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Tax Reform Options Presented by Tony Quain ECON-825 Professor Klein October 24, 2006. Contents. Introduction 3-6 The Federal Income Tax 7-11 Five Tax Reforms 12-28 Efficiency Comparison 29-32 Equity Expectations 33-37

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Tax reform options presented by tony quain econ 825 professor klein october 24 2006

Tax Reform OptionsPresented by Tony QuainECON-825 Professor KleinOctober 24, 2006


  • Introduction 3-6

  • The Federal Income Tax 7-11

  • Five Tax Reforms 12-28

  • Efficiency Comparison 29-32

  • Equity Expectations 33-37

  • Administration, Intrusion, Compliance, Evasion 38-42

  • Transition Issues 43-47

  • Political Viability 48-51

  • Recommendation 52-53

  • References 54-58


  • Our Inquiry

    • What are the main problems with the current federal income tax?

    • What are some tax reform alternatives to the federal income tax?

    • How do these tax reform options compare in the following aspects?

      • Efficiency

      • Equity

      • Administration, Intrusiveness, Compliance, and Evasion

      • Transition Issues

      • Political Viability

    • Which type of tax reform is most desirable, given the relative advantages and political viability?


  • Assumptions

    • During our discussion, we will use the following assumptions:

      • Reform would be limited to U.S. federal government revenue

      • Reform would eliminate federal taxes on personal income and corporate income, but not payroll taxes, excise taxes, estate taxes, customs, or other miscellaneous taxes

      • Income taxes were $1.205 trillion in 2005 ($927 bln. Individual, $278 bln. Corporate), or 56% of all U.S. federal taxes

      • Reform must be revenue neutral, i.e. it must replace the 56% of federal revenues or indicate what part of the income tax would remain in place


  • Five Tax Reforms

    • The five types of tax reform to be examined will include (in order of the degree of change, least radical to most):

      • Flat Tax

      • Retail Sales Tax (RST)

      • Value-Added Tax (VAT)

      • Geo-Rent Tax (GRT)

      • Head Tax

    • All of these have many variations; I will use the most simplified (or popular) variation where possible, but will explain other significant variations


  • Tax-inclusive and Tax-exclusive Rates

    • For consistency, all rates will be quoted as tax-inclusive unless specified

    • Tax-inclusive: the tax rate is the percentage of the tax base given up in taxes; the tax is “carved out”

    • Tax-exclusive: the tax rate is a percentage of the tax base added to the base; the tax is “added on”

    • Example:

      • A 15% tax-inclusive sales tax rate on a sale of $2,000 yields a tax of $300 and a total sale price of $2,000; the equivalent tax-exclusive rate is 17.65% (of $1,700)

      • A 15% tax-exclusive sales tax rate on a sale of $2,000 yields a tax of $300 and a total sale price of $2,300; the equivalent tax-inclusive rate is 13.04% (of $2,300)

    • Tax-exclusive rates are always higher than the equivalent tax-inclusive rate

    • Income taxes and VAT taxes are usually quoted as tax-inclusive rates

    • Sales taxes are usually quoted as tax-exclusive rates

The Federal Income Tax

  • Problems with the Federal Income Tax

    • Economic Inefficiency

      Provisions in the tax code cause distortions in economic decision-making

      • The income tax creates an “excess burden” beyond the tax itself by making people substitute untaxed activities for taxed activities (Slemrod 2005)

        • $200 bln. annually (est.); 17% of revenues (Jorgenson 2001)

        • 30%-50% of revenues (Slemrod 2005)

          Particularly damaging distortions include: (Hubbard 1997)

        • Saving and investment decisions

        • Inter-sectoral and Inter-asset distortions (corporate vs. non-corporate; owner-occupied housing vs. business capital)

        • Financial distortions (corporate debt/equity structure; dividend decisions)

      • Tax expenditures: losses of revenue due to deductions and carve-outs

        • $945 bln. (FY2006 est.); 78% of revenues (Hungerford 2006)

The Federal Income Tax

  • Problems with the Federal Income Tax (contd.)

    • Tax avoidance: the elasticity of taxable income, not simply labor supply, responds to the income tax rate; as a result, tax revenues experience diminishing (and possibly negative) returns to increases in tax rates (Slemrod 2005)

      • $284 bln. annually for individual income tax alone (Feldstein 1999)

  • Inequity

    • Equity only seen as a problem by those who disagree with current progressivity

    • Progressive tax rates transgress Adam Smith’s principle of proportionality; they violate “vertical equity” (proportional tax: the more you get, the more you pay) and replace it with “ability to pay” redistribution (Hall 1995)

      • Six individual tax brackets: 10%, 15%, 25%, 28%, 33%, 35%

      • Eight corporate tax brackets: 15%, 25%, 34%, 39%, 34%, 35%, 38%, 35%

    • Tax expenditures (“targeted” tax provisions) and widespread evasion violate “horizontal equity” (people in similar circumstances should bear equal tax burdens) (Hall 1995)

The Federal Income Tax

  • Problems with the Federal Income Tax (contd.)

    • Administration and Enforcement

      • Enforcement costs are high due to complexity and evasion:

        • $10.2 bln. (FY2005) to fund enforcement by the IRS (ERP 2006)

    • Intrusiveness

      • Inhibitions of personal and business privacy

      • Costly measures taken to avoid intrusiveness

    • Complexity and Compliance

      • Complexity: income taxes are inherently complex because of (1) complicated timing rules for capital expensing and (2) inflation distortions of interest payments (McClure 1995)

        • Complexity causes taxpayers, the IRS, and tax experts to make errors (CHC 2003)

      • Compliance: represents deadweight losses of productive capacity

        • $200 bln. annually in direct and opportunity costs of compliance (CHC 2003)

The Federal Income Tax

  • Problems with the Federal Income Tax (contd.)

    • Evasion

      • Evasion includes non-filing, underreporting, and underpayment

        • IRS claims the “Tax Gap” for income taxes is $230 bln. annually: $197 bln. (individual), $33 bln. (corporate) (IRS 2004)

    • Rent-seeking

      • Lobbyists spend society’s resources obtaining tax expenditures

The Federal Income Tax

  • Adam Smith’s Four Taxation Maxims

    • Proportionality (“The subjects of every state ought to contribute to the support of the government … in proportion to the revenue which they respectively enjoy”) (Smith 1981) Federal Income Tax fails(see (2) Inequity)

    • Certainty (“The tax which each individual is bound to pay ought to be certain, and not arbitrary”) (Smith 1981)Federal Income Tax fails(see (5) Complexity)

    • Timeliness (“Every tax ought to be levied at the time, or in the manner in which it is most likely to be convenient for the contributor to pay it”) (Smith 1981)Federal Income Tax fails(does not permit immediate expensing of capital)

    • Unobtrusiveness: (Smith 1981)

      • No excess enforcement Federal Income Tax fails(see (3) Enforcement)

      • No excess burden Federal Income Tax fails(see (1) Inefficiency)

      • No excess evasion Federal Income Tax fails(see (6) Evasion)

      • No intrusion Federal Income Tax fails(see (4) Intrusiveness)

Five Tax Reforms

  • 1. Flat Tax – How it Works

    • The variant I use is the Hall-Rabushka Flat Tax, introduced in 1981

    • The Flat Tax is a reform of the income tax system that eliminates tax expenditures (itemized deductions, credits, etc.) and tax brackets; individuals and businesses would both be subject to one “flat” rate

    • Businesses would be subject to a “Business Tax”:

      • Taxable income would be gross revenue minus “Allowable Costs”:

        • Purchases of goods, services, and materials

        • Wages, salaries, and pensions

        • Purchases of capital equipment, structures, and land

      • Note that for purposes of this tax businesses would use cash accounting; there would be immediate write-off of investment (with a carry-forward provision)

Five Tax Reforms

  • 1. Flat Tax – How it Works (contd.)

    • Individuals would be subject to an “Individual Wage Tax”:

      • Total compensation includes wages and salary plus pension and retirement distributions

      • Personal allowances deducted from total compensation:

        • Personal allowance for filer:

          • Single: $12,800 (H-R: $9,500)

          • Married filing jointly: $25,600 (H-R: $16,500)

          • Head of household: $19,200 (H-R: $14,000)

        • Allowance for each dependent (not incl. spouse): $6,000 (H-R: $4,500)

      • Interest, dividends, and capital gains would not be taxed

      • Non-wage earners (sole proprietors, etc.) would file a Business Tax only, unless they paid themselves a wage

    • Variant A: no personal allowances

Five Tax Reforms

  • 1. Flat Tax – Problems

    • Retains the income tax: leaves open the possibility of returning to a more complicated and graduated system over time

    • Foreign goods bias: domestic goods for export are taxed while foreign goods for import are not; this puts domestic goods at a disadvantage

    • Government bias: while government workers are subject to the wage tax, government enterprise (such as USPS) is not subject to the business tax

Five Tax Reforms

  • 1. Flat Tax – Factfile

  • In Operation:

  • Estonia 26% (1994-)

  • Lithuania 27% (1995-)

  • Latvia 25% (1996-)

  • Russia 13% (2001-)

  • Ukraine 13% (2003-)

  • Iraq 15% (2004-)

  • Slovakia 19% (2004-)

  • Romania 16% (2005-)

  • Illinois 3%

  • Indiana 3.4%

  • Massachusetts 5.3%

  • Michigan 3.9%

  • Pennsylvania 2.9%

  • Revenue neutral rate: 17.25%

  • (Hall 1995) adjusted

  • Origins: Income tax introduced by Pitt the Younger in 1798

  • Ideology: free-market political establishment; bargainers; those who are resigned to keeping the income tax but want to eliminate the inefficiencies and inequities of tax expenditures and tax brackets

  • Endorsements:

  • Arthur Laffer

  • Bruce Bartlett

  • Milton Friedman

  • Steve Forbes

  • Dick Armey

  • Arnold Schwarzenegger

  • Aliases: Yield-Exemption Tax

Five Tax Reforms

  • 2. Retail Sales Tax – How it Works

    • The Retail Sales Tax is assessed on retail (final) sales only; wholesale producers do not pay the tax; it is added on to goods at the point of final sale

    • To avoid “cascading” (whereby businesses pay the tax on investment purchases that are sold again and therefore taxed again), businesses would be able to recover taxes paid on goods purchased for resale

    • Government purchases and investments are subject to the tax, to avoid economic distortions

    • Businesses would collect the tax, but incidence falls on consumers

    • Individuals would not file tax returns

    • Exports are excluded; imports sold domestically are included

    • Variant A: “FairTax” includes a rebate to poverty level income for all

    • Variant B: lower rate or exclusion of certain goods or services

Five Tax Reforms

  • 2. Retail Sales Tax – Problems

    • No current experience of use at the national level

    • Unlike the VAT, enforcement of a sales tax at the necessary percentage would be onerous due to lack of audit trail; evasion would be a crucial problem (Slemrod 2005)

Five Tax Reforms

  • 2. Retail Sales Tax – Factfile

  • Origins: Spain introduced a sales tax in 1342;

  • Kentucky was first state in 1934

  • Revenue neutral rate: 13% (tax-incl)

  • (Edwards 2005) adjusted

  • In Operation:

  • 45 U.S. states

  • California highest (7.25% tax-excl)

  • 9 Canadian provinces

  • PEI highest (10.6% tax-excl)

  • Endorsements:

  • Stephen Moore

  • Laurence Kotlikoff

  • Grover Norquist

  • Wayne Angell

  • Paul Rubin

  • Vernon Smith

  • John Linder

  • Aliases: FairTax,

  • National Sales Tax

  • Ideology: abolitionists (sixteenth amendment must be repealed); nativists (sales taxes as “American” practice)

Five Tax Reforms

  • 3. Value-Added Tax – How it Works

    • The Value-Added Tax is assessed on every business as a fraction of each sale, net of purchases made by that business; in this sense it taxes the “value added” at each stage of production, rather than only the final value sold at retail; nevertheless, the same percentage of a retail and a value-added tax should theoretically net the same revenue

    • Businesses would collect the tax, but incidence falls on consumers

    • Individuals would not file tax returns

    • Exports are excluded, except for that (wholesale) portion which is transacted between businesses within the U.S.; imports are taxed on any value added by American wholesalers/retailers

    • Variant A: lower rate or “zero rate” of certain goods or services

Five Tax Reforms

  • 3. Value-Added Tax – Problems

    • Coordination with state retail sales tax schemes is fraught with major complications; states would need to change their sales tax schemes to a VAT piggy-back (Mack 2005) (McClure 1995)

    • Since it is somewhat hidden from the retail consumer (it can be stated but is nevertheless absorbed in the price), it obscures the cost of government (Slemrod 2005)

Five Tax Reforms

  • 3. Value-Added Tax – Factfile

  • In Operation:

  • 25 EU nations

  • U.K. 17.5%

  • France 19.6%

  • Germany 19%

  • Sweden 25%

  • 39 other nations

  • Australia 10%

  • China 17%

  • Mexico 15%

  • All Canadian provinces 6%-14%

  • Michigan 1.9% (1975-2009)

  • Revenue neutral rate: 13% (tax-incl)

  • (Edwards 2005) adjusted

  • Origins: Invented by French economist Maurice Lauré in 1953

  • Aliases: Goods and Services Tax (GST),

  • Single Business Tax (SBT),

  • Business Transfer Tax (BTT)

  • Ideology: Mainstream economists; Euro-philes; “Big-government” conservatives

  • Endorsements:

  • Bruce Bartlett

  • Bill Thomas

Five Tax Reforms

  • The Flat Tax, RST, and VAT as Consumption Taxes

    • The Flat Tax, RST, and VAT call themselves consumption taxes since saving and investment are not taxed

    • The Hall-Rabushka Flat Tax is actually a modification of a classic Value-Added Tax: (Slemrod 1997)

      From the Hall-Rabushka Flat Tax:

      • Eliminate the personal and dependent exemptions in the personal income tax

      • Abolish the personal income tax

      • Disallow the deductibility to business of payments to labor and pensions

        = The traditional consumption-based Value-Added Tax

  • Macroeconomic identities show that various consumption taxes are equivalent: (Auerbach 1997)

    Consumption = Income – Savings = Wages + Returns to Capital – Investment

    RST = USA Tax = VAT or Flat Tax

Five Tax Reforms

  • 4. Geo-Rent Tax – How it Works

    • The Geo-Rent Tax is a tax on the implicit rental value of land, exclusive of the value of improvements; “land” includes all surface area (including water), airway corridors, and the electro-magnetic spectrum

    • The tax would apply to all owners of land, including household, commercial, and government-owned real estate; taxing government land adds pressure to manage, maintain, and retain an efficient amount of public land

    • Land values would be assessed as they are presently for property taxes, which usually distinguish between site and improvement value

    • Assessment would be done either by adapting existing state/local assessment systems or by a national revenue collection agency

Five Tax Reforms

  • 4. Geo-Rent Tax – Problems

    • Insufficient revenue: Even if geo-rents are taxed at 100%, the revenue raised would not be sufficient to replace income taxes (Foldvary 2005)

    • Assessment: Valuation is inexact and subject to manipulation; land site values can only be determined in the exchange of the market (Rothbard 1957)

Five Tax Reforms

  • 4. Geo-Rent Tax – Factfile

  • Origins: Invented by American political economist Henry George in 1879 (but the idea of taxing the non-labor value of land has been around since John Locke)

  • Revenue neutral rate: 69%

  • (Tideman 2002) adjusted

  • Endorsements:

  • Adam Smith

  • John Stuart Mill

  • Milton Friedman

  • Thomas Paine

  • William F. Buckley, Jr.

  • Albert Jay Nock

  • Sun Yat Sen

  • Winston Churchill

  • Ralph Nader

  • In Operation:

  • Estonia

  • Taiwan

  • Singapore

  • Hong Kong

  • Sydney, Australia

  • Canberra, Australia

  • Fairhope, AL

  • Arden, DE

  • Ideology: Progressives;

  • Environmentalists (“we all own the world”)

  • Geo-libertarians (libertarians who believe in the private possession of land but not land as private property)

  • Aliases: Land Value Tax, Site Value Tax

Five Tax Reforms

  • 5. Head Tax – How it Works

    • The Head Tax is a tax of a nominal dollar amount assessed to every individual over a certain age (for our example, over 18)

    • It is not based on income, or consumption, or any economic activity; since the amount of tax paid does not vary due to economic choices, it has no impact on economic activity

    • Businesses would not be assessed a tax

    • Individuals who are citizens or residents would be assessed a tax

    • Variation A: No age limitation (include children)

    • Variation B: Exclude the insane, the infirm, or the incarcerated

    • Variation C: Tax amount is based on age (to attempt to coincide with lifetime income stream), with young paying lower

Five Tax Reforms

  • 5. Head Tax – Problems

    • Insolvency: some people simply would not be able to pay (not in the normal sense of “I must pay for food, shelter, cable first”, but in the sense that they would not actually have enough money at all); a “carry forward” provision could ameliorate but not solve this

Five Tax Reforms

  • 5. Head Tax – Factfile

  • Origins: Assessed by John of Gaunt in England in 1380

  • Revenue neutral rate: $5,407 (annual)

  • In Operation:

  • Not presently in operation anywhere

  • Recent trials:

  • England/Wales (1990-92)

  • Scotland (1988-92)

  • Endorsements:

  • Steven Landsburg

  • Keith Joseph

  • Margaret Thatcher

  • Aliases: Poll Tax; Lump-sum Tax

  • Ideology: Libertarian academics

Efficiency Comparison

  • Taxes and Incentives

    • The effects of the five tax reforms on economic activity:

      • Income taxes discourage work, investment, and entrepreneurial activity

      • Consumption taxes (RST, VAT) discourage consumption

      • Geo-Rent Taxes arguably do not discourage anything (sprawl?)

      • Head taxes are non-contingent and do not discourage anything (is this true?)

    • Is complete elimination of tax incentivization desired?

    • Is any economic activity good in itself (positive externalities or ethical merit)? Work? Saving?

    • Is any economic activity bad in itself (negative externalities or vice)? Consumption? Work?

Efficiency Comparison

  • Consumption Taxes and Labor Supply

    • Because of inter-temporal substitution, there is no long-term effect on labor supply arising from the shift in taxation from income (work) to consumption (Auerbach 1997)

    • However, the reduction of tax rates at the margin (whether on income or on consumption) and the investment potential in deferred consumption should result in an increase in labor supply (Auerbach 1997)

    • Any consumption tax would increase labor supply by 6% initially, then decline eventually to original level (Jorgenson 1997)

    • The Flat Tax would add 4% more work hours and 3% total output to GDP (Hall 1995)

    • The Retail Sales Tax would add 5% more work hours initially, eventually to diminish to 1% in 20 years (Kotlikoff 1995)

Efficiency Comparison

  • Consumption Taxes and Saving

    • Consumption taxes eliminate the inter-temporal consumption distortion that arises from taxing savings (Metcalf 1995(1))

    • If the savings elasticity with respect to the interest rate is positive, a consumption tax should increase the savings rate (Metcalf 1995(1))

    • The Flat Tax would raise the ratio of capital stock to GDP from 5.0 to 6.2; this would result in a 3% increase in GDP; interest rates would fall by 20% to reflect a new after-tax rate similar to a tax-free rate (Hall 1995)

    • The Retail Sales Tax would raise the capital stock by 8%; this would result in a 6% increase in GDP; interest rates would fall by 8% (Moore 1995)

Efficiency Comparison

  • GRT and Head Tax Efficiency

    • GRT:

      • While the improvement value of land has some supply elasticity, the site value of land (which GRT taxes) is theoretically completely supply inelastic

      • The demand for land, however, could shift to alternatives (e.g., internet over brick-and-mortar) and would change the use and development of land

    • Head Tax:

      • The Head Tax is theoretically completely non-contingent, and thus completely efficient

      • Caveats:

        • The age breakpoint and carry-forward rules may influence behavior in light of borrowing constraints

        • Decisions of American residency and citizenship may be influenced

Equity Expectations

  • Measuring Distribution

    • Taxation per dollar of annual income is traditional distributional measure

    • Distribution measures (progressivity/regressivity) and taxes that target them:

      • Taxation per dollar of wealth (GRT)

      • Taxation per dollar of income

      • Taxation per dollar of consumption (Flat Tax; RST; VAT)

      • Taxation per dollar of benefits

      • Taxation per person (Head Tax)

    • Distribution timeframes:

      • Annual timeframe (politician view; affects political viability)

      • Lifetime timeframe (economist view; true equity)

    • Distribution adjusted for evasion:

      • Measured by how much tax is owed (this is used)

      • Measured by how much tax is paid

Equity Expectations

  • Annual and Lifetime Measurement

    • Distinction between annual income and lifetime income makes consumption taxes appear proportional with respect to income (Metcalf 1995(2))

    • Two caveats: (Metcalf 1995(2))

      • Non-taxed consumption (leisure): to the extent that the income elasticity of leisure exceeds one, leisure is not taxed and consumption taxes are progressive; however, evidence shows that income elasticity of leisure is one or less

      • Non-taxed bequests: to the extent that the income elasticity of bequests is less than one, bequests are not taxed and consumption taxes are regressive; however, bequests may be implicitly taxed in the sense that the value is reduced

Equity Expectations

  • Distribution Estimation

    • Flat Tax (B+) is income and consumption progressive, due to personal deductions

    • RST (A-) and VAT(A) are income regressive and consumption flat on an annualized basis, but are both income and consumption flat over a lifetime

    • GRT (A-):

      • Adherents claim that all of the incidence is on present landowners

      • Realistically, incidence falls on land users, whether renter or owner

      • Businesses which use land push incidence onto consumers

      • On an annual basis, GRT is probably loosely income and consumption progressive, since renters use less land per dollar of income than owners

      • On a lifetime basis, GRT is probably loosely income and consumption regressive, since differences in lifetime income will not be wholly captured by land use

    • Head Tax (D) is income and consumption regressive

Equity Expectations

  • Tax Distribution Elasticity Matrix

    ▲ = Tax increases more than proportionally with increases in measure (“progressive”)

    ▬ = Tax increases in proportion with increases in measure (“flat”)

    ▼ = Tax increases less proportionally (or decreases) with increases in measure (“regressive”)

Equity Expectations

  • Distribution Flexibility

    • Flat Tax can extend progressivity by augmenting the personal deductions or introducing new deductions

    • RST and VAT can introduce progressivity by reduced-rating or zero-rating of low-income goods and services or by rebates or consumption credits to all adults

    • Head Tax can reduce annual regressivity by varying with age

Administration, Intrusion,

Compliance, Evasion

  • Administration and Enforcement Costs

    • Current income tax (C): $10.2 bln. annually (ERP 2006)

    • Flat Tax (B): higher than VAT or RST because of individual returns, less than current income tax

    • RST (B+): $12 bln. annually (1% of revenues); this is a credit to cover costs, not an estimate of costs (Burton 1997)

      • VAT should be more expensive to administer than RST because more information is collected and audited (Bickley 2004)

    • VAT (B+): $1.8 bln. annually (Metcalf 1995)

    • GRT (A-): assessment formulas and property registration; should be low

    • Head Tax (A-): some enforcement difficulties but otherwise easy; should be very low

Administration, Intrusion,

Compliance, Evasion

  • Intrusion

    • Current income tax (C): heavy intrusion on personal and business privacy

    • Flat Tax (B): intrusion on business transaction privacy and on individuals, but limited

    • RST (A-): intrusion on retail business, but less than VAT or Flat Tax

    • VAT (B+): intrusion on business transaction privacy, but limited

    • GRT (A): no intrusion

    • Head Tax (A): no intrusion

Administration, Intrusion,

Compliance, Evasion

  • Compliance Costs

    • The most dramatic gains over the current system are in compliance costs

    • Current income tax (C): $200 bln. annually (CHC 2003)

    • Flat Tax (B): no estimate; while individuals would need to comply, compliance costs would be similar to other consumption taxes because business would bear the overwhelming majority of compliance costs in tracking credits

    • RST (B+): $6 bln. annually (0.5% of revenues); this is a credit to cover costs, not an estimate of costs (Burton 1997)

    • VAT (B): $5 bln. annually (Bickley 2006)

    • GRT (A-): no estimate; record-keeping of property transactions; should be very low as property does not turnover as quickly as general consumption

    • Head Tax (A): no estimate; since only individuals comply, and computation and record-keeping are not necessary, costs should be extremely low

Administration, Intrusion,

Compliance, Evasion

  • Tax Evasion

    • Evasion is higher the higher the tax rate; there will be more total evasion with a 20% tax on either sales or income than with a 10% tax on each

    • For most taxes, there is a tax rate above which avoidance and evasion result in lower tax revenues

    • Current income tax (C): 23% of collected revenue (IRS 2004)

    • Flat Tax (B+): since under-reporting of non-wage income is the largest problem of current evasion, this would substantially diminish evasion

    • RST (C):

      • Estimate of state evasion: 13%; likely to be higher if rates are higher (Due 1994)

      • Since the high rate would apply to the total sale and is paid completely by retailers, the incentive for evasion is higher than Flat Tax or VAT

      • Shorter audit trails than Flat Tax or VAT facilitates evasion

Administration, Intrusion,

Compliance, Evasion

  • Tax Evasion (contd.)

    • VAT (B+):

      • Reduced evasion compared to a national sales tax: (Mack, 2005)

        • Demand for input credits creates self-enforcement mechanism and paper trail

        • Reduced tax liability for each business (includes retailers, wholesalers, producers)

      • European estimates of evasion are generally under 10% (Bickley 2006)

        • United Kingdom 2%-4%; France 3%; Netherlands 6%; Belgium 8%; Italy 40%

    • GRT (A):

      • Land can not be hidden; taxes on land are extremely difficult to evade

    • Head Tax (B):

      • Head taxes are theoretically difficult to evade, since proof of compliance can be tied to any government service (driver’s license, benefits, etc.)

      • Nevertheless, there is a very strong incentive for evasion and many people may be able to go “underground”

Transition Issues

  • Out with the Old: Tax-preferred vehicles

    • Saving and investment vehicles:

      • Retirement accounts $125 bln. (FY2006) (Hungerford 2006)

        • Savings are not taxed under any reform; tax would not be paid on distributions

      • Tax-exempt municipal bonds $26 bln. (FY2006) (Hungerford 2006)

        • Interest rates would be higher for these projects but lower for other bonds; eliminates excessive local government debt financing

    • Housing deductions:

      • Mortgage financing $69 bln. (FY2006) (Hungerford 2006)

        • Eliminates excessive property inflation

    • Health care financing:

      • Elimination of employer deduction of health care expenses $91 bln. (FY2006) (Hungerford 2006) (one step towards correcting America’s ailing health sector!)

Transition Issues

  • Out with the Old: Current System Parasites

    • Tax professionals: not all would go (the replacement tax and other taxes still need due attention), but a majority cover federal income taxation

      • Tax collectors (35,010) (BLS 2006)

      • Tax preparers (58,850) (BLS 2006)

      • Tax accountants

      • Tax attorneys

      • Tax lobbyists

    • Should they be compensated or retrained (GI Bill)? Compensation opens itself up to fraud; retraining is debatable

    • Depending on transition period to new tax, retraining may be unnecessary

Transition Issues

  • In with the New

    • Consumption Taxes:

      • Double taxation of wealth: switching from income to consumption taxation entails double taxation of all existing wealth and inventory, since it was taxed once as income (in the old scheme) and will be taxed again when it is used for future consumption (in the new scheme); this is the biggest transition issue

        • Possibility of a large consumption binge before transition

        • Should existing holders of wealth be compensated? Public finance theorists are split, but the case (on both efficiency and equity grounds) for not compensating is compelling (Metcalf 1995(2))

      • Price changes: businesses will either “pass forward” the new tax in the form of higher prices, or reduce the cost of factor inputs (wages)

        • If higher prices, people and businesses with money instruments suffer a real loss

        • If lower wages, businesses and individuals with inventories suffer a real loss

        • Generally, it is expected that higher prices will occur and nominal wages will stay the same (Hall 1997); monetary policy would make a one-time adjustment (Bradford 1995)

Transition Issues

  • In with the New (contd.)

    • Depreciation: businesses with existing depreciation balances will need to be able to write-off the remaining balance; this will cost $108 bln. a year in lost revenue for 5 years (Hall 1995)

    • Interest deductions: individuals with mortgages or other deductible interest may ask for relief; but then the interest should become taxable to the lender (Hall 1995)

    • Housing: to avoid the distortion between the purchase of new and existing housing, new housing should be taxed upon first sale and existing housing should be taxed upon first sale after tax enactment (Metcalf 1995(2))

Transition Issues

  • Transition Summary

    • Flat Tax (B): 1-2 years; works within existing tax system; transition would be similar to Tax Reform Act of 1986

    • RST (C): 5 years (Burton 1997); new at the federal level

    • VAT (D): more time to implement than RST, since it is new (Bickley 2004)

    • GRT (F): 20 years; compensation of existing landowners would require a very gradual phase-in (Foldvary 2005)

    • Head Tax (A-): depends on equity issues

Political Viability

  • The Equity Problem

    • The equity problem is perhaps the largest political issue for tax reform

    • All other arguments (efficiency, compliance, etc.) in favor of tax reform may not be able to overcome the opposition created by the equity problem

    • All consumption taxes (Flat, RST, VAT) and the Head Tax are vulnerable to attack on the grounds that they are less progressive than the current income tax system, and thus “favor” the rich and harm the poor

    • The change from progressivity to a “flat” treatment per dollar of consumption (or per head) is in fact one of the intended goals of all four of these reforms

    • The reduction of vertical inequity (generally considered unfair) is somewhat ameliorated by the reduction of horizontal inequity (considered more fair)

    • The Flat Tax is less vulnerable on these grounds because the personal allowances retain some progressivity; in effect, the low-income and high-income earners are better off and middle-income earners worse off

Political Viability

  • Flat Tax Popularity

    • The Tax Foundation asked over 2,000 adults the following question in 2005 and 2006: “If you could choose one plan to collect all federal taxes, of these listed, which federal tax plan would you prefer?”


      • A flat-rate income tax with no deductions 37% 33%

      • A national sales tax 19% 20%

      • The current graduated income tax with deductions 19% 21%

      • Unsure 25% 26%

        (Chamberlain 2006)

    • This shows the continued popularity of the Flat Tax over both the current system and a national Retail Sales Tax; note that personal and dependent deductions were not even mentioned for the Flat Tax

Political Viability

  • Passage Hurdles

    • All five tax reforms can be enacted by Congressional passage of a law, signed by the President

    • Some notes:

      • VAT: States with RSTs should pass legislation to change to VAT

      • RST: States with RSTs may need legislation to better combine with federal RST

      • GRT: As this is not an indirect tax, it may require a constitutional amendment

      • Head Tax: Constitutional amendment repealing Amendment XXIV should not be necessary (only applies to taxes on voting)

    • All except the Flat Tax should pass a constitutional amendment to repeal Amendment XVI, which gave Congress the authority to tax income

Political Viability

  • Political Challenge

    • Flat Tax (A-): popular in Congress; has decade of somewhat positive exposure outside the beltway; easily understood

    • RST (B): more popular in Congress than the Flat Tax; gaining momentum recently; evasion problems raised by opponents

    • VAT (C+): difficult to explain; European flavor suppresses support; not well-known in the United States; opposed by right-wing as “money machine”

    • GRT (B-): esoteric; unknown; could easily garner support from left and right; will be vehemently opposed by land owners

    • Head Tax (F): very radical; scary; equity concerns a killer; political Armageddon; hated in Canada, Britain, and elsewhere


  • Grand Comparison

    The current income tax baseline grade is a “C” in all categories (except Transition)


  • Flat Tax

    • All reforms appear better than the current income tax

    • The Hall-Rabushka Flat Tax is recommended because:

      • It is competitive with other reforms in all aspects of reform, including efficiency, equity, administration, intrusiveness, compliance, and evasion

      • It has the easiest and fairest transition route of all reforms, and is thereby the least risky reform

      • It appears the least radical way to a consumption tax; and thus,

      • It is the most politically viable

    • The Geo-Rent Tax is a powerful and attractive idea that should be tested at the state level to assess the revenue, incidence, and equity implications


  • A-C

    Auerbach, Alan J. "The Future of Fundamental Tax Reform." The American Economic Review 87.2 (1997): 143-46.

    Bartlett, Bruce. "Flat-Tax Comeback." National Review Online, 2003.

    Bickley, James M. A Value-Added Tax Contrasted with a National Sales Tax. Washington, DC: Congressional Research Service, Library of Congress, 2004.

    ---. Value-Added Tax: A New U.S. Revenue Source? Washington, DC: Congressional Research Service, The Library of Congress, 2006.

    Boskin, Michael J., ed. Frontiers of Tax Reform. Hoover Institution Press, 1995.

    Bradford, David F. "Consumption Taxes: Some Fundamental Transition Issues." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 123-50.

    Burton, David R. and Mastromarco, Dan R. Emancipating America from the Income Tax: How a National Sales Tax Would Work. Washington, D.C.: The Cato Institute, 1997.

    Cato Handbook for Congress. Washington, DC: The CATO Institute, 2003.

    Chamberlain, Andrew. 2006 Annual Survey of U.S. Attitudes on Tax and Wealth. Washington, DC: Tax Foundation, 2006.


  • D-H

    Due, John F., and John L. Mikesell. Taxation. 3rd ed. Washington, DC: Urban Institute Press, 1994.

    "The Economic Report of the President." Ed. Council of Economic Advisers: U.S. Government Printing Office, 2006. 1-410.

    Edwards, Chris. Options for Tax Reform. Washington, D.C.: The Cato Institute, 2005.

    Feldstein, Martin. "Tax Avoidance and the Deadweight Loss of the Income Tax." The Review of Economics and Statistics 81.4 (1999): 674-80.

    "Flat Tax." Wikipedia.

    Foldvary, Fred E. "Geo-Rent: A Plea to Public Economists." Econ Journal Watch 2.1 (2005): 106-32.

    Hall, Robert E. "Potential Disruption from the Move to a Consumption Tax." The American Economic Review 87.2 (1997): 147-50.

    Hall, Robert E. and Rabushka, Alvin. The Flat Tax. Second ed: Hoover Institution Press, 1995.

    Hubbard, R. Glenn. "How Different Are Income and Consumption Taxes?" The American Economic Review 87.2 (1997): 138-42.

    Hungerford, Thomas L. Tax Expenditures: Trends and Critiques. Washington, D.C.: Congressional Research Service, Library of Congress, 2006.


  • I-M

    IRS Strategic Plan, 2005-2009. Washington, DC: Internal Revenue Service, 2004.

    Jorgenson, Dale W. "The Long-Run Dynamics of Fundamental Tax Reform." The American Economic Review 87.2 (1997): 126-32.

    Jorgenson, Dale W. and Yun, Kun-Young. Investment Volume 3: Lifting the Burden: Tax Reform, the Cost of Capital, and U.S. Economic Growth. Cambridge, MA: MIT Press, 2001.

    Kies, Kenneth J., et al. Discussion of Issues Relating To "Flat" Tax Rate Proposals. Washington, D.C.: Joint Committee on Taxation, U.S. Congress, 1995.

    Kotlikoff, Laurence J. "Saving and Consumption Taxation: The Federal Retail Sales Tax Example." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 160-80.

    "List of Soc Occupations". Washington, DC, 2006. Bureau of Labor Statistics, Department of Labor. 10/12/06. <>.

    Mack, Connie III, et al. Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System. Washington, D.C.: The President's Advisory Panel on Federal Tax Reform, 2005.


  • M-P

    McClure, Charles E. Jr. and Zodrow, George R. "A Hybrid Approach to the Direct Taxation of Consumption." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 70-90.

    McGeveran, William A. Jr., ed. The World Almanac and Book of Facts 2006. New York, NY: World Almanac Books, 2006.

    McNulty, John K. "Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United States: A Tax Policy Discussion of Fundamental Tax Reform." California Law Review 88.6 (2000): 2095-185.

    Metcalf, Gilbert E. "The Role of a Value-Added Tax in Fundamental Tax Reform." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 91-109.

    ---. "Value-Added Taxation: A Tax Whose Time Has Come?" The Journal of Economic Perspectives 9.1 (1995): 121-40.

    Moore, Stephen. "The Economic and Civil Liberties Case for a National Sales Tax." Frontiers of Tax Reform. Ed. Michael J. Boskin. Stanford, CA: Hoover Institution Press, 1995. 110-20.

    "Poll Tax." Wikipedia.


  • R-Z

    Rothbard, Murray. The Single Tax: Economic and Moral Implications. Irvington-on-Hudson, NY: Foundation for Economic Education, 1957.

    Slemrod, Joel. "Deconstructing the Income Tax." The American Economic Review 87.2 (1997): 151-55.

    ---. ""Options for Tax Reform": A Review of the 2005 Economic Report of the President's Tax Chapter." Journal of Economic Literature 43.3 (2005): 816-22.

    Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. Vol. 2. 2 vols. Indianapolis, IN: Liberty Fund, 1981.

    Tait, Alan A. Value Added Tax: International Practice and Problems. International Monetary Fund, 1988.

    Tideman, Nicolaus, et al. "The Avoidable Excess Burden of Broad-Based U.S. Taxes." Public Finance Review 30.5 (2002): 416-41.

    "Value Added Tax." Wikipedia.