on the fairness of the income tax relative 

to a tax on consumed income comes down to a subjective choice between 

income and consumption as the more appropriate standard for measuring 

both economic equals and economic inequality for tax purposes. If the 

accumulation of wealth has value beyond the consumption that it can 

buy -- if it confers power, prestige, or peace of mind -- then annual 

consumption does not measure equals. In that case, a consumed income 

tax would unavoidably be unfair even if it assessed the same tax on 

all individuals with the same lifetime income. 

A distinction is sometimes made between wealth that individuals 

accumulate during their lifetimes as a result of their own energies, 

and wealth that is inherited from previous generations. The treatment 

of gifts and bequests under a consumed income tax then becomes an 

important factor in judging the overall fairness of the system.

- 210 - 

Indeed some supporters of a consumed income tax consider such a tax 

equitable only if gifts and bequests are taxed to both the donor and 

the beneficiary. 

D. Transition Problems 

One of the most serious obstacles to adoption of a consumed income 

tax is the treatment of existing wealth. Movement to a tax on 

consumed income raises special transition issues beyond those that 

result from any broad-based tax reform. The unique issues involve how 

consumption out of wealth accumulated under the current income tax 

("old wealth") should be treated, and how repayment of debt incurred 

under the current system ("old debt") should be treated. 

There are three possible approaches to these issues, each of which 

has significant drawbacks. 

Taxing old wealth. First, all old wealth could be subject to tax 

when consumed. With no special transitior. rules, old wealth would be 

treated the same as newly accumulated wealth. Taxing old wealth (and 

deducting repayment of old loans) would broaden the tax base immedi 

ately, and thus permit low tax rates, but it would be an inequitable 

approach to transition and fraught with compliance problems. 

All wealth existing on the effective date of the new tax would 

have to be registered and considered to be in qualified accounts. 

Taxpayers would have a clear incentive to understate assets. This 

could be done most easily by converting them to cash or balances held 

abroad. Such assets could then be fed back into the system as saving 

or used for tax-free consumption. Though this problem would be 

temporary, until all hidden assets had been revealed, the revenue loss 

and inequities it would produce would be enormous. To prevent 

hoarding of cash, it might be necessary to introduce a new system of 

money on the effective date of the consumed income tax. To prevent 

hoarding in foreign accounts, even more far-ranging steps, possibly 

including foreign exchange controls, would be necessary. 

Individuals consuming out of old wealth would generally be taxed 

twice: Once when they had saved under the income tax out of after-tax 

dollars, and then again when they consume under the new tax on 

consumed income. This would be particularly difficult for the elderly 

because many would have saved without counting on a second tax on 

their consumed income. Conversely, issuers of old debt would receive 

a windfall gain. They would deduct interest and repayments o f 

principal, even though the loan was never included in their tax base. 

Special relief could be provided to older taxpayers, but only by 

complicating the system considerably. The practical difficulties of 

wealth inventory at the beginning of the new tax system and the 

extreme inequities of taxing old wealth and subsidizing old debt make 

this approach infeasible. 

Exempting old wealth. Second, all old wealth could be exempt from 

the new tax. If all wealth owned on the day the consumed income tax

- 211 - 

became effective were considered to be in nonqualifed accounts, then 

these savings would not be subject to tax when used for consumption, 

and double taxation would not be a problem. This approach, however, 

would allow wealthy holders of old wealth to eliminate all tax lia 

bility for years into the future (perhaps generations) simply by 

shifting assets from nonqualified accounts to deductible qualified 

accounts, thereby reducing their tax liability. Separate accounting 

for old and new wealth would greatly complicate comp1,iance and admini 

stration. The reduction in the tax base would necessitate such high 

marginal tax rates on the remaining tax base that any efficiency gains 

from a consumed income tax would be postponed for decades. 

Partial exclusion of old wealth. A middle ground solution would 

be essential, in which taxpayers were allowed some minimal amount of 

tax-free consumption from accumulated wealth. One possible approach 

to reduce windfall gains and losses would be to allow a limited amount 

of old wealth accumulated out of after-tax income to buy tax-free 

consumption, but to allow a deduction only for new saving (not for 

repayment of debt). Windfall gains and double taxation of existing 

wealth would be reduced, but not eliminated. Distinguishing between 

old and new saving would be difficult and would require complex rules, 

such as those required to determine what portion of the trillions of 

dollars worth of existing land, housing, stocks, and other forms of 

wealth was purchased out of after-tax income. MOreOVer, 1,imitations 

on tax-exempt consumption would be difficult to monitor and to 

administer when the taxpaying unit changes. At the very least, such a 

partial exclusion of consumption would complicate tax compliance and 

administration for nearly a generation. 

Iv. 

Conclusions 

The tax on consumed income has considerable attraction. Partic 

ularly important is the fact that under the consumed income tax the 

most vexing problems in the measurement of income from business and 

capital that plague the current income tax simply do not exist. By 

comparison, the oft-repeated economic advantages of neutrality toward 

saving and of equity from a lifetime perspective appear to be 

secondary. 

The disadvantages of a consumed income tax appear to outweigh 

these advantages. First, the advantages are purchased at the cost of 

excluding all capital income from tax, a policy that is questionable 

on equity grounds. Moreover, exempting capital income from tax as a 

matter of course implies that certain activities can be accorded 

preferential treatment only by taxing them at negative effective tax 

rates. The implications of negative tax rates for the misallocation 

of the nation's capital stock are striking, indeed. 

Second, the first nation to implement a tax on consumed income 

will find itself totally out of step with the international 

conventions for the taxation of multinational business.

-- 212 - 

Third, while a consumed income tax would be simpler for business, 

it would probably not be simpler for most individuals. Withholding 

would probably be Less accurate and more taxpayers would be required 

to file estimated taxes, 

Fourth, the transition to a tax on consumed income raises 

especially troublesome problems. It would not be satisfactory either 

to tax all consumption out of previously accumulated wealth or to 

exempt all such consumption. But any system of partial exemption 

would cause considerable complexity for a generation of taxpayers. A 

different type of transition problem involves the possibility of preeffective 

date hoarding to avoid paying tax on consumption. 

Fifth, advocates of a tax on consumed income do not agree on the 

proper tax treatment of gifts or bequests. Some would support a 

consumed income tax only if gifts and bequests were treated as taxable 

consumption of the donor; others would strenuously oppose taxing these 

transfers to the transferror. The implications for the pattern of tax 

burdens on wealthy individuals are quite profound. 

All things considered, the Treasury Department has decided against 

proposing a tax on consumed income and in favor of a modified flat tax 

on income.

I. Introduction 

- 213 - 

Chapter 10 

VALUE-ADDED TAX AND RETAIL SALES TAX 

In addition to the income tax reforms described above, the 

Treasury Department also considered a different option, the imposition 

of a national sales tax. This chapter describes the types of sales 

taxes considered and their advantages and disadvantages, with emphasis 

on their economic effects. Volume I11 of the Tax Reform Report discusses 

these issues in much greater detail, focusing on the valueadded 

tax. This is the form of sales tax that would be most appropriate 

for use at the Federal level, if a decision was ever made in favor 

of a national sales tax. 

11. Alternative Forms of Sales Taxation 

Sales taxes may be single stage in nature, applying to only one 

stage in the production or distribution process, such as a retail or 

manufacturers tax, or to all stages, such as a value-added tax. only 

two types of general sales tax deserve serious consideration for adoption 

by the Federal Government, a retail sales tax and a value-added 

tax extending through the retail. level. Sales taxes that do not 

include the retail level, such as a manufacturers or wholesale tax or 

a value-added tax that stopped at the wholesale level, are inferior 

alternatives and should not be considered for the United States. 

A. Retail Sales Tax 

Forty-five of the states, the District of Columbia, and many local 

governments have a retail sales tax, a single-stage tax that applies 

to all sales to final consumers, not just those made by retailers. A 

retail sales tax is levied on all final or retail sales of goods and 

services except those that are exempt from tax. More than one half of 

the states, for example, exempt food consumed at home for distribu 

tional reasons. Most services are not taxed, except in a few states, 

partly to achieve social objectives and partly for administrative 

reasons. Many, but not all, sales to business firms are exempt. This 

exemption is achieved by allowing firms to make tax-free purchases of 

various categories of goods, such as those purchased for resale, or by 

exempting certain items commonly bought only by businesses, such as 

equipment and machinery. The exemption of business purchases is 

necessary to prevent a product, or inputs into its production, from 

being taxed more than once as it moves through the production-distri 

bution process. Exports (other than those made directly by foreign 

tourists in the united States) are not taxed under a retail sales tax, 

but imported goods are taxed when sold at retail in a state with a 

sales tax. 

459-370 0 - 84 - 9

- 214 - 

The operation of a 5 percent retail sales tax is illustrated in 

the simple two-stage example in Table 1. It is assumed that a winery 

grows its own grapes, makes no purchases of produced goods from other 

firms, and makes no retail sales, but sells $200 worth of wine to a 

grocery store. The grocer sells the wines purchased from the winery 

to households for $300. With a retail sales tax, no tax would apply 

on the sales by the winery to the grocer because these are not retail 

sales; since the wine purchased is for resale, the grocer is registered 

to make tax-free purchases. But the grocer would collect $15 on 

his retail sales of $300. (See line d.) 

Compared to a tax with numerous exceptions and exclusions, a 

broad-based retail sales tax would be less likely to interfere with 

decisions by individuals and business firms on what to consume and 

what to produce and would be easier to administer. Ideally, a comprehensive 

retail sales tax would apply to all consumpti’on expenditures. 

For 1988, the projected level of total personal consumption 

expenditures is about $3,100 billion and each percentage point of a 

tax levied on this total would therefore yield about $31 billion. In 

fact, any realistic sales tax base would probably be well below this, 

because of the difficulty or inadvisability of taxing certain types of 

consumer expenditures. As explained below, a more realistic, but 

comprehensive base would base be about $2,400 billion. 

8. Value-Added Tax 

Though the value-added tax is unfamiliar to most Americans, it is 

imposed throughout much of the rest of the world. A value-added tax 

that extends through the retail level is levied on each firm in the 

production and distribution chain, from the extraction of raw materials 

through the manufacturing and distribution processes, to the 

last sale to final customers. Thus, under a comprehensive value-added 

tax, all businesses, not just those that sell at retail, would pay tax 

on their sales. An important characteristic of a value-added tax is 

that tax is applied only to the value added by the firm, that is, to 

the excess of its sales over its purchases of goods from other business 

firms. A value-added tax is usually collected by the tax credit 

method; each firm applies the tax rate t o its taxable sales, but is 

allowed a credit for value-added tax paid on its purchases of goods 

and services for business use, including the tax paid on purchases of 

capital equipment under a consumption-type value-added tax. As a 

result, the only tax for which no credit would be allowed would be 

that collected on sales made to households, rather than to businesses. 

Since the sum of the values added at all stages in the production and 

distribution of a good are equal to the retail selling price of the 

good, the revenue base of a retail sales tax and a value-added tax 

with the same coverage are theoretically identical, and a given tax 

rate will yield the same amount of tax revenue under either approach. 

Thus, despite its multistage character, a value-added tax is very much 

like a retail sales tax in that it is a tax on expenditures by consumers.

- 215 - 

Table 10-1 

ILLUSTRATION OF A RETAIL SALES TAX 

AND A VALUE-ADDED TAX 

(Tax Rate is 5 Percent) 

Assumed Facts Winery 

Grocery 

Store Total 

a. Sales 200 300 ** 

b. Purchases 0 200 ** 

c. Value added (a-b) 200 100 ** 

Calculation of Retail Sales Tax 

d. Tax (5% of a, for grocer only) * 15 15 

Calculation of Value-Added Tax 

e. Tax on sales (5% of a) 10 15 ** 

f. Credit for tax on purchases 

(5% of b) 

0 10 ** 

g. Net tax (e-f) 10 5 15 

* Retail sales tax is collected only on retail sales by grocer; it 

is not levied on sales by the winery. 

** Not relevant for illustration.

- 216 - 

The value-added tax can also be illustrated using the simple 

example in Table 1. Both the winery and the grocery store would collect 

the 5 percent tax on their sales ($10 and $15, respectively, on 

sales of $200 and $300), and both would be allowed a credit for tax 

paid on business purchases. In this example, the winery has no purchases 

from other firms and thus no credit for tax paid, but the 

grocer is allowed a credit for the $10 in tax collected by the winery 

on sales to the grocer. Since the tax is on final consumers, no 

credit is allowed for the $15 of tax collected on the grocer's sales 

to households. As with a retail sales tax, value-added tax would not 

be charged on export sales, but it would apply to imports. 

This illustration reveals a key characteristic of the value-added 

tax: it is simply an alternative means of collecting a tax that has 

ultimate effects quite similar to those of a retail sales tax. This 

point is further illustrated in the example of Table 1 by noting that 

the total amount of tax collected from the winery and the grocer under 

the value-added tax, $15 (see the "total" column in line g), is the 

same as that collected from the grocer alone under a retail sales tax 

(see line d). Consideration of more detailed examples involving imports, 

exports, capital goods, intermediate goods, and more complex 

processes of production and distribution does not seriously alter this 

fundamental conceptual equivalence between an ideal retail sales tax 

and a value-added tax of the type most likely to be imposed in the 

United States. 

This similarity between the two taxes greatly simplifies the task 

of Americans trying to understand and assess the advantages and disad 

vantages of the unfamiliar value-added tax. For most purposes, one 

can simply consider the pros and cons of a "sales tax," without asking 

whether the tax is to be implemented as a retail tax or as a value- 

added tax. Only if it is decided that a Federal sales tax may be 

desirable must attention turn to more detailed consideration of the 

differences in the way the two taxes are administered and to the eco 

nomic effects created by those administrative differences. These dif 

ferences are considered briefly below and in greater detail in Volume 

111. 

C. Advantages of uniform Rates 

To avoid unintended distortions in consumer behavior, a sales tax 

should constitute a uniform percentage of all consumption expenditures. 

This objective can be best achieved with a broad-based retail 

sales or value-added tax imposed at a single rate. Still, the experience 

of the states with the retail sales tax and of European countries 

with the value-added tax shows that it may be necessary to exclude 

some goods or services from the tax base for distributional reasons or 

to help achieve social objectives. For example, exclusion of food or 

medical care may be deemed necessary to avoid imposing an undue burden 

on those below the poverty level, and education and religious activities 

may be excluded from taxation as a way of encouraging these 

activities. Any exclusions from the tax base, however, should be kept

- 217 - 

to a minimum and should be solidly justified on the basis of distribu 

tional, social, or administrative necessity. Apart from the exclu 

sions that are necessary to achieve these goals, there should be only 

one rate of tax, and it should be applied to a comprehensive tax base. 

There are both administrative and economic reasons for this judgment. 

First, differences in rates impose on business firms and their 

employees the necessity to know which rate to apply to any given item 

and the obligation to make the proper distinction as sales are made. 

If orange juice, for example, is tax free, but juice substitutes are 

taxed at the standard rate, and orange soda is taxed at a higher 

luxury rate, then each grocery store clerk must know which rate to 

apply to these different products. Distinctions of this type also 

greatly complicate tax administration, since it is necessary for 

auditors to verify the rates reported on various sales. 

The use of multiple or differential rates also interferes with tax 

neutrality by distorting consumer choices away from highly taxed items 

and toward lightly taxed ones. The end result is reduced consumer 

satisfaction and a less efficient use of the economy's resources. 

This is why it would be preferable not to exclude food from the tax 

base, if there is an acceptable and effective alternative for reducing 

the sales tax burden on the poor. For the same reasons, services, as 

well as goods, should be subject to tax. The failure to tax expendi 

tures on services favors those persons with relatively strong pref 

erences for services and distorts consumption away from commodities 

and toward services. Moreover, if services are not taxed, the tax 

rates on taxable sales or on income must be higher than otherwise in 

order to raise a given amount of revenue, thereby creating further 

distortions and disincentives. 

Nor should higher rates be applied to "luxuries" or to goods 

deemed not to be necessities in an effort to increase the progressivity 

of the tax system. Doing so distorts consumption decisions and 

creates difficulties in complying with the tax and in administering 

it. Moreover, it is unnecessary. Given the existence of a progressive 

individual income tax, it is far easier to increase progressivity, 

if that is the goal, by adjusting the structure of income tax 

rates. 

D. Sales Taxes Unworthy of Consideration 

The retail sales tax and a value-added tax extending through the 

retail level are the only types of sales tax that should be considered 

for adoption by the United States. Thus, even if a Federal sales tax 

is thought useful, the United States should categori,callyreject: a 

single-stage tax levied before the retail level, such as a manufactur 

ers or wholesale tax; a value-added tax that does not include the re- 

tail stage; and a multiple-stage "turnover" or cascade tax that allows 

businesses no credit for tax paid on purchases for business use.

- 218 - 

Developing countries view nonretail taxes as attractive since the 

number of taxpayers needs to be kept to a manageable size for administrative 

and enforcement purposes. Moreover, recordkeeping is often 

not adequate to apply a sales tax to the numerous small firms at the 

retail level in developing countries. Instead, these countries may 

simply collect tax at the manufacturing (or import) stage or on wholesale 

sales to retailers. In the United States, in contrast, there is 

no administrative or compliance argument against including the retail 

level in a sales tax; state experience with the retail sales tax amply 

and persuasively demonstrates this. 

There are many economic and administrative disadvantages to 

excluding the retail stage from a sales tax. These can be discussed 

for a single-stage tax that excludes the retail level, though the same 

arguments would apply to a value-added tax that is "truncated" to 

exclude retailing. Such a tax would be equivalent to a single-stage 

tax imposed at the wholesale level. 

Suppose that a major oil company is economically integrated from 

the oil field to the service station, owning oil fields, refineries, a 

wholesale distribution system, and even retail outlets. It would 

clearly be unfair and distortionary to exclude all of the company's 

retail sales from taxation, just because the company sells its own 

products directly to consumers. Rather, to be fair and neutral it 

would be necessary to impute a value to the products at the wholesale 

level in order to achieve parity with those retailers not associated 

with a comparable integrated company. But to assign a value, for tax 

purposes, to "sales" between affiliated enterprises would be administratively 

burdensome, possibly open to abuse, and it would be especially 

difficult in those industries in which products are not 

standardized and in which there are few sales occurring at market 

prices between unrelated parties. 

Even in the absence of any manipulation of imputed prices and the 

administrative effort that would be required to prevent it, omitting 

the retail level from the tax base would create economic distortions 

that would waste resources and favor or penalize both consumers and 

firms in a capricious and haphazard manner that was totally unrelated 

to any policy objective. A retail sales tax or value-added tax that 

extended through the retail level and applied to most goods and services 

would be neutral between types of consumption. By comparison, a 

tax that excluded the retail level would favor products of industries 

with a high percentage of value added at the retail level. That is, 

it would favor products with high retail margins. Services would 

probably be excluded from a nonretail tax because they are inherently 

a retail activity. A nonretail tax would create an incentive to restructure 

business operations to minimize tax liability, basically by 

transferring functions and costs forward beyond the point of impact of 

the tax. In the case of a manufacturers tax, for example, activities 

that might ordinarily be undertaken by a manufacturer and reflected in 

the manufacturer's price, such as advertising and transportation, 

would be spun off to separate subsidiaries beyond the manufacturing 

sector or purchased from unrelated firms in order to keep them out of

- 219 

the tax base. The manufacturing level tax employed by Canada is 

notorious for these types of difficulties and a value-added tax is 

currently under consideration as a replacement. 

A multiple-stage turnover tax is even worse than a single-stage 

tax levied before the retail level. Under such a tax, goods are subject 

to tax each time they are sold. Thus the amount of tax ultimately 

imposed on a given product depends on how many times it has turned 

over (been sold) during the production-distribution process. This 

distorts economic decisions and produces undesirab1,e incentives for 

tax-motivated vertical integration, something a value-added tax avoids 

by allowing a credit for tax paid on all purchases for business use. 

In addition, a turnover tax discriminates against products in which 

value added occurs early in the production-distribution process, much 

as a manufacturers or wholesale tax does. Finally, it is impossible 

to remove a turnover tax from exports precisely, since the amount of 

tax that has been paid on a given product depends on the degree of 

vertical integration and whether value is added early or late in the 

production and distribution chain. For the same reason, it is impossible 

to levy a tax on imports to compensate exactly for taxes paid on 

comparable goods produced domestically. Merely applying the tax to 

the tariff-inclusive value of imports is not sufficient because the 

imported value will not necessarily be the same as the value at which 

the manufacturers or wholesale tax would apply to a domestic good. It 

is for reasons such as these that turnover taxes have long been 

considered unacceptable and that the European countries abandoned the 

turnover tax in favor of the value-added tax when the Common Market 

was established. 

111. Pros and Cons of a National Sales Tax 

A Federal retail sales or value-added tax that included the retail 

level would have both advantages and disadvantages. Since little 

needs to be said in describing the advantages, they are simply listed 

here. The disadvantages are described in greater detail, since they 

are more specific to this particular form of taxation. 

A. Advantages of a Sales Tax 

A national sales tax would have several major advantages that are 

discussed in detail in Volume 111. If it were used to replace part of 

the income tax, a Federal sales tax would allow even lower income tax 

rates. By taking pressure off the definition and measurement of taxable 

income, a sales tax would help reduce income tax avoidance and 

evasion as well as lessen the incentive to shelter income from the 

income tax. Based on consumption, rather than income, a national 

sales tax would not discriminate against saving the way the income tax 

does. Accordingly, it may increase the level of private saving and 

generate a corresponding increase in capital formation and economic 

growth. A broad-based sales tax would almost certainly distort 

economic choices less than the income tax does. In contrast to the 

income tax, it would not discourage capital-intensive methods of 

production or risk taking and it would be neutral with regard to 

--

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consumption behavior, neither encouraging nor discouraging consumption 

of particular goods or services. 

One claim commonly made for a value-added tax, that it would 

improve the competitive position of U.S. products in world markets, is 

generally incorrect. Under international rules, exports may be sold 

free of any sales tax and imports pay the same sales tax as 

domestically-produced goods. Thus, a value-added tax could be rebated 

on goods that are exported; similarly, value-added tax could be 

collected on imported goods, either at the time of importation or at 

the first domestic sale. The refund of taxes on exports and 

collection of tax on imports, known as border tax adjustments, are 

sometimes likened to an export subsidy and import tariff, which, at 

fixed exchange rates, would stimulate exports and discourage imports. 

But these border tax adjustments simply allow U.S. exports to 

occur free of value-added tax; they do not reduce the price at which 

U.S. exports were sold before the tax was imposed, Imposing the tax 

on imports merely places imports on an equal tax footing with domestic 

goods. Thus, by itself, a value-added tax is no more likely than a 

retail sales tax to have favorable effects on international trade. A 

retail sales tax would not apply to exports either, and it would apply 

to retail sales of imported goods. Only if a sales tax replaced part 

of a tax that could not be rebated on exports or collected on imports, 

such as the corporation income tax, would there be reason to expect 

that U.S. products would be more competitive. This would only happen, 

however, if the substitution of a sales tax for the corporate income 

tax did not cause the domestic price level to increase and if exchange 

rates are fixed. 

B. Disadvantages of a Sales Tax 

1. Growth of government. The United States stands almost alone 

among the developed countries of the free world in not levying a national 

sales tax. Virtually all of the members of the European 

Economic Community (EEC) employ a national value-added tax. (Greece, 

which recently joined the Community, is scheduled to adopt a valueadded 

tax on January 1, 1986). 

Of the twenty-three members of the 

Organization for Economic Cooperation and Development (OECD), only two 

countries -- Japan and Turkey -- use neither a value-added tax nor a 

general sales tax. 

The lack of a national sales tax in the United States is reflected 

closely in the percentage of Gross Domestic Product (GDP) devoted to 

public use in the United States and in other countries. In 1982 total 

tax revenues at all levels of government averaged 30.5 percent of GDP 

in the United States. The comparable figure for the EEC countries was 

40.1 percent and for the countries of the OECD, exclusive of the 

United States, it was 37.1 percent. In the United States, sales taxes 

(state and local) took approximately 6 percentage points less of GDP 

than in the EEC and in the OECD (exclusive of the United States). It 

is not only sales taxes that are lower in the United States; corporate 

income and social security taxes also are substantially lower in the

- 221 - 

United States than in many other developed countries. Still, these 

figures suggest that even if a sales tax were initially imposed as a 

partial replacement for the income tax in a revenue-neutral change, 

public spending in the United States would eventually be greater with 

a national sales tax than without one. 

2. Regressivity. A general sales tax is often criticized as unfair 

to lower income individuals and families. There are two aspects 

to this equity argument: the absolute burden of the tax on the lowest 

income groups, and the regressi,vityof the tax or the relatively higher 

burden of the tax at the lower income levels thap at the higher. 

As explained below, there are four alternatives for lessening the 

burden of the tax on the poor. For those individuals and families 

that are above the poverty level of income and thus subject to the 

income tax, the regressivity of a sales tax can be offset through the 

adjustment of income tax rates or through non-refundable credits 

against the income tax. 

3. Effect on prices. Assuming an accommodating monetary policy, a 

sales tax would almost certainly increase the price level by roughly 

the percentage it represents of consumption spending. That is, a 4 

percent sales tax that applied to 75 percent of consumption expenditures 

wouldiincrease the general price level by about 3 percent. 

Although this would be a one-time occurrence, not an annual increase, 

it might cause "ripples" of wage increases, because of cost-of-living 

adjustments! and these could be reflected in further price increases. 

To the extent the sales tax replaced part of the income tax, there 

would be little offsetting reduction in prices or wages. 

4. Administrative costs. Administration of a Federal value-added 

tax would require substantial additional resources. The Internal 

Revenue Service estimates that once the administrative program was 

fully phased in, the annual administrative costs would run about $700 

million (at 1984 prices), or about 0.4 percent of revenues from a 10 

percent broad-based value-added tax. To administer a value-added tax, 

the IRS would require approximately 20,000 additional personnel. 

5. Federal pre-emption. States, and more recently local governments, 

consider the sales tax base their exclusive fiscal domain. 

Federal imposition of a sales tax might reduce somewhat the ability of 

state and local governments to tax that base and would therefore be 

seen by those governments as an unwelcome intrusion. This concern 

could be reduced if Federal adoption of a retail sales tax led to 

increased cooperation between the various levels of governments in tax 

administration and collection. This cooperation would be much easier 

to achieve if the Federal Government adopted a retail sales tax than 

if it adopted a value-added tax. If the state and Federal tax bases 

were identical, state taxes could be collected by the Federal 

Government as it collected its own tax. Of course, a Federal sales 

tax could not simply be collected by the states, because of the 

current differences in state tax bases.

- 222 - 

IV. Relevance of the European Experience 

Though the reasons that motivated the European countries to switch 

to the value-added tax during the late 1960s and the 1970s are largely 

irrelevant for the present debate in the United States, European ex 

perience does contain important lessons for the United States. Before 

adopting the value-added tax, most of the members of the EEC had mul 

tiple-stage turnover taxes of the type described and analyzed above. 

As a result, the switch to the value-added tax represented a rational-. 

ization and clear improvement of the European tax systems, rather than 

the creation of a new source of revenue. The United States, by com 

parison, does not have an inefficient sales tax that needs to be over- 

hauled. 

The European switch to the value-added tax involved a relatively 

minor change in tax administration. Therefore, few additional admin 

istrative resources were required. By comparison, since the United 

States has no Federal sales tax, a substantial increase in IRS admin 

istrative resources would be required to implement a value-added tax. 

Because the European value-added taxes replaced existing sales 

taxes, there was little effect on consumer prices or on the distribu 

tion of tax burdens across income classes. By comparison, an American 

value-added tax would raise prices in the year it was introduced and 

would add a regressive element to the Federal tax system, unless steps 

were taken to reduce the regressivity. 

European experience also indicates that a consumption-type valueadded 

tax, collected by the tax credit method, would be the most 

appropriate type for the United States and that serious administrative, 

compliance, and efficiency problems are involved in the use of 

the tax to achieve non-revenue objectives. That is, multiple rates of 

tax and efforts to favor certain types of consumption by exclusions or 

lower rates involve significant costs and complexities, as well as 

revenue losses. 

V. Tax Ease and Revenue Potential 

Total personal consumption expenditures are estimated to be about 

$3,100 billion in 1988; each percentage point of a value-added tax 

levied on this total would yield $31 billion. In fact, the tax base 

is likely to fall well below total consumption, for a number of reasons. 

Since certain items would be excluded either for distributional 

or administrative reasons, a more realistic, but broad, base would be 

about $2,400 billion in 1988 levels of expenditure. If food consumed 

at home also is excluded, the tax base would fall to $2,000 billion. 

The most important items of personal consumption that are excluded 

from the tax base in arriving at these figures are described briefly 

below and discussed more fully in Volume 111. 

Owner-occupied housing is difficult to tax under any sales tax. 

Ideally, housing services would be taxed over the life of a house, but 

this is clearly impossible because of the difficulty of valuing the

- 223 - 

housing consumed by owner occupants, the value of the so-called "imputed 

rent" or what the house would rent for on the open market. 

Since the "rent" on owner-occupied housing cannot be taxed, it would 

be unfair and distortionary to tax the rents on tenant-occupied residential 

housing. One alternative would be to tax newly-constructed 

housing while excluding the rental value of residential housing from 

the tax base (both tenant- and owner-occupied). This alternaive would 

reduce the base by about $290 billion in 1988. If this approach 

imposes an unacceptable tax burden on housing, another alternative, 

following the practice with state retail sales taxes, would be to tax 

the cost of materials entering into new housing construction, repair, 

an6 alterations. 

A number of other personal consumption items would also probably 

not be included even in the most comprehensive value-added tax base 

for a variety of reasons. Medical care, educational expenses, and 

religious and welfare expenses would probably not be taxed for social 

and distributional reasons. Because of the problems of defining value 

added, it would be difficult to tax certain banking services and 

insurance, and tax could not be collected on the consumption expenditures 

of Americans travelling abroad, but foreigners travelling in 

the United States would pay tax on some items. There also would be 

pressure to exclude urban transit service, which is heavily subsidized. 

Combined with the proposed treatment of housing, exclusion 

of all of these items from the tax base would result in a comprehensive 

value-added tax base of about $2,400 billion, or 77 percent of 

total personal consumption expenditures of $3,100 billion. 

VI. 

Reducing Regressivity 

The most frequent objection to any form of general sales tax is 

its regressivity, and especially the burden it places on families with 

incomes below the poverty level. Regressivity within the portion of 

the population subject to the income tax -- roughly those above the 

poverty level in the present proposals for income tax reform -- can be 

offset by changes in income tax rates or by tax credits; but no adjustment 

of tax rates or non-refundable credits can eliminate the 

sales tax burden on those below the income tax threshold. 

There are four possible approaches to removing the burden of a 

sales tax on low-income households below the income tax threshold. 

First, food for home consumption can be excluded from the tax base. 

This approach is followed in 27 of the state sales taxes. (One state 

uses a lower rate for food.) There are, however, problems with this 

approach. Even though expenditures on food consumed at home are regressive 

(a larger percentage of income being spent on food at low 

income levels than at middle and upper income levels), about 80 

percent of the revenue loss from excluding food from the tax base 

would be from expenditures by those wih incomes above the poverty 

level. Given the administrative and economic advantages of applying 

uniform rates to a comprehensive base, exclusion of food is not a 

desirable way to reduce regressivity.

- 224 - 

A second approach would be to establish a system of refundable 

credits under the income tax to offset the burden of the sales tax on 

the consumption expenditures necessary for a minimum standard of 

living. Though this approach could, in principle, effectively 

eliminate the burden of a sales tax on an essential level of consumption, 

it also suffers from a number of drawbacks. First, if the 

credit is available to all taxpayers, rather than just low income 

individuals and families, it is expensive. If the credit were available 

to everyone, it would absorb about one-third of the revenue from 

the sales tax. While it would reduce the burden of the sales tax for 

families below the poverty line, 90 percent of the credit would go to 

those above the poverty level. This demonstrates that the credit 

should be phased-out for incomes above the poverty level; a credit 

that is phased-out between the poverty level of income and 150 percent 

of that level would absorb about a tenth of the revenue from a sales 

tax. A phased-out credit, however, would be more complex and, in 

effect, would generate higher marginal income tax rates'over the 

phase-out range. A credit of either type may also be viewed as establishing, 

in embryonic form, the administrative machinery for a new 

social program such as a family assistance plan. It can be argued 

that the desirability of such a program should be debated explicitly 

in the context of welfare reform, rather than being introduced as a 

by-product of adopting a sales tax. Several of the states, however, 

have used this approach for lessening the burden of the sales tax 

without kindling a debate over welfare reform. 

The third approach is indexed transfer payments. If all families 

below the poverty income line received government transfers, and no 

one else did, it would be relatively easy to overcome the low-income 

burden of a sales tax; transfers could simply be increased to offset 

the sales tax paid by low income families. But not all low income 

individuals and families receive transfers, and many above the poverty 

level do receive them. Even so, adjustment of transfers offers a 

third potential means of reducing sales tax burdens on the poor. 

A personal exemption type of value-added tax would be a fourth 

method of eliminating the sales tax burden on low-income families. 

Under this approach, which would differ substantially from a conventional 

value-added tax, workers would be considered to be "sellers" of 

labor services and would be subject to a value-added tax, but they 

could not take credits for value-added tax on their purchases of 

consumption goods. Employers would be allowed a credit for the taxes 

"charged" by employees on their wages. Treating employees as sellers 

of labor, rather than employees, changes the value-added tax in one 

crucial way: it would allow the introduction of personal exemptions 

in the calculation of the value-added tax liability of workers. That 

is, workers could be allowed an exemption from value-added tax for a 

specified amount of the income earned from "selling" their labor to 

the employer. This approach could alleviate the burden of the tax on 

low-income individuals receiving labor income, but it would not help 

those not receiving labor income, such as retirees without pensions or 

the unemployed. The approach also raises some questions about whether

- 225 - 

the tax would be shifted to consumers to the same extent that a 

tradi,tionalvalue-added tax would be shifted. 

VII. Value-Added Tax versus Retail Sales Tax 

The value-added tax and the retail sales tax are collected in dif 

ferent ways; thus they have somewhat different administrative impli 

cations and economic effects, despite their basic similarity. On 

balance the administrative advantages of the value-added tax appear to 

outweigh the primary administrative advantage of the retail sales tax 

in the American context, its much greater familiarity. 

Purchases for business use should not be taxed under a sales tax; 

otherwise production techniques will be distorted, the value of a 

product will be taxed more than once, and exports will be penalized. 

IJnder a value-added tax any tax collected on capital goods, intermediate 

products, or other inputs to the production-distribution process 

is allowed as a credit against the tax imposed on the sales made by 

the purchasing firm. This means that goods and services purchased for 

business use are automatically freed from tax; by and large, only 

goods and services sold to households are ultimately taxed under the 

value-added tax. Tax auditors need only to check the purchasing firm 

to ensure that purchases for which a credit is claimed were used for 

business purposes. By comparison, it is more difficult under a retail 

sales tax to completely exempt all business purchases. Firms must 

provide exemption certificates to their suppliers to buy tax free, and 

auditors must check both the supplier and purchaser in cases of doubt. 

At the state level, this system of exemption certificates applies only 

to goods purchased for resale or goods that become component parts or 

physical ingredients of produced goods; other purchases, such as 

machinery and equipment, are only exempt if specifically provided in 

the state statute. The end result is that not all business purchases 

are free of retail sales tax; about 20 percent of sales tax revenue is 

from taxing business purchases. 

Another important advantage of the value-added form of sales tax 

is the fact that tax is collected as products move from stage to stage 

in the production-distribution process. Thus by the time a product 

reaches the retail stage, much of its total value has already been 

taxed. (In the example of Table 1, two-thirds of the tax was 

collected from the winery, and only one-third from the grocer.) This 

means that tax evasion at the retail level is less of a problem under 

a value-added tax than under a retail sales tax; under the latter tax, 

evasion at the retail level means that no tax is collected. (Of 

course, all previously collected revenue from the value-added tax 

could be lost if the retailer understates sales but claims a credit 

for all value-added tax paid on purchases.) The possibility of 

collecting tax before the retail level can be particularly important 

in the case of sales by street vendors and purveyors of certain 

services in the legal underground economy. A Federal sales tax of as 

little as 4 percent, together with state and local taxes, could 

produce a combined rate of tax of 10 percent or more in many states, 

and the combined rate could easily exceed 15 percent if the value-

- 226 - 

added tax approached European rates. Rates this high could increase 

the incentives for evasion. 

Related to this advantage is the audit trail provided by the chain 

of taxes and credits with the value-added tax. In the example of 

Table 1, the grocer can only claim credit for tax paid on purchases 

from the winery if the grocer can produce an invoice documenting that 

he was charged tax by the winery. Auditors can then trace the invoice 

back to see that the winery remitted to the government the tax claimed 

as a credit by the grocer. There is no such paper trail under a 

retail sales tax. 

VIII. 

Implementation 

A value-added tax could not be imposed quickly by employing the 

existing personnel and practices of the Internal Revenue Service. 

Rather, it would be necessary to employ and train additional IRS 

agents, acquire additional computer capability, establish new adminis 

trative procedures, and engage in a major effort in taxpayer educa 

tion. These requirements are described more fully in Volume 111. The 

Internal Revenue Service estimates that it would need 18 months after 

enactment before it could begin to administer a value-added tax. 

Thus, if legislation imposing a value-added tax were enacted in late 

1985, the tax could be made effective July 1, 1987. 

The one-time start-up costs for recruiting and training IRS 

agents, acquiring enhanced computer capabilities, and educating the 

public about the value-added tax are substantial. These start-up 

costs indicate clearly that the value-added tax should not be considered 

as a temporary source of revenue. Moreover, given the magnitude 

of both the start-up costs and the on-going annual costs of administration 

and compliance, it would be unwise to introduce a value-added 

tax at less than at a rate of 5 or 6 percent. (Some experts believe 

that imposition at a rate below 10 percent would not be sensible.) 

Ix. 

Conclusions 

Because of its inherent regressivity, a Federal value-added tax or 

other form of general sales tax should not be adopted as a total replacement 

for the income tax. Implementing a Federal sales tax would 

be costly and it would take time. Therefore, it does not seem desirable 

to introduce a Federal sales tax solely as a replacement for part 

of the present income tax, even though doing so would take pressure 

off the latter. Reform of the income tax, along the lines proposed in 

Chapters 5 through 7 is a more appropriate avenue of fundamental tax 

reform in a revenue neutral context. 

For economic and administrative reasons any Federal sales tax that 

is adopted should extend through the retail level and should be 

applied as widely as possible at a uniform rate of tax. The value 

added technique appears to be somewhat preferable to the retail sales 

technique as a means of implementing a sales tax.

- 227 - 

A Federal sales tax would have considerable advantages and serious 

disadvantages. These must be weighed carefully in deciding whether a 

sales tax should be imposed. The advantages include neutrality toward 

saving, capital formation, production techniques, and consumption de 

cisions. The disadvantages are reqressivity, a one-time increase in 

prices, Federal intrusion into the sales tax area, the administration 

and compliance costs of a new Federal sales tax, and the likelihood of 

greater public expenditures. Any proposal for introducing a sales tax 

should include steps to relieve the tax burden on low-income indivi 

duals and families.

- 229 - 

APPENDIX A 

EFFECTIVE DATES AND TRANSITION RULES 

Implementing the Treasury Department's reform proposal will 

involve a fundamental tradeoff. On the one hand, immediate 

implementation of the proposals would be desirable in order to capture 

as soon as possible the gains in equity, economic neutrality and 

simplicity described at length in this report; immediate implementation 

would also be the simplest policy, as it would avoid 

inevitably complex transition rules. On the other hand, immediate 

implementation of the proposals would be unfair and disruptive; 

taxpayers who made commitments based on the current tax structure 

would suffer unanticipated gains and losses when the tax law was 

changed suddenly. Such reform-induced windfall gains and losses 

amount to essentially arbitrary redistributions of income and are 

therefore an undesirable, if inevitable, consequence of reform. The 

magnitude of the gains and losses induced by implementation of the 

Treasury Department's proposal could be reduced by delaying or 

phasing-in implementation or by using "grandfathering" provisions 

which guarantee current tax treatment to taxpayers who made commitments 

based on current law. 

The Treasury Department's proposal provides for a fair and orderly 

transition by striking a balance between the conflicting objectives of 

maximizing the equity, economic neutrality and simplicity gains of 

rapid implementation and minimizing the arbitrary redistributions of 

income induced by unexpected tax reform. All four of the implemetation 

options described above -- immediate coupled with 

grandfathering provisions, delayed, phased-in, and immediate -- are 

utilized toward this end. The proposed effective dates and transition 

rules for each element of the Treasury Department's proposal are 

summarized in Table A-1; the listing of proposed changes corresponds 

to those in Appendixes 5-A, 6-A, and 7-A. The proposed effective 

dates and transition rules assume that legislation is introduced in 

early 1985, and that the reform package is enacted on July 1, 1985 

with a general effective date of January 1, 1986. 

The proposed transition rules can be divided into four general 

categories. Detailed descriptions of the transition rules are 

provided in Volume 11. The four general categories are summarized as 

follows. 

(1) Immediate implementation with grandfatherinq. Where feasible, 

grandfathering provisions are effective in avoiding reform-induced 

windfall gains and losses. They have the effect of applying the new 

tax laws to new commitments but avoiding a change in the tax treatment 

of commitments made on the basis of current law. Elements of the 

proposal which provide for permanent grandfathering of existing

- 230 - 

commitments include the new real economic depreciation rules, the 

elimination of the investment tax credit, the extension of the at risk 

rules, the elimination of a variety of special expensing and 

amortization rules and other subsidies, the taxation of certain life 

insurance and annuity income, the new treatment of insurance company 

loss reserves, changes in the treatment of irrevocable non-grantor 

trusts, and the unification of the estate and gift tax laws. Note 

that whenever grandfathering occurs, it will generally benefit 

taxpayers to qualify for such treatment. In order to prevent a flood 

of tax-motivated commitments made prior to the general enactment date, 

grandfathering frequently will be granted only to commitments made 

prior to the date legislation is introduced; note that such treatment 

is more generous than granting grandfathering only to commitments made 

prior to the announcement date of a proposal, as has sometimes 

occurred in the past. 

Grandfathering can also be provided on a temporary basis, where 

the goal is to reduce the windfalls caused by reform, but to subject 

all commitments to the same tax treatment by some fixed point in time. 

This is the approach taken for reform in the area of fringe benefits, 

where the new rules will apply as contracts expire or, at the latest, 

by January 1, 1989; also, application of the new rules will be delayed 

for one year in the cases of the two largest fringe benefits, 

employer-provided health care and life insurance, in order to allow 

time for employers and insurance companies to adjust to the new tax 

law. Similarly, partnerships existing prior to the date legislation 

is introduced will not be subject to the new corporate-type taxation 

until January 1, 1990. 

Treatment similar in spirit to temporary grandfathering is 

proposed in several areas where the proposal will eliminate unfair 

preferential tax treatment, but immediate implementation would result 

in a large one-time increase in income as previously tax-advantaged 

income is brought into the tax base. In these cases, the adverse 

effects of the one-time increase in income will be tempered by 

allowing the increase in income to be spread evenly over a fixed 

number of years for tax reporting purposes. This treatment is 

proposed for the elimination of special bad debt deductions and the 

deduction for additions to "protection against loss" accounts by 

property and casualty insurance companies, the restriction of the use 

of cash accounting, and the new rules for insurance policyholder 

loans. 

(2) Delayed implementation. Delayed implementation of some of the 

Treasury Department's proposals is recommended for four reasons. 

First, delay reduces the magnitude of reform-induced redistri 

butions by postponing the change in tax liability and by allowing time 

for existing commitments to expire. For these reasons, interest 

indexing will be postponed until January 1, 1988, and capital gains 

indexing (on non-depreciable assets) will be postponed until January 

1, 1989.

- 23:l - 

Second, delay allows time for rebudgeting in cases where the 

elimination of preferential tax treatment should be offset by 

appropriate increases in Federal, state or local expenditures. For 

this reason, the changes in the taxation of military compensation and 

of unemployment and workers' compensation will be delayed until 

January 1, 1987. 

Third, delay allows time for adjustment to new rules. Many of the 

changes in the taxation of estates will be delayed for one year in 

order to allow estate planners time to adjust to the new rules. 

Similarly, the replacement of the possessions tax credit with a wage 

credit will be delayed for one year to allow businesses time to adjust 

to the new tax structure. 

Fourth, repeal of the individual and corporate minimum taxes -- 

subject to full implementation of the reform proposal -- will be 

delayed until January 1, 1990 in order to subject to taxation existing 

preferences which are grandfathered. 

(3) Phased-in implementation. Phasing-in implementation is 

recommended for several elements of the Treasury Department reform 

package. Since phasing-in involves a modified form of delayed 

enactment, it not only has the advantage of reducing the magnitude of 

reform-induced redistributions, but also the further advantage of 

capturing some of the equity and economic neutrality gains from reform 

immediately. Phasing-in is recommended for the dividend relief 

proposal, the elimination of the itemized deduction for state and 

local taxes, the new limit on charitable contributions, the 

elimination of graduafed corporate tax rates, the extension of the 

limit on interest deductions, and the denial of business deductions 

for entertainment expenses and meal costs in excess of a limit. 

(4) Immediate implementation. In many cases, the Treasury 

Department's reform proposals can be implemented immediately with 

little effect on existing commitments. The changes in the zero 

bracket amount, personal exemptions, and a variety of credits and 

deductions fall into this category; the changes in individual and 

corporate rates will be delayed for six months solely to achieve the 

goal of revenue neutrality in the initial year after enactment. 

Similarly, the extension of Individual Retirement Accounts and the new 

rules on pension distributions will be implemented immediately. 

Another class of proposals where reform should be implemented 

immediately are those involving provisions that are particularly 

objectionable in terms of violating equity principles. These include 

some changes in trust rules, limits on deductions for business 

expenses away from home, and highly preferential special rules for 

life and property and casualty insurance companies. Similarly, in 

view of the strong equity and neutrality arguments for elimination of 

the special preferences for the energy and natural resource 

industries, the Treasury Department proposes that these preferences be 

repealed immediately; to reduce the impact of immediate implementation

- 232 - 

or1 the energy industry, the repeal of the windfall profits tax will be 

accelerated by three years, with the scheduled three-year phase-out 

beginning on January 1, 1988 instead of JatlUaKy 1, 1991.

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APP~IXc 

The attached tables summarize some highlights of the tax systems 

of several major U.S. trading partners. 

The tables should be read with caution, as many of the features 

which determine the impact or burden of a tax cannot be accurately 

presented in such a summary form. For example, it requires a great 

deal of information to define the base of an income tax; but without 

doing so, little can be learned from a comparison of tax rates. Even 

if one could measure the base and rate for a selected pattern of income 

ant3 deductions, it is difficult to select income levels which 

represent comparable living standards in different countries and lines 

of activity. 

For such reasons, the tables select certain aspects of foreign tax 

systems which can be more easily compared in a summary fashion, seek 

ing to minimize both complex qualifications and inaccuracy. The for 

eign countries included in the comparison are France, Germany, the 

Netherlands, Sweden, the United Kingdom, Japan and Canada. 

Level and Composition of Taxes 

Part I of the table illustrates the share of tax revenues in total 

domestic production in the respective countries and the extent to 

which each country relies on different types of taxes. 

The figures shown include taxes imposed at all levels of government. 

Part I shows that the share of tax revenues in domestic 

production varies substantially among the countries compared. Japan 

and the United States are at the lower end of the scale with ratios of 

27 and 30 percent, respectively. In Canada, Germany, and the United 

Kingdom, the ratios fall between 35 and 40 percent. And in France, 

the Netherlands, and Sweden the ratios are roughly 45 to 50 percent. 

The composition of tax revenues varies even more markedly. Japan, 

with the lowest ratio of taxes to output, relies more heavily than any 

of the other countries on the corporate income tax as a source of tax 

revenues. Corporate income taxes account for 20 percent of total tax 

revenues in Japan, compared to only 3 percent in Sweden, which has the 

highest ratio of taxes to output. Total income taxes (not including 

social security taxes) account for about 45 percent of tax revenues in 

the United States, Japan, Canada, and Sweden; but except in Japan, 36 

to 40 percent of the total are individual income taxes with corporate 

income taxes contributing only 3 to 8 percent. 

France relies relatively little on income taxation. Social security 

taxes and sales taxes account for more than 75 percent of total

- 256 - 

French tax revenues. Social security taxes are also particularly high 

in Germany and the Netherlands. 

Sales taxes are more important in all of the other countries than 

in the United States or Japan. However, even if sales taxes were ignored, 

only in Canada would the tax/output ratio fall below that in 

the United States; the other countries which have higher ratios than 

the United States would continue to do so. This suggests that sales 

taxes are often an additional source of revenue rather than a 

substitute for other taxes. 

Individual Income Taxes 

Part I1 summarizes some features of individual income taxes. 

Unlike Part I, it describes only national level taxes. Part I1 shows 

that the marginal rates of individual income tax in the United States 

are relatively low under current law and the top rate will be even 

lower under avproposed broad-based income tax. Recognizing that 

nominal rates of tax can present a misleading picture, section B in 

dicates the average tax rate of a "typical" taxpayer in each of the 

countries, based on 1982 data. The typical taxpayer is defined as the 

taxpayer with the median income level for that country at that time. 

The U.S. tax burden ranks 4th in the group of seven countries, with an 

average tax rate that is higher than that in three of the other 

countries, but lower than that in the other four. 

Five of the seven foreign countries surveyed provide some infla 

tion adjustment for the tax threshold and bracket rates in the 

personal income tax. Beginning in 1985, the United States will be in 

line with that practice as well. 

Corporate Income Tax 

As shown in Part 111, five of the seven countries provide tax 

relief for dividends paid from income that is subject to tax at the 

corporate level. The proposed U.S. system will also bring our 

practice into line with other countries on this point. 

Part 111 also summarizes corporate tax rates at the national level 

and provisions for capital cost recovery. The proposed reduction in 

the U.S. corporate tax rate will bring that rate below that in any of 

the other seven countries. (Sweden also has a low national rate but 

imposes a substantial local corporate income tax.) 

The proposed U.S. system will provide more protection against 

inflation-induced mismeasurement of income than that of our other 

trading partners. Our treatment o f capital cost recovery in general 

will be more in line with the practice of other countries, with 

respect to both equipment and structures, under the proposed system 

than it is under present law. 

Part 111 further illustrates that the proposed adoption of a per- 

country limitation on the foreign tax credit would be consistent with

- 257 - 

the typical practice of other countries that employ a foreign tax 

credit. 

Sales Taxes 

Finally, Part IV of the table gives some details on the rates and 

bases of value added taxes imposed in the five European countries con 

sidered. The United States, Canada and Japan do not have a national 

value added tax. However, Canada imposes a Federal general sales tax 

at the manufacturers’ level, and there are provincial sales taxes at 

the retail level. Many U.S. states also impose general sales taxes. 

The table does not attempt to give a comprehensive picture of the 

scope of value added taxes, but simply points out that, even within 

the European Economic Community, it has been difficult to standardize 

the treatment of different transactions.

- 258 

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U.S. GOVERNMENT PRINTING OFFICE : 1984 0 - 459-370

Tax Reform for Fairness, Simplicity and Economics Growth

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