perab tax reform report
TRANSCRIPT
No. 1EXECUTIVE OFFICE OF THE PRESIDENT
The P resident’s ECONOMIC RECOVERY ADVISORY BOARD
The Report on Tax Reform Options:Simplification, Compliance, and Corporate Taxation
AUGUST 2010
The President’s Economic REcovERy AdvisoRy BoARd
No. 1EXECUTIVE OFFICE OF THE PRESIDENT
The Report on Tax Reform options:
Simplification, Compliance, and Corporate Taxation
AUGUST 2010
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The President’s Economic REcovERy AdvisoRy BoARd
Board Members
PaulA.Volcker,Chairman
AnnaBurger
JohnDoerr
WilliamH.Donaldson
MartinFeldstein
RogerW.Ferguson
MarkT.Gallogly
JeffreyR.Immelt
MonicaLozano
JimOwens
CharlesPhillips
PennyPritzker
DavidSwensen
RichardL.Trumka
LauraD’AndreaTyson
RobertWolf
AustanGoolsbee,StaffDirectorandChiefEconomist
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PREFACEWhatfollowsisareportofthePresident’sEconomicRecoveryAdvisoryBoard(PERAB)onop-tionsforchangesinthecurrenttaxsystemtoachievethreebroadgoals:simplifyingthetaxsystem,improvingtaxpayercompliancewithexistingtaxlaws,andreformingthecorporatetaxsystem.
TheBoardwasaskedtoconsidervariousoptionsforachievingthesegoalsbutwasaskedtoexcludeoptionsthatwouldraisetaxesforfamilieswithincomeslessthan$250,000ayear.Weinterpretedthismandatenottomeanthateveryoptionweconsideredmustavoidataxincreaseonsuchfami-lies,butratherthattheoptionstakentogethershouldberevenueneutralforeachincomeclasswithannualincomeslessthan$250,000.Asimilarprincipleofrevenueneutralitywasusedinthe1986taxreformlegislationinwhichchangesthatraisedrevenuewerecombinedwithcutsinpersonalincometaxrates.Thespecificchangesweconsideredcaneitherraiseorlowerrevenue.Werealizethatrevenueneutralitybyincomeclassmightresultinincreasesordecreasesintaxliabilityforsub-groupsorindividualtaxpayerswithineachincomeclass–thatis,revenueneutralitymightresultin“winners”and“losers.”WehopethattheAdministrationandtheCongresswillselectchangesthataredesirableontheirmeritsandnotworryaboutthedistributionaleffectsofeachofthemin-dividually.TheentirepackageofoptionsselectedshouldbeevaluatedbytheTreasuryortheJointCommitteeonTaxation(JCT)toseewhatimpactithasontaxliabilitybyincomeclass.If,asseemslikely,thepackageraisestaxesforsomeincomegroupsandlowersthemforothers,thiscouldbeoffsetbyadjustmentstothestandarddeduction,taxratesorotherprovisions.Ofcourse,eveniftheratesareadjustedtoberevenueneutralineachincomeclass,therewillbeindividualtaxpayerswhogainandlose.Wedidnottrytoholdalltaxpayersharmlessintheoptionsweevaluated,andwewerenotaskedtodosobythePresident.Itwouldbeimpossibletodosowithoutsubstantialcostsintermsoflostrevenues.
TheBoardgatheredinformationfrombusinessleaders,policymakers,academics,individualciti-zens,laborleaders,andmanyothers.Ourfindingsaretheresultofmonthsofinputfrommanypeople, andwe thank them for their advice. Inaddition,over theyears therehavebeenmanyreportsontaxreformoptionsbybothgovernmentagenciesandprivateentities. Therehasalsobeensubstantialacademicresearchontheseissues.Wehavebenefitedgreatlyfromstudyingthesepreviousreportsandmaterials.
TheBoardwasnotaskedtorecommendamajoroverarchingtaxreform,suchasthe1986taxre-form,thetaxplansproposedbythe2005TaxReformPanel,orproposalsforintroducingavalue-addedtaxinadditiontoorinlieuofthecurrentincometaxsystem. Wereceivedmanysuggestionsforbroadtaxreform,andsomemembersofthePERABbelievethatsuchreformwillbeanessentialcomponentofastrategytoreducethelong-termdeficitofthefederalgovernment. Butconsistentwithourlimitedmandate,wedidnotevaluatecompetingproposalsforoverarchingtaxreforminthisreport.
Finally,itisimportanttoemphasizeattheoutsetthatthePERABisanoutsideadvisorypanelandisnotpartoftheObamaAdministration.Wehaveheardtheviewsofexpertsinthegovernmentinthesamewaythatwehaveheardtheviewsofoutsideexpertsandinterestgroups.Wehaveat-temptedtodistilltheseviewsinthisreporttoprovideanoverviewoftheadvantagesanddisadvan-
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tagesoftaxreformoptionsthatachievethethreegoalsofourmandate:taxsimplification,greatertaxcompliance,andcorporate taxreform.Ourreport ismeant toprovidehelpfuladvice to theAdministrationasitconsidersoptionsfortaxreforminthefuture. ThereportdoesnotrepresentAdministrationpolicy.
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TABLE OF CONTENTS
I. LIST OF FIGURES AND TABLES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
II. SIMPLIFICATION OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
a. Option Group A: Simplification for Families . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
i. Option 1: Consolidate Family Credits and Simplify Eligibility Rules . . . . . . . . . . . 6
1. Consolidate Family Benefits into a Work Credit and a Family Credit . . . 8
2. Combine the EITC, Child Tax Credit, and the Child Dependent Exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3. Consolidate the Child Tax Credit and Dependent Exemption, and Repeal (or Reduce) Some Education Credits . . . . . . . . . . . . . . . . . . . 10
ii. Option 2: Simplify and Consolidate Tax Incentives for Education . . . . . . . . . . . . 10
iii. Option 3: Simplify the “Kiddie Tax” (Taxation of Dependents). . . . . . . . . . . . . . . . 15
iv. Option 4: Simplify Rules for Low-Income Credits, Filing Status, and Divorced Parents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1. Harmonize the EITC and Additional Child Tax Credit. . . . . . . . . . . . . . . . . 17
2. Simplify Filing Status Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3. Eliminate the “Household Maintenance Test” for “Estranged” Spouses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4. Simplify the EITC for Childless Workers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
5. Clarify Child Waivers in the Event of Divorce or Separation . . . . . . . . . . 22
b. Option Group B: Simplifying Savings and Retirement Incentives. . . . . . . . . . . . . . . . . . . . 23
i. Option 1: Consolidate Retirement Accounts and Harmonize Statutory Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
ii. Option 2: Integrate IRA and 401(k)-type Contribution Limits and Disallow Nondeductible Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
iii. Option 3: Consolidate and Segregate Non-Retirement Savings . . . . . . . . . . . . . 29
iv. Option 4: Clarify and Improve Saving Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1. Make the Saver’s Credit a Match . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2. Expand Automatic Enrollment in Retirement Savings Plans . . . . . . . . . 31
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v. Option 5: Reduce Retirement Account Leakage . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
vi. Option 6: Simplify Rules for Employers Sponsoring Plans . . . . . . . . . . . . . . . . . . 32
vii. Option 7: Simplify Disbursements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
viii. Option 8: Simplify Taxation of Social Security Benefits . . . . . . . . . . . . . . . . . . . . . 34
c. Option Group C: Simplify Taxation of Capital Gains. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
i. Option 1: Harmonize Rules and Tax Rates for Long-Term Capital Gains . . . . . 37
1. Harmonize 25 and 28 Percent Rates on Capital Gains . . . . . . . . . . . . . . 37
2. Simplify Capital Gains Taxes on Mutual Funds . . . . . . . . . . . . . . . . . . . . . . 38
3. Small Business Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
ii. Option 2: Simplify Capital Gains Tax Rate Structure . . . . . . . . . . . . . . . . . . . . . . . . 39
iii. Option 3: Limit or Repeal Section 1031 Like-Kind Exchanges . . . . . . . . . . . . . . 40
iv. Option 4: Capital Gains on Principal Residences . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
d. Option Group D: Simplifying Tax Filing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
i. Option 1: The Simple Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
ii. Option 2: Data Retrieval. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
iii. Option 3: Raise the Standard Deduction and Reduce the Benefit of Itemized Deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
e. Option Group E: Simplification for Small Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
i. Option 1: Expand Simplified Cash Accounting to More Businesses. . . . . . . . . . 48
ii. Option 2: Simplified Home Office Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
iii. Option 3: Simplify Recordkeeping for Cell Phones, PDAs, and Other Devices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
f. Option Group F: The AMT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
i. Option 1: Eliminate the AMT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
ii. Option 2: Modify and Simplify the AMT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
III. COMPLIANCE OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
a. Background on Compliance and the Tax Gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
b. General Approaches to Improve Voluntary Compliance and Reduce the Tax Gap . . . . 56
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c. Option 1: Dedicate More Resources to Enforcement and Enhance Enforcement Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
d. Option 2: Increase Information Reporting and Source Withholding . . . . . . . . . . . . . . . . . 59
e. Option 3: Small Business Bank Account Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
f. Option 4: Clarifying the Definition of a Contractor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
g. Option 5: Clarify and Harmonize Employment Tax Rules for Businesses and the Self-Employed (SECA Conformity) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
h. Option 6: Voluntary Disclosure Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
i. Option 7: Examine Multiple Tax Years During Certain Audits . . . . . . . . . . . . . . . . . . . . . . . 63
j. Option 8: Extend Holding Period for Capital Gains Exclusion on Primary Residences. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
IV. CORPORATE TAX REFORM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
a. Overview of the Corporate System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
b. Option Group A: Reducing Marginal Corporate Tax Rates. . . . . . . . . . . . . . . . . . . . . . . . . . 69
i. Option 1: Reduce the Statutory Corporate Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
ii. Option 2: Increase Incentives for New Investment/Direct Expensing . . . . . . . . 71
c. Option Group B: Broadening the Corporate Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
i. Option 1: Provide More Level Treatment of Debt and Equity Financing . . . . . . 72
ii. Option 2: Review the Boundary Between Corporate and Non-Corporate Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
iii. Option 3: Eliminate or Reduce Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
1. Eliminating the Domestic Production Deduction. . . . . . . . . . . . . . . . . . . . . 78
2. Eliminate or Reduce Accelerated Depreciation . . . . . . . . . . . . . . . . . . . . . 78
3. Eliminate Other Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
A. Special Employee Stock Ownership Plan (ESOP) Rules . . . . . . . . . 79
B. Exemption of Credit Union Income from Tax . . . . . . . . . . . . . . . . . . . . 79
C. Low-Income Housing Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
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V. ADDRESSING INTERNATIONAL CORPORATE TAX ISSUES . . . . . . . . . . . . . . . . . . . . . . . . 81
a. The Current U.S. Approach to International Corporate Taxation. . . . . . . . . . . . . . . . . . . . . 82
b. Box 1: The Foreign Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
c. Economic Effects of the Current U.S. Approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
i. Effects on the Location of the Economic Activities of U.S. Multinationals . . . . 85
ii. Effects on the Costs of U.S. Companies and their Foreign and Domestic Competitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
iii. Erosion of the Business Tax Base through Transfer Pricing and Expense Location . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
iv. The Costs of Administering and Complying with the Current U.S. System . . . 88
v. Option 1: Move to a Territorial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
vi. Option 2: Move to a Worldwide System with a Lower Corporate Tax Rate. . . . 91
vii. Option 3: Limit or End Deferral with the Current Corporate Tax Rate . . . . . . . . 93
viii. Option 4: Retain the Current System but Lower the Corporate Tax Rate . . . . 94
VI. ACKNOWLEDGMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
VII. APPENDIX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
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I. LIST OF FIGURES AND TABLES
Figure 1: Family–Related Tax Credits per Family Taxpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 1: Comparison of Provisions Relating to Families with Children . . . . . . . . . . . . . . . . . . . . . . 7
Table 2: Summary of Education Provisions, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Figure 2: The Process for Claiming the EITC and Additional Child Credit . . . . . . . . . . . . . . . . . 18
Table 3: Employer-Sponsored Retirement Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Figure 3: Retirement Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Table 4: Taxation of Social Security Benefits (Single Taxpayer) . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Table 5: The Gross Tax Gap, by Type of Tax, Tax Year 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Table 6: Individual Income Tax Underreporting Gap and Net Misreporting Percentage, by Visibility Groups, Tax Year 2001. . . . . . . . . . . . . . . . . 54
Table 7: Marginal Effective Tax Rates on New Investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Figure 4: Top Statutory Corporate Tax Rates U.S. and OECD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Table 8: Shares of Total Business Returns, Receipts and Net Income, 1980-2007 . . . . . . . . . 74
Table 9: Special Tax Provisions Substantially Narrow the Business Tax Base . . . . . . . . . . . . . . 76
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II. SIMPLIFICATION OPTIONSThetaxcodeiscomplex.Thiscomplexityimposessignificantcostsonaffectedtaxpayersandisre-flectedintheamountoftimeandmoneythatpeoplespendeachyeartoprepareandfiletheirtaxes.Taxpayersandbusinessesspend7.6billionhoursandincursignificantout-of-pocketexpenseseachyearcomplyingwithfederalincometaxfilingrequirements. Inmonetaryterms,thesecostsareroughlyequivalenttoatleastonepercentofGDPannually(orabout$140billionin2008).Thesecostsaremorethan12timestheIRSbudgetandamounttoabout10centsperdollarofincometaxreceipts.TheIRSestimatedthatfor2008,taxpayersfilingForm1040spentanaverageof21.4hoursonfederaltax-relatedmatters.Mosttaxpayers—about60percent—nowpaytaxpreparerstofillouttheirreturns,andatleast26percentusetaxsoftware.Speciallytargetedprovisionsnowrequirelow-incometaxpayers,SocialSecurityrecipients,individualssubjecttotheAlternativeMinimumTax(AMT),andmanyothergroupstocalculatetheirincomesmultiplewaysandmultipletimes.Theburdenofthiscomplexityfallsespeciallyheavilyonlower-incomefamiliesandonhouseholdswithcomplicatedlivingarrangements.Familiesclaimingachild-relatedcreditareabout40per-centmorelikelytouseapaidpreparer,andmorethan70percentoflow-incomerecipientsoftheEarnedIncomeTaxCredit(EITC)usedapaidpreparertodotheirtaxes.Forbusinessesandtheselfemployed,thecomplianceburdenisparticularlyhigh,andbecausethisburdenhasalargefixedcomponent,thesecostsareregressive.Thecomplexityofthetaxcodeispartlytheresultofthefactthatnewprovisionshavebeenaddedoneatatimetoachieveaparticularpolicygoal,butwithinadequateattentiontohowtheyinteractwithexistingprovisions. Thisresultsinduplicativeandoverlappingprovisions,multipledefini-tionsofconceptslikeincomeanddependentchildren,differencesinphaseouts,anddifferencesinthetimingofexpiringprovisions.Between1987and2009,theinstructionbookletssenttotax-payersfortheForm1040increasedinlengthfrom14pagesto44pagesoftext.Thetaxcodehasbecomemorecomplexandmoreunstableoverthelasttwodecades,inpartbecauselegislatorshaveincreasinglyusedtargetedtaxprovisionstoachievesocialpolicyobjectivesnormallyachievedbyspendingprograms.Therehavebeenmorethan15,000changestothetaxcodesince1986,andacurrentJCTpamphletlists42pagesofexpiringprovisions.Thecomplexityresultsinerrorsandmistakesthatadverselyaffecttaxcomplianceandaddtoad-ministrativeandenforcementcosts.InternalRevenueService(IRS)studiessuggestthatnon-com-plianceishigheramongfilersfacedwithcomplexeligibilityrulesandrecordkeepingrequirements.Forexample,anIRSstudysuggestedthatbetween23and28percentofEITCpaymentsinfiscalyear2006wereincorrect.Similarly,theGovernmentAccountabilityOffice(GAO)estimatedthatfortaxyear2005,19 percentofeligibletaxfilersfailedtoclaimeitheratuitiondeductionorataxcreditforwhichtheywereeligible.ThecomplexityofthesystemalsomakesitharderfortheIRStodoitsjobbyincreasingthedifficultyofidentifyingnon-compliantandimproperbehavior.
Beyondthesedirectcoststhatcanbemeasuredintime,money,andrevenuelosttononcompli-ance,thecomplexityofthetaxsystemisatremendoussourceoffrustrationtoAmericantaxpayers,reducesthesystem’stransparency,andunderminestrustinitsfairness.
Thetaskforcereceivedmanydifferentideasfortaxsimplification.Inthisreport,wegrouptheseideasintoafewbroadcategories:SimplificationforFamilies;SimplifyingSavingsandRetirement
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Incentives;SimplifyTaxationofCapitalGains;SimplifyTaxFiling;SimplificationforSmallBusi-nesses;andtheAMT.
a. Option Group A: Simplification for FamiliesInourpublicmeetings, in conversationswith taxexperts, and through submissions from indi-vidualtaxpayers,taxprovisionsrelatedtofamiliesandchildrenwereamongthemostcitedsourcesofcomplexityinthetaxcode.Thetaxcodeprovidesnumerouscreditsanddeductionsthatreducetaxesforfamilieswithchildrenandforchild-relatedexpenseslikedaycareandeducationcosts.Thereisalsoaspecialratestructureforunmarriedindividualswithfamilyresponsibilities.Cur-rently,morethan50milliontaxpayerswithchildrenclaimatleastoneofthesechild-relatedtaxbenefits;mostfamilieswithchildrenreceiveatleasttwoandfrequentlythreeormore.
Each of these child-related provisions has different eligibility rules, many of which are difficulttointerpretorenforceandsomeofwhichweheardcriticizedasunfairandarbitrary.Confusionabouttherulesforthesebenefitscontributestomistakesandnoncompliance.Inaddition,havingmanydifferentbenefitsoftenrequiresparentstomakemultiplecalculationstocomputeeachcreditamount,eitherbecausethecreditsaredeterminedonaspecificdefinitionofearningsoranalterna-tivemeasureofincome,orbecauseabenefitphasesoutincertainincomeranges.Someprovisionscanbecalculatedinalternativeways,requiringparentstotrydifferentcalculationstopickthemostadvantageousone.Thesystemalsorequireschildren(ortheirparents)tofilemillionsofreturnsthatraiselittlerevenue.
Togetanideaofwhythisisaproblem,taketheexampleofamiddle-classfamilywithteenagechil-drenaged16and19,theeldestastudentwholivesawayatcollegeandissupportedbytheparents.Thefamilyhastypicalmiddle-classincome,averybasicfamilystructure,andonlywageincome.Undercurrentlaw,thefamilyiseligibletoclaimdependentexemptionsforbothchildren,allowingtheparentsadeductionagainsttheirtaxableincome.Becausetheyhaveonechildunder17theyarealsoeligibleforthe$1,000childtaxcredit.Thecollegestudentistoooldforthechildcredit,buttheparentsmaybeabletoclaimoneofanumberofeducationcreditsforthestudentdependingontheamountoftheireducationalexpenditures.
Despitethesimplicityofthissituation,theprocessforclaimingthebenefitsforwhichthisfamilymaybeeligibleisnon-trivial. Theinstructionsforclaimingthedependentexemptionincludeamulti-partchecklistandmorethantwopagesofinstructions.Adependentchildmustnormallybe18oryoungerandresidewiththeparents,butanexceptionappliesforastudentlivingawayatschool.(However,justbecausetheolderchildisacollegestudentforthepurposesofthedepen-dentexemptiondoesnotnecessarilymakehimeligibleforeducationcredits,whicharegovernedbyothereligibilityandrecordkeepingrequirements.)Beforecalculatingthechildtaxcreditfortheyoungerchild,theparentsmustreadthroughaneligibilitytestintendedtoscreenouttaxpayersincertainraresituations.Likethevastmajorityoffamilies,thesesituationsdonotapplytothefamilyinthissimpleexample,sotheycanskiptothenext(andforthemfinal)step:a10-line,two-pageworksheetneededtocalculatethesizeofthechildtaxcredit.Inthistheyarefortunate—afamilywithlessincomeormorechildrenmayneedtocalculateanalternativedefinitionofincomeandfile
5Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
anadditionaltwo-page,13-lineformfortheadditionalchildtaxcredit,andafamilywithhigherincomemayhavetocalculateareducedbenefit.
Because theparents in this examplepay tuition for thecollege student, the familywould likelyqualifyforatleastthreedifferenteducationbenefitsbutmustchooseonlyone.Makingthischoicewillrequiretheparentstoconsultanadditionalpublication,makethreeseparatecalculationstofindthemostadvantageousbenefit,andthenfileadditionalformstoclaimthecredit.
Becausebothchildrenareclaimedasdependentsbytheirparents,theymaybesubjecttothe“kid-dietax,”requiringthecollegestudenttofileaseparatedependentreturnevenifthestudentearnsaslittleas$950.Ifthechildrenhavehighenoughincomes,theymaybetaxedattheparents’taxrate,requiringparentsandchildrentocoordinatetheirfilings.
Ascomplicatedasthesestepsare,thisfamilyhasitrelativelyeasy. Athigherincomelevels,thechild taxcredit,dependentexemption,andeducationcreditsallphaseout (indifferent incomeranges), requiring additional calculations for each credit or deduction, and raising effective taxratesonfamilyincome.Atlowerincomelevels,thesituationisarguablymorecomplex.ParentsmustmakecalculationsbasedondifferentdefinitionsofincometoclaimbenefitsliketheEITC(arefundableworkcreditwhosevalueistiedtothenumberofchildren)ortheadditionalchildtaxcredit—calculationsthatcanrequiremorethan100linesonworksheetsinsomecases.Itislittlewonderthatthevastmajorityofthepoorestfamiliesmustpayataxpreparertoclaimtheseben-efits.Ontopofthis,manyfamily-relatedtaxprovisionsarepredicatedonfamilyrelationships,theresidenceofthechild,andexpendituresmadebytaxpayerstosupportthechildandmaintainthechild’shousehold. Theserulesaredifficulttounderstandandfollow,particularlyforfamiliesincomplicatedlivingsituations—householdsthatincludeextendedfamilyandmultiplegenerations,orthatareheadedbyanunmarried,separated,ordivorcedparent.
Whileexplainingthecomplexitiesofthecurrentfamilyandchildtaxprovisionstous,expertsem-phasizedthattheyexistforgoodreasons:topromoteequityandtoembodytheprinciplethattaxburdensshouldreflectdifferencesamongfamiliesintheirabilitytopay;todefrayemployment-re-latedchild-careexpenses;toencouragehighereducation;andtoprovideincentivestowork.Somelevelofcomplexityisrequiredtotargetthesegoalsappropriately.Moreover,thephase-outsofeligibilityforcreditsandthelimitationsofeligibilityoftenreflectfiscalrestraintortheprincipleof“verticaleq-uity”—theideathatfamilieswithgreaterabilitytopayshouldshoulderalargershareofthetaxburden.
Thus,therearetradeoffsbetweensimplifyingexistingfamilyandchildtaxprovisionsandachievingtheseothergoalsoftaxpolicy.Thedistributionalandincentiveeffectsofproposedsimplificationmeasuresmustbeconsidered.Butthecaseforsimplificationhasbecomestrongerovertheyearsasaresultofthegrowingnumberoffamily-relatedprovisionsandtheirapplicabilitytoagrowingnumberofmiddle-classtaxpayers.
Expertsalsotoldusthatanotherdifficultyisthatmeaningfulsimplificationoffamilyanddepen-dentprovisionswouldeitherbecostly in termsof foregone taxrevenuesorwouldcreate losersamongcertainlowerandmiddle-incomehouseholds.Thisdifficultyreflectsthegenerosityofcur-rentprovisionsforlower-andmiddle-incomehouseholdsandtheoverlappingofprovisionsthatbenefitslightlydifferentgroupsofhouseholds.Thescheduledexpirationofportionsoftheseprovi-
6Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
sionsin2011mayprovideanopportunitytoreviewandconsolidatetheremainingfamilyandde-pendentprovisionswhileensuringthatthevastmajorityoflower-andmiddle-incomehouseholdsremainatleastaswelloffastheywouldbeaftertheprovisionsexpired.
Belowweoutlinefouroptionsforsimplifyingthetaxtreatmentoffamilies.Some(butnotall)oftheoptionscompriseseveralproposals.
i. Option 1: Consolidate Family Credits and Simplify Eligibility Rules
Recurrentcriticismsofthepresentfamily-relatedcreditsanddeductionsarethattherearetoomanydifferentcreditsandthatfiguringouthowtoclaimeachbenefitisdifficultandtimeconsuming.
Familiesoftenreceivemultiplebenefitsinasingleyear.In2005,morethan80percentoffamiliesclaimingoneoftheEITC,ChildTaxCredit,ordependentexemptionclaimedmorethanoneandalmost30 percentclaimedallthree.Figure1illustratestheaveragenumberofchild-relatedcred-itsandexemptionsclaimedpertaxpayerwithchildrenatdifferentlevelsofincome.Asthefigureshows,taxpayersearningcloseto$25,000receive,onaverage,aboutthreedifferentcredits.Asin-comerisesthesecreditsphaseoutandtaxpayersbecomeineligibleforcertainbenefits.BecauseoftheexpansionoftheEITCandthechildtaxcreditundertheAmericanRecoveryandReinvestmentAct(ARRA),thenumberoftaxpayersreceivingmultiplecreditshasincreased.
Figure 1: Family–Related Tax Credits per Family Taxpayer
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0 20 40 60 100 140 180
Dependent Exemption Education Credits Child Tax Credit EITC
Cre
dit
s cl
aim
ed p
er t
axp
ayer
wit
h c
hild
ren
Source: Statistics of Income Public Use File (2005).
Adjusted Gross Income ($ thousands)
Source:StatisticsofIncomePublicUseFile(2005).
This isburdensomebecauseeachcreditordeduction isgovernedbyslightlydifferenteligibilityrulesandbenefitcalculations.Table1providesadescriptionofthelargestchild-relatedbenefitsandacomparisonofrulesthatgoverneachone.Asthetableshows,eachbenefitisreduced(phasedout)inadifferentrangeandatadifferentrate.Manyofthecreditsrequiremultiple,sometimesdozensoflinesofcalculations,andeachdefinesaneligiblechildusingadifferentcombinationofage,residency,andrelationshiprequirements.
7Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Tabl
e 1
: Com
paris
on o
f P
rovi
sion
s R
elat
ing
to F
amili
es w
ith C
hild
ren
D
epen
den
t E
xem
pti
on
Ch
ild T
ax C
red
itE
arn
ed In
com
e Ta
x C
red
itC
hild
an
d D
epen
den
t C
are
Tax
Cre
dit
Hea
d o
f H
ou
seh
old
F
ilin
g S
tatu
sE
du
cati
on
Cre
dit
s
Tax
ben
efit
(200
9)D
educ
tion
of $
3,6
50
fo
r ea
ch d
epen
dent
.
Cre
dit o
f $
1,0
00
pe
r ch
ild. P
artia
lly
refu
ndab
le.
Cre
dit u
p to
$3
,04
3
for
one
child
, $5
,02
8
for
two
child
ren,
and
$
5,6
57 f
or m
ore
than
two
child
ren.
R
efun
dabl
e.
Cre
dit o
f up
to 3
5%
of
up
to $
3,0
00
of
wor
k-re
late
d ex
pens
es
for
one
child
, $6
,00
0 if
m
ore
than
one
.
Mor
e fa
vora
ble
rate
sc
hedu
le a
nd h
ighe
r st
anda
rd d
educ
tion
than
for
oth
er
unm
arrie
d ta
xpay
ers.
$2
,50
0 f
or A
mer
ican
O
ppor
tuni
ty T
ax C
redi
t (A
OTC
); $
2,0
00
for
Li
fetim
e Le
arni
ng
Cre
dit (
LLC
); an
d ot
hers
. AO
TC p
artia
lly
refu
ndab
le.
Ph
ase-
Ou
t Th
resh
old
(Jo
int
File
rs)
Ove
r $
25
0,0
00
Ove
r $
11
0,0
00
Ove
r $
21
,42
0P
hase
s-do
wn
in 1
6
step
s fr
om $
15
,00
0 to
$
43
,00
0.
NA
Ove
r $
16
0,0
00
for
the
AO
TC. O
ver
$1
00
,00
0
for
LLC
.
Ph
ase-
Ou
t R
ate
(Jo
int
File
rs)
2.9
7 p
erce
nt p
er
exem
ptio
n5
per
cent
21
.06
per
cent
Cre
dit f
alls
fro
m 3
5
perc
ent o
f ex
pens
es
to 2
0 p
erce
nt o
f ex
pens
es in
pha
se-o
ut
rang
e.
NA
12
.5 p
erce
nt p
er
stud
ent f
or th
e m
axim
um A
OTC
cre
dit.
1
0 p
erce
nt f
or L
LC.
Max
imu
m L
ines
to
C
alcu
late
Cre
dit
10
64
40
34
NA
42
Ag
e R
equ
irem
ent
Und
er 1
9 o
r un
der
24
an
d a
stud
ent;
any
age
if pe
rman
ently
and
to
tally
dis
able
d.
Und
er 1
7.
Und
er 1
9 o
r un
der
24
an
d a
stud
ent;
any
age
if pe
rman
ently
and
to
tally
dis
able
d.
Und
er 1
3; a
ny a
ge
if un
able
to c
are
for
him
self
or h
erse
lf.
Und
er 1
9 o
r un
der
24
an
d a
stud
ent;
any
age
if pe
rman
ently
and
to
tally
dis
able
d.
Und
er 1
9 o
r un
der
24
and
a s
tude
nt; a
ny
age
if pe
rman
ently
an
d to
tally
dis
able
d;
your
self
or y
our
spou
se a
t any
age
.
Res
iden
cy
req
uir
emen
t
Qua
lifyi
ng c
hild
mus
t liv
e w
ith ta
xpay
er
for
over
one
hal
f of
the
year
. Oth
er
non-
qual
ifyin
g ch
ild
rela
tives
mus
t liv
e w
ith
the
taxp
ayer
for
the
entir
e ye
ar. E
xcep
tion
for
stud
ents
at s
choo
l.
Exc
eptio
n fo
r di
vorc
ed
pare
nts.
Sam
e as
dep
ende
nt
exem
ptio
n.
Chi
ld m
ust l
ive
with
ta
xpay
er f
or o
ver
one
half
of th
e ye
ar.
Mus
t liv
e w
ith th
e ta
xpay
er f
or th
e pe
riod
durin
g w
hich
th
e ex
pens
es w
ere
incu
rred
. E
xcep
tion
for
divo
rced
par
ents
.
Qua
lifyi
ng c
hild
mus
t liv
e w
ith th
e ta
xpay
er
for
over
one
hal
f of
th
e ye
ar.
Sam
e as
dep
ende
nt
exem
ptio
n.
8Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Allof thesedifferencesrequireparentstoconsultpagesof instructions,multiplechecklists,andoccasionally to turn to alternative publications to determine whether their child or dependentqualifiesforacreditordeduction. Moreover,becauseeligibilityrulesforcreditsaresimilarbutnotidentical,manyofthesetaxformsandchecklistsaskforsimilaror,insomecases,exactlythesameinformation.Forexample,aparentclaimingthedependentexemption,thechildtaxcredit,EITC,anddependentcarecreditmustreportthesamechild’snameandSocialSecuritynumberfourtimes,andmayhavetocalculateandreporttheirearningsonfourdifferentforms.Becausethephase-outsofthesecreditsarealldifferent,eachcreditmayneedtobecalculatedseparately.Incertaincases,thebenefitamountmustbecalculatedusingalternativemeasuresofincome.Forexample,thedependentexemptionanddependentcarecreditphaseoutasadjustedgrossincome(AGI)increases,butthechildtaxcreditphasesoutwithamodifiedversionofAGI;theEITC,addi-tionalchildtaxcredit,anddependentandchildcarecreditsuseearningsintheircalculations—andthedefinitionof“earnings”isnoteventhesamefortheEITCandadditionalchildtaxcredit.
Manyfamilieswillnotreceivethesamesetofbenefitsfromyeartoyear.Manyfamilieswithtran-sitorily lowincomebecauseofunemployment,maternity leave,or illnesswillbeeligiblefortheEITCforonlyoneyear.Childrenwillageoutofthedependentandchildcarecreditat13andthechildtaxcreditat17.Theywillbecomenewlyeligibleforeducationbenefitsat18or19butmaynotreceivethesameeducationcreditforeachyearofschool.Thislackofconsistencyrequiresparentstolearnnewruleseachyearandreducesthefamiliarityoftaxpayerswiththebenefitsforwhichtheyareeligible.
Consolidating taxbenefits for familieswouldreduce thenumberofcreditsanddeductionsandstandardizeeligibilityrules,eliminatingmuchofthecomplexity,computationalburden,taxpayerconfusion,anddifficultieswithenforcementinthecurrentsystem.Aconsolidationthatreducedthenumberofcreditsneednotreducetaxbenefits;benefitamountscouldbeadjustedtomaintainthecurrentlevelanddistributionofsuchbenefits.Asnotedabove,mostparentsreceivemultiplecredits.Moreover,mostofthedifferencesineligibilityforfamilyandchildcreditsdependonfam-ilyincomeandtheagesofchildren,suggestingthatsomecreditscouldbecombinedbyadjustingageorincomeeligibilityrules.Consolidatingcreditsmaytakeanynumberofpermutations,butsomegeneralprinciplesapply.Thissectionprovidesthreeexamplesofconsolidationstoillustratepotentialoptionswiththeprosandconsofeach.
1. Consolidate Family Benefits into a Work Credit and a Family Credit
The proposal and its advantages: Theexpertsweheardfromrepeatedlyreferencedanoptionadvocatedbythe2005TaxReformPan-elandmodifiedinapolicypaperfromtheCenteronBudgetandPolicyPrioritiesbyJasonFurman.In the 2005 Panel’s option, the dependent exemption, standard deduction, and child tax creditwereconsolidatedintoa“FamilyCredit”availabletoalltaxpayers,andtheEITCwasreplacedbya“WorkCredit.”Thedependentcarecreditwaseliminated,andspecifictaxbenefitsforhigheredu-cationwerereplacedwithasimilarlygenerousextendedfamilycreditforfulltimestudentsunderage22.Thevalueofthesenewcreditswascalibratedtomirrorthelevelanddistributionofbenefitsavailabletofamiliesundercurrentlaw.
9Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Advocatesofthissystempointtonumeroussimplifications.Thisoptionreplacesanarrayoftaxbenefitswithtworelativelysimplecredits,eliminatinganumberofoverlappingprovisions.TheFamilyCreditwouldprovideauniformtaxbenefitthatdoesnotphaseoutwithincome,eliminat-ingthephase-outcalculationsofthepersonalanddependentexemptions,thechildtaxcredit,andthedependentandchildcarecredit.TheWorkCreditwouldreplacetheEITCandtherefundableportionofthechildtaxcredit,andwouldmaintainworkincentives.Calculatingbenefitswouldbesimplifiedbecauseduplicativecomputationsofincomeandearningswouldbeeliminated.Replac-ingmultipleeducationbenefitswithafixedbenefitforfamilieswithfulltimestudentswouldmain-tainthesubsidytopursuehighereducation,butwithoutthecomplexitiesassociatedwithclaimingeducationbenefitsandrequirementstomaintainrecordsforqualifyingexpenses.Withonlytwocredits,anumberofstepsinthetaxfilingprocesswouldbeeliminated.Additionally,withfewercredits,theabilityoftaxpayerstogamethesystembyshiftingdependentsbetweenunmarriedpar-entsortootherrelativestoachievelargertaxbenefitswouldbereduced,improvingcompliance.
Disadvantages:Inordertosimplifythecalculationofbenefits,theFamilyCreditproposedbythe2005TaxReformPanelwouldnotphaseoutwithincome,asdoesthechildtaxcreditandotherbenefitsundercur-rentlaw. Intheabsenceofphase-outs,theproposalwouldsignificantlyincreasethecostofthecreditandloserevenuerelativetocurrent law. Somenon-standardstudents—olderstudentsorpart-timestudents—couldloseeducationcredits.Inaddition,thevalueoffamily-relatedbenefits,particularly refundablecredits like theadditionalchild taxcreditand theEITC,have increasedsince2005,makingthedistributionoffamily-relatedbenefitsmorevariableacrossincomegroups.Withonlyonephase-outofbenefitsintheWorkCredit,the2005Panel’srecommendationwouldnotreplicatethecurrentprogressivityoffamilybenefits.Intheabsenceofotherchangestothetaxsystem,twooreventhreephase-outswouldbeneededtoapproximatethephase-outsoftheEITC,thechildtaxcredit,educationbenefits,andthepersonalexemption,andachievetheprogressivityofthecurrentsystem.
Movingfromsixtypesoffamilybenefitstotwowouldalsoreducetheabilitytousethetaxcodetotargetbenefitstospecificgroups.Thecurrentsystemreflectsadesiretoprovidegreaterbenefitstoyoungerchildren,totaxpayerswithhighereducationexpensesorchild-careexpenses,tofamiliesincertainlivingarrangements,andtotaxpayersbasedontheirmaritalstatus.Consolidatingcred-itswouldresultinthesedifferentgroupsfacingmoresimilartaxburdens.
2. Combine the EITC, Child Tax Credit, and the Child Dependent Exemption
The proposal and its advantages: Thesethreeprovisionswouldbecombinedintoasinglefamilybenefitwithharmonizedeligibilityrequirements,andthecreditwouldberefundablefortaxpayerswith(uniformlydefined)earnedincome. Thisoptionwouldreducethecomplexityof family-relatedbenefitsbyeliminatingtwoprovisions(andtheirassociatedinstructions,checklists,andworksheets).MultiplecomputationsfortheadditionalchildtaxcreditandEITCwouldbeeliminated,andothereligibilityruleswouldbeharmonized,streamliningthefilingprocess.
10Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Disadvantages:Becausethephase-outsforeachofthesecreditsdiffersubstantiallyundercurrentlaw,amorecom-plicatedphase-outschedulewouldberequiredtomaintainthecurrentdistributionofbenefits.Theage-eligibilityrulesofthedependentexemptionandchildcreditdiffer.Hence,extendingtheben-efitsofthechildtaxcredittohigher-incomechildrenwouldeitherreducetaxrevenuesorrequireareductionintaxbenefitsforchildrenunderage17.Thedependentexemption(orasimilarben-efit)wouldberequiredfornon-childdependents,likeelderlyparents,limitingthesimplificationbenefits.Harmonizingrulesacrossthesecreditscouldraisetaxesforcertaingroups—forexample,applyingtheEITCeligibilityrulestothecombinedcreditwouldeliminatechild-relatedbenefitsfornon-U.S.residentsandfornon-custodialparents.
3. Consolidate the Child Tax Credit and Dependent Exemption, and Repeal (or Reduce) Some Education Credits
The proposal and its advantages: This option would apply the same age tests used for the dependent exemption to the child taxcredit,allowingfamilieswithchildrenunderage24whoarefull-timestudentstoreceivethechildtaxcredit.Theeducationcreditsavailabletothisgroupwouldthenbereducedorrepealed,buttheLifetimeLearningCredit(LLC)wouldbeofferedtotaxpayerswhocannotbeclaimedasdepen-dents.Inadditiontotheadvantagesofthepreviousoption,additionalsimplificationwouldarisebyreplacingthemultitudeofeducationbenefitswithasimpleflatcredit,eliminatingthird-partyreportingfromuniversitiesandburdensomerecordkeepingforexpenseslikebooksandsupplies.Complianceandenforcementofthesecreditswouldimproveandtaxpayerswouldnolongerneedtomakemultiplecalculationstolearnwhicheducationcredittotake.
Disadvantages:Again,dependingonthevalueoftheconsolidatedcreditandthequalifiedexpensesofstudents,somefamiliesmayreceivelargerorsmallercredits.
ii. Option 2: Simplify and Consolidate Tax Incentives for Education
Thetaxsystemincludesatleast18differentprovisionsbenefitingtaxpayerswitheducationalex-penses(seeTable2).Someprovisionsreducethecostofeducationdirectly,includingtheAmeri-canOpportunityTaxCredit(AOTC),theLLC,thetuitionandfeesdeduction,andthestudentloaninterestdeduction.Otherprovisionsencouragesavingforfutureexpenseswithsavingsbondsorthroughtax-preferredaccounts(thesearediscussedingreaterdetailinthesectionundersavingsincentives).
11Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Tabl
e 2
: S
umm
ary
of E
duca
tion
Pro
visi
ons,
20
09
Ty
pe
of
Ben
efit
Qu
alif
yin
g E
xpen
ses
Elig
ible
Ind
ivid
ual
sM
axim
um
An
nu
al A
mo
un
t In
com
e Li
mit
s
(sin
gle
/jo
int
file
rs)
Am
eric
an O
pp
ort
un
ity
Cre
dit
(ef
fect
ive
thro
ug
h 2
010)
Per
stu
dent
cre
dit a
gain
st
tax
Tuiti
on, r
equi
red
fees
, non
-ac
adem
ic fe
es, b
ooks
, su
pplie
s, e
quip
men
t
Taxp
ayer
, spo
use
or
depe
nden
t in
first
4
year
s of
hig
her
educ
atio
n pu
rsui
ng d
egre
e en
rolle
d at
leas
t hal
f-tim
e
$2
,50
0: 1
00
% o
f th
e fir
st
$2
,00
0 a
nd 2
5%
of
the
next
$2
,00
0 (
inde
xed
for
infla
tion)
Pha
se-o
ut b
egin
s at
$
80
,00
0/$
16
0,0
00
Ho
pe
Sch
ola
rsh
ip
Cre
dit
Per
stu
dent
cre
dit a
gain
st
tax
Tuiti
on a
nd r
equi
red
fees
Taxp
ayer
, spo
use
or
depe
nden
t in
first
2
year
s of
hig
her
educ
atio
n pu
rsui
ng d
egre
e en
rolle
d at
leas
t hal
f-tim
e
$1
,80
0: 1
00
% o
f th
e fir
st
$1
,20
0 a
nd 5
0%
of
the
next
$1
,20
0 (
inde
xed
for
infla
tion)
Pha
se-o
ut b
egin
s at
$
50
,00
0/$
10
0,0
00
Life
tim
e Le
arn
ing
C
red
it
Per
taxp
ayer
cre
dit
agai
nst t
ax
Tuiti
on a
nd r
equi
red
fees
Taxp
ayer
, spo
use
or
depe
nden
t in
post
-se
cond
ary
or p
rofe
ssio
nal
educ
atio
n
$2
,00
0: 2
0%
of
the
1st
$
10
,00
0 to
tal a
cros
s al
l elig
ible
stu
dent
s in
ho
useh
old
(not
inde
xed
for
infla
tion)
Pha
se-o
ut b
egin
s at
$
50
,00
0/$
10
0,0
00
Stu
den
t lo
an in
tere
st
ded
uct
ion
A
bove
-the
-line
ded
uctio
n
Tuiti
on, r
equi
red
fees
, no
n-ac
adem
ic fe
es,
book
s, s
uppl
ies
and
equi
pmen
t, ro
om a
nd
boar
d
Taxp
ayer
, spo
use,
or
depe
nden
t$
2,5
00
Pha
se-o
ut o
ver
$5
5,0
00
-$
70,0
00
($
11
0,0
00
-$
14
0,0
00
join
t file
rs)
mod
ified
AG
I.
Ed
uca
tio
n
exp
ense
s d
edu
ctio
n
(e
ffec
tive
th
rou
gh
20
09)
Abo
ve-t
he-li
ne d
educ
tion
Tuiti
on a
nd r
equi
red
fees
Taxp
ayer
, spo
use
or
depe
nden
t rec
eivi
ng
high
er e
duca
tion
$4
,00
0 o
r $
2,0
00
sub
ject
to
inco
me
limits
Ded
uctio
n lim
ited
to
$4
,00
0 if
mod
ified
AG
I is
less
than
$6
5,0
00
($
13
0,0
00
join
t); a
nd to
$
2,0
00
if m
odifi
ed A
GI
is le
ss th
an $
80
,00
0
($1
60
,00
0 jo
int)
,
Dep
end
ent
exem
pti
on
fo
r ch
ildre
n a
ged
19 t
hro
ug
h 2
3
Per
sona
l exe
mpt
ion
dedu
ctio
n fo
r de
pend
ent
stud
ents
age
d 1
9 th
roug
h 2
3
NA
Stu
dent
enr
olle
d fu
ll-tim
e fo
r at
leas
t 5 m
onth
s of
pr
eced
ing
year
$3
,50
0 (
inde
xed
for
infla
tion)
Pha
se-o
ut b
egin
s at
$
16
6,8
00
($
25
0,2
00
jo
int fi
lers
) A
GI
Ear
ned
Inco
me
Tax
Cre
dit
fo
r d
epen
den
t fo
r ch
ildre
n a
ged
19
thro
ug
h 2
3
Ref
unda
ble
cred
it fo
r fa
mili
es w
ith s
tude
nts
child
ren
aged
19
thro
ugh
23
NA
Stu
dent
enr
olle
d fu
ll-tim
e fo
r at
leas
t 5 m
onth
s of
pr
eced
ing
year
$2
,91
7 f
or f
amili
es w
ith a
si
ngle
dep
ende
nt c
hild
Pha
se-in
com
plet
e at
$
8,5
80
. Pha
se-o
ut
begi
ns a
t $1
5,74
0.
Pha
se-o
ut c
ompl
ete
at
$3
3,9
95
Em
plo
yer
pro
vid
ed
edu
cati
on
ass
ista
nce
p
rog
ram
(E
AP
)
Exc
lusi
on f
rom
gro
ss
inco
me
for
empl
oyer
pr
ovid
ed e
duca
tion
assi
stan
ce
Tuiti
on, r
equi
red
fees
, non
-ac
adem
ic fe
es, b
ooks
, su
pplie
s, e
quip
men
t and
sp
ecia
l nee
ds
Em
ploy
ee$
5,2
50
(no
t ind
exed
for
in
flatio
n)
Lim
its o
n sh
are
of
bene
fit th
at c
an g
o to
the
high
ly c
ompe
nsat
ed, n
o in
divi
dual
inco
me
limits
12Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Tabl
e 2
: S
umm
ary
of E
duca
tion
Pro
visi
ons,
20
09
(con
tinue
d)
Ty
pe
of
Ben
efit
Qu
alif
yin
g E
xpen
ses
Elig
ible
Ind
ivid
ual
sM
axim
um
An
nu
al A
mo
un
t In
com
e Li
mit
s
(sin
gle
/jo
int
file
rs)
Can
cella
tio
n o
f d
ebt
Exc
lusi
on f
rom
gro
ss
inco
me
for
inco
me
from
ca
ncel
latio
n of
cer
tain
st
uden
t loa
ns
NA
Bor
row
er w
ho w
orks
for
a
cert
ain
perio
d of
tim
e in
ce
rtai
n pr
ofes
sion
sN
one
Non
e
Bu
sin
ess
exp
ense
d
edu
ctio
n
Ite
miz
ed d
educ
tion
Mos
t bus
ines
s or
wor
k re
late
d ed
ucat
ion
expe
nses
incl
udin
g tr
ansp
orta
tion
and
child
care
Taxp
ayer
or
spou
seN
one
Ove
rall
limita
tion
on
item
ized
ded
uctio
ns
may
app
ly to
AG
I ove
r $
15
6,4
00
Sch
ola
rsh
ips
and
fe
llow
ship
s
Exc
lusi
on f
rom
gro
ss
inco
me
for
scho
lars
hips
an
d fe
llow
ship
s
Tuiti
on, r
equi
red
fees
, non
-ac
adem
ic fe
es, b
ooks
, su
pplie
s, e
quip
men
tD
egre
e ca
ndid
ate
Non
eN
one
Tuit
ion
red
uct
ion
Exc
lusi
on f
rom
gro
ss
inco
me
for
tuiti
on
redu
ctio
nTu
ition
Em
ploy
ee o
f co
llege
, sp
ouse
or
depe
nden
t; gr
adua
te s
tude
ntN
one
Non
e
Trad
itio
nal
an
d R
oth
IR
As
Exc
eptio
n fr
om 1
0%
ad
ditio
nal t
ax o
n ea
rly
dist
ribut
ions
Tuiti
on, r
equi
red
fees
, non
-ac
adem
ic fe
es, b
ooks
, su
pplie
s, e
quip
men
t, ro
om
and
boar
d, s
peci
al n
eeds
Taxp
ayer
, spo
use,
chi
ld
or g
rand
child
(en
rolle
d at
le
ast h
alf-
time
for
room
an
d bo
ard)
Non
eN
one
Qu
alifi
ed T
uit
ion
P
lan
(Q
TP)
or
529
Pla
n
Exc
lusi
on f
rom
gro
ss
inco
me
for
dist
ribut
ions
fr
om Q
TP a
ccou
nts
Tuiti
on, r
equi
red
fees
, non
-ac
adem
ic fe
es, b
ooks
, su
pplie
s, e
quip
men
t, ro
om
and
boar
d, s
peci
al n
eeds
, an
d co
mpu
ter
tech
nolo
gy*
(*AR
RA
add
ition
)
Any
pos
t-se
cond
ary
stud
ent (
enro
lled
at le
ast
half-
time
for
room
and
bo
ard
)
Non
eN
one
Co
verd
ell E
du
cati
on
S
avin
gs
Acc
ou
nt
E
xclu
sion
fro
m g
ross
in
com
e fo
r di
strib
utio
ns
Tuiti
on, r
equi
red
fees
, non
-ac
adem
ic fe
es, b
ooks
, su
pplie
s, e
quip
men
t, ro
om
and
boar
d, a
nd s
peci
al
need
s
Any
stu
dent
, inc
ludi
ng
prim
ary
and
seco
ndar
y (e
nrol
led
at le
ast h
alf-
time
for
room
and
boa
rd)
Con
trib
utio
ns li
mite
d to
$2
,00
0 p
er y
ear,
per
reci
pien
t
Pha
se-o
ut o
f el
igib
ility
fo
r co
ntrib
utio
ns f
rom
$
95
,00
0-$
11
0,0
00
(s
ingl
e fil
ers)
Sav
ing
s b
on
d in
tere
st
Exc
lusi
on f
rom
gro
ss
inco
me
for
U.S
. sav
ings
bo
nd in
tere
stTu
ition
and
req
uire
d fe
es
Taxp
ayer
, spo
use,
or
depe
nden
t N
one
Pha
se-o
ut $
50
per
$
10
00
, fro
m $
67,1
00
-$
82
,10
0 (
sing
le fi
lers
)
Gif
t ta
x ex
clu
sio
n
E
xclu
sion
for
tuiti
on p
aid
dire
ctly
to e
duca
tiona
l in
stitu
tion
Tuiti
onA
ny s
tude
ntN
one
Non
e
13Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
ThepurposesofthedifferentcreditsandprovisionsdescribedinTable2aretoencourageeduca-tionalinvestmentandtohelpreducethecostofhighereducation.However,theexpertsweheardfromarguedthatthecurrentmultiplicityofcreditsis,atbest,aninefficientwaytoachievethosegoals.First,thecurrentsystemobscuresthetaxbenefitofeducationalinvestmentsuntilaftertheyaremade.Thisreducesthevisibilityoftheincentivesandmakestheseprovisionslesseffectiveatpromotingeducationalinvestment.Moreover,taxcreditshaveuptoa10-monthlagbetweenwhentuitionorothercostsareincurredandwhenthecreditisawarded,somethingthatposesintolerablefinancinghardshipsonthosewithoutsubstantialincomeorotherresources.Asecondconcernisthatthetaxbenefitsforwhichastudentattendingcollegeiseligiblearedifficulttounderstand.Forexample,severaloftheeducationbenefitsaremutuallyexclusive—aparent(orstudent)mayclaimonlyoneofthedeductionfor“tuitionandfees,”theLLC,ortheAOTCforaparticularstudent.Thus taxpayersmustevaluatemultipleprovisionsandmakealternativecalculations—oftenwellaftereducationalexpendituresaremade—tofigureouttheireligibilityfordifferenttaxcreditsandtheamountsforwhichtheyareeligible.Thus,theincentivesinthesecreditsareneithertranspar-entenoughnor timelyenough toencourageeducation formany taxpayers. ExpertscontrastedthesebenefitswiththeprogramofPellGrants,whichtargetlower-incomegroupsandareawardedconcurrentlywithapplicationandadmissiontocollege.ManyarguedthatPellGrantsaremorehelpfultothepoorandtomiddle-incomehouseholdsthanrefundablecredits,andthatincreas-ingeducationalfundingforthesegroupsmaybebetterdonethroughimprovedPellGrantsthanthroughthetaxsystem.
Anotherconcernisthatthecreditsandotherprovisionsarethemselvescomplexandconfusing,makingithardfortaxpayerstoclaimthebenefitsproperly.Thepublicationthatdiscusseseduca-tionbenefitsoffers11definitionsofa“qualifyingexpense”anda“qualifyinginstitution”foratotalof12education-relatedtaxprovisions.Inmanycases,thesealternativedefinitionsimplysubstan-tivedifferencesinwhatqualifiesforataxbreak:taxpayerscannotclaimmostcreditsforcostsofroomandboard,butmayusefundsfromaneducationsavingsaccountordeductinterestfromastudentloantopayforthosecosts.Similarly,theAOTCisavailableforastudentpursuingadegreeinthefirstfouryearsofpost-secondaryeducation,whiletheLLCisavailableforanunlimitednum-berofyearsandtonon-degreestudents.TaxpayersmaytakemultipleAOTCsformultiplestudentsbutonlyoneLCCindependentlyofthenumberofstudents;theymaybeunawarethattheycantaketheAOTCforonestudentandtheLLCforanother.Thesystemissufficientlycomplicatedthatmanytaxpayersfailtoclaimeducationbenefitstowhichtheyareentitled.TheGAOreportedthat19percentofeligibletaxfilersin2005didnotclaimeitheratuitiondeductionorataxcreditthatcouldhavereducedtaxliabilitybyanaverageof$219,probablyduetothecomplexityofthetaxprovisions.Taxpayersmayalsoerroneouslyclaimtaxbenefitstowhichtheyarenotentitledormaynotclaimthecreditwhichwouldbemostadvantageoustothem.
Finally,thesystemimposessizablecomplianceandrecordkeepingburdensonstudents,parents,andeducational institutions. Collegesanduniversitiesmustdocumentenrollmentand tuition,andtaxpayersmustdocumentandmaintainrecordsofpaymentsforqualifiedtuitionandfeesand
14Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
othernon-reportedexpenses, likebooksandsupplies.1 Administeringthesebenefits isdifficultbecausetheIRScannotevaluatemanyclaimswithoutanintrusiveaudit.
Overall,thesystemofeducationtaxbenefitswouldbemoreeffectiveiftheincentivesweremoretransparentandtimely,andbenefitswereeasiertoclaimandenforce.
The proposal and its advantages: Replacing the large number of subsidies that exist to help taxpayers pay for current educationexpenseswithoneortwoalternativeswouldeliminatemultiple,redundantdefinitions,pagesofinstructionsandworksheets, andwouldreduce theneed for individuals tocompute their taxesmultiple times. Taxpayers would know in advance which credit they are eligible for and whatamounttheywouldreceive,increasingthetransparencyofthetaxcodeandthesalienceofincen-tives. Harmonizingthedefinitionofqualifiededucationalexpenseswouldhelpfamiliesunder-standwhichexpensesaredeductibleandwhicharenot.Fromanadministrativeperspective,itisimportanttorecognizethatcomplianceandadministrationareeasierforqualifiedexpensesliketuitionforwhichthereisgoodthird-partyreporting,andmoredifficultforexpensesthatarehardfortheIRStodocumentlikeexpensesforbooks,orexpensesthatmightbeconsideredabusive,likerentforaluxurycondo.
Some experts suggested modest changes like allowing the tuition and fees deduction, which isredundantformostfamilies,toexpirewhilesimplifyingandnarrowingthedefinitionofqualifiedexpensesforcertainbenefits.Amorebroad-reachingreformwouldconsolidateeducationcreditswithotherfamily-andchild-relatedcredits.Forexample,oneproposalwouldextendeligibilityforthechildtaxcredittoanytaxpayerclaimingadependentexemptionforafulltimestudentuptoage23,whileeliminatingorreducingcertaineducationcredits.Thisproposalcouldreplacehard-to-administerandunderstandeducationcreditswiththerelativelysimplechildtaxcreditrequiringlittlerecordkeepingorcomplianceeffort.
Theliteratureonbehavioraleconomicsemphasizesthatthepresentationofincentivesoftenaffectsthechoices individualsmake. Recent researchshows that simplyfillingout federal studentaidformsatthetimetaxpayersfiletheirreturnswouldinfluencethelikelihoodthattheyenrollthem-selvesortheirchildreninschool.Thisresearchsuggeststhatabetterintegrationofstudentaidpro-visionswiththetaxsystemandamorevisiblepreviewofthetaxbenefitsavailabletostudentscouldencourageenrollmentwithoutrequiringincreasesinthevalueofgovernment-providedsubsidies.
Disadvantages:Aconcernwithaconsolidationofcreditsisthatthecurrentvariationincreditsandeligibilityrulesreflectsthevariationintypesofstudentsandtypesofeducationalinvestments. TheAOTCandLLCprovideoverlappingcoveragetomostcollegestudentsandmostchoosetheAOTCbecauseofitsmoregenerousbenefits.However,aconsolidationthateliminatedtheLLCwouldeitherdepriveabout7millionpart-timestudentsfromtheseeducationbenefitsorextendmorecostlybenefitstothislargegroup.Similarly,aproposaltoreplacecertaineducationcreditswithanextendedchildtaxcreditwouldneedtoaddressbenefitsforthealmost7millionstudentsovertheageof25.Har-
1 Universitiescanreporteithertuitionbilledortuitionpaid,whichmayleadtoconfusiononthepartofthetax-payeranderrorsintheamountsofdeductionstheyclaim.
15Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
monizingrulesregardingqualifiedexpenseswouldalsorequiredifficulttradeoffs.Partofthecom-plexity,recordkeeping,andadministrativeburdenarisesfromhard-to-documentexpensesrelatedtobooks,supplies,androomandboard.Eliminatingtheseexpenseswouldsimplifythecreditandimprovecompliance,butwouldprovideequaltreatmenttotaxpayerswithunequalexpenditures.
iii. Option 3: Simplify the “Kiddie Tax” (Taxation of Dependents)
Currentlawrequiresapproximately10milliondependentstofiletaxeseachyeartoreportrelativelysmallamountsoftax.This“kiddietax,”enactedtopreventparentsfromreducingtheirfamily’staxliabilitiesbyshiftinginvestmentincometotheirchildren,includesrulesthatcanrequireadepen-denttofileareturnwithaslittleas$950ofinvestmentincome.Ifinvestmentincomeexceedsasecondthresholdof$1,900,theincomeistaxedatratesthatdependontheincomeofsiblingsandparents.Thetaxgenerallyappliestochildrenunderage18,full-timestudentsage19to24whocanbeclaimedasdependents—eveniftheyarenotclaimed—andtoelderlyordisableddependents.Abouthalfofkiddietaxfilersarecollegestudentsandabout40percentarebetweenage14and 18.In2005,5.7milliondependentfilers(outof9.9million)paidlessthan$50intaxes,andmostofthose5.7millionowednotaxesandfiledonlytogetarefund.
Inadditiontostringentfilingrequirements,thetaxcalculationitselfisparticularlycomplex.Inthemostbasiccaseofdependentsreceivingonlyinvestmentincome,thefirst$950isexemptbasedonaspecialstandarddeductionfordependentfilers,thenext$950istaxedatthedependent’staxrate,andadditionalincomeistaxedattheparents’taxrate,ifhigher.Ifthedependenthasearnedin-come,sayfromasummerjob,thestandarddeductionismorecomplexanddependsonthecombi-nationofearnedandinvestmentincome.Inmostsituations,thedependent’sstandarddeductionislessthanthestandarddeductionforothersinglefilers.Ifaparenthasmorethanonechildsubjecttothekiddietax,anevenmorecomplicatedprovisionrequiresaddinguptheinvestmentincomeofallthechildrenandtheparentsandthenallocatingtheresultingadditionaltaxamongthechil-dren’staxreturns.Navigatingtheserulesrequiresa28-pageIRSbookletthatincludesworksheetstocalculatethedependent’staxableincomeandtaxliability.
Theinterdependencebetweenadependent’staxreturnandthatofsiblingsandparentscancreatesignificant issues incertainsituations. First, thisrequirescoordinationamongfamilymemberswhenfilingtaxes,whichmaybedifficultwhenstudentsareawayatcollegeorwhenfamilydisputesmakeitdifficulttoobtaintherequiredinformationaboutparents’returns.Additionally,interde-pendencerequiresspecialrulestodealwithamendedreturnsandtheAMT.Theseprovisionsap-plytoindividualswhocouldbeclaimedasdependentsofanothertaxpayerregardlessofwhethertheyareactually claimedornot. Thus, aparentdoesnot escape thecomplexity simplybynotclaimingadependent.Collegestudentswhocouldbeclaimedasdependentsshouldbefilingtheirreturnsasdependentfilersandmayneedtocoordinatetheirreturnswiththoseoftheirparentsandsiblingsiftheyaresubjecttothekiddietax.Inmanyinstances,thekiddietaxcouldbeconsideredtobeataxonafamily’slackofsophistication.Thatistypicallythesituationwhenfamiliesdonotunderstandorusethespecialtaxprovisionsthatprovidefavorabletaxtreatmentforfundssetasideforthedependent’seducation.
16Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
The proposals and their advantages: Theburdenofthekiddietaxarisesbecauseofthelowfilingthresholdthatrequirestaxpayerstofilemillionsofreturnsthatgeneratelittlemoney,becauseofthefactthatmillionsmustfileforrefundsdespiteowingnotaxes,andbecausethecomputationoftherequiredtaxisitselfcomplicated.Thefilingburdencouldbereducedbyraisingthestandarddeductionfordependentsandbyimprov-ingrulesforwithholdingsothatfewerdependentworkershadtaxeswithheldonsmallamountsofincome.Providingasafeharborwithholdingexemptionforyoungfilers(lessthanage18,forexample)wherebyindividualsandemployerswerenotpenalizedforimposingzerowithholdingwouldreducethenumberofdependentsrequiredtofilejusttoreceivearefund. Becausethesetaxpayers owe little in taxes, the compliance issues and revenue consequences would be small.Similarly,raisingthestandarddeductionfordependentscouldreducetheburdenoffilingsignifi-cantlyatarelativelysmallrevenuecost;doublingthe$950standarddeductionto$1,900makesasinglethresholdatthecurrentkiddietaxlevelandmakes300,000dependentreturnsnon-taxable.
Therearealsoseveraladvantagestosimplifyingthetaxcalculationfordependentswhomustfile.First,eliminatinganyinteractioninthecalculationofthetaxratebetweenthedependent’sincomeandsiblings’incomewouldreducethenumberofcomputationsrequiredatrelativelysmallrevenuecost.Theadditionalstepofeliminatinginteractionswithaparent’staxratewouldprovidegreatersimplification,butpolicymakerswouldneedtochoosewhichtaxratetoapplytoadependent’sinvestmentincometoensurethatparentswerenotavoidingtaxesbytransferringassetstotheirchildren.Oneoptionwouldtaxadependent’sordinaryincomeandamodestamountofinvest-mentincomeatthetaxratefordependentsandthentaxanyremaininginvestmentincomeatthemaximumrate.Anotheroptionwouldusetheratescheduleforfiduciaryreturns,whichhasnar-rowertaxbrackets.
Disadvantages:Raisingthefilingthresholdorincreasingtheamountofincometaxedatthedependentratecouldincreaseparents’incentivetoshelterinvestmentincomeastheirchildren’s,sincethetaxrateforchildrenisgenerallylowerthanthatoftheparents.Simplificationthatappliedthetoptaxratetothedependent’sincomeoverathresholdtodiscouragesuchshelteringcouldraisetaxratesonde-pendentswithrelativelymodestamountsofincome.Taxinginvestmentincomeofdependentsatthemaximumratecouldbeviewedaspunitiveasitwouldmeantaxingthatincomeataratehigherthantheparents’rateinmostcases.
iv. Option 4: Simplify Rules for Low-Income Credits, Filing Status, and Divorced Parents
Anumberofexpertscitedtherulesthatapplytolow-incomeprovisionsliketheEITC,thechildtaxcredit,andheadofhouseholdfilingstatus,asparticularlycomplex,inconsistent,difficulttointer-pretandtoenforce,andinequitable.Theseprovisionsproviderefundablecreditsforlow-incomehouseholdsandreducethetaxburdenforfamilieswithchildren.
Some of the complexity associated with claiming these credits is illustrated in Figure 2, whichshowstheactualchecklists,worksheets,andformsalow-incomeparentmustnavigatetoclaimand
17Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
calculatetheEITCandtherefundablechildtaxcredit.Additionalcomplexityarisesfromthevaria-tionindefinitionsandeligibilitycriteriaforthedifferentprograms.Becausetheeligibilitycriteriaaffectonlyaverysmallsubsetoftaxpayersformanyoftheseprovisions,theadditionalcomplexityprovideslittlebenefitintermsofrevenuecollection.
Anadditionalcostofthecomplexityoftheseprovisionsisincreasednoncompliance.AccordingtotheIRS,errorsinclaimingtaxcreditsanddeductionsincludingthosedescribedabovecontrib-uted$32billiontothetaxgapin2001.InitsmostrecentstudyofEITCnoncompliance,theIRSestimatedthattheEITCover-claimratewasabout27percent.Whilecomplexityisoftencitedasareasontaxpayersoverclaimcredits,otherstudiespointoutthatbetween15and25 percentofap-parentlyeligibleindividualsdonotclaimtheEITC,possiblyduetothecomplexityoftheeligibilityrulesandthecreditcomputation.Hence,thecomplexityoftheseprovisionsalsoresultsintaxpay-ersforgoingthebenefitstheyareprovidedbylaw.
1. Harmonize the EITC and Additional Child Tax Credit
Figure2showstheactualformsataxpayerclaimingboththeEITCandtheadditionalchildtaxcreditmayneedtofiletoclaimthesebenefits(andthefigureexcludesotherformsforotherbenefitssuchaparentwouldlikelyclaim).MuchofthecomplexityillustratedinthefigurearisesbecauseofdifferencesbetweentheEITCandtheadditionalchildtaxcreditthatrequiretaxpayerstoassesseligibilityunderdifferentrulesandtocalculatebenefitsindifferentways.Forexample,boththeEITCandtheChildTaxCreditarepredicatedonearnedincome.However,thedefinitionofearnedincomediffersbetweenthetwocredits,andfamilieswiththreeormorechildrencanchooseamongalternativedefinitionsofearningsforthechildtaxcredit.Thislatterprovisionalonerequiresoveronemillionfamiliestocomputetheircreditstwiceinordertomaximizetaxsavings.
18Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Figure 2: The Process for Claiming the EITC and Additional Child Credit Figure 2: The Process for Claiming the EITC and Additional Child Credit
Form 1040 Instructions: Lines 64a and 64b – Earned Income Credit (EIC) (Steps 1-2)
Form 1040 Instructions: Lines 64a and 64b – EIC (Steps 3-4)
Form 1040 Instructions: Lines 64a and 64b – EIC (Steps 5-6)
Schedule EIC – Earned Income Credit
Form 1040 Instructions: Worksheet A – EIC – Lines 64a and 64b
Form 1040 Instructions: Worksheet B – EIC– Lines 64a and 64b (Parts 1-4) Form 1040 Instructions:
Worksheet B – EIC– Lines 64a and 64b (Parts 5-7)
Form 8812 – Additional Child Tax Credit
Form 8812 Instructions: Earned Income Chart – Line 4a
Pub. 972: 1040 and 1040NR Filers – Earned Income Worksheet
Pub. 972: Child Tax Credit Worksheet (Part 1)
Pub 972: Child Tax Credit Worksheet (Part 2)
Form 1040 Instructions: Child Tax Credit Worksheet – Line 51 (Part 1)
19Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Figure 2: The Process for Claiming the EITC and Additional Child Credit
Form 1040 Instructions: Lines 64a and 64b – Earned Income Credit (EIC) (Steps 1-2)
Form 1040 Instructions: Lines 64a and 64b – EIC (Steps 3-4)
Form 1040 Instructions: Lines 64a and 64b – EIC (Steps 5-6)
Schedule EIC – Earned Income Credit
Form 1040 Instructions: Worksheet A – EIC – Lines 64a and 64b
Form 1040 Instructions: Worksheet B – EIC– Lines 64a and 64b (Parts 1-4) Form 1040 Instructions:
Worksheet B – EIC– Lines 64a and 64b (Parts 5-7)
Form 8812 – Additional Child Tax Credit
Form 8812 Instructions: Earned Income Chart – Line 4a
Pub. 972: 1040 and 1040NR Filers – Earned Income Worksheet
Pub. 972: Child Tax Credit Worksheet (Part 1)
Pub 972: Child Tax Credit Worksheet (Part 2)
Form 1040 Instructions: Child Tax Credit Worksheet – Line 51 (Part 1)
20Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Totargetbenefitstotheneedy,theEITCusesinvestmentincomeasaproxyforwealth,andin2010limitseligibilitytofamilieswithunder$3,100ininvestmentincomefromsourceslikecapitalgains,propertysales,rents,royalties,andnetincomefrompassiveactivities.Thistest,whichisnotap-pliedtotherefundablechildtaxcredit,requiresadditionalinstructionsanda16-lineworksheet.
The proposal and its advantages: Harmonizingtherulesgoverningeligibility,thedefinitionofearnedincome,andthecalculationofbenefitsfortheEITCandthechildtaxcreditwouldeliminatethemultipleschedulesrequiredforfamilieswiththreeormorechildren.Thiscouldpotentiallyhalvethenumberofcalculationsandworksheetsneededtofigurethesecreditsandeliminatepagesofinstructions.
Inaddition,reducingthescopeofthedefinitionofdisqualifiedinvestmentincometoonlythemostcommonincomesourcesreportedonthe1040wouldreducethecomplexityoftheinstructions.Eliminatingthetestentirelywouldprovidefurthersimplification,andwouldreducetheimplicittaxonsavingandassetaccumulationinworkingfamilies. Alternatively,thesametestcouldbeappliedtoboththeEITCandtheadditionalchildtaxcredit.Thiswouldbeasimplificationinthesensethatfamilieswouldfaceconsistentrequirementsforbothcredits.
Disadvantages:Thecomplexityofthesecreditspartiallyreflectsthedesiretotargetbenefitstocertaingroups.Aharmonizationof rules thatadopted theEITCdefinitionofearningsandofqualifyingchildrenwouldreducethesizeoftherefundablechildtaxcreditforcertaingroups,oreliminateitentirelyforsomefamilieswiththreeormorechildren.Forexample,endingmultiplecomputationsforthechildtaxcreditwouldeliminatethechildtaxcreditforafewhundredthousandfamilieswiththreeormorechildrenlivinginPuertoRico,whocurrentlyfilelargelytoreceivethisbenefit.
Eliminatingorsimplifyingthedisqualifiedincometestwouldexpandeligibilitytofamilieswithpotentiallyconsiderableassetsandwealth;withouttheinvestmentincometest,about500,000tax-payerswouldbecomeeligiblefortheEITC.Asimplification(ratherthanelimination)ofthetest,however,wouldexpandeligibilitylessandatasmallerrevenuecost. Alternatively,applyingthedisqualifiedincometesttotheadditionalchildtaxcreditwouldreduceeligibilityforthatcreditandincreaserevenues.
2. Simplify Filing Status Determination
Unmarriedtaxpayerslivingwithdependentsmayqualifytofileasheadofhousehold,afilingstatusthatprovidesa largerstandarddeductionandmoregenerous taxbrackets. Similarly, taxpayerswhoqualifyas“survivingspouses”afterthedeathofaspousemayusethesamestandarddeduc-tionandtaxbracketsappliedtomarriedcouples.Ineithercase,toqualify,ataxpayermustpayoverhalfthecostofmaintainingthehomeinwhichheorsheresideswiththedependentduringtheyear(thehouseholdmaintenancetest).Thistestisburdensomebecauseitrequirestaxpayerstoproduceandretaindocumentationshowingtheirhouseholdexpenditures,andbecauseofthecomplicateddefinitionofwhatisorisnotaqualifyingexpenditure.Therecordkeepingrequire-mentsareafrequentsubjectofenforcementdisputesbecausetheycannotbeverifiedintheabsenceofacumbersomeaudit.
21Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
The proposal and its advantages: Eliminatethehouseholdmaintenancetestforunmarriedtaxpayerswhoresidewithandclaimadependent,andallowthemtoclaimheadofhouseholdfilingstatus(orsurvivingspousestatus)withoutregardtowhethertheymaintainthehomeinwhichtheyreside.Alternatively,eliminateheadofhouseholdfilingstatusentirelyandrequirethatunmarriedtaxpayersfilereturnsassinglefilers.Eitherofthesechangeswouldeliminatealengthyworksheetanditsinstructions,andreducerecordkeepingformorethan24millionfilers.Eliminatingheadofhouseholdfilingstatusentirelywouldremoveaseparateratescheduleandstandarddeduction.
Disadvantages:Thisoptionwouldcausemarriagepenaltiestoincreaseunlessspecialruleswereappliedforunmar-riedparentswhoresidetogether.Asinglehomewithmultiplefamiliescouldpotentiallyincludemultipleheadsofhousehold.Ifheadofhouseholdfilingstatuswereeliminated,thestandardde-ductionforhouseholdheadswouldshrinkandsometaxpayerswouldbebumpedintohighertaxbrackets.The2005TaxReformPaneladvocatedeliminatingheadofhouseholdfilingstatus,butsuggestedaddressingthesedistributionalconcernsbyreplacingitwithataxcreditforunmarriedindividualswithfamilyresponsibilities.
3. Eliminate the “Household Maintenance Test” for “Estranged” Spouses
MarriedindividualscannotclaimtheEITCunlesstheyfilejointlyorunlesstheyqualifytofileasheadofhouseholdasan“estranged”or“abandoned”spouse.Toqualifyasanabandonedspouse,ataxpayermustlivewithhisorherchildapartfromhisorherspouse,andmustalsopassthehouse-holdmaintenancetestdescribedabove. Becauseofthecomplexityoftheruleandthedifficultyofmaintainingappropriaterecords,thisrulecontributessignificantlytonon-compliance:almost11percentofEITCoverpaymentsin1999wereduetomarriedtaxpayersfilingassingleorheadofhouseholdwhodidnotmeettherequirements.Manyoftheseclaimswouldnotbeerroneousabsentthehouseholdmaintenancetest.
The proposal and its advantages: Eliminatingthetestwouldreducetherecordkeepingburdenofthisprovisionandimprovecompli-ance.(Analternativeproposalwithasimilareffectwouldallowmarriedtaxpayerswhofilesepa-ratereturnstoclaimtheEITCprovidedtheylivewithachildandapartfromtheirspouse.)ThiswouldalsoimproveequitybyextendingthesametreatmenttoabandonedspouseswhomaybeunabletoprocureadivorceascurrentlyprovidedtodivorcedparentswhoautomaticallyqualifyfortheEITC.Thistreatmentwouldmorecloselyreflectthetreatmentofotherchild-relatedbenefitslikethechildtaxcreditanddependentexemption,whichareavailableindependentlyoflivingar-rangementsandtomarriedtaxpayersfilingseparatereturns.Thecurrenttestcontributestoacci-dentalnoncompliancebecausetaxpayersinthesesituationsappeartoclaimtheEITCerroneously,notrealizingtheyareineligible.
22Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Disadvantages:Eliminatingthetestwouldexpandeligibilitytoabroadergroup.However,therevenuelossislikelytobemodest,inpartbecausemanyineligibletaxpayersalreadytakeuptheEITCmistakenly.
4. Simplify the EITC for Childless Workers
The proposal and its advantages: Therulesthatapplytolow-incomefamiliesincomplicatedlivingsituationsareasourceofaddi-tionalcomplexitywhenclaimingtheEITC.Aworkerthatliveswitha“qualifyingchild”butdoesnotclaimthechildfortheEITCmaynotclaimtheEITCforchildlessworkers.Thismeans,forex-ample,thatanunclethatliveswithhissisterandherchildisnevereligibletoclaimachildlessEITC.Allowingrelativeswhoarenotthechild’sparenttoclaimtheEITCforchildlessworkerseveniftheylivewithaqualifyingchildwouldequalizethetreatmentofsimilarindividualsregardlessoftheirlivingarrangementsandwouldeliminateanerror-provokingregulation.
Disadvantages:ExpandingEITCeligibilitywouldreducerevenues.However,themaximumchildlessEITCis$457and,inpractice,manyindividualsaffectedbytheruleprobablyalreadytakethecrediterroneously,implyingtherevenuelosseswouldbesmall.Someofthetargetingthatmotivatesthecurrentcom-plexitywouldbelost,andthesimplificationgainswouldbeminimizedbecauserulesprohibitingco-residentunmarriedparentsfromreceivingthechildlessEITCwouldberequiredtoreducemar-riagepenalties.
5. Clarify Child Waivers in the Event of Divorce or Separation
Therulespertainingtodivorcedandseparatedparentsareparticularlycomplexanddissimilartotherulesthatapplytootherparents.Divorcedorseparatedparentsareallowedtoexchangetheirrights tocertainchild-relatedbenefits—thedependentexemptionandthechildcredit—butnotothers,liketheEITC.Theserulesburdenalltaxpayerswhoreadinstructionsandfillinchecklists.Theyalsoburdendivorcedfamilies,whomayhavetocomputetheirtaxesunderdifferentscenariostocalculatetheirmaximumtaxsavings.Moreover,thesebenefitsareincreasinglylitigatedinchildsupportordivorcesettlements,resultinginapatchworkofrulingsfromstatecourtsthatnowde-terminewhomayclaimthese federalbenefits. TherulealsoreducesEITCcompliancebecausenoncustodialparentswhoclaimthechildtaxcreditandotherbenefitsmayalsointentionallyorerroneouslyclaimtheEITCaswell.Finally,thissituationmayproducea“divorcesubsidy”bypro-vidingparentswiththeabilitytolowertaxesbyseparating.
The proposal and its advantages: Oneoptiontoaddressthissituationistoeliminatetheabilityofdivorcedorseparatedparentstoexchangetaxbenefits.Thiswouldsimplifytheinstructionsforalmostallchild-relatedbenefitsbyeliminatingthespecialprovisionsfordivorcedparents.Thiswouldalsoimprovehorizontalequitybytreatingpeopleinsimilarcustodialandresidentialsituationsthesameway.
23Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Disadvantages:Adownsidetothisisthatitcouldincreasecomplexityintheinterimifcurrentagreementsweregrandfathered. Suchachangewould increase taxesonnoncustodialparentscurrentlyclaimingchild-relatedbenefitsandwouldreducetaxesoncustodialparents.Theeconomiceffectofsuchachange isuncertain,asparentscouldpresumablyundothisredistributionbymodifyingchildsupportagreements. However,giventhat thedependentexemptionisworthmoretotaxpayersinhighertaxbrackets,theneteffectofsuchachangecouldbetoraiserevenuesintheaggregateifnoncustodialparentsareinhigherbrackets.
b. Option Group B: Simplifying Savings and Retirement Incentives
Morethan20provisionsinthetaxcodeprovideincentivestosaveforretirementandforotherpurposeslikeeducationandmedicalexpenses.Weheardthatindividualscanbeintimidatedandconfusedbothbythesheernumberofaccountstochoosefromandbythefactthateachaccountisgovernedbyadifferentcombinationofrulesregardingeligibility,contributionlimits,andwhenmoneymaybewithdrawn.Weheardconcernsthatthisconfusionreducestake-upofretirementplansbyworkersandthepropensityofemployerstoofferplans,withnegativeeffectsonthegoalofincreasingsaving.Giventhatsavingincentiveprovisionsinthetaxcodearethethird-largesttaxexpenditure—costing$118billionin2008—itisimperativethattheirpublicbenefitsjustifytheircost.
We heard three types of criticisms of the current system. First, many argued that the array ofoptionspresentedtoindividualhouseholds,businesses,andtheiremployeesmakesitdifficulttochooseaplaninthefirstplaceandthecomplicatedrulesmakeithardtounderstandtheincentivestosave,underminingtheireffectiveness.Asecondgrouppointedoutthatformostworkersthechoiceofanemployer-sponsoredsavingplanwasnotthelargestissue—mostemployeesatmediumandlargeemployersareonlyeligibleforoneplan,forexample,a401(k)iftheyworkforaprivateemployerora403(b)iftheyworkforanon-profit. Thisgroupsuggestedthatmostofthecostsofcomplexityariseatsmalleremployersandforemployeeswithmorecomplicatedemploymentsituations. Thisgroupemphasizedadministrativehurdles foremployers sponsoringaplanandinequitiescausedbythedifferentrules;theysuggested“behavioral”interventions(likeautomaticenrollment)toraisesavingswithinthecurrentsystem.Athirdconcernraisedbysomeexpertswasthatthedistributionofbenefitsofthecurrentsetofsavingsincentiveswasnotwellalignedwiththepublicgoalsof increasingsavingsamonggroupswith lowsavingsrates; insteadmostof thebenefitsofsavings-relatedtaxprovisionsaccruetohigher-incomegroupswhoalreadyhavehighpropensitiestosave.AccordingtotheTaxPolicyCenter,about84 percentofthetaxexpenditureforretirementsavingsincentivesaccruestotaxpayersearningmorethan$100,000.
Improvingtheeffectivenessoftaxpreferencesforretirementsavingcouldbeachievedalongmul-tipledimensions. Consolidatingaccountsandharmonizingruleswouldsimplifytheretirementsystemformanyworkersandemployers.Otherrules,likethosegoverningwhenandhowmoneymaybewithdrawnfromaccountscouldalsobechangedtoreducetheburdenontaxpayers.Inad-
24Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
dition,incentivestosavecouldbeimprovedwithsimplebehavioralinterventions,likeautomaticenrollmentandofferingtheSaver’sCreditasamatchinsteadofacredit.
Wediscusseightoptionsforsimplifyingsavingsandretirementincentives.
i. Option 1: Consolidate Retirement Accounts and Harmonize Statutory Requirements
Thetaxcodeoffersmorethanadozenvarietiesoftax-favoredretirementsavingaccountsinclud-ingthe401(k),SavingsIncentiveMatchPlanforEmployees(SIMPLE)401(k),Thrift,403(b),gov-ernmental457(b),SalaryReductionSimplifiedEmployeePensionPlan(SARSEP),andSIMPLEIndividualRetirementAccount(IRA)plans.Theseaccountsoftenhavedifferentrulesregardingeligibility,contributionlimits,andwithdrawals.
Table3belowprovidesdetailsonafewrepresentativeemployer-sponsoredretirementplansandsummarizesmanyofthekeyregulationsgoverningtheplans.2Asthetablemakesclear,thereisawidevarietyofrulesacrossplans.Mostplanspenalizeearlywithdrawalsfromretirementaccounts,butsomeretirementplansallowearlywithdrawalswithoutpenalty for“hardship”(usingdiffer-entdefinitionsofhardship)orallowforloans;othersallowearlywithdrawalsformedical,homebuying,oreducationalexpenses;andsomeaccountsdefine“early”asbeforeage59½andsomeasanytimebeforeanemployeeleavesafirm.Therulesforwhenanemployeemay“rollover”contri-butionsfromoneaccounttoanotherhavebeenpartiallyharmonized,buttherearestillcertainac-countswhichcannotberolledintoothers,orcanonlyberolledoverafterawaitingperiod.Ontheemployerside,differentplanshavedifferentrulesforwhichemployeesmustbecovered,withsomerulesfocusingonage,someoncompensation,andsomeonmorecomprehensive“coverage”tests.
2 ThetabledoesnotincludeindividualplanslikeTraditional,non-deductible,orRothIRAs,noreducation-relatedaccountslike529plansorCoverdellplans,normedicalexpensesavingsaccountslikeHealthSavingsAccountsorMedicalSavingsAccounts.
25Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Tabl
e 3
: Em
ploy
er-S
pons
ored
Ret
irem
ent P
lans
P
ayro
ll D
edu
ctio
n I
RA
SE
PS
IMP
LE I
RA
P
lan
SIM
PLE
401
(k)
Saf
e H
arb
or
401(
k)Tr
adit
ion
al
401(
k)40
3(b
)45
7(b
)
Sp
on
sor/
Elig
ible
E
mp
loye
rA
ny e
mpl
oyer
Any
em
ploy
er
Em
ploy
er w
ith
10
0 o
r fe
wer
em
ploy
ees
and
no o
ther
qu
alifi
ed p
lan
Em
ploy
er w
ith
10
0 o
r fe
wer
em
ploy
ees
and
no o
ther
qu
alifi
ed p
lan
Any
em
ploy
er
othe
r th
an a
st
ate
or lo
cal
gove
rnm
ent
Any
em
ploy
er
othe
r th
an a
st
ate
or lo
cal
gove
rnm
ent
Pub
lic
educ
atio
n em
ploy
ers
and
tax-
exem
pt
50
1(c
)(3
) or
gani
zatio
ns
Sta
te a
nd lo
cal
gove
rnm
ents
; non
-ch
urch
tax-
exem
pt
orga
niza
tions
Max
imu
m
Em
plo
yee
Co
ntr
ibu
tio
n$
5,0
00
$
0
$1
1,5
00
$
11
,50
0
$1
6,5
00
$
16
,50
0
$1
6,5
00
$
16
,50
0
Em
plo
yer
Co
ntr
ibu
tio
nN
one
Opt
iona
lR
equi
red
Req
uire
dR
equi
red
Opt
iona
lO
ptio
nal
Opt
iona
l
Max
imu
m
Tota
l E
mp
loye
r +
E
mp
loye
e C
on
trib
uti
on
$
5,0
00
Less
er o
f 2
5
perc
ent o
f co
mpe
nsat
ion
and
$4
9,0
00
.
$1
1,5
00
by
empl
oyee
plu
s 2
or
3 p
erce
nt
mat
ch u
p to
$
24
5,0
00
in
com
pens
atio
n.
$4
9,0
00
or
10
0 p
erce
nt o
f co
mpe
nsat
ion.
$4
9,0
00
or
10
0 p
erce
nt o
f co
mpe
nsat
ion.
$4
9,0
00
or
10
0 p
erce
nt o
f co
mpe
nsat
ion.
$4
9,0
00
or
10
0 p
erce
nt o
f co
mpe
nsat
ion.
$1
6,5
00
or
10
0 p
erce
nt o
f co
mpe
nsat
ion.
Cat
ch-u
p
Co
ntr
ibu
tio
ns
$1
,00
0
$0
$
2,5
00
$
2,5
00
$
5,5
00
$
5,5
00
$5
,50
0;
addi
tiona
l co
ntrib
utio
n of
$
3,0
00
allo
wed
fo
r ce
rtai
n em
ploy
ees
with
m
ore
than
15
ye
ars
of s
ervi
ce.
$5
,50
0; m
ay a
llow
ad
ditio
nal c
atch
-up
cont
ribut
ions
up
to $
28
,00
0 th
ree
year
s pr
ior
to th
e ye
ar o
f no
rmal
re
tirem
ent a
ge.
Wh
en c
an
fun
ds
be
wit
hd
raw
n
wit
ho
ut
pen
alty
?
Sub
ject
to IR
A
rule
s; a
fter
age
5
9 1
/2
Sub
ject
to IR
A
rule
s; a
fter
age
5
9 1
/2
Sub
ject
to IR
A
rule
s; a
fter
age
5
9 1
/2
Sub
ject
to
40
1(k
) ru
les;
af
ter
age
59
1
/2
Sub
ject
to
40
1(k
) ru
les;
af
ter
age
59
1
/2
Sub
ject
to
40
1(k
) ru
les;
af
ter
age
59
1
/2
Aft
er a
ge 5
9
1/2
.
Aft
er s
ever
ance
fr
om e
mpl
oym
ent
or 5
9 1
/2.
Har
dsh
ip
Wit
hd
raw
al
allo
wed
?N
oN
oN
o
Yes,
if
dist
ribut
ion
is n
eces
sary
to
sat
isfy
“im
med
iate
and
he
avy
finan
cial
ne
ed.”
Yes,
if
dist
ribut
ion
is n
eces
sary
to
sat
isfy
“im
med
iate
and
he
avy
finan
cial
ne
ed.”
Yes,
if
dist
ribut
ion
is n
eces
sary
to
sat
isfy
“im
med
iate
and
he
avy
finan
cial
ne
ed.”
Yes,
if
dist
ribut
ion
is n
eces
sary
to
sat
isfy
“im
med
iate
and
he
avy
finan
cial
ne
ed.”
Yes,
for
“u
nfor
esee
able
em
erge
ncy.”
Loan
s al
low
ed?
No
No
No
Yes
Yes
Yes
Yes
Yes
26Th e R e p o r t o n Ta x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e Ta x a t i o n
Thecurrentsystemalsoprovidesdifferentcontributionlimitsandeligibilitylimitstodifferentem-ployees,dependingonwheretheywork,whatretirementoptionstheiremployerchoosestopro-vide(ifany),andonindividualcharacteristicsliketheemployee’sage.Taxpayerswhoseemployersofferaretirementplanpaylessintaxes(iftheyortheiremployerscontributetoaqualifiedretire-mentplan)thanthosewhoseemployersdonot. In2010,individualemployeesatfirmsthatdonotsponsorretirementaccountsarelimitedtoIRAcontributionsof$5,000(or$6,000if50yearsorolder). Employeesatfirmsthatofferretirementaccountsmaychoosetodeferupto$16,500($22,000if50yearsorolder),pluswhatevertheiremployerchoosestocontributeuptoacombinedtotalof$49,000. Participants inaSEPmaycontributeupto25percentofcompensationupto$49,000.Employeesatcertaingovernmentalemployerscancontribute(includingmatches)uptoboth403(b)and457plans;theireffectivecontributionlimitis$33,000($44,000if50yearsorold-er).Self-employedindividualsandsmallbusinessownersdirectboththeemployeeandemployercontributionstotheirownplansandhavediscretiontocontributeupto$49,000.Differencesincontributionlimitsandeligibilityrulesleadtoinequitiesintaxburdens.Manyexpertsalsobelievethatsuchdifferencesunderminetheefficiencyofthetaxincentivesforincreasingsavingbecausethemoregenerouslimitsandeligibilityrulesprimarilybenefitindividualswhoalreadysavemorethanaverage.Thus,theseprovisionsmayencouragetheseindividualstoshifttheirsavingtotax-advantagedaccountsratherthantoincreasetheirsaving.However,thecurrentruleswereformedwithcompetingpolicyobjectives inmind. Forexample,offeringhighercontribution limits foremployer-sponsoredplansrelativetoindividualplansprovidesanimportantincentiveforemploy-erstochoosetosponsoraplan.
Administrativeandcompliancecostshavealsobeencitedasadeterrenttoemployersponsorshipofretirementplans.Onlyabouthalfofprivateemployersofferadefinedcontributionretirementplantotheirworkers.Forsmallbusinesses,theadministrativecostsareparticularlylargerelativetothesizeofthebusiness,andlessthan25 percentsponsoranyretirementplan.SIMPLEandsimi-larplansexistlargelytoreducethesecosts.Nevertheless,facedwithmanychoices,smallbusinessownersmayhavetospendconsiderabletimeandenergychoosingthe‘optimal’planforthemselvesandtheirworkers.Smallbusinessownersmayalsodesiretochangethestructureastheirbusinessgrows,creatingfurthercomplications.
Themultiplicityofemployer-sponsoredretirementplansmayalsoburdenemployees.Employeesmayberequiredtoevaluatemultipleaccountsandchooseamongalternativeoptions,discouragingordelayingparticipation.Inthecurrentsystem,anynumberofcommonlifeeventscandisruptaworker’ssavingplan.Marriageordivorce,jobchanges,orchangesinincomeallcanresultinwork-ersbecomingineligiblefortheirpreviousplanorsuddenlyeligibleforanewplan.Often,thesechangesarenotrecognizeduntil tax timetheyearaftersavingscontributionsaremade;special(andunfamiliar)taxprovisionslike“recharacterizations”andnondeductibleTraditionalIRAswerecreatedtoaddressthesetypesofsurprises.Aworkerwhochangesjobsfrequentlymayhavemul-tipleretirementaccountsspreadamongpastemployers,eachholdingonlysmallsumsofmoney.Frequently,workerschangingjobshavetheirretirementcontributionsreturnedtotheminlump-sumdistributionsratherthanrollingthemoverintoanotheraccount.Suchdistributionsreduceretirementsavingsandexposeworkerstounexpectedtaxpenalties.
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The proposals and their advantages: Experts suggested consolidating employer-based retirement accounts and simplifying eligibilityandcontributionrules. Consolidatingplansandsimplifyingruleswouldreducecosts forbusi-nessesaswellashelpclarifyincentivesandsimplifysavingforworkers.Afirststepcouldharmo-nizerulesandsimplify tax-preferredsavingsaccountsby imposinguniformrules foreligibility,contributions,andadministration.Forexampleaconsolidatedsetofrulescouldfollowexistingcontributionlimitsandregulationsfor401(k)plans.Particularareaswhereharmonizationmaybedesirableincludetherulesforpenaltiesforhardshipwithdrawals—thedefinitionof“hardship”dif-fersplan-to-planandsomeaccountsdonotallowhardshipwithdrawals—andrulesallowingloansagainstcertainplanbalances.Simplifiedrulesregardingpaperwork,reporting,andlegalliabilitycouldbeappliedtothesmallestemployerstofurtherreducetheiradministrativecosts.
Certainretirementaccountsappearverysimilar—like401(k)s,403(b)s,and457plans—andareinmanywaysredundant.Theyaredistinctbecausetheywerecreatedtoservedifferentemploy-ers—forprofits,non-profits,andgovernments—buttheyservethesamebasicfunctionforeach.Consolidatingsuchplanscouldeliminateextraaccounts, rules,anddocumentation,andwouldsimplifythenumberandvarietyofaccountsforworkerschangingjobsbetweensectors.Forex-ample,asmallgroupofworkers(includingstateuniversityprofessors)whoarecurrentlyeligibleforunusuallyhighcontributionswouldbeheldtothesamecontributionlimitaseveryoneelse.
Amoreaggressiveconsolidationwouldeliminatemoresignificantsourcesofcomplexity.Forex-ample,the2005TaxReformPaneladvancedaplantoconsolidateemployer-baseddefinedcon-tributionplansintoonework-basedaccount(withcurrent-law401(k)limits),allindividualplansintooneindividualaccount,andallspecialpurposesavingsaccountsintooneaccountforsavingsotherthanforretirement.Thisconsolidationwouldhavesweptoutrulesforphase-outs,minimumdistributionsandotherprovisions.Thisplanwasalsopartofabroaderreformintendedtoincreaseopportunitiesfortax-freesavings.Itwouldalsohaveexpandedthesizeofaccountsandeligibilityforaccounts,eliminatingphase-outsandmakingtheaccountsavailabletoalltaxpayers.However,the2005Panelalsorecommendedreducingtaxesoncapitalgainsatthesametime,makingtax-preferredaccountslessdesirableandlimitingtherevenuecostofofferingsuchplans.Overall,thereformsproposedby the2005Panel increasedopportunities for retirement savingandreducedtaxesonsavingingeneral,whilemakinguprevenueelsewhere.
Disadvantages:Themultiplicityofplantypespartiallyreflectsadesiretoofferplanswithreducedadministrativecosts,likeSIMPLEplans,forsmallbusinesses.Consolidationoftheseaccountscouldincreasetheadministrativeburdenonsmallfirms.Muchoftheburdensomecomplexityarisesfromprovisionstolimitthebudgetarycostoftax-preferredvehicles,topromotebroadparticipationinplans(likecoveragetests),andtoensurethattaxsubsidiesavailableforsavingsdonotaccruedisproportion-atelytohigh-incomegroups(likephase-outsand“nondiscrimination”rules).Easingtheseprovi-sionswouldconflictwiththegoalstheyaremeanttoachieve.
Thesimplificationbenefitsofconsolidatingcertainaccountscouldultimatelybemodest.Thethreeplansdescribedaboveareofferedonlybyemployersintheprivatesector,thenon-profitsector,and
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thegovernmentsector,respectively;employeesinthosesectorsoftenhavenochoicesandtherulesthatapplyarethesameformostemployeeswithinthosesectors.
Appliedtothecurrenttaxsystem,aplanlikethatinthe2005proposalwouldloseconsiderablerev-enueandwouldsignificantlyexpandtax-preferredsavingsopportunitiestohigher-incomegroups,whoalreadydisproportionatelybenefitfromthem.Therefore,aconsolidationofaccountswouldneedtoaddressboththerevenuecostanddistributionalconsequences,forexample,bylimitingthetaxadvantagesofaccountsforhigher-incomegroupsbyphasingoutthesizeofthedeductionavailableforcontributionsorbyapplyingaflatcredit(ratherthanadeduction)forcontributions.
ii. Option 2: Integrate IRA and 401(k)-type Contribution Limits and Disallow Nondeductible Contributions
Undercurrentlaw,deductiblecontributionstoIRAsarephasedoutforhigher-incomegroupswhilecontributionstoemployerplansarenot,andthephase-outrangediffersbasedonwhetheranem-ployeeiscoveredbyanemployer-sponsoredplan.LargelytoallowindividualswhoareineligibletomakedeductibleIRAcontributions(oftenduetounexpectedincomeorotherrulesdiscoveredattaxtime)toavoidtheadministrativehassleofhavingtotakeoutexcesscontributionsattheendoftheyear,individualsareallowedtomakenondeductiblecontributionstoTraditionalIRAs.Thisrequiresthemtofilesupplementalannualformstotrackthecostbasisoftheassetsinaccounts,andtopaytaxontheincomeearnedintheseaccountsinasingularway.
The proposal and its advantages: OneproposalwouldallowallworkersirrespectiveofincometocontributetoeitherorbothanIRAandanemployer-sponsoredplan.ThecurrentlimitsforcontributionstoIRAsandemployerplanswouldbemaintained($5,000and$16,500,respectively),butthecombinedcontributionswouldbelimitedtothe401(k)limit($16,500).NondeductibleIRAscouldbeeliminatedbecauseincomelimitsoncontributionswouldberemoved.EliminatingnondeductiblecontributionstotraditionalIRAswouldreducethenumberofIRAvehiclesandwouldsimplifyrecordkeepingforparticipat-ingtaxpayers.ComplicatedIRAqualificationandphase-outruleswouldberepealed.Thiswouldalsoencourageadditionalend-of-tax-yearsavingbyworkerswithemployment-basedretirementcoverage.
Disadvantages:TheproposalcouldreducerevenuestotheextentthatincreasingIRAeligibilityresultsingreatertakeup.Moreover,eligibilitywouldbeincreasedprimarilyathigherincomelevels.However,bothconcernsarereducedbythefactthatmosthighincometaxpayersgenerallyalreadyhaveaccesstomoregenerousplans.Anotherdownsideisthatintegratingcontributionsuptoacombinedlimitwoulditselfaddsomecomplexitybyrequiringindividualstotrackcontributionsinmultipleac-countsandensurethatthesumofcontributionsfellbelowthelimit.
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iii. Option 3: Consolidate and Segregate Non-Retirement Savings
Overthepast30years,therehasbeenagrowinglistoftax-preferredsavingsvehiclesfornonre-tirementpurposes, includingSection529plans (whoserulesare setby statesandvarywidely),CoverdellIRAs,HealthSavingsAccounts(HSAs),ArcherMedicalSavingsAccounts(MSAs),andFlexibleSavingsAccounts(FSAs). TaxpayerswithIRAsandcertainemployer-sponsoredretire-mentaccountsmayalsowithdrawfundsfromthoseaccountsforeducationandmedicalexpensesorotherpurposes. Anindividualsavingforbothretirementandforotherpurposes facesevenmorechoiceswhendecidingwhichaccountoraccountsprovidethebestalternative.
The proposal and its advantages: Oneproposalwouldconsolidateallthesenon-retirementsavingsprogramsunderasingleinstru-ment.Contributionstothisinstrumentcouldbetax-deductibleuptoalimit,asiscurrentlythecaseforHSAs.Alternatively,contributionscouldbemadewithaftertaxdollars,asiscurrentlythecasefor529andCoverdellplans.Earningswouldaccumulatetax-free,andallqualifieddistribu-tionswouldbeexcludedfromgrossincome.
Segregating non-retirement savings into a consolidated health and education account that wasseparatefromaccountsforretirementsavingswouldsimplifyrulesforbothretirementandnon-retirementaccounts,reduceadministrativecosts,andlimitpre-retirement“leakage”fromretire-mentaccounts.Consolidatingmultipleeducationsavingsplansandmedicalsavingsplanswouldmakethistaxexpendituremoreeffectiveatincreasingsaving.(ThePERABgrouponretirementrecommendssegregatingretirementsavingsaccounts fromtax-advantagedsavingsaccounts forotherpurposesandimposingstrict limitsontheuseoffundsinretirementsavingaccountsfornon-retirementpurposes.)
Analternativeplanwouldconsolidatealleducationsavingsinonetypeofaccount,andallhealthsavingsinanother. Forexample,FSAs(whichareemploymentbased)couldbereplacedwithanewnon-retirementsavingvehiclethathassometaxpreferencesbutdoesnotsubjecttheaccountholdertostringentyear-endforfeiturerequirements.
Disadvantages:Disallowingnon-retirementusesofIRAsoremployerplanscouldreducethedesirabilityofthoseplans,potentiallyreducingparticipation.(However,reductionsinIRAusecouldpresumablyre-sultinincreasesinthesespecialaccounts.)HSAsaredesignedtoimproveincentivesinhealthcarespendingandareintegratedwithspecifichealthinsuranceplans;itwouldnotmakesensetocom-bineHSAdollarswithmoneydestinedforotheruses.Moreover,suchaproposalcouldbecostlydepending on eligibility rules and contribution limits. Mixing savings plans for education andmedicalexpenses,whichcurrentlyhavedisparatetaxtreatmentforcontributionsandvarywithstatelawsorhealthinsuranceparameters,maycreatesignificantwinnersandlosers.
iv. Option 4: Clarify and Improve Saving Incentives
Researchsuggeststhatanumberoftaxprovisionsintendedtoincreasesavingcouldbeimprovedbystrengtheningsavingsincentivesandbyadoptingrulesthatallowforautomaticsaving. One
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specificprovisionthatcouldbeimprovedistheSaver’sCredit,acreditthatprovidesasubsidytolow-incomeworkersformakingvoluntarycontributionstoretirementplans,like401(k)sandIRAs(muchlikehigher-incomegroupsreceiveataxsubsidyfortheircontributions).Severalfeaturesofthecredithavemadeitlesseffectivethanitmightotherwisebe.Mostsignificantly,thesavingincentivesprovidedbythecreditarenotvisibleorsalienttotaxpayersbecauseofthedesignandpresentationofthecredit.Researcherssuggesttheopacityoftheincentivesisonereasonthattake-upofthecreditisextremelylow.
Inaddition,arbitrary“cliffs”inthematchingratewithrespecttoincomeandothercomplicationsonthematchformulamakeitdifficulttounderstandanduse.Forexample,atcertainpointsinthescheduleataxpayermayloseupto$1,200increditsforearninganextra$1inincome.
Otherconcernsweheardaboutthecurrentsystemwerethelowparticipationratesandsmallcon-tributionsbyemployeesinsavingsplanssponsoredbytheiremployers.Thereareseveraloptionsforremedyingtheseproblems.
1. Make the Saver’s Credit a Match
ResearchershavedemonstratedthatthedesignoftheSaver’sCreditreducesitsefficacy.Inanex-perimentinvolvingthousandsoflow-incometaxfilersatH&RBlocktaxpreparationoffices,Dufloetal.(2006)showedthatmatchingIRAcontributionsinlieuoftaxcreditscansignificantlyraisetake-upandcontributions.Intheexperiment,increasingtheeffectivefederalSaver’sCreditvaluehadtrivialeffectsonparticipationinIRAs.Incontrast,presentingthecreditasamatch—with-outchangingtheactualvalueofthecredit—actually improvedparticipationsignificantly. Con-tributionstoretirementaccountswerealsolargerwhenthecreditwaspresentedasamatch.Theresearchersconcludedthattaxpayersweremoreresponsivetomatchingincentivesbecausetheyaremoretransparentandeasiertounderstandthansimilarlygeneroustaxcreditsinthecurrentsystem.Inadditiontochangingitsformtoamatch,theSaver’sCreditcouldbemademoregener-ousanduniversal,andthelossinrevenuescouldbeoffsetbyreducingoreliminatingsomeoftheothertaxdeductionsforretirementsavingthatdisproportionatelybenefitthosewithhighincomes.
The proposal and its advantages: DesigningtheSaver’sCredittobemorelikeamatchwouldincreaseitssalienceanditseffectivenessasanincentivetopromotesaving.
AnadditionalimprovementwouldadjustthematchorcreditratetophasedownwithAGIinsteadofabruptlyendingasinthecurrentsystem.Removingthe“cliffs”inthecurrentcreditstructurewouldremovetheveryhigheffectivemarginaltaxratesforthemanysaverswhousethecredit.(TheSaver’sCreditproposalincludedintheFY2011Budgetaddressesthisissue.)
Disadvantages:Administrativehurdleswouldneedtobeaddressedinordertomakeamatchinggrantwork.Forexample,amatchingcreditwouldneedtobedirectlydeposited intotheretirementaccountsofqualifiedtaxpayers,requiringnewproceduresandadministrative infrastructureat theIRSoratfinancial institutions. Specificprovisionswouldneed toaddresshowthecreditwouldapply to
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RothversusTraditionalIRAs. Transformingthe“cliffs”inthecreditintoasmootherphase-outwouldreducesomeveryhighmarginaltaxrates,butphase-outscanbedifficulttounderstandandaddcomplexity.Also,dependingonthespecificproposal,thisideacouldaddtothecostoftheprogram.
2. Expand Automatic Enrollment in Retirement Savings Plans
The proposal and its advantages: Underautomaticenrollmentemployersdirectlydepositasmallpercentageofeachpaycheckintoworkers’retirementaccountslike401(k)sorevenintoworkers’IRAs,unlesstheemployeeaffirma-tivelytellstheemployernottodoso.Employeeswouldmaintainfullchoiceoverwhetherandhowmuchtheywanttosavebecausetheycouldchoosetooptoutoftheplanorsaveadifferentamount.Asinthecurrentsystem,employerscouldeasilymatchemployeecontributions.Researchshowsthatautomaticenrollmentboostsparticipationinretirementplanstomorethan90percent,andisparticularlyeffectiveatincreasingtheparticipationoflow-incomeandminorityworkers.
Thepolicyisfeasible,andcouldbetailoredwithappropriatesafeguardstoensurethattheadminis-trativeburdenonsmallemployersisnottoogreat.Indeed,thePresident’sFY2011BudgetincludesaproposaltorequireemployersinbusinessforatleasttwoyearsandwithmorethantenemployeestoofferanautomaticIRAwithregularpayrolldeductionstotheiremployees.(Employerssponsor-ingaqualifiedretirementplan,SEP,orSIMPLEwouldbeexempt.)
Inaddition,otherautomaticfeaturesofaccountscouldbeimplementedtofurtherencouragesav-ing.Forexample,providinganautomaticdefaultinvestmentchoicelikealife-cyclefundorauto-maticescalationofcontributionscouldincreasecontributionsandassetaccumulation,andreducetherisksofpoorinvestmentchoices.Similarly,theautomaticannuitizationofretirementbalancescouldhelpworkersachieveasteadystreamofincomethatisguaranteedforlife.
v. Option 5: Reduce Retirement Account Leakage
A sizable fraction of separated workers who receive lump-sum distributions (particularly smalldistributionsof$5,000orless)fromtheiremployers’retirementplansdonotrollitovertoanotherqualifiedplanorIRA.Someseparatedworkersdonotpaybackoutstanding401(k)loans(inwhichcasetheloanbecomesawithdrawal).Moreover,manyIRAholdersalsotakeearlywithdrawalsforotherexpenses.Thefailuretorollover401(k)fundsorpayback401(k)loans,aswellasthetenden-cytotakeearlywithdrawalsfromIRAs,canreducesavingsthathavebeensetasideforretirement.
The proposals and their advantages: Uponleavingajob,anemployee’splanbalancewouldberequiredtoberetainedintheexistingplanorwouldbeautomaticallytransferredtoanIRAaccountoranaccountwiththeirnewemployer.This“AutomaticRollover”wouldensurethatamountsputasideforretirementcontinuetogrow.
Limitsontax-freeandpenalty-freedistributionsfornon-emergencypurposescouldbetightenedtoreduce“leakage.”Tax-freedistributionsfromindividualaccountscouldbemadeonlyafterage
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59½(asundercurrentlawforthemajorityofaccounts),orintheeventofdeathordisability,orforastandarddefinitionof“hardship”suchasthatcurrentlyappliedto401(k)plans.Applyingthemorestringentrulesfor401(k)stoIRAsandotheraccountswouldclosetheexceptionsforearlywithdrawalsforeducation,first-timehomebuyerexpenses,andmedicalexpensesthataremorelenientinIRAs.Earlydistributionswouldbetreatedastaxableincomeandwouldbesubjecttoanadditional10percenttax,similartothepenaltypaidonearlywithdrawalsfromRothIRAsundercurrentlaw.Theseruleswouldensurethataccountssetasideforretirement(andrewardedfordo-ingsowithgeneroustaxbenefits)wouldstillbethereatthetimeofretirement.
Disadvantages:Requiringrolloversorthemaintenanceofaccountsforsmallamountsofmoneywouldraisead-ministrativeburdensonemployersandfinancialintermediaries.LimitingtheabilitytotakeearlydistributionsfromIRAsandotheraccountscoulddiscouragetheuseoftheseaccounts.Moreover,itmaybedifficulttolimitearlywithdrawalsforpopularexpenditureslikeeducationortotrytolimithardshipwithdrawals.
vi. Option 6: Simplify Rules for Employers Sponsoring Plans
Abouthalfofallworkersarenotofferedaretirementplanatwork.Onereasonisthattheadminis-trativeburdensofemployer-sponsoredplansdiscouragesomebusinesses—particularlysmallbusi-nesses—fromadoptingthem.
Muchoftheemployer-sidecomplexityarisesfromprovisionsthatensurethatthebenefitsofsav-ings-relatedtaxexpendituresaredistributedfairlytoworkersatagivenfirmandnotjusttotheownersortohighly-paidexecutives.Forexample,“nondiscriminationrequirements”applyasetof tests that ensure that highly compensated employees do not receive disproportionately highbenefitsrelativetootheremployees.Satisfyingthetestcanrequireemployersandsmallbusiness-estoexaminethecontributionamountsoftheiremployeesthroughouttheyearandadjusttheirown contributions accordingly to avoid penalties. The complexity surrounding these rules hasincreasedbecauseofrelatedprovisionsthatallowemployerscertainexemptionsfromtheoriginalrules.“Cross-testing”allowsalternativemethodsoffulfillingthenondiscriminationrequirementsandhasspawnedanewgenerationofpensionplansengineeredtoallowgreatertax-freesavingsforhighlycompensatedemployees.Similarly,SocialSecurityintegration(or“permitteddisparity”rules)allowsforhighercontributionlimitsforemployeesearningovertheSocialSecuritymaxi-mum($110,000for2010).
The proposal and its advantages: Oneoptionwouldbetosimplifythenondiscriminationtest,forexamplebysimplifyingthedefini-tionofahigh-paidemployeeandtoprovideastandardsafeharbortoavoidtheserequirements.Analternativeproposalwouldrepealnondiscriminationrulesentirelyandrequireallplanstomeetasafeharborstandard.Thisoptionwouldrequireallmediumandlargeemployerplanstohaveminimumcontributionstandardswithnon-electiveand/ormatchingemployercontributions;thecurrentSIMPLE401kplansafeharborrequirementscouldbeapplied tosmallemployers. Thecross-testingandSocialSecurityintegrationrulescouldbeeliminated.
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Thesechangeswouldsimplifyplanadministrationandregulationthroughtherepealofthenon-discriminationrules,andreducetheadministrativecostofplanmaintenance. Appropriatesafeharborprovisionscouldbedesignedtoensurecontributionadequacy.Onbalance,thesechangeswouldlikelyincreasetaxrevenueswhiledirectingagreaterportionofthecurrenttaxexpendituretomiddle-classworkers.
Disadvantages:Ifsafeharborrequirementsaretoostringent,thiscoulderodeplansponsorship,especiallyforsmallandmidsizedemployers.
vii. Option 7: Simplify Disbursements
AtaxpayermusttakeMinimumRequiredDistributions(MRDs)frommostretirementaccountsstartingattheageof70½.(TherulesdonotapplytoRothaccounts.)Therulesgoverningthesedistributionsarecomplex—requiringcalculationsinvolvingage-specificsurvivalfactors—andthecalculationsareevenharderforretireeswithmorethanoneaccount.Taxpayerswhofailtocomplywiththeserulesareassessedapenaltyof50percentoftherequireddistribution.
The proposal and its advantages: Eliminatingminimumrequireddistributionsforindividualswithretirementassetsbelowathresh-oldwouldrelievemanytaxpayersfromtheburdenoftheseregulationsatarelativelysmallrev-enuecost.AsFigure3shows,mosthouseholdsheadedbyindividualsoverage70holdrelativelysmallamountsintheirretirementaccounts:about35percentofthesehouseholdswithretirementaccountshave less than$25,000 inretirement-accountassetsandmore thanhalfofhouseholdshavelessthan$50,000.Apolicythatexemptedtaxpayerswithtotalaccountbalancesoflessthan$50,000fromMRDswouldrelievemorethanhalfofthosecurrentlyaffectedbyMRDsfromtherules.Moreover,becausetheaccountsthatwouldbeaffectedbythisproposalarerelativelysmall—theyaccountforonly6percentofretirement-accountassets—therevenuelosseswouldbesmall(about55percentofassetsareheldinaccountslargerthan$500,000).
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Figure 3: Retirement Accounts(Individuals Age 70 and Over)
0
10
20
30
40
50
60
0 100,000 200,000 300,000 400,000 500,000
Fraction of Accounts Fraction of Assets
Account Value ($)
Source: Survey of Consumer Finances (2007)
Per
cen
t
Source:SurveyofConsumerFinances(2007).
Disadvantages:This proposal retains the complex rules for about half of taxpayers currently subject to theMRDrules.
viii. Option 8: Simplify Taxation of Social Security Benefits
ThetaxationofSocialSecuritybenefitsisamongthemostdifficultpartofcalculatingincometaxesformostelderlytaxpayers.Determiningtheamountofbenefitssubjecttotaxinvolvesan18-lineworksheetthatrequiresretireestocalculateanalternativemeasureofincomeandthencomparethis“modifiedadjustedgrossincome”(MAGI)toathree-tieredscheduletodeterminetheamountofSocialSecuritybenefits to include in taxable income.Thisphase-in schedule results in steepmarginaltaxrates—ashighas85 percentabovethenormalrate—onordinaryincome,discourag-ingwork,imposinghighratesoftaxationonincomefromretirementaccounts,andencouraginginefficient“taxplanning”toavoidpayingthetax.Theuseofsoftwaretoprepareincometaxreturnseliminatesthecomputationalburden,butitdoesnoteliminatetheproblemstaxpayershaveinpre-dictinghowmuchoftheirbenefitswillbesubjecttotaxationortheirmarginaltaxrate.Becausetheincomethresholdsintheformulaarenotindexedforinflation,moreandmoreSocialSecurityrecipientsaresubjecttotheseprovisionsovertime,andmorepeoplewhowouldordinarilybenon-filershavetofileonthebasisofthistaxalone.
The proposal and its advantages: Simplifying the formula used to calculate the tax on Social Security benefits would reduce thecomplianceburdenonoldertaxpayersandimproveeconomicefficiency.First,replacingthemulti-
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tieredphase-inschedulewithasinglephase-inwouldeliminateanumberoflinesontheworksheetandmakethetaxationofbenefitsmoretransparent.Forexample,insteadofthecurrentsystemthatrequiresincludingeitherzero,50,or85 percentofbenefitsintaxableincomedependingondifferent MAGI thresholds, one could specify a single percentage rate—say 40 percent—over asinglethreshold. Suchachangewouldrepresentareturntothepre-1993system. Second,onecouldsimplifythecalculationofMAGI,forexamplebyeliminatingtheinclusionofSocialSecuritybenefitsinMAGIentirely.
Inthisoption,MAGIwouldbedefinedasallnon-SocialSecurityincome(excludingthe50 percentofbenefitscurrentlyincludedinMAGI),theMAGIthresholdforincludingSocialSecuritybenefitsinincomesubjecttotaxationwouldbeloweredto$12,000ofMAGIforasingletaxpayer($24,000marriedfilingjointly),and$0.40ofbenefitswouldbeincludedinAGIforeach$1ofMAGIoverthethreshold. Table4 illustratestheadvantagesanddisadvantagesofsuchachange. Thetableshowstheaveragetaxrates,marginaltaxrates,andamountofSocialSecuritybenefitssubjecttotaxunderthecurrentsystemandunderasimplifiedsystem.Theexampleisintendedtoberoughlyrevenueneutral (basedon2005data),andto illustrate the tradeoffs involved insimplifying theformula.
Table 4: Taxation of Social Security Benefits (Single Taxpayer)Example: (1) (2) (3) (4) (5) (6)
Total Income 20,000 40,000 40,000 40,000 50,000 110,000
Ordinary Income 10,000 15,000 20,000 30,000 35,000 95,000
Social Security Income 10,000 25,000 20,000 10,000 15,000 15,000
Current Law
Benefit Amount Subject To Tax – 1,250 2,500 5,350 11,725 12,750
Marginal Tax Rate on Ordinary Income 10.0% 15.0% 22.5% 27.8% 46.2% 28.0%
Average Tax Rate 0.3% 1.7% 3.9% 8.7% 11.1% 19.3%
Alternative: 40% Phase-In, $12,000 Threshold on Ordinary Income
Benefit Amount Subject To Tax – 1,200 3,200 7,200 9,200 12,750
Marginal Tax Rate on Ordinary Income 10.0% 14.0% 21.0% 21.0% 35.0% 28.0%
Average Tax Rate 0.3% 1.7% 4.1% 9.4% 9.8% 19.3%
ThisproposalwouldsimplifythecalculationofbenefitsbyreducingthecalculationsforMAGI—taxpayersnolongerneedtoincludeafractionofbenefitsinMAGI—andeliminatingthecalcula-tionofmultiplephase-ins—iftaxpayersareaboveathreshold,theyaretaxedonaflatpercentageofbenefitsoverthethreshold,similartothesystemthatexistedpriorto1993.Asisapparent,thealternativesystemresultsinlowermarginaltaxratesonordinaryincomefortaxpayerswithinthephase-inrangeofthecurrentsystem.Thischangereducestheincentivesforinefficienttaxplan-ningandimprovestheincentivestoworkandsave.
Disadvantages:While thiswould lowermarginal taxrates for some taxpayersandoverallaveragemarginal taxrates,somepeoplewouldfallintothephase-inrangesotheywouldfacesomewhathighermarginal
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rates.Thispolicywouldcreatewinnersandlosers.Forexample,peoplewithhighSocialSecurityincomebutlownon-SocialSecurityincomewouldpaymoreintaxes.Indeed,individualswiththesametotal income—like those incolumns2-4—wouldbeaffectedslightlydifferently,andsomewouldpayslightlymoreandsomeslightlyless.Tomaintainrevenuewhileloweringthephase-inrateto40 percent,thephase-inthresholdwouldneedtobelower—whilesomelow-incometax-payerswouldpaylessintaxes,otherswouldpaymore.Anadjustmenttotheadditionalstandarddeductionfortaxpayersage65andovercouldbeusedtooffsetthesedistributionaleffects.
c. Option Group C: Simplify Taxation of Capital GainsCapitalgainsaretaxedattheindividuallevelatspecialrateswhichdependonfactorslikethetypeofincomeortypeofasset,theholdingperiodoftheasset,andotheraccountingrules.Long-termcapitalgainsandqualifiedstockdividendsaretaxedseparatelyfromotherincomeatratesof0per-centor15percent.Thecapitalgainsrulesslatedtoreturnin2011include10and20percentbasicratesand8and18percentratesforgainsonassetsheldover5yearsTheAdministration’sBudgetcallsfora20percenttaxrateonlong-runcapitalgainsanddividendsstartingin2011.Inaddi-tion,startingin2013,therecentlyenactedPatientProtectionandAffordableCareActimposesanew3.8percentMedicarecontributiononcapitalgainsandotherinvestmentincomeofmarriedtaxpayerswithAGIover$250,000($200,000forsingletaxpayers).3Thisincreasesthetopstatutoryrateoncapitalgainsto23.8percent.Thecapitalgainsrateofmosthigh-incometaxpayersisalsoaffectedbythe“Pease”3-percentphase-outof itemizeddeductions,whichadds1.19percentagepointstotheeffectiverate.
Thesystemofcapitalgainsalsoincludesspecialratesforcertaintypesofinvestment.Long-termgainsoncollectibles—forexample,gold,jewelry,orart—aretaxedatordinarytaxratesuptoa28percentmaximumrate.Gainsfromthesaleofcertainsmallbusinessstockaretaxedatordinaryratesuptoamaximumof28percentbutwithexclusionsof50,60,75or100percentdependingonwhenthestockwasinitiallyissuedandwhetherthecorporationislocatedinanenterprisezone.Thetaxationofthegainoncertainrealestate(Section1250realproperty)isparticularlycomplex,andproceedsfromasingletransactionmaybetaxedpartiallyatordinaryrates,partiallyas“unre-capturedSection1250gain”subjecttoordinaryratesuptoa25percentmaximum,andpartiallyatthecapitalgainsrate.(Moreover,themaximumrateof25percenton“unrecapturedSection1250gain”appliestotheportionofthegainattributabletodepreciationdeductedatpotentiallyhigherordinarytaxrates.) Inthecaseof“carriedinterest,”capitalgainstreatmentisappliedtocertainincomethatdoesnotrepresentareturnoninvestedcapital.
Becausecapitalgainsaretaxedseparatelyfromotherincome,taxpayersmustcomputethetaxoncapitalgainsanddividendsonanalternativeschedule.Further,becausethereisnotenoughroomonScheduleDforallofthespecialratesandprovisions,manyofthesearenowincludedinseparateschedulesintheinstructions.Havingseparateschedulesincreasestaxpayerburdenandmakesitmoredifficulttocheckwhethertaxpayersareproperlycomputingtheirtaxbecausetheseschedules
3 Thetaxappliestothelesserofthetaxpayer’snetinvestmentincomeandmodifiedAGIinexcessofthe$250,000or$200,000incomethresholds.ThenewdefinitionofmodifiedAGIaddsbackanyforeignincomeexclusioninexcessofanydeductionsandexclusionsdisallowedwithrespecttothatincome.
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arenotsenttotheIRS.Thismayincreasethelikelihoodthattaxpayerswillclaimtaxbenefitstowhichtheyarenotentitledandthusincreasenoncompliance.Inadditiontocontributingpagesofinstructionsandworksheets,havingmultipletaxratesfordifferenttypesofcapitalgainsaffectstheafter-taxrateofreturnondifferentassets,distortinginvestmentdecisions.
Anothersourceofcomplexityariseswhenacapitalgainhasoccurredandthuswhentaxesaredue.Anexchangeofproperty,suchasasale,generallyisataxabletransaction—i.e.,youpaythetaxwhenyousellanasset.However,severalprovisionsallowtaxesoncapitalgainsincometobedeferredorforthegaintobecalculateddifferently,addingcomplexityandprovidingincentivesforsociallyunproductivetaxplanning.Forexample,presentlawprovidesthatnogainorlossisrecognizedifpropertyheldforproductiveuseinatradeorbusinessorforinvestmentpurposesisexchangedforlike-kindproperty(aSection1031exchange).Althoughtraditionallike-kindexchangestypi-callyinvolvetwopersonstradingrealpropertywitheachother,thisformofexchangehasgivenwayovertimetoexchangesintermediatedbyathirdpartymarketmaker.MosttransactionsthatoccurunderSection1031onlylooselyresembleanexchangeandinsteadeffectivelyconferrollovertreatmentonawiderangeofbusinesspropertyandinvestments.Rollovertreatmentisconferredonlyifthetaxpayercomplieswithaseriesofcomplicatedrules,andthereismuchuncertaintysur-roundingthesetransactions.
Anotherareaofconcernisthetaxationofcarriedinterest.Themanageror“generalpartner”ofaninvestmentfundtypicallyreceivestwotypesofcompensation:amanagementfeeandapercentageofprofitsgeneratedbytheinvestmentscalleda“carriedinterest.”Themanagementfeeistaxedasordinaryincome,butthecarriedinterestisgenerallytaxedatthelowercapitalgainstaxratetotheextentthattheunderlyinginvestmenthasgeneratedlong-termcapitalgainseligibleforthelowerrate.Manytaxexpertsconsidersomeorallofthecarriedinterestascompensationformanagers’services,andthereforearguethatsomeorallof thiscompensationshouldbetaxedasordinaryearnedincome,asisperformance-basedpayinotherprofessions.
Wediscussfouroptionsforsimplifyingthetaxationofcapitalgains.
i. Option 1: Harmonize Rules and Tax Rates for Long-Term Capital Gains
1. Harmonize 25 and 28 Percent Rates on Capital Gains
Whenataxpayerdeductsdepreciationexpense,thetaxpayer’scostbasisisreducedbytheamountofdepreciationclaimed.Thus,whenthetaxpayerlatergoestoselltheasset,hemayhaveagainasaresultofclaimingthepreviousdeduction.Sincethedepreciationwasdeductedatordinaryincometaxrates,itmakessensethatanygainduetothedeductionshouldbetaxed(“recaptured”)atordinaryrates,andthisishowmostassetsaretreated.However,gainsoncertainrealestatesales(so-calledSection1250gains)aretaxedatordinaryratesonlyupto25percent.Similarly,collect-iblesaretaxedatordinaryrates,butuptoamaximumrateof28percent.
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The proposal and its advantages: Sincetheseparatecapitalgainsrateaddscomplexitytoformsandtaxplanningandtherationaleforapreferentialrateisweakinbothcases,onereformoptionwouldbetotaxSection1250recaptureandcollectiblesatordinarytaxrates.Asmallersimplificationwouldusethesamerateforbothprovisions:25percent,28percentoranintermediateratesuchas27percent.
Disadvantages:Realestateheldforinvestment(non-owneroccupied)andcollectiblesinvestorswouldbeadverselyaffectedbyeliminatingorraisingthesepreferentialrates.
2. Simplify Capital Gains Taxes on Mutual Funds
Investorsinmutualfundscurrentlyhavethechoiceofusingseveraldifferentmethodsofcomput-ing theirbasis forpurposesof computingcapital gain. Theycanchoose theaveragecostbasismethod,thefirst-in,first-outmethodorthespecificidentificationofsharesmethod.Specificiden-tificationisthemosttaxpayerfriendlyasitallowssellingthosesharesthathavethehighestcostandthusthelowestcapitalgainfirst.First-in,first-outisgenerallyleasttaxpayerfriendlyastheoldestsharesaremorelikelytohavebeenpurchasedwhenstockpriceswerelower,resultinginalargertaxablegain.Theaveragecostmethodwouldgenerallybeinbetweenthesetwomethods.Withnewreportingofbasisrequirementsineffect,however,thiscreatesthepotentialforconfusionanderrorsiftaxpayersuseadifferentmethodthanusedbythemutualfund.
The proposal and its advantages: Requiringstandardizationusingtheaveragecostmethodforallsharesinaparticularmutualfundaccountwouldprovidethegreatestsimplificationandbeacompromiseamongthemethodsavail-able.Taxpayerswouldstillhavesomeflexibilityasseparateaccountswouldbetreatedseparately.Asatransitionmeasure,thiscouldbemandatoryonlyfornewsharespurchasedafterdateofen-actment(oralternativelystartingatthebeginningofthatcalendaryear).Thisoptionwouldalsohelpimprovecomplianceasovertimeallmutual-fundgaininformationwouldbecomputedandreportedbymutualfunds.
Disadvantages:Somemutualfundinvestorswouldfacehighereffectivetaxratesontheirmutualfundinvestments.
3. Small Business Stock
Thesmallbusinessstockexclusion(Section1202)hasahighlycomplexsetofrequirementsthatmustbemetthroughouttheholdingperiodofashareholderwhohopestobenefitfromtheexclu-sion.Thecomplexrequirementsaredesignedtopreventabuseofthisgenerousprovision.Inad-dition,theSmallBusinessInvestmentActhasbeenrepealed,andtherearenowonlyafewsmallgrandfatheredSpecializedSmallBusinessInvestmentCompanies(SSBICs).BecausecapitalgainstaxrateshavedeclinedsubstantiallyandtheexcludedgainsaretaxedasapreferenceundertheAMT,thereisalmostnobenefitfromtheseexclusions.Boththesmallbusinessstockexclusionand
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therolloverofqualifiedsmallbusinessstockgainshavesufferedfromcomplianceissuesbecauseoflimitedreportingrequirementsandenforcementbytheIRS.TheIRSdoesnotreceivethird-partyinformation on eligibility of stock owners of potentially qualified small business stock, makingtheprovisiondifficult toenforce. Therolloverprovisionhasalsobeencriticizedbecauseof theshort6-monthholdingperiod,whichmainlybenefitsinsidersandtradersratherthanlong-terminvestors.Thisprovisionhasbeendescribedasataxbenefitallowingazerocapitalgainstax,butsomesmallbusinessinvestorsdonotre-investtheirgainsinreplacement-qualifiedsmallbusinessstock.ThePresidentproposedazeropercentcapitalgainsrateonequityinvestments(stock)insmallbusinessesanda75percentexclusionwasenactedforinvestmentsin2009and2010aspartofARRA.
The proposal and its advantages: Somesimplificationcouldbeachievedbyallowingthe100percentexclusionforstockpurchasesstartingin2009andchangingtheprior50percentexclusionoffordinaryincometaxratestoa25percentexclusionoffcapitalgainsrates. Thissimplificationwouldretaintheextraincentiveforqualifyingsmallbusinessinvestmentsandresultinsimilareffectivetaxrateswhilegreatlysimplify-ingthetaxcalculations.Thealternativeofrepealingthesespecialsmallbusinessprovisionsforpre-2009investmentswouldstillprovidetheseinvestmentswiththebenefitsofthegeneralpreferentialrateforlong-termcapitalgains.Whateveroptionischosen,improvedreportingisrequiredtohelppreventabuseofthisprovision.
The rollover of gains from qualified small business stock (Section 1044) into an investment inanotherqualifiedsmallbusinessstockcouldberepealedorreformedbylengtheningtheholdingperiodfrom6monthstoatleastoneyear.Theshort6-monthholdingperiodrequirementisincon-sistentwiththe“patientcapital”rationaleforspecialsmallbusinessstockincentives.
Disadvantages:Eliminatingthesmallbusinessstockexclusionwouldraise the taxrateon investments insmallbusinesses.However,fewbusinessesactuallymakeuseoftheseprovisions,sotheeffectwouldbelimited.
ii. Option 2: Simplify Capital Gains Tax Rate Structure
Thecombinationoftheexpirationofthezeroand15percentcapitalgainstaxratesin2011,thePresident’sproposalfora20percentrateoncapitalgainsoftaxpayerswithincomesover$250,000andthe3.8percentMedicaretaxoncapitalgainsofhigh-incometaxpayersintherecentlyenactedhealthcarebill,suggeststhatitistimelytoreviewthetaxationofcapitalgains.
Thebasic10and20percentratesenactedin1997(alongwiththedepreciationrecaptureprovi-siondiscussedabove)werethoughttoallowreductionofthetopcapitalgainsratewithoutlossoftaxrevenuebecauseoftherevenueefficiencyofthedesignoftheproposal.Thezeropercentrateundercurrent lawraises littlerevenue(onlythroughtheeffectof includingthefullcapitalgainonincome-basedphase-outprovisions). Thezeroratealsoraisesquestionsaboutwhetherevenmiddle-incometaxpayersshouldpaysomecapitalgainstaxontheircapitalgainsincome.
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The proposal and its advantages: Oneoptionwouldbetoconverttheseparateratesintoa50 percentexclusion.A50percentexclu-sionwouldresultinapproximatelythesametopincometaxrate(19.6percentvs.20percent)whileimposingratesof5and7.5percentongainsoftaxpayersinthe10and15percenttaxbrackets.Suchapercentageexclusionwouldsimplifythecomputationofthetaxoncapitalgains,especiallyifothercapitalgainsprovisionswerealsoconvertedintopercentageexclusions.Thesamepercent-ageexclusionwouldapplytonetcapitallossestomakethetaxtreatmentsymmetricandreduceanyrevenuelosses.Whiletheseparatecalculationofthetaxoncapitalgainsisslightlymorecompli-catedthananexclusion,simplificationbenefitswouldcomefromcleaninguptheotherprovisionsonspecialtypesofcapitalgains.
Amoremodestoptionwouldbetoreplacethezeropercentratewiththe5percentcapitalgainsrateineffectfrom2001through2007fortaxpayerswithtaxableincomeplacingtheminthe10or15 percentratebrackets. While thiswould increase taxes forsomemiddle-incomeindividuals,capitalgainsareinfrequentandtendtoberelativelysmallinthisincomerange.Asaresult,theoverallincometaxofthesehouseholdswouldstayroughlythesamebecauseofchangestootherprovisions in the simplification package. The 5 percent rate would raise capital gains taxes onhigher-incometaxpayerswithoutdistortingtheirdecisionsaboutstocksalesbecausethosedeci-sionswouldbeaffectedonlybythemaximumratethatappliedtotheirgains.
Disadvantages: Asignificantdrawbackofsuchanexclusionisthatthebasicincomemeasure(AGI)wouldbedis-torted,especiallyfortaxpayerswhoseincomeconsistsprimarilyofcapitalgains.Thisdistortionwouldaffectthestartingpointsforincomephase-outsandpublishedtablesthatuseAGItoshowthedistributionofincome.However,thismightbeanappropriatetreatmentforindividualsforwhomalargecapitalgainisaone-timeorinfrequentevent.
iii. Option 3: Limit or Repeal Section 1031 Like-Kind Exchanges
The proposal and its advantages: OnesimplificationoptionistotightentheeligibilityforthistreatmenttobetteraligntheoperationofSection1031withthejustificationsfortaxdeferraltreatment.Analternativeoptionwouldbetodisallowdeferralofgainonlike-kindexchanges.Otherproposalswouldlimittherollovertoprop-ertyincertaincases.Forexample,someproposalswouldmakedevelopedpropertyandstructuresaseparatecategoryfromundevelopedland.Somedevelopersareabletodefertaxationcontinu-allybyrollingovergainsfromthesaleofdevelopedpropertiesintonewinvestmentinincreasingamountsofland.
Disadvantages:Theproposalwould raise tax ratesonrealproperty. TheSection1031provision interactswithandisanescapevalveforcapitalgainstaxrates. Thus, it ismostimportantforcorporationsastheyfacea35percentcorporatecapitalgainstaxrate.Substantiallimitationoflike-kindexchangeruleswouldincreasethepressuretoreducethecorporatecapitalgainsrate(ortheoverallcorpo-
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raterate).Ontheotherhand,limitingthelike-kindexchangerulescouldpartiallyfundalowercorporaterate.
iv. Option 4: Capital Gains on Principal Residences
Homeownersmayexcludeupto$500,000($250,000forasingleindividual)ofcapitalgainfromthesaleofprincipalresidencesprovidedthehomewastheirprincipalresidenceintwoofthelastfiveyears.Thisprovisionwasenactedasasimplificationmeasure—atthetimeofenactmentover95percentofhomesalesproducedcapitalgainsbelowtheexclusionamountandevenfewersalesweresubjecttotaxiftheymettheholdingperiodrequirement—andasamiddle-classtaxbreak.Withthepassageoftime,therealvalueoftheexclusionhasbeeneroded,limitingsimplificationbenefits.4
Calculatingthecapitalgainisitselfacomplexprocedurebecausethetaxbasisofthehome—thead-justedpurchasepriceagainstwhichtocomparethesalesprice—includestransactioncosts,fees,in-vestments,andrenovations(butnotroutinemaintenance)thatoccurredsincepurchase.Recordsdocumentingallofthoseexpenditures(oftencoveringmanyyearsofexpenditures)arerequired.
The proposal and its advantages: Theseissuessuggestindexingtheexclusionforinflation.Ahigherthresholdwouldpreventtheero-sionofthesimplificationbenefitsofthisprovisionandpreventincreasingnumbersofhomeownersfrompayingtaxesonappreciatedresidences.
Disadvantages:Indexingthethresholdforinflationwouldexpandthealreadyveryfavorabletreatmentaffordedtoowner-occupiedhousingandwouldbenefitthosewiththelargestcapitalgains.
d. Option Group D: Simplifying Tax FilingBasedonIRSresearch,onaverageindividualtaxfilersspendmorethan17hoursontax-relatedmatterseachyear.Overall,thatmeansthattheroughly140millionfilersexpendalmost2.5billionhoursdevotedtofederalincometaxes.Inadditiontothetimecost,taxpayersspend$32billionpayingaccountants,lawyers,andtaxpreparersorpurchasingtaxsoftware.Alltold,themonetizedcost(at$25perhour)ofthiscomplianceburdenforindividualtaxpayersisabout$92billion. Ofcourse,thesecalculationsignorethehard-to-monetizecostsoffrustrationandanxiety.
About30percentofthetimeisspentactuallypreparingandsubmittingataxreturn,andthere-maining70percentisspentonrecordkeeping,taxplanning,andothertax-relateditems.Record-keepingalone isnearlyhalfof the total timeburden. Muchof that isdevoted todocumenting
4 Therelativelyshortholdingperiodrequirementoftwoyearsandallowingrepeatuseeverytwoyearsisthoughttoinviteabuseoftheprovisionbyhomebuilderslivinginahousetheybuiltfortwoyearstogettax-freeearningsfromtheirprofitonthehouse,byconversionofrentalorvacationpropertiesintoprincipalresidences,andbyse-rialfixer-upperspecialistswhoalsogettax-freeincomeontheirlaboronthehouse.Anoptioninthecompliancesectionaddressesthisissue.
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wages, incomefromdividends, interest,retirementdistributions,andothersources,anddeduc-tions for mortgage and student loan interest or IRA contributions—information that is usuallyprovidedbythirdpartiestotheIRSalready.Thentaxpayersmustinputthisinformationandotherroutineinformationlikenames,SocialSecuritynumbersandchildren’sages,intothecorrectformsonworksheets,whichonaveragetakesanother4hoursand20minutesaccordingtotheIRS.5
Inourmeetings,wewereurgedtoconsiderreformstoreducetheburdenoffilingthroughinfor-mationtechnology,particularlythrough“returnfree”systemslikeCalifornia’s“ReadyReturn”pilotprogram.Thisprogramtargetedasmallgroupofindividualswiththesimplesttaxreturns–singleindividualswithnodependents,noitemizeddeductions,andonlywageincome—andmailedthemapre-filledreturn.Allofthecontentontheformwasprovidedusingcomputerrecords.Partici-pants’SocialSecuritynumberswereusedtoretrieveearningsdatafromtaxrecordsalreadysup-pliedtoCaliforniabyemployers,andinformationontheindividualsliketheirfilingstatuswassup-pliedfromlastyear’sreturn.(Individualswhosetaxsituationhadbecomemorecomplicatedstillhadtofileafullreturn.)Individualssimplyhadtochecktomakesurethattheinformationonthepre-filledreturntheyhadreceivedwascorrect,signtheform,andmailitback.Amongthosewhochosetoparticipate,themedianuserreportedsaving40minutesand$30,andparticipantsgaveravereviews,with98percentsayingthattheywantedtousetheprogramagainthefollowingyear.Thesetimeandmoneysavingbenefitsofautomaticfilingdonotincludetheadditionalbenefitsofreducedfrustrationbytaxpayersandtheirincreasedtrustinthesystem.Lessthan5percentoftheroughly2millioneligibletaxpayersparticipated,however.
Someestimatethatitwouldbepossibletoserveupto40percentofallU.S.taxpayerswithasimilarsystem,savinghundredsofmillionsofhoursandbillionsofdollarsinpreparationfees,whileactu-allyreducingthecosttotheIRSofadministeringthetaxsystembyreducingerrorsandresultantinvestigations.
The California experience also highlighted certain challenges to simplifying the filing process.Taxpayerswithcomplicatedreturns,withincomefromunreportedsources,likeself-employmentincome,orwithunreporteddeductions, likecharitablecontributions,wouldbehard toaccom-modate. Asthecostsoffilingaredisproportionatelybornebythosewithcomplexreturns, thislimitssomeofthepotentialcostsavingsfromfilingsimplification.Inaddition,modifyingthefilingsystemwouldrequirechangesfortheIRSandtheSocialSecurityAdministrationandfortheem-ployersandotherthirdpartieswhoarerequiredtosubmitinformationtotheIRSandwhowouldnowhavetosendinthatinformationonamuch-compressedtimeframe.Inaddition,newtech-nologicalsystemsanddatabaseswouldneedtobedevelopedandimplemented.Currently,theIRSdoesnotreceiveandprocessthird-partyreportedinformationintimeforthefilingseason.Thus,thetimingofreportingandprocessingwouldneedtobeaccelerated,withassociatedinvestmentsinadministrativepersonnelandcomputinginfrastructureateachstepoftheprocess.(Californiaprocesseditsstateunemploymentinsurancerecordsforwagesbytaxfilingseasonforthisproject,andwagesforunemploymentpurposesarenotnecessarilythesameasforincometaxpurposes.)
We received two primary options for simplifying the filing process; implementing either—orboth—wouldsubstantiallyreducethecomplianceburdenformillionsoftaxpayers.
5 Theseestimatesincludethemuchlargeramountsoftimeandmonetarycostsoftaxpayerswithbusinessincome,suchassoleproprietors.Fortaxpayerswithoutanybusiness-relatedincome,theaverageburdenislower.
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i. Option 1: The Simple Return
The proposal and its advantages: Oneoption,modeledaftertheCaliforniapilotprogram,istosendtaxpayersapre-filledreturn.Taxpayerswith relatively simple returnswould receiveapre-filled tax return from the IRS thatincludedinformationtakendirectlyfromemployersandfromlastyear’sreturnaswellasapre-liminarycalculationoftaxliability.Taxpayerswouldberesponsibleforupdatingtheirreturnsasneeded—forexample,changingthenumberofdependents,addingadeductionforhomemort-gageinterest,oraddinginself-employmentincome—butmanytaxpayerswouldhavenochangesandwouldonlyhavetosignandreturntheirpre-filledreturns.
Taxpayerswithrelativelysimplereturnswouldbe themost likely initialcandidates for thepro-gram,startingwiththemorethan17milliontaxpayerswithonlywageincomeandsimplefamilyarrangements.Fromthere,theprogramcouldreasonablybeexpandedtoasmanyas60 milliontaxpayers—abouthalfofthetotalnumber—whohavethird-partyreportedincomeandwhodidnotitemizedeductions.
Providing pre-filled returns would relieve millions of taxpayers from the chore of filling in taxforms,whetheronpaperorviataxsoftware,andwouldreducethefrustrationandanxietyoftax-payersattaxtime.
Disadvantages:Thisoptionalonewouldprovidelittlerelieffortaxpayerswithcomplicatedreturns,taxpayerswithbusinessincome,orlow-incomefilersincomplicatedlivingarrangements.Taxpayersinthesesitu-ationswouldstillneedtofilearegularreturn.Further,theIRScurrentlyhasneitherthecomput-inginfrastructure,northeabilitytoobtaininatimelymannertherequiredthird-partyreportsofincomeanddeductionsneededtofilloutacompletereturn,evenforsimplereturns.Consider-ableinvestmentintechnologyandmanpowerwouldberequiredtoimplementsuchasystem.(Asindicatedbelow,suchinvestmentwouldalsoberequiredtoincreaseoveralltaxcomplianceandreducethetaxgapsignificantly.)Apre-filledreturnthatomittedcertainincomesourcesorthatmisstatedataxpayer’sincomeordeductionsinthetaxpayer’sfavorcouldreducetaxcomplianceandcollectionsbyrevealingthegapsinthegovernment’sinformation.However,complianceforsuchincomesources,likecashreceiptsbysmallbusinesses,isverypooralready.(AstudyofCali-fornia’sReadyReturnconcludedthattheprograminfactreducedrevenuesonlyslightly.)Adaptingthesystemtoaddressallthespecialcreditsforlow-incomehouseholdswithchildren,retirementsavings,orotherpurposeswouldbedifficultorimpossibleunlessthosecreditswerealsosimplified.Finally,evenwithtechnological improvements, theIRSwouldnotbeable topreparereturnsassoonafterthecloseoftheyearasmanytaxpayerscurrentlyfiletheirreturnsinordertoobtaintheirtaxrefunds.Thus,theattractivenessoftheprogramforlower-incomefamilieswhoreceivelargerefundsduemainlytotheEITCandchildcreditsmightbelimited.California’sReadyReturnwasapaperformmailedtotaxpayers.Theuseofapaper-basedfilingsystemwouldtendtoeliminatethebenefits(suchasautomaticcomputations,fewercomputationalerrors,andreduceddataentrycosts)ofelectronicallypreparedandsubmittedreturnsforboththeIRSandtaxpayers.
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ii. Option 2: Data Retrieval
The proposal and its advantages: An alternative—or auxiliary—proposal would allow taxpayers (or their preparers) to downloadtheirowntaxinformationfromtheIRS.Insteadofmailingapre-filledreturntotaxpayers,theIRSwouldprovideasecuredatabasewhereindividualscouldlookupandretrievethird-partyreportedinformation,likewages,interestincome,dividends,incomefromsaleofsecurities,statetaxespaid,anddeductionslikehomemortgageinterest,allofwhichtaxpayersmustcurrentlyassembleandfillinthemselves.Allofthisinformationismaintainedbythirdpartiesandcouldbemadeavailableinadatabase.Ratherthanbeingmailedtothetaxpayeritem-by-itemtheinformationwouldbeavail-ablefordownloadingdirectlyintothetaxpayer’sreturnathisconvenience.Eliminatingmuchofthepaperworkneededtopreparetaxeswouldsavetime,decreasetaxpayerfrustration,andreduceerrorsintranscriptionandothermistakes.Whiletaxpayerswouldstillneedtofilloutotherinfor-mationonthetaxformlikecharitablecontributionsandcertaincapitalgains,thisoptionhastheadvantageofprovidingfilingsimplificationtoalltaxpayers,notjustthosewithsimpletaxreturns.Mostindividuallineitemsreportedbythemajorityoftaxpayersaresubjecttothird-partyreport-ing,evenforhigh-incometaxpayers,whotendtohavethemostcomplicatedreturns.
Disadvantages:Oneconcernisthatelectronicstorageanddownloadingoftaxinformationtoindividualtaxpay-ersbytheIRSwouldbesubjecttosecuritybreaches.Butproponentsofthisapproacharguethatthestandardsforsecurityforotheronlinetransactionsareveryhighandtheypointoutthatonlinesystemscouldimprovesecuritycomparedtomailinghundredsofmillionsofpaperformsacrossthecountry.Asinthepreviousoption,dataretrievalmightmaketaxpayersawareofalltheitemstowhichthegovernmentdoesnothaveaccessandmakehonestreportingoftheseitemslesslikely.Thisoptionwouldalsorequireadditionalresourcesforinvestmentsintechnologyanddatabases.Also, thisoptionhas the samecosts anddifficulties asOption1ofgetting the third-partydatasubmittedandprocessedearlyenough toenable taxpayers tofile their returnsandobtain theirrefundsontheircurrentschedule.Moreover,ifthirdpartiesnolongerhadtosendcopiesdirectlytotaxpayers,theywouldnotbeabletoacceleratetheirtaxfilingbyusingtheinformationsenttothemdirectly.
iii. Option 3: Raise the Standard Deduction and Reduce the Benefit of Itemized Deductions
Taxpayerschooseeithertotakethestandarddeductionortoclaimthesumofitemizeddeductionswhencalculating their taxable income,generallydependingonwhich is larger. Taxpayerswhoitemizetheirdeductionsmustmaintainrecordsofthosedeductionsandfileanadditionalschedulewiththeirreturn,andadditionalrecordkeepingandreportingisrequiredbythirdpartiesforde-ductionssuchasmortgageinterest.Taxpayerswhotakethestandarddeductiondonotfacetheserequirements.
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Overall,in2007,50milliontaxpayersor38percentofregulartaxpayers(otherthandependentfil-ersandthosewhofiledonlytoclaimastimulusrebate)claimeditemizeddeductions.Theitemiza-tionrateincreaseswithincome:forthosewithAGIunder$50,000,18 percentitemize;55percentwithAGIbetween$50,000and$75,000;73percentwithAGIbetween$75,000and$100,000and89percentofthosewithAGIover$100,000.Itemizationishighestfortaxpayersage45to64andlowerforyoungertaxpayersandthoseage65andover.Manytaxpayersinthe$50,000to$100,000incomerangehaverelativelymodestamountsofitemizeddeductionsandcouldberelievedoftherecordkeepingburdenifthestandarddeductionwerehigher.
The proposal and its advantages: Increasingthestandarddeductionandreducingthebenefitofitemizingdeductionswouldsim-plifythefilingprocess,reducerecordkeepingrequirementsformanytaxpayers,andrelievesometaxpayersfromfilingareturnentirely.Forexample,aproposalcouldlimititemizeddeductionsto75 percentofcertainexpensesandusetheresultingrevenueraisedtoincreasethestandarddeduc-tion.Suchalimitationalreadyappliestocertaindeductionslikebusinessexpensesforfoodanden-tertainmentandfortotalitemizeddeductionsforhigh-incometaxpayers.Therevenuesgeneratedbythislimitationcouldthenbeusedtofinanceasubstantialincreaseinthestandarddeduction.
Increasingthestandarddeductionwouldmeanthatmanymorepeoplewouldchoosetotakethestandarddeductionratherthanitemizing,meaningthatfewerpeoplewouldneedtospendtimekeepingrecordsofeligibledeductionsandresultinginmorestreamlinedreturns.Raisingthestan-darddeductionwouldoffsetthereduceddeductionformostlower-andmiddle-incomeitemizers.
Some rough calculations that ignore potential behavioral responses illustrate the effects of thisoption.6 Thecalculationssuggestthatlimitingitemizeddeductionsto75percentwouldgenerateenoughrevenuetoincreasethestandarddeductionby55to85percent,dependingonwhetherthePresident’staxproposalsintheBudgetareenactedorcurrentlawapplies.Forexample,undercur-rentlawwiththeAMTprovisionsindexedforinflation(theso-calledAMT“patch”),thestandarddeductioncouldbeincreasedbyupto85percentby2015.Underthisscenario,nearly30milliontaxpayerswouldshiftfromitemizingdeductionstoclaimingthestandarddeductionby2015,whileabout26milliontaxpayerswouldcontinuetoitemizedeductions.Thiswouldprovideasubstantialamountofsimplificationfortaxpayerswhonolongerneedtoitemizedeductions.ThepercentageoftaxpayerswithAGIbetween$60,000and$75,000whoitemizewoulddecreasefrom51percenttoabout18percent,providingsubstantialsimplificationwhilestillallowingitemizationforthosewith large amounts of such deductions. Among taxpayers in this income group, tax liabilitieswouldbereducedorremain thesame forabout70percentof taxpayers. Moreover, tax liabili-tieswouldremainthesameorbereducedfor96percentoftaxpayerswithAGIlessthan$50,000underthisoption.Taxeswouldincreaseformorethanthree-fourthsoftaxpayerswithAGIover$200,000.Overalongerhorizon,thestandarddeductioncouldbeincreasedfurtherorrevenuescouldbeallowedtorisebecauseitemizeddeductionstypicallyrisefasterthantheinflation-indexedstandarddeduction.
6 Possiblebehaviorresponsescouldincludereductionsincharitabledonationsandsometaxpayersusingsavingstopaydowntheirmortgagessincetheinterestwouldnolongerbefullydeductible.Inaddition,overtimestateandlocalgovernmentsmightreconsidertheirmixoftypesoftaxes,feesandborrowing.
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Limitingitemizeddeductionswouldalsoimproveeconomicefficiency.Certainitemizeddeduc-tions—forexamplethedeductionformortgageinterest—providesubsidiesforspecificactivitiesthatencouragethemrelativetootherpossiblymoreproductiveactivities.
SeverallimitationsonitemizeddeductionswereincludedintheTaxReformActof1986,andtheAdministration’s Budget proposal recommends limiting the benefit of itemized deductions forhigher-incometaxpayersto28 percentratherthanuptotheordinaryincometaxrateof35percent.
Disadvantages:Limitingitemizeddeductionswouldbecriticizedonfairnessgrounds.Forexample,limitingchari-tablecontributionswouldreducethe incentives togivetocharityandcouldthereforeadverselyaffectbothcharitableorganizationsandtheirbeneficiaries.Deductionsforwork-relatedexpenseswouldalsobehardtolimit—thecostsofproducingincomearefullydeductibleforallbusinessesandfortheself-employed,butcurrentlyonlypartiallydeductibleforemployeeswithunreimbursedexpenses.Similarly,thedeductionforlargemedicalexpendituresisintendedtoadjustforabilitytopayandthethresholdhasrecentlybeenincreasedtoonlyallowdeductionsover10percentofAGI.Limitingitemizeddeductionswouldalsoraisetaxesmorefromthosewithlargedeductionsthanotherwisesimilarlysituatedtaxpayerswithfewerdeductions. Forexample,homeownerswouldseetheirtaxesrisemorethanrenters.Theremaybemoreefficientwaystolimitthecostsofchari-tabledeductionswithoutreducingtheincrementalincentivetogive,suchasamodestfloorunderdeductions,likethe1 percentfloorsuggestedbythe2005TaxReformPanel,orafixeddollarfloorsuggestedbyothers.
e. Option Group E: Simplification for Small Businesses
Simplified Accounting for Small BusinessesSmallbusinessesspentcloseto1.8 billionhourscomplyingwiththeincometaxin2004andpaidasmuchas$16billionforprofessionalhelp,accordingtoonestudy.Thesecompliancecostsfalldisproportionatelyonsmallerbusinesses,assmallerfirmsbearalargercomplianceburdenrelativetothesizeoftheirbusinessthandolargerfirms.Forthesmallestbusinesses—thosewithonetofiveemployees—theaveragemonetizedcostofcomplianceisestimatedtobe$4,500peremployee.Ac-cordingtotheNationalFederationofSmallBusiness’sProblemsandPrioritiesPoll,taxcomplexityranksfifthof75issues.Thiscomplexityisaprimaryreasonwhy87percentofsmallbusinessown-ersrelyonapaidtaxpreparer.
Thelargestcostoftaxcomplianceforsmallbusinessesisthetimeburdenassociatedwiththead-ditionalrecordkeepingneededforcomplyingwithtaxaccounting.Businessesmayneedtokeepatleasttwosetsofbooks,oneforfinancialaccountingandanotherfortaxaccountingpurposes;oftenbusinessesmustalsomaintainadditionalsetsofaccountsforstatesthathavede-coupledfromfed-eraltaxrules.Formostsmallbusinesses,thesebooksmaynotbethatdifferentbecausetheyalreadyusecashaccountingforbothfinancialandtaxpurposes;about80percentofbusinesseswithgrossreceiptslessthan$500,000andthatmakeorsellgoodsusecashaccountingfortaxpurposes.Withcashaccounting,firmsgenerallyincludeallreceiptsingrossincomeintheyeartheyarereceived,
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anddeductmanyexpenseswhenpaid—exceptforthecostsofmaterialsandsupplies,inventories,andothercapitalexpenditures.Taxpayerscannotdeducttheircostsformaterialsandsuppliesuntiltheyareused.Similarly,taxpayersgenerallymaynotdeductthecostsofinventoryuntilthegoodsaresold.However,manysmalltaxpayersneedonlycapitalizethecostsofmerchandisepurchasedforresale. Othercosts,suchasdirectlaborcostsandoverheadcostsmaybeexpensedbythesesmalltaxpayers.Nevertheless,thetaxrulesrequireevenverysmallfirmstomaintainrecordsforpurchasedsuppliesandinventorybeyondtheyearinwhichtheywerebought.Similarly,expendi-turesfordepreciablepropertymustbedeductedovertime,andthedepreciatedbasistrackedfromyeartoyear.Currentlawprovidessomereliefbyallowingsmallbusinessestodeductimmediatelyup to$250,000of investments incertainproperty. (This limit is scheduled todecline toabout$135,000in2011.)
Inadditiontodirectbookkeepingcosts,recordkeepingatsmallfirmsisfrequentlysubjecttoerror.AccordingtooneIRSstudy,somerecordkeepingitemsreportedonthereturnsofsoleproprietor-shipshaveerrorratesover50percent.
Witnessesalsocitedthedifficultyofclaimingadeductionforthebusinessuseofahomeasadrainonsmallbusinesses.Nearlyhalfofsmallbusinessesarehome-basedandmanycouldbeeligibletodeducthomeofficecosts.However,toqualifyforthedeductionanumberofstringenttestsmustbemetandrecordsdocumentinghouseholdandbusinessexpendituresrelatedtotheofficemain-tained.Forexample,aself-employedworkerusingadenforbusinesspurposesmayneedtodocu-mentcostsforutilities,mortgageinterestorrent,andgeneralrepairs,allocatethosecoststothebusinessportionofthehome,andotherwisedifferentiatecostsspecificallyrelatedtothebusiness(likeadedicatedphoneorfaxline)fromthoserelatedtothehome.Also,therearestrictrequire-ments that limit thedeductibilityofhomeofficeexpensesbygenerallyrequiring that thehomeofficespacebeusedexclusivelyforbusiness.
Afinalissueraisedbymanybusinessrepresentativesdealswithproperty(otherthanhomeoffices)that potentially has both business and personal uses, such as automobiles, computers, and cellphones–knownas“listed”property.Topreventthetakingoftaxdeductionsforthepersonaluseoflistedproperty,Congressrequirestaxpayerstoreportasincomethepersonaluseofthisproperty.Strictlyspeaking,inordertocomplywiththeserules,employersandemployeesmustgocallbycallthroughcellphonerecordstoallocatebusinessandpersonaluse.
i. Option 1: Expand Simplified Cash Accounting to More Businesses
The proposal and its advantages: “Simplifiedcashaccounting”or“checkbookaccounting”eliminatestheneedtomaintainmulti-yearrecordsforsupplies,inventories,andmostdepreciableproperty. Inthissystem(advocatedby the 2005 Tax Reform Panel), taxable income for most small businesses would simply equalcashreceiptsminuscashbusinessexpenses—includingcashoutlaysforinventories,materials,anddepreciablepropertyotherthanbuildings.Ratherthanhavingtokeepanadditionalsetofbookssolelyfortaxpurposes,smallbusinessescouldsimplyusetheircashflowrecords—mainlytheir
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bankaccounts.Expandingfullcashaccountingtoallbutthelargestfirmscouldallowmillionsofsmallbusinessestosimplifytheirtaxaccountingandlowertheircompliancecosts.Relievingsmallbusinessesoftheburdenofmaintainingtheserecordscouldfreeupresourcesformoreproductiveusesand,bysimplifyingrules,couldreduceerrorsandimprovecompliance.Taxpayerscurrentlyusingcashaccountingarethevastmajorityofbusinesses,buttheyaccountforonlyasmallshareofoverallbusinessactivity.Hence,thedollaramountsinvolvedforprovisionsrelatedtosupplies,in-ventories,anddepreciablepropertyareverylow,makingthecurrentrecordkeepingrequirementsrelatedtosuchpropertyonerousrelativetotherevenuegained.
Anadditionalbenefitofthisoptionisthatitcouldfacilitateimprovementsinthird-partyreportingandthereforecompliance forsmallbusinesses. Undersimplifiedcashaccounting, thebankac-countofabusinessessentiallyrecordsthetaxableincomeofthebusiness—receiptsminusexpens-es.Iffirmswererequiredtomaintainaseparateaccountforthesetransactions,reportingbybanksontheseaccountswouldprovidetaxadministratorswithmorecompleterecordsoftheincomeofsmallbusinesses.(Thisproposalisdiscussedfurtherintheoptionstoimprovecompliance.)
Disadvantages:Providingsimplifiedcashaccountingtosmallfirmswouldreducethepresentvalueofrevenuescollected.Inaddition,certainadministrativeissueswouldneedtobeaddressedwithapermanentlawsuchashowtotreatfirmsmovingacrossthethresholdforsimplifiedaccounting.Transitionissues,likehowcurrentinventoriesweretreated,wouldneedtobeaddressed.Aggregationruleswouldbeneededtopreventlargebusinessesfromcreatingsmallerunitstotakeadvantageofthesimplifiedtreatment.
ii. Option 2: Simplified Home Office Deduction
The proposal and its advantages: Simplifyingthehomeofficedeductionwouldreducetherecordkeepingandcomplianceburdenonsmallfirms.Oneapproachwouldpermitastandarddeduction—aflatdollaramount—forhome-basedbusinesses, similar to thestandarddeduction for individual taxpayers. At-homeworkerswouldfileScheduleC(incomefromself-employment)onlyifself-employmentgrossincomeex-ceeded that threshold and would be permitted a safe harbor for expenses up to that amount—recordkeepingforthoseexpenseswouldbeeliminated. Businessescouldchoosetocontinuetofollowthecurrenthomeofficedeductionrules,ortheycouldchoosethenewstandarddeduction.Underanalternativeapproach,at-homeworkerscoulduseastandardizedformulamoresimilartothecurrentmethodthatisbasedonthesizeofthehomeoffice.Taxpayerswouldfiguretheirde-ductionbymultiplyingthesquarefootageoftheirofficebyastandardhomeofficerate,eliminatingtheneedtomaintainrecordsdocumentingcostsforhomeexpenditures.Eitherofthesesimplifi-cationswouldreducetheburdenofclaimingahomeofficedeductionandwouldencouragemoretaxpayerstodeductexpensesassociatedwiththebusinessuseoftheirhome.
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Disadvantages:Eitheroftheseprovisionswouldlikelyreducerevenuesbyincreasingthelikelihoodthattaxpay-erswouldclaimtheseexpensesand,forsometaxpayers,theamountofexpensestheycouldclaimwouldincrease.(Thisrevenuelosscouldbereduced,forexample,ifonlyexpensesoverathresholdcouldbeclaimed.)Manyofthestricttestsappliedinthecurrentsystemaredesignedtodiscourageabusiveuseofthehomeofficededuction.Taxpayerswouldstillhavetomeettheeligibilitycondi-tionsfordeductinghomeofficeexpenses.Finally,addinganoptionalstandarddeductioncouldac-tuallyincreasetaxpayerburdenwithoutdecreasingrecordkeepingcosts,sincemanywouldelecttocomputebothways(standarddeductionandexactmethod)andthendeductthelargerofthetwo.
iii. Option 3: Simplify Recordkeeping for Cell Phones, PDAs, and Other Devices
The proposal and its advantages: DeclassifyingcellphonesandPDAs from“listedproperty”wouldeliminate the requirement todocumenteachindividualcallandallowfirmstodeducttheexpensesusingthesamemethodstheyuseforotherexpenses.(TheAdministration’s2011Budgetincludedthisproposal.)Alternatively,the IRScouldprovidea safeharbormethodunderwhichacertainpercentageofcellphoneorPDAusewasdeemedtobeforpersonaluse.Forexample,50percentofthecostofanemployer-providedcellphonecouldbeassumedtobeforpersonaluse.Thesesimplificationswouldeliminateacostlyrecordkeepingrequirementforbusinesses.
Disadvantages:Removingcellphonesandotherpersonaldigitalassistants (PDAs) fromclassificationas“listedproperty”wouldencouragefirmstoofferemployeesdevicesandphoneplansasfringebenefits,increasing theneed toclarify thecircumstances inwhich thosebenefitsmaybeexcluded fromincome.
f. Option Group F: The AMTTheitemthatwasmentionedmore thananyother taxprovisionwas the individualAlternativeMinimumTax(AMT).TheAMTisaparalleltaxsystemthatrequiresmillionsofAmericanstocalculatetheirtaxestwice,onceundertheregulartaxandonceundertheAMT,andthentopaythehigherofthetwo.WithoutlegislativeinterventiontoincreasetheAMTexemptionamount,morethan28milliontaxpayerswouldneedtopaytheAMTin2010;by2020thenumberwouldclimbtomorethan53million.Evenwithrelief,in2009about4milliontaxpayerspaidAMT(in2020,withtheAMT“patch”almost8millionfilerswouldpaytheAMT).Millionsmorefaceduncertaintyaboutwhether theywouldbe subject to theAMT—andbehitwitha “surprise” taxpayment—andneededtofilloutapreliminaryformandreadpagesofinstructionsjusttofindoutwhethertheywouldneedtofileanAMTreturn.Moreover,becausetheAMTadjustmentseliminatemanypopularexemptionsanddeductionsincludingthosefortaxpayeranddependentexemptions,thestandarddeduction,stateandlocaltaxes,andbusinessexpenses,theAMTnowthreatenstoen-
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snaremanyordinaryhouseholds.WithoutcontinualAMT“patches”thevastmajorityoftaxpayersaffectedbytheAMTwouldearnlessthan$200,000.
TheuncertaintycreatedbytheAMTisaprimaryconcern—manyarguedthatwhatataxpayerowesattaxtimeshouldneverbeasurprise.Inaddition,manycitedthedirectburdenofcalculatingtheAMTonthe55-lineform.OthercommentsfocusedonthemanyfeaturesoftheAMTthatseemedatoddswithcommonfeaturesoftheregularincometaxsystem.Forexample,manyaskedwhytheAMTeliminatespersonalexemptionsandthereforetreatsfamiliesofdifferentsizesthesame,whiletheordinaryincometaxincludesmanyprovisionstoaddresshorizontalequity.
i. Option 1: Eliminate the AMT
The proposal and its advantages: MostobserverssuggestedeliminatingtheAMTentirely,andeliminatingalltheheadachesoftheAMTdirectly.
Disadvantages:ThemajorproblemwithcompleterepealoftheAMTiscost:estimatesfromavarietyofsourcessuggestthatrepealingtheAMTwouldcostontheorderof$1.4trillionover10yearsrelativetothecurrentpolicybaseline.“Patching”theAMTbyindexingitsparametersattheir2009levelswouldlimitthenumberofAMTtaxpayerssubstantially—tomillionsratherthantensofmillionsoftax-payers—butwouldstillcostjustover$1trillionovertenyears.AlternativeoptionstoeliminatetheAMTfortaxpayersbelowsomeincomethreshold—sayunder$250,000—wouldalsoreducethenumberofAMTtaxpayerssignificantlybutwouldstillbeveryexpensive—reducingrevenuesbyanamountsomewherebetweenthetwoestimatesabove.
Legislatorshavehistorically“patched”theAMTeachyear(asisnowassumedintheAdministra-tion’sBudgetproposal),sothede-factocostofrepealingtheAMTisaboutthe$320 billiondiffer-ence(over10years)betweenfullrepealandindexingthe“patch”forinflation.
ii. Option 2: Modify and Simplify the AMT
The proposal and its advantages: AnalternativeoptionwouldbetosimplifytheAMTandharmonizeitsprovisionsmorecloselywiththoseintheregularincometax.ThecomplianceburdenoftheAMTarisesbecausetheAMTadjustmentsaresufficientlyopaquethattaxpayerscannotpredictwhethertheywillbesubjecttotheAMTandbecausemanytaxpayersmustfillouttheirtaxestwice,usingadifferentsetofrulesandadifferentsetofcalculationseachtime.IfwearestuckwiththeAMTbecauseofthecostsofrepeal,wecouldatleastmakeitlessburdensome.
TheAMTscheduleincludes28adjustmentstoordinaryincomethatareoftenonlyslightlydifferentfromsimilarprovisionsintheordinaryincometax.Medicalexpensesaredeductibleontheregularscheduleonlytotheextenttheyexceed7.5 percentofincomebut10 percentfortheAMT.(There-centhealthcarelegislationeliminatedthisdifference.)Thedefinitionofdeductiblehomemortgage
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interestisslightlydifferentfortheAMT.EmployeestockoptionsaretaxedwhenexercisedundertheAMTbutonlywhenthestockissoldundertheindividualincometax.Toeliminatethepos-sibilityofbeingtaxedtwiceonthesamecompensation,AMTtaxpayersgetacreditagainsttaxespaidinthefuturewhenthestockissoldandregulartaxliabilityisincurred;hencethenetrevenueisgenerallyclosetozero.Inthemeantime,however,thetaxpayermustcarryforwardtwodifferentbasesintheoptionsandstockandcontinuefilingAMTreturnsforinterveningyears.Harmoniz-ingtheseprovisionswouldimprovethepredictabilityofAMTliability,savealotofpaperwork,andmakethesystemmoretransparent.
Manyoftheotheradjustmentsapplytoveryfewtaxpayersandcouldpotentiallybeaddressedelse-whereinthetaxcode.In2006,fewerthan10,000taxpayersofthe8.6millionwhofiledtheAMTmadeadjustmentsforobscureitemslike“electinglargepartnerships”(811taxpayers),thediffer-encebetweenregulartaxandAMTtreatmentof“researchandexperimentalcosts”(1,743taxpay-ers),or“intangibledrillingcostpreference”(5,969taxpayers).Addressingtheseissueselsewhereinthetaxcode—forexample,bymodifyingthetaxtreatmentonlyforthosefewtaxpayers“electinglargepartnerships,”wouldrelieveAMTfilersfromhavingtodealwiththeseprovisions.
Finally,aconsolidationoffamily-relatedtaxcreditsanddeductions,asdiscussedabove,couldre-ducethenumberofAMTtaxpayers.SincepersonalexemptionsarenotdeductibleforAMTpur-poses,havingalargefamilyincreasesthelikelihoodofbeingsubjecttotheAMT.Ifthestandarddeductionandpersonalexemptionswereeliminatedandconsolidatedwitha“familycredit,”thiswouldharmonizetreatmentoffamiliesbetweentheregulartaxandtheAMTandcouldbeusedtoreducethenumberofAMTfilers.
Disadvantages:Muchof theburdenofcalculating taxes twicewouldremain. Harmonizationof individual taxprovisionswouldhelporhurtindividualsaffectedbyindividualprovisions.
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III. COMPLIANCE OPTIONSThesecondofthechargestotheTaxReformgroupwastosuggestoptionsforimprovingtaxpayercomplianceandreducingthetaxgap.
Mosttaxpayersreportandpaytheirtaxesvoluntarilyandontime.Overall,thefederaltaxsystemachievesahighlevelofvoluntarycompliancewithtaxpayerspayingabout83.7percentofalltaxesdueinatimelymanner.Theremainingfractionofunpaidtaxesisoftencalledthegrosstaxgap—thedifferencebetweentheamountof taxpayers’ taxobligationforagivenyearandtheamountthatisactuallypaidontime.Thisgapwasestimatedtobe$345billionintaxyear2001.(ThereisnomorerecentIRSestimate.)Ofthe$345billion,voluntarylatepaymentsandIRSenforcementbroughtinapproximately$55billion,leavinga“nettaxgap”of$290 billionofunpaid,uncollectedtaxes.Thisgapresultsprimarilyfromtheunderreportingofincome,withmuchsmalleramountsarisingfromtaxpayerswhofailtofile,orwhofileanddeclareincomebutfailtopay.Thetotaldol-laramountofunpaidtaxeshaslikelyincreasedsince2001becauseofthegrowthintheeconomyandthegrowthintaxrevenues.
Despitethehighratesofvoluntarycompliance,anunacceptablylargeamountofthetaxthatshouldbepaidisnot. Thisdirectlyaffectsfederalrevenues,resultingin largerfederaldeficits,butalsoreducestaxrevenuesforstateandlocalgovernments,whichoftenrelyoninformationreportedonfederaltaxreturns.Noncompliancealsoforcescomplianttaxpayerstoshoulderadisproportion-ateshareoftheburdenofgovernmentfinance.Thetaxgapthereforerepresentsanunfairburdenplacedoncompliant taxpayerswhomustultimatelypaymore forgovernmentservices—anad-ditionalburdenthatrunstothousandsofdollarspertaxpayertosubsidizethosewhodonotpay.Honestbusinessesareputatacompetitivedisadvantagerelativetothosethatcheat,andeveryonesufferswhentaxpayersinadvertentlyunderpaytheirtaxes.Therefore,reducingthetaxgapisaboutmorethanjustincreasinggovernmentrevenues.Itisalsoaboutensuringthateveryonepaystheirfairshare,whichinturnsupportsthewillingnessoftaxpayerstovoluntarilycomplywiththetaxsystemandtheirtrustinit.
Reducingthetaxgapisnotaneasytask.Thenettaxgapdoesnotrepresent“taxdue”billsthattheIRScouldsendtotaxpayers.Rather,thetaxgapprimarilyreflectsanestimateofnoncompliancethattheIRShasreasontobelieveexists,muchofwhichhasnotbeenspecificallyidentified,andwhich,inmanycases,theIRShaslimitedresourcesorabilitytoassessorcollect.(Indeed,limitedIRSresourcesarethemainreasontheofficialestimateofthesizeofthetaxgapisnearlyadecadeold.)Furthermore,someofthetaxgapresultsfromtaxpayerswhomayhaveinsufficientfundstopaythetaxestheyoweorfrombusinessesthatnolongerexist.Morefundamentally,substantiallyreducingthetaxgapcouldrequirebothasignificantincreaseinIRSenforcementcapabilitiesandwouldrequiremoreintrusiveenforcementmeasuresthanmaybeacceptabletoCongressandthepublic.Moreover,additionalresourcesforcollectionandenforcementwouldcompeteforlimitedgovernmentresourcesthatcouldbeusedforotherpurposes.
BothCongressandtheIRShavetakensignificantactionstoreducenoncomplianceandtheassoci-atedtaxgapinrecentyears,andmanyofthesechangeswererecentlyorwillsoonbeputintoeffect.Forexample,informationreportingwillbeenhancedbytworequirementsforcreditcardpayment
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andstockbasisreporting.Additionally,therecentlypassedForeignAccountTaxComplianceAct(FATCA)willaddrobustreportingforinternationaltransactionsandprovidetheIRSkeyinfor-mationtohelpidentifyoffshoretaxabuses. Intherecentlyenactedhealthlegislation,Congressexpandedtherequirementforbusinessestoreportaggregatepaymentsof$600ormoreperyeartorecipientsforallgoodsandservicesandtobothnon-corporateandcorporatepayees.Beginningin2011,taxreturnpreparerswhofile10ormorereturnswillberequiredtofilethosereturnselec-tronically.TheAdministration’sBudgetincludesadditionalcomplianceproposalsthatwouldaffectworkerclassificationandincreaseinformationreportingforitemslikerentalpropertyexpensepay-ments,privateseparateaccountsoflifeinsurancecompanies,andgovernmentpaymentsforcertainpropertyandservices,aswellasotherchanges.
Inorderforthesechangestobefullyeffective—bothfromataxcomplianceperspectiveandfroma“customerservice”perspectiveofhelpingtaxpayersavoidmistakesandprovidingtimelierprocess-ingofreturns—theIRSwillneedtodevotenewresourcestargetedintheseareas;meanwhile,theIRSwillstillneedtomaintainitseffortselsewhereprovidingtaxpayerserviceandreducingtax-payerburdensintheadministrationoftaxlaws.Asaresult,theIRSwillneedadditionalfundingbecausewithoutadequateresources,thesenewprovisionswillnotbeeffective.
a. Background on Compliance and the Tax GapIRSresearchshedslightonthetypesofnon-complianttaxpayersandthekindsofincomeandde-ductionswherenoncomplianceismostsevere.Thefollowingtableshowstheestimatesofcompli-ancebytypeoftaxes.Over70percentofthegrosstaxgapisattributabletotheindividualincometax,andsoleproprietorsmakeupmorethanhalfofthispercentage.
Table 5: The Gross Tax Gap, by Type of Tax, Tax Year 2001Type of Tax Gross Tax Gap ($ Billions) Share of Gross Tax Gap
Individual Income 245 71%
Corporate Income 32 9%
Employment 59 17%
Estate 8 2%
Excise NA NA
Totala 345 100%
a. Itemsmaynotaddduetorounding.Source:Figure2,“ReducingtheFederalTaxGap,”IRS&Treasury,August2,2007.
Noncompliancecantaketheformofnotfilingrequiredreturns,underreportingincomeonfiledreturns,orunderpayingtaxesthatarereportedontime. Itisestimatedthat82.6percentofthegrosstaxgapwasattributabletounderreportingoftax(includingunderreportedincomeorover-stateddeductionsandcredits)fortaxyear2001.Theoveralltaxgapisdominatedbytheunder-reportingofindividualincometax,estimatedat$197billion.Table6categorizessourcesofindi-vidualincomeaccordingtothevisibilityofthetypeofincomeandtheassociated“netmisreporting
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percentage.”7 Whiletheaccuracyofreportingvarieswidelyfordifferenttypesofincomeorde-ductions,thereportingcomplianceisgreatestwherethereissubstantialinformationreportingorwithholding,suchasforwagesandsalaries.
Table 6: Individual Income Tax Underreporting Gap and Net Misreporting Percentage, by Visibility Groups,
Tax Year 2001
Visibility Group – Type of Income or OffsetUnderreporting Gap
($ Billions)Net Misreporting
Percentagea
Total Underreporting Gap 197 18%
Items subject to:
Information reporting and withholding (wages, salaries, etc.) 10 1%
Information reporting (interest, dividends, pensions, social security benefits, etc.) 9 5%
Some information reporting (capital gains, S corp. & partnership, deductions, exemptions, etc.) 51 9%
Little or no information reporting (proprietor income, rents & royalties, “other” income, etc.) 110 54%
-- Non-farm proprietor income 68 57%
-- Rents & royalties 13 51%
-- “Other income” 23 64%
a.NetMisreportingPercentage–seefootnote7Source:Figure5,“ReducingtheFederalTaxGap,”IRS&Treasury,August2,2007.
Thelargestsourceofunderreportingofincomeisindividualincometaxforincomesourcesnotsubject to withholding or document matching. Voluntary compliance is very high for incomesubjecttobothwithholdingandinformationreporting—morethan99percentofwageandsalaryincomeactuallyreportedonFormsW-2isdisclosed,andthereportingrateonincomesubjecttothird-partyreportingis95percent.ComplianceislowwheretheIRSdoesnotreceivethird-partyreporting,orwherethatreportingisincomplete,andwheretheIRSdoesnothave“lineofsight”toseetransactionsandaccounts.Forexample,theincomereportingpercentagedropsto20percentfor incomeearnedbycertainsoleproprietors(called“informalsuppliers”)whooperate“offthebooks”onacashbasisinareassuchasstreetvending,door-to-doorsales,ormoonlightinginatradeorprofession.Underreportingofbusinessincomebysmallbusinesses,inparticular,accountsforapproximately$153billion—44percent—ofthetaxgap.TheIRSestimatesthatonlyabouthalfofself-employmenttaxesowedareactuallypaidontime,andthattheunderreportingofbusinessincomebyindividualincometaxpayerscosttheTreasury$109billionintaxyear2001.
7 “Netmisreportingpercentage”istheaggregatenetamountofincomemisreporteddividedbythesumoftheab-solutevaluesoftheamountthatshouldhavebeenreported.Theestimatesoftheamountsthatshouldhavebeenreportedaccountforunderreported incomethatwasnotdetectedbytherandomaudits(wheretheburdenofproofisontheauditor)withoutacorrespondingadjustmentforunclaimedoffsets(e.g.,deductions,exemptions,statutoryadjustments,andcredits)thatwerenotdetected(wheretheburdenofproofisonthetaxpayer).
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b. General Approaches to Improve Voluntary Compliance and Reduce the Tax Gap
Whenweaskedexpertshowto improvevoluntarytaxcomplianceandreducethetaxgap, theyadvocatedbroadandgeneralprinciplestopromotecompliance.
Onethemeweheardrepeatedlywasthatvoluntarytaxcompliancewouldbeincreasedbyhavingasimpler,moretransparentandmoreeasilyunderstoodtaxsystem,andfromstableandconsistenttaxlaw.Thecomplexityofthecurrenttaxcoderesultsdirectlyininvoluntaryerrorsandfacilitatesintentionalevasion.Areaswherethetaxcodeisparticularlycomplex—theEITC,taxcreditsanddeductionsforeducationexpenses,andlimitsoncontributionstoretirementsavingsplans—arewell-knownsourcesofunintentionalerrors.Onestudyofcapitalgainsfoundthat33percentoftaxpayerswhomisreportedgainsfromsecuritiessalesoverstatedtheircapitalgains. Thesetax-payers overpaid and thus are unlikely to be trying to cheat. Complex provisions also facilitateintentionalnoncompliance(evasion)inpartbecausetheymakeitdifficultfortheIRStodeterminewhetherataxpayeriscomplyingwiththelawabsentasubstantialandsophisticatedaudit.
Wealsoheardalotabouttheneedforpredictabilityandstabilityinthetaxsystem.Themorecer-taintytaxpayershaveaboutthelawandthemorepredictablethelawisfromyeartoyear,theeasieritisfortaxpayerstocomplywiththelawandthelesslikelyitisfortaxpayerstomakeunintentionalerrors.However,taxruleschangealmosteveryyear:therehavebeenmorethan15,000changessince1986andchangesareincreasinglycommon.Inaddition,temporaryprovisionsareincreas-inglyusedforthingslikeeducationcredits,stimulusrebates,disasterarearelief,losscarrybacks,orthefirst-timehomebuyercredit.Thesechangesareconfusingtotaxpayersandtotaxprofession-als.Additionally,eachyeartaxpayersmustawaitreauthorizationsofexpiringtaxprovisionsliketheResearchandExperimentationcredit,AMTrelief,orthesalestaxdeduction.TheJCT’slistofexpiringfederaltaxprovisionsincludesmorethan240provisionsthatexpireby2020.
Expiringandtemporaryprovisionsandotherchangestotaxlawincreasethecostofcomplianceandcreateunpredictability for individuals,resulting inmoreconfusionandmistakes. Fromanadministrativeperspective,suchchangesrequiremajorreprogrammingofcurrenttechnologysys-tems,new informationbooklets,publications, and forms,andreeducating taxpayers,preparers,administrators,andenforcementofficers.AllofthesecostsdivertresourcesfrommoreproductiveusesandreducetheIRS’sabilitytoestablishbestpractices. Forexample,therecenthomebuyercreditwasparticularlychallengingtoadministerandenforce,andtheriskoffraudwassignificantbecauseofuncertaintyaboutappropriatedocumentationrequirementsandareluctancetoimposeexcessivereportingburdensontaxpayersseekingtolegitimatelyavailthemselvesofthecredit.
Asecondthemeweheardwasthatinvestmentsinresearchandtechnologywouldbenecessarytoimprovecomplianceandreducethetaxgap.ContinuedimprovementstoinformationtechnologyanddatabaseswouldprovidetheIRSwithbettertoolstopromotecompliance.Improvingtechno-logicalresourceswouldenabletheIRStoensureallbusinessesandworkersareinthetaxpaymentsystemandthusincreasetheproductivityofexistingIRSresources. Suchimprovementswould
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alsospeedrefunds,helpwithcustomerservice,andprovideasteppingstonetowardsystemslikedataretrievalthatwouldmakefilingeasier.
AdditionalresearchisessentialtoenabletheIRStobetterunderstandsourcesofnoncompliance,identifywaystominimizetaxpayerburdenarisingfromcomplianceactivities,andtargetresourcesthatfacilitatevoluntarycompliance.Unlessweunderstandthecausesofnoncompliance,wewillcontinuetohavedifficultyknowingwhetheritisinadvertentorintentionalorwhetheritisfacili-tatedbycertainindividualsororganizations,andwewillnotknowhowtostopit.
Afinalthemewasimprovingtaxadministration.ExpertspointedoutthattheIRShasmultipleobjectivesthatincludeprovidingservicefortaxpayers,collectingrevenue,anddistributingbenefitsthroughcreditsandrefunds,andthatthesedifferentobjectivescompeteforbudgetresources.Newresourcescouldbeusedtohelpdevelopmodernandadaptableadministrationmethods,improvethe design of tax forms and educational materials, improve audit and enforcement procedures,andincreaseauditsandcollectionactivitieswhereappropriate.Anoverarchingthemeidentifiedinthecomplianceareaisthatcomplianceeffortscouldbebettertargetedwithanincreaseduseofelectronicdata.Notonlywouldthisallowfasterprocessing,butitwouldalsoprovidebettercapa-bilitiesfordataanalysisinresearchingareasofnoncompliance.
Wealsoreceivedsomemorespecificoptionsforimprovingcompliance.
c. Option 1: Dedicate More Resources to Enforcement and Enhance Enforcement Tools
Incertainareas,enforcementthroughauditsisoftentheonlywaytouncoverunderreportingofin-come.Overall,infiscalyear2009,theIRSexamined1.4millionorabout1.0percentofindividualtaxreturns.Theexaminationratesrangedfrom0.4percentofsimplereturnswithtotalpositiveincomeunder$200,000upto10.6percentofreturnswithAGIof$10millionandover.Theexami-nationrateswerelowerforsimplerreturnssuchasthosewithonlywageandinvestmentincomeandhigherforreturnswithcharacteristicsknowntohavehighernoncomplianceratesincludingbusinessandrentalincome.Mostexaminationsareconductedbysimplecorrespondencewiththetaxpayer,whilemoreseriousorcomplexissuesmayrequireaformalfieldaudit.
Inaddition,theIRSchecksfortheaccuracyofinformationonmillionsofadditionalreturns.Over2.8millionnoticesweresentoutunder the“matherror”program,which isauthorizedbystat-ute.TheprogramallowstheIRStoidentifyfactuallyinconsistentormissingreturninformationinspecificareas(whicharedefinedbystatute)andcorrect theamountsreportedduringreturnprocessingpriortoissuingataxrefund.Forexample,theIRShasmatherrorauthoritytodenyearnedincometaxcreditstotaxpayerswhofailtoprovidevalidSocialSecuritynumbersforeachchildforwhomthecreditisclaimed.Themostcommonmatherrorsrelatetothecomputationoftheamountoftax,theEITC,thenumberandamountofpersonalexemptions,andthestandardoritemizeddeductions. ExpandingthesetofcircumstanceswheretheIRSmayusematherrorauthoritytoadjustareturnduringprocessingcouldreducethenumberofincorrectrefundsandreducetheneedtouseaformalaudittocorrectmistakes.
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UndertheAutomatedUnderreporter(AUR)Program,theIRSmatchestaxreturnstoinformationreturnsreportedbythirdpartiesandcontactstaxpayerstoresolvediscrepanciesandidentifyunre-portedincome.Infiscalyear2008,theIRShad4.8millioncontactsundertheAURProgramthatresultedin$16.5billionofadditionalassessments.
Asstatedearlier,Congresshasenactedanumberofprovisionstoimprovecompliancethatwillgointoeffectoverthenextseveralyears,andtheAdministration’sBudgetincludesadditionalpropos-alstoreducethetaxgap.Inorderfortheseeffortstobeeffectiveinimprovingcompliance,theIRSwillneedadditionalresourcestargetedtocompliance. TheIRSreceived1.9billioninformationreturnsinfiscalyear2008andwillbereceivinglargernumbersinthefutureasadditionalinforma-tionreportingrequirementsarephasedin.TheFY2011BudgetrequestfortheIRSis$12.6billion,representinganincreaseof$487.1millionor4.0percentfromthefiscalyear2010enactedlevel.Ofthetotalbudgetrequested,$2.3billionisfortaxpayerservices,$5.8forenforcement,$4.1foroperationssupport,and$387millionforbusinesssystemsmodernization.TheindependentIRSOversightBoardsupportedtheaddedfundingforIRSenforcementandBusinessSystemsModern-izationprogramtoupgradeIRScomputersystemsandinformationtechnology,andrecommendedevenmoreforIRStaxpayerserviceandbasicIRSoperationssupport.
Anadditionalconsiderationisthedesignoftaxforms.Whileminimizingtaxpayerburdenisanimportantcriterion,IRSformsandpublicationscouldbereviewedandredesignedtoimprovecom-pliance.Forexample,aproposednewscheduleforcorporatetaxpayerswasintendedtoimprovecompliancebyrequiringthereportingofcertainitemsthatmightindicatetheuseofquestionablearrangementsordeductionsthatcouldbeconsideredinselectingfirmsforaudit.Evidencesug-geststhedesignoftaxformsmatters:arecentstudyindicatedthatwhenthethresholdforreportingspecificinformationaboutnoncashcharitabledeductionswasincreasedto$500,alargenumberoftaxpayersincreasedtheirclaimedcharitabledeductionstojustbelowthatthreshold.AdditionalresourceswouldbeneededfortheIRStoimplementandfullyusetheinformationfromredesignedforms.
The proposal and its advantages: MoreresourceswouldenabletheIRStoincreasethenumberofexaminationsandfollow-upsofmismatchesbetweeninformationdocumentssubmittedandtaxreturnsfiled,checkmorequicklyformatherrorsandmissinginformationinreturns,andpursueauditsandcollectionsmoreef-ficientlyandwithalowerburdenoncomplianttaxpayers.Moreresourceswouldalsorelievethebudgetarytradeoffsbetweenenforcementandprovisionoftaxpayerservices. Enforcementrev-enuewas$48.9billioninfiscalyear2009throughcollection,examinationanddocumentmatchingforatotalIRS-widereturnoninvestment(ROI)of4.2to1. Thisfigureexcludestheadditionalrevenuesthatenforcementproducesbydeterringnon-compliancefromoccurringinthefirstplace.Withadditionalresources,theIRSwillcontinueinitiativesimplementedwiththecurrentfundingandestablishnewinitiativestohelpincreaseenforcementrevenue.
Disadvantages:Spendingonenforcementandreportingrequiresreal resourcesboth in termsofdirectcostsofenforcementandthecosttotaxpayersintimeandfrustration.Manyassumethatitisoptimalto
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increaseenforcementuntiltheadditionaldollarofenforcementbringsinanadditionaldollarofrevenue.Thisassumptionignoresthefactthatincreasingenforcementusesrealresources—hiringauditorsandrequiringtaxpayerstospendtime—thatcouldbeusedmoreproductivelyelsewhere.Instead,expertsadvisethatenforcementspendingshouldincreaseonlytothelevelwheretheto-talcostofanadditionaldollarofrevenuegainedbyenforcementjustequalsthecostofraisinganadditionaldollarofrevenuethroughsomeothermeans,forexamplebyanincreaseintaxrates.Economistsgenerallybelievethatmosttaxesreduceproductiveeconomicactivitysothatthetruecostofraisingadollaroftaxrevenuethroughthetaxsystemexceedsadollar—typicalestimatesofthetotalcostrangebetween$1.30to$1.50.Fromthisperspective,enforcementeffortsshouldbeincreasedonlytothepointwhereanadditionaldollarofenforcementstillbringsinmorethanthecostofraisingadollarofrevenue.Inaddition,onemustconsiderthatthedirectcostsofadditionalenforcementareonlyonepartofthetotalcostsofincreasedauditing.Anincreaseinauditshasitsdownside,asitcouldbeviewedasintrusiveandonerousfortaxpayers.
d. Option 2: Increase Information Reporting and Source Withholding
Comprehensivethird-partyinformationreportingisanimportantcomponentofachievingahighrateofvoluntarycompliance.Taxcomplianceisextremelyhighfortaxpayerssubjecttowithhold-ingandthird-partyinformationreporting.Asdiscussedearlier,amongworkerswhosewagein-comeisreportedonFormW-2,thenoncompliancerateisonlyabout1percent.ComplianceislowwheretheIRSdoesnotreceivethird-partyreporting,orwherethatreportingisincomplete.
The proposal and its advantages: Expanding information reporting to income sources with little third-party coverage would im-provecomplianceandreducethetaxgapinthoseareaswithouttheneedforadditionalaudits.Forexample, thenewprovisions inFATCAwill significantlyhelp theIRSto lookthroughfinancialintermediariestoidentifyU.S.persons.Historically,however,reportingforinternationaltransac-tionshasnotbeenstrong;afurtherenhancementcouldbemadebyimposingarequirementtoreportoninternationalwiretransfersbyfinancialinstitutions.
Inaddition, expandeduseof reportingon independent contractorsbybusinesses could reduceunderreportingintraditionallycashbusinesses.Requiringwithholdingonlargepaymentstoin-dependentcontractorsandbusiness-to-businesspaymentscouldfurtherincreasecompliance,al-thoughitcouldhaveadverseimpactsonindependentcontractors,especiallythosewhoprovidecombinationsofgoodsandservices.
Disadvantages:Third-partyreportingimposesburdensonthirdparties—generallybusinessesbutpotentiallyin-dividuals—aswellastheIRS. Likeenforcementcosts,thecostofreportingisarealsocialcost.Expandedreportingonindependentcontractorswouldbeburdensomeformanyindividualswhoarenotcurrentlyrequiredtodosuchreporting.Becauseofexpansionsofinformationreportinginrecentlegislation,thepotentialforfurtherrequirementsmaybemorelimited.
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e. Option 3: Small Business Bank Account ReportingUnderreportingofsmallbusinessincomemakesup44percentofthetaxgap–thelargestsourceofunderreportedincome.SmallbusinessownersdonottypicallyreceivewagesandsalariesthatarereportedtotheIRSandsubjecttowithholding.Inaddition,manypaymentstosmallbusinessesarenotsubjecttoinformationreporting,sotheaccuracyofthisinformationonabusinesstaxpayer’sreturncannotbeverifiedbasedonthird-partyreportedinformation.ThisprovidesopportunitiesfortaxpayerstounderreporttheirincomeandmakesitdifficultfortheIRStoidentifynoncompli-ance.
The proposal and its advantages: Inconjunctionwithasimplifiedtaxaccountingsystemforsmallbusinessesthatpermitscashac-counting(describedinthesectionontaxsimplification),asmallbusinesswouldberequiredtouseadesignatedbankaccountforallbusinessreceiptsandexpendituresthatissegregatedfromanypersonalbankaccount.Thebankwouldberequiredtoreportthereceiptsandexpenditureswithinthedesignatedaccountannually.
Theproposalwouldofferbothsimplificationandcomplianceimprovements.Asdescribedabove,simplified cash accounting for small businesses would allow business owners to dispense withmany onerous tax accounting provisions, as their checkbook account would effectively providealltheirtaxrecords.Moreover,allowingbusinessestoexpensecertaindepreciablebusinessassetscouldprovideapositiveincentiveintheformofbettercashflowandlowereffectivetaxratestooptintothesystem.
Disadvantages:Bankaccountreportingwouldrequiremillionsofsmallbusinessestoopenandpayforseparateaccounts. Additionally,many soleproprietorshipsusebankaccountsandcredit cards forbothpersonalandbusinessuse.Requiringseparatebusinessaccountswouldhavelessimpactoninten-tionalnoncompliancethanoninadvertentnoncompliance.
f. Option 4: Clarifying the Definition of a Contractor Businessesarerequiredtowithholdincomeandpayrolltaxesonbehalfoftheiremployees,butarenotrequiredtodosoforindependentcontractors. (Inaddition,abusinessmustfulfillrequire-mentsunderlaborlawsforemployeesthatgenerallywouldnotapplytocontractors.)Thedistinc-tionbetweenanemployeeandacontractoristhereforeimportantforthewithholdingoftaxesandreportingofincome—whicharecrucialforensuringtaxcompliance—andforapplyinglaborlawssuchasminimumwages,workplacesafety,oreligibilityforunemploymentbenefits.
However,therulesfordistinguishingbetweenindependentcontractorsandemployeesarecom-plicated,basedonlongstandingcommonlaw,anddependonasmanyas20factorsrelatedtotherelationshipbetweentheworkerandthebusinessthatfrequentlymustbeappliedonacase-by-casebasis. Inaddition, the rules fordistinguishingemployeesandcontractorsaredifferent forincometaxesandpayrolltaxesandforpurposesoflaborlaws.Moreover,somerulesapplytoall
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workers,whileotherrulesexcludespecificcategoriesofworkers,suchasengineers,designers,orprogrammers.Additionally,forbusinessesthathavehistoricallyclassifiedworkersasindependentcontractors,aspecialprovision(Section530oftheRevenueActof1978)providesa“safeharbor”exceptionfromtheusual20-factortest.Underthesafeharbor,theIRSmaynotreclassifyworkersasemployees—evenprospectivelyorfornewlyhiredworkers.
Becauseindependentcontractorsarenotsubjecttowithholdingandinformationreportingislesscomprehensive, inadvertent misclassification of workers as independent contractors because ofcomplexityandtheclassificationofemployeesascontractorsatfirms“grandfathered”underthesafeharborrulestendstoreducetaxcompliance.Existingrulessometimesalsoplacefirmsclas-sifyingtheirworkersasemployeesatacompetitivecostdisadvantagerelativetootherfirmsthatclassifytheirworkersascontractors.
The proposal and its advantages: RepealingthecommonlawrulesandallowingtheIRStopublishguidanceonworkerclassificationwouldreducemisclassificationanddisputes. ClarificationofthedistinctionbetweenemployeesandcontractorsandtheeliminationoftheSection530safeharborwouldimprovetaxcomplianceandhelpreducethetaxgap.Applyingthesamerulesequallytoallfirmswouldhelptoleveltheplayingfieldbetweenemployerswhotreatworkersasemployeesversusthosewhoclassifythemascontractors.
Disadvantages:EliminatingtheSection530safeharborprovisionwouldalmostcertainlyleadtomanymorework-ersbeingclassifiedasemployeesratherthancontractors,requiringsomeburdensomechangesforbothemployeesandemployers,evenforthosealreadyincompliancewiththeirtaxes.(Themajor-ityoffirmsandworkers,however,alreadyabidebytheseconditions.)Conversely,repealingthecommonlawrulesforworkerclassificationwithitsnecessaryconcurrentsimplificationandsafeharborruleswouldundoubtedlyallowserviceprovidersandservicerecipientstogether(orservicerecipientsalone)todevelopworkarrangementssothatmoreworkerswouldbetreatedasindepen-dentcontractors.Suchworkerswouldlosethebenefitsofthesocialsafetynet—includingworkers’compensation,unemploymentinsurancebenefits,andvariousfederal,stateandlocalhealthandsafetyprovisions—availableforworkersclassifiedasemployees.
g. Option 5: Clarify and Harmonize Employment Tax Rules for Businesses and the Self-Employed (SECA Conformity)
Self-employedindividualspayemployment(payroll)taxesontheirself-employmentincomeun-der the Self Employment Contributions Act (SECA) just as employers and employees pay em-ploymenttaxesonwagespaidtoemployees.Similarly,generalpartnersinapartnership(suchaslawyersatalawpartnership)aregenerallysubjecttoemploymenttaxesonpaymentstheyreceivefromthepartnership.However,limitedpartnersandScorporationshareholdersareexemptfrom
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theserules,andthelawforownersoflimitedliabilitycorporations(LLCs)isunclear.OwnersofScorporationsinsteadareinstructedtopaythemselves“reasonablecompensation”andmustpayemploymenttaxesuponthatamount,likeanyotheremployee.ThisdifferentialtreatmentprovidesincentivesforshareholdersofScorporationstounderreporttheircompensationandinsteadre-ceivetheirbusinessincomeasdistributionsthatarenotsubjecttoemploymenttax.ThismayresultinlowereffectivetaxratesonshareholdersinScorporationsandmembersofLLCsthaninotherbusinessesortheself-employed.Atpresent,generalpartnerspayemploymenttaxon100percentoftheiractiveearningswhileothertypesofownersmaypaylittleornothing.
The proposal and its advantages: Thisoptionwouldrequireallpartners,LLCmembers,andScorporationshareholderstopayself-employment taxes(SECA)onthedistributions fromtheirbusinesses(other thanthosewhodonotmateriallyparticipateinthebusiness).ThiswouldessentiallyapplythesametaxtreatmenttoLLCmembers,limitedpartners,andScorporationshareholdersthatcurrentlyappliestotheselfemployedandtogeneralpartners.(Exclusionsincurrentlawforspecifiedtypesofincomeorlosssuchasinterestandrentalincomewouldremainineffect.)Thiswouldimprovetheequityandfair-nessinthetaxsystembytreatinggeneralpartners,limitedpartners,LLCmembers,Scorporationshareholders,andself-employedworkersequally.
The proposal would raise considerable revenue—perhaps $50 to $60 billion over ten years—bylimitingtheunderreportingofreasonablecompensationbyScorporationshareholders,thelackofemploymenttaxclarityforLLCmembers,andthepotentialfortaxavoidancebylimitedpartners.
Inaddition,thisoptionwouldeliminatethedifficult-to-administerconceptof“reasonablecom-pensation”formosttaxpayersandwouldclarifyandsimplifyrulesforLLCmembersandlimitedpartners.Theproposalalsoeliminatesemploymenttaxesasadistortioninthechoiceoforganiza-tionalform.
Disadvantages:Therevenuesraised fromtheproposalwouldcomeprimarily fromownersof smallbusinesses.Moreover,itwouldimposeemploymenttaxesonincomethatispartiallyareturnoncapitalratherthanareturnonlabor.Providinganexclusionforinvestedcapitalispossible,butcouldbedifficultandcomplicatedtocalculateandadminister.
h. Option 6: Voluntary Disclosure ProgramsVoluntarydisclosureprogramsortemporarytaxamnestieshavebeenproposedasameanstobringnon-complianttaxpayersbackintothetaxsystem,andincreasefuturecomplianceandrevenues.Undersuchprograms,taxpayerswhovoluntarilycomeintothetaxsystemandpaythetaxestheyowewouldbesubjecttoreducedpenaltiesorinsomecasesnopenaltiesatall.Stategovernmentsandmanyforeigngovernmentshaveusedamnestiesinthepast,andthefederalgovernmentre-centlyprovidedaperiodofvoluntarydisclosurefortaxpayershidingincomeabroad.
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The proposal and its advantages: Theseprogramscouldincreaserevenuesintheneartermandimprovefuturecompliancebybring-ingtaxevadersbackintothesystemandinformingtaxadministratorsabouttaxevasionpractices.Themosteffectiveprogramsgenerally involve increasedfutureenforcementorpenalties todis-couragetaxpayersfromwaitingforthenextvoluntaryprogram.
Disadvantages:Inpractice,theevidenceontheseprogramsismixed.Moststates(andcertainforeigncountries)haveofferedmultipleprograms,whichmayactuallyprovideincentivesforcontinuedevasiontotheextentthattaxpayersbelievetheywillbeforgiveninthefuture.Theexperienceofstatesisthatmosttaxpayersusingtheseprogramswerealreadyfilingtaxesandonlyamendedoldreturns;fewnewtaxpayerswerebroughtin.Eventherevenuesupposedlyreceivedfromamnestiesissubjecttodebate.Muchamnestyrevenuemerelyrepresentsacceleratedreceiptofrevenuethatwouldhavebeenpaid laterastheresultofenforcementactivities,andthebenefitsofamnestiesforrevenuepurposesarereducedbytheforgivenessofinterestandpenaltiesthatwouldotherwisebereceived.
i. Option 7: Examine Multiple Tax Years During Certain Audits
Currently,thestatuteoflimitationforauditingindividualsandbusinessesextendsbackonlythreeyears.Giventhelonglagininformationgatheringandprocessing,auditorsmaybeabletoinves-tigateonlyoneyearoftaxrecordsbeforethelimitrunsout,evenifnoncomplianceisdiscoveredthatmighthaveoccurredinprioryearsaswell.Thelimitcanbeextendedbacktosixyearsifnon-compliancegreaterthan25percentoftotalliabilityisfound,butthisisahighthreshold.Thusanauditorwhodiscoversapatternofnoncompliancethatwaslikelytohaveoccurredinmanyyearscannotlookforthatpatterninpriorreturns.
The proposal and its advantages: Multi-yearauditsaregenerallyusedforlargerbusinesses.Expandingtheirusetosmallerbusiness-esandindividualswouldreducenoncomplianceandwouldenabletheIRStouseauditresourcesmoreefficiently.Inaddition,alongerstatuteoflimitationswherethereareadjustmentsbyastatethatcouldaffectfederalliability,asproposedintheAdministration’sBudget,wouldalsofacilitatemulti-yearauditsandcouldincreaseIRSauditefficiency.Anotheroptionistolowerthethresholdfor IRS auditors to re-open earlier returns when they have found noncompliance. The currentstandardisquiterestrictivesothatIRSagentsarerarelyabletogobackbeyondthethree-yearopenperiod.
Disadvantages:Alongerstatuteoflimitationscouldbemoreburdensomefortaxpayersrequiredtokeeprecords.AnextensionwithoutconditionsmightbeseenasreducingtheincentivefortheIRStoinitiateandresolveenforcementactionspromptly.
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j. Option 8: Extend Holding Period for Capital Gains Exclusion on Primary Residences
Homeownersmayexcludeupto$500,000($250,000forasingleindividual)ofcapitalgainfromthesaleofprincipalresidencesprovidedthehomewastheirprincipalresidenceintwoofthelastfiveyears,andtheexclusionmaybeusedeverytwoyears.Therelativelyshortholdingperiodrequire-mentoftwoyearsandthepotentialforrepeatuseeverytwoyearsinvitesabuseoftheprovision.Some homeowners may seek to convert rental or vacation properties into principal residences.Buildersorserialfixer-upperspecialistsmayalsousetheprovisiontogettax-freeearningsfrombuildingorremodelinghomesbylivinginthemfortwoyears.
The proposal and its advantages: The2005TaxReformPanelandexpertsweheardfromproposedlengtheningtherequiredholdingperiodtothreeyearsoutofsix,orfouryearsoutofseven,andalsoincreasingthetimebetweenuses.Alongerholdingperiodwouldlimitabuses.Taxpayersinhardshipsituationswouldstillbeeligibleforapro-ratedmaximumexclusionifforcedtosellduetodeathofaspouse,divorce,jobchangeorotherreasonscurrentlyallowedbyIRSregulations.Otherstudieshavesuggestedim-provedinformationreportingofprincipalresidencesalescouldimprovecompliance.Thischangecouldbeimplementedinconjunctionwithincreasingorindexingthemaximumexclusionasdis-cussedearlierundersimplificationoptions.
Disadvantages:Lengtheningtheholdingperiodcouldincreasetaxesonsometaxpayerswhomovemorefrequentlybutdonotqualifyforoneoftheexceptions.
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IV. CORPORATE TAX REFORMTheUnitedStateshasthesecondhigheststatutorycorporateincometaxrateintheOrganizationforEconomicCo-operationandDevelopment(OECD)behindJapan.Despitethehighstatutoryrate,theaverageeffectivetaxratepaidbycorporationsisclosetotheOECDmedian,andthecor-poratetaxraisesrelativelylittlerevenue—thefourthlowestintheOECDasashareofGDP.Onereasonforthisapparentincongruityisthatthecorporatetaxbaseisrelativelynarrowcomparedtothesizeofthebusinesssector.Abouthalfofbusinessincomenowaccruesto“pass-through”entitieslikeScorporationsandpartnerships;althoughtheincomeofsuchpass-throughentitiesissubjecttotaxattheindividuallevel,itisexcludedfromthecorporatetax.Inaddition,thebusinesstaxsystem—whichoftenappliestonon-corporatebusinessesaswellascorporatebusinesses—hasnumerousprovisionsforspecialdeductions,credits,andothertaxexpendituresthatbenefitcertainactivities.Theseprovisionsreducetheeffectivetaxratebelowthestatutoryrate.
Thecombinationofahighstatutoryrateandnumerousdeductionsandexclusionsresultsinanin-efficienttaxsystemthatdistortscorporatebehaviorinmultipleways.Thehighstatutorycorporatetaxratereducesthereturntoinvestmentsandthereforediscouragessavingandreducesaggregateinvestment.Base-narrowingfeaturesofthebusinesstaxsystemcreateincentivesthatfavordebtoverequity,encourage investment intax-favoredequipmentandcertainotherassetsoverotherkindsofinvestment,anddrivecapitaloutofthecorporatesectorintonon-corporateformsofbusi-ness.AdditionalinefficienciesresultfromthewaytheU.S.taxestheforeignincomeofU.S.multi-nationalcorporations(MNCs),andfromdifferencesbetweentheU.S.approachandthewayothernationstaxtheforeignincomeoftheircompanies.
Distortions in thecorporate tax systemhavedeleteriouseconomicconsequences. Becausecer-tainassetsandinvestmentsaretaxfavored,taxconsiderationsdriveoverinvestmentinthoseas-setsattheexpenseofmoreeconomicallyproductiveinvestments.Becauseinterestisdeductible,corporationsareinducedtousemoredebt,andthusbecomemorehighlyleveragedandtakeonmoreriskthanwouldotherwisebethecase.Becausethecorporatetaxresultsinhighereffectiveratesoncorporatebusinesses,businessactivityandinvestmentareshiftedtonon-corporatebusi-nesseslikepartnershipsandScorporations,ortonon-businessinvestmentslikeowner-occupiedhousing.8BecauseMNCsdonotpayincometaxesonincomeearnedbyforeignsubsidiariesuntilthatincomeisrepatriated,thosefirmshaveincentivestodeferrepatriation,toshifttaxableprofitstolow-taxjurisdictions,andtoengageincostlytaxplanning;nevertheless,thesystemofinterna-tionaltaxationmakesU.S.MNCslesscompetitiveinforeignmarketsandevenathome.Becauseofitscomplexityanditsincentivesfortaxavoidance,theU.S.corporatetaxsystemresultsinhighadministrativeandcompliancecostsbyfirms—costsestimatedtoexceed$40billionperyearormorethan12percentoftherevenuescollected.AllofthesefactorsacttoreducetheproductivityofAmericanbusinessesandAmericanworkers,increasethelikelihoodandcostoffinancialdistress,anddrainresourcesawayfrommorevaluableuses.Mostofthesedistortionsalsoaffectbusinessesbeyondthecorporatesector.
8 Thereducedindividualincometaxrateondividendsandcapitalgainsprovidespartialrelieffromthecombinedeffectsoftheindividualandcorporateincometaxesontheafter-taxreturnstoinvestmentinthecorporatesector.
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Theexpertswespoketobelievethatthecurrentcorporatetaxsystemisdeeplyflawedandinneedofreform.Weheardrepeatedlythatreformsthatmovethebusinesstaxsystemfromonewithahightaxrateandanarrowtaxbasetoonewithabroadertaxbaseandalowertaxratecouldcorrectanumberofdistortionsassociatedwiththecurrentsystem.Wealsoheardfrombusinessrepre-sentativesthatthedistinctiveU.S.approachtotaxingtheforeignincomeofU.S.multinationalswasputtingthematacompetitivedisadvantageintheirforeignoperations.Someexpertsandbusinessrepresentativesarguedthatmovingtowardaterritorialsystemlikethatusedbymostotherdevel-opednationscouldreducethisdisadvantage,whileothersadvocatedaworldwidetaxsystematalowerratetoachievethesameobjective.
a. Overview of the Corporate SystemU.S.corporationspaytaxesontheirtaxableincome—totalreceiptsminuscostsofdoingbusinessandotherdeductionsincludingwages,rawmaterialsandsupplies,depreciation,andinterestex-pense—onaprogressivescalewithatopstatutoryfederalrateof35percent.Statecorporatetaxesincreasetheaverageoveralltopstatutoryratetojustover39percent.Comparedtootherdevelopedcountries,theU.S.statutorytaxrateishigh:themedianstatutorycorporateratein2009amongOECDcountrieswas28percent.
However,theeffectivefederaltaxrateonnewinvestmentsbycorporationsisactuallylowerthan35percentbecauseoftaxcreditsanddeductionsthatreducetaxesowed.Afterfactoringinthesedeductionsandthebenefitsoffinancinginvestmentsusingdebt,theoveralleffectivemarginaltaxrateonnewinvestmentsinthecorporatesectorisabout29percentaccordingtoonerecentTrea-surystudy.
Thisrateisstillhigherthanthetaxrateoncomparableinvestmentsbynon-corporatebusinessesoronothernon-businessinvestments, inpartbecausebusinessincomeearnedbybusinessesincorporateformissubjecttotwolayersoftaxation:corporationspaytaxontheircorporateincomeand then individualspay taxondistributions fromcorporations (ondividendpayments)oronthecapitalgainsfromappreciatedcorporatestock. Incontrast,businessincomeearnedbysoleproprietorships,partnerships,andScorporationsis“passedthrough”tothetaxreturnsofthebusi-nessowners.Althoughsuchpass-throughbusinessesgenerallycalculateincomeinthesamewayascorporations(usingthesameaccountingrulesandbenefitingfromthesamedeductionsandcredits),iftheownersareindividuals,thebusinessincomefromthesesourcesistaxedonlyonceattheindividuallevel.
Oneresultofthissystemisthattaxburdensoncapitalincomeinthenon-corporatesector(i.e.,businessesnotoperatedthrough“Ccorporations”)arelowerthaninthecorporatesector.9Thisfavorsnewinvestmentsandnewbusinessformationinnon-corporatebusinessesrelativetocorpo-ratebusinesses.Indeed,businessincomeaccruingtothesenon-corporatebusinesseshasincreased
9 Economistsgenerallybelievethatpartoftheburdenofthecorporateincometaxisultimatelyshiftedtoownersof other types of capital, including the owners of pass-through businesses organized as partnerships, LLCs orsoleproprietorships.Thisshiftingoccursbecausetheshiftofinvestmentfromthecorporatesectortothenon-corporatesectorreducestherateofreturninthenon-corporatesectorandthusreducestheafter-taxreturnsofthosebusinessowners.
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overtime,andtheyaccountedforabouthalfofallnetbusinessincomein2007,upfromabout20 percentin1980.In2004amongasampleofOECDcountries,theU.S.hadthehighestshareofbusinesseswithprofitsof$1millionormorethatwerenotincorporated(66 percentintheU.S.comparedto27percentinMexico(thesecondhighestshare)and26 percentintheU.K.).
Anotherfeatureofthecurrenttaxsystemisthatinterestpaidbybusinesses(bothcorporateandnon-corporate)isdeductible,butdividendpaymentsarenot.Thusbusinesseshaveincentivestofavordebtfinanceratherthanequityfinance,evenaftertakingintoaccountthepersonalincometax,whichtaxesinterestincomemoreheavilythandividendsandcapitalgains.Thecurrentsystemthereforeresultsinhigheffectivetaxratesonequity-financedinvestmentsandloweffectiveratesondebt-financedinvestment.Thisprovidesincentivesforbusinessestofinancenewinvestmentswithdebt,andtomaintainahigherlevelofdebtintheircapitalstructure,increasingthelikelihoodoffinancialdistressandbankruptcy.
Manyadditionalinefficienciesresultingfromthecorporatetaxsystemarisefromprovisionsthatconferfavorabletreatmentoncertainbusinessactivitiesorexpendituresbutnotonothers. Forexample,thecostofinvestmentsinplantandequipmentarerecoveredovertimethroughdeprecia-tionallowanceswhereasinvestmentsincertainintangibleassetslikeresearchanddevelopmentandadvertisingaredeductedimmediately.Depreciationschedulesforsometangibleassetsreflectde-preciationratesthatarefasterthantrueeconomicdepreciation(therealdeclineintheasset’svalueovertime),whilethoseforotherassetsreflectslowerrates.Incomefromcertainactivitiesisalsotaxedatlowerratesbecauseofaspecialdeductionfordomesticproductionactivities.Businessesmayalsoclaimtaxcreditsforcertainactivities,forexample,forresearchandexperimentationorforlow-incomehousinginvestment. Asaresultoftheseandotherspecialprovisionsinthetaxcode,incomefromdifferenttypesofassetsistaxedatverydifferentrates.Moreover,thecorporatetaxandotherbusinesstaxesshiftcapitalfrommanufacturingandservicestoowner-occupiedrealestate,whichissubsidizedinotherwaysbythetaxsystem.Whilemostofthesediscrepanciesaffectbothcorporateandnon-corporatebusinesses,theireffectismagnifiedfortheformerasaresultoftheadditional,entity-leveltaxationforsuchbusinesses.
Overall,thecurrentcorporatetaxsystemcontainsnumerousprovisionsthatencouragebusinessestoinvestincertainkindsofassetsortoengageincertainkindsofactivitiesfortaxreasonsratherthanforreasonsofeconomicefficiency.
Table7showstheeffectivemarginaltaxrates—thetaxratesthatapplytoanadditionaldollarofinvestmentinvarioustypesofassets—thatresultfromthecurrentsystemasestimatedinarecentTreasurystudy.Thetableshowsthatcorporatebusinessesfacehighereffectivemarginaltaxratesthannon-corporatebusinesses;thatequity-financedcorporateinvestmentsfacemuchhighereffec-tivemarginaltaxratesthandebt-financedinvestments;andthattheeffectivemarginaltaxrateonowner-occupiedhousingisclosetozero.Withincorporatebusinesses,taxratesalsovarysignifi-cantlybyassettypeand,aswillbeseenlater,evenonanasset-by-assetbasis.
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Table 7: Marginal Effective Tax Rates on New Investment
Effective Marginal Tax Rate
Business 25.5%
Corporate Business 29.4%
Asset Type
Equipment 25.3%
Structures 34.2%
Land 32.9%
Inventories 32.9%
Financing
Debt financed -2.2%
Equity financed 39.7%
Non-corporate Business 20.0%
Owner-occupied housing 3.5%
Economy wide 17.3%
Source: Treasury Conference on Business Taxation and Global Competitiveness:BackgroundPaper.U.S.DepartmentoftheTreasury,OfficeofTaxAnalysis2007.
TheU.S. systemfor taxing the foreign-earned incomeofdomesticcorporations isalsoasourceofinefficiency.TheU.S.taxestheforeign-earnedincomeofdomesticcorporationsnotwhentheincomeisearnedbutwhentheresultingprofitsarerepatriatedtotheUnitedStates.However,theU.S.statutoryrateishighcomparedtootherOECDcountries,whichhavereducedtheirstatutoryrates(asseeninFigure4)andhaveoffsetsomeoftherevenuelossbybroadeningthecorporatetaxbase.
Figure 4: Top Statutory Corporate Tax Rates U.S. and OECD
20
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30
35
40
45
50
55
1981 1985 1991 1996 2001 2006
United States
Median OECD
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Notes: Selection of OECD countries with data available from 1981 to 2009. OECD average is weighted by 2007 GDP in PPP excluding U.S. Corporate tax rates include both national and subnational taxes. Source: OECD
Per
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Notes:SelectionofOECDcountrieswithdataavailablefrom1981to2009.OECDaverageisweightedby2007GDPinPPPexcludingU.S.Corporatetaxratesincludebothnationalandsubnationaltaxes.Source:OECD.
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Asa resultof thesedifferencesbetween theU.S.and theOECDcountries,U.S.firmsoperatingabroadreportthattheyoftenfacehighereffectivetaxratesontheiroverseasactivitiesthanforeigncompetitorfirms.InadditiontoaffectingtheinternationalcompetitivenessofU.S.firms,thegrow-inggapbetweentheU.S.corporatetaxrateandthecorporatetaxratesofmostothercountriesgen-eratesincentivesforU.S.corporationstoshifttheirincomeandoperationstoforeignlocationswithlowercorporatetaxratestoavoidU.S.taxes.Overtimeascorporatetaxrateshavefallenaroundtheworld,theseincentiveshavebecomestronger.
Animportantconsiderationwhenaddressingtheaboveissuesthroughreformistheproblemoftransition.Manyoftheproposalsdiscussedbelowresultinshiftingtaxburdens,withcertainbusi-nessesfacinghighertaxburdensandothersfacinglowerones.Thosefacinghigherburdenswillnaturallyseekrelief.However,transitionrelieftoaddresssuchissuescoulddecreaserevenuesorcouldreducethegainsfromsuchchangesiftransitionreliefnecessitatedhighercorporatetaxratestomaintainoverallcorporatetaxrevenues.
b. Option Group A: Reducing Marginal Corporate Tax Rates
Thehigheffectivetaxratesthatapplytocorporateinvestmentsresultinsignificanteconomicdis-tortionsandalowertaxrateoncorporateinvestmentswouldresultindesirablechangesinanum-berofareas.Thetwomostfeasibleandeffectivewaystoreducethetaxrateoncorporateinvest-mentsaretoreducethestatutorycorporatetaxratedirectlyortoincreasethevalueofdeductionscorporationsmaytakefornewinvestment. BecausethehighstatutorycorporatetaxrateintheU.S.causesorexacerbatesmanydistortionsinthecurrenttaxsystem,loweringtheratewouldre-ducetheseinefficiencies.Alternatively,providingaccelerateddepreciationorimmediateexpensingofcorporateinvestmentswouldresultinsimilarimprovementsinefficiency. Reducingeffectivemarginaltaxrateswithoutsignificantrevenuelosseswouldrequireapplyingthetaxtoabroaderincomebase,andadiscussionofoptionstobroadenthebaseareincludedinOptionGroupB.
i. Option 1: Reduce the Statutory Corporate Rate
The proposal and its advantages:Inthisoption,thetopstatutorycorporatetaxratewouldbeloweredfrom35percent.Eachper-centagepointdecreaseinthecorporatetaxratereducescorporatetaxrevenuesbyabout$120 bil-lion over 10 years.10 In a revenue-neutral reform, these revenue losses could be offset by basebroadeningmeasureslikethosedescribedinOptionGroupB.
Loweringthetopratewouldreducethecostofanumberofsignificanteconomicdistortions.Intheaggregate,alowercorporateratewouldlowertheoveralltaxoncapital,encouragingsavingandnewinvestment.Theadditionalsavingandinvestmentbycorporationswouldincreasethestock
10 Thisexerciseassumesthatthetoptwocorporatetaxbracketrates(currently34percentand35percent)areeachreducedbyonepercentagepoint.
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ofavailablecapital—newbusinesses,factories,equipment,orresearch—improvingproductivityintheeconomy.
Reducingthecorporateratewouldalsoreducetherelativeadvantagesofalternativeinvestments.Thisisimportantbecauseinvestmentdecisionsshouldreflecttheireconomicreturnratherthantheirtaxadvantages.First,alowerratewouldhelpleveltheplayingfieldacrosscorporateandnon-corporateinvestmentandwouldreducetheincentiveforbusinessestoorganizeinnon-corporateforms.Thiswouldcontributetoamoreefficientallocationofresourcesbetweenthecorporateandnon-corporatesectorsandcouldencouragetheexpansionofthecorporatesectorwithresultantincreasesincorporatetaxrevenuesoverthelongterm.Second,alowercorporatetaxratewouldreducetherelativeadvantageofinvestmentsinnon-businessassetslikeresidentialrealestate.Resi-dentialrealestateisalreadyheavilytaxadvantaged,andmanyexpertsbelievethatasaresultofthese taxsubsidies, investments inowner-occupiedrealestateprovidea lowereconomicreturnthaninvestmentselsewhere.Third,alowercorporatetaxratewouldreducetheincentivetousedebtratherthanequitytofinancenewinvestments.Thiscouldresultinlowerdebtlevels,reducingthelikelihoodoffinancialdistressatover-leveredfirms,andresultinginloweraggregaterisksfromcorporatebankruptcies.Finally,intheinternationalcontext,alowercorporateratewouldlowerthecostofcapitalforAmericanfirms,makingthemmorecompetitiveinrelationtoforeignfirmsbothabroadandathome.ItwouldalsoreducetheincentivesofU.S.companiestoshiftoperationsabroad and to structure their operations and finances to shift profits to lower-tax jurisdictionsabroad,orforforeigncompaniestoacquireU.S.companiesortheirforeignsubsidiaries.
Disadvantages:Areductioninthecorporatetaxratewouldhaveseveraldisadvantagesaswell.First,asalreadynoted,itwouldreducetaxrevenuessignificantly,andthisrevenuewouldneedtobereplacedtoavoidincreasingthefederaldeficit.Second,itwouldreducetaxesoninvestmentsalreadymadebyexistingcompanies.Asaresult,comparedtoothermoretargetedtaxcutstoencourageinvestment,areductioninthecorporatetaxratewouldhaveasmallerincentiveeffectonnewinvestmentperdollaroftaxrevenuelost.Third,loweringthecorporateratetoalevelwellbelowthetopindividualincometaxratecouldencourageboththeshiftingofincomefromtheindividualincometaxbasetothecorporatetaxbaseandtheshelteringofincomeincorporations,althoughtheincentiveofindividualstoshiftincomewouldbelimitedbythedoubletaxationwhentheywanttoconsumethosefunds.11
11 Forexample,ifthetopindividualtaxrateincreasedto39.6percentandthetopcorporateratefelltobelow30 per-centorso,someindividualswouldfinditadvantageoustoreorganizetheirbusinessactivitiesasCcorporations.Thiswouldallowthemtopaythelowercorporatetaxrateontheirbusinessearningsandtodeferpaymentoftaxattheindividualrateuntiltheearningsweredistributedorthestockofthecorporationweresold.Deferralwouldreducethepresentvalueoftheindividualincometaxliability.Moreover,thetaxcouldbeeliminatediftheindi-vidualheldthestockforlife,becausethetaxbasisofthestockwouldbesteppeduptothefairmarketvalueuponthedeathoftheindividualshareholder.Whileexistinglawlimitstosomeextenttheabilitytoaccumulateearningsinacorporation,additionalsafeguardscouldberequiredtopreventrevenuelossifthedisparitybetweencorporateandindividualratesweresufficientlylarge.
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ii. Option 2: Increase Incentives for New Investment/Direct Expensing
The proposal and its advantages: Reducingthetaxburdenonlyfornewinvestmentisanalternativeapproachtoreducingtheeffec-tivetaxrateoncorporateincome.Businessescouldbeallowedto“expense”alloraportionoftheirnewinvestmentimmediately—i.e.todeductthecostofinvestmentagainsttaxableincomeintheyeartheinvestmentwasmadeinsteadofrecoveringitgraduallyovermanyyears.Thebusinesstaxsystemalreadyallowsanumberofvariantsofthisideathroughaccelerateddepreciation(allowingbusinessestotakedepreciationallowancesfasterthanimpliedbytrueeconomicwearandtear)andtemporarybonusdepreciation(allowingfirmstoimmediatelyexpense50percentofnewinvest-mentduringthepreviousrecession);smallerbusinessesarealsocurrentlyallowedtoimmediatelyexpensecertaininvestmentsuptoalimit.Infact,theseprovisionsarethelargesttaxexpenditureforbusinesses:priortotherecession,aTreasurystudyestimatedthataccelerateddepreciationandexpensing provisions (excluding temporary provisions enacted for economic stimulus) reducedrevenuesbymorethan$660billionovertenyears.
Inadditiontomanyoftheadvantagesofcuttingthecorporatetaxratedescribedabove,expensingcouldprovidemore investmentperdollarof taxrevenue lost thansimplycuttingthecorporateratebecause“oldcapital”wouldnotreceiveataxbreak.Providingexpensingforphysicalcapitalwouldalsoeliminatethedifferentialtaxtreatmentbetweeninvestmentsinphysicalcapital,whicharecurrentlydeductedovermanyyears,andinvestmentsincertainintangiblecapital(likeresearchanddevelopment,oradvertising),whichbusinessescancurrentlydeductimmediately.Immedi-ateexpensingofinvestmentalsohascashflowbenefitsforbusinessesbecausethetaxdeductionisreceivedinthetaxyearinwhichaninvestmentismaderatherthaninfutureyears.Intheinterna-tionalcontext,lowerratesonnewinvestmentswouldmaketheU.S.moreattractiveforforeignanddomesticinvestors.
Disadvantages:Expensingwouldreducerevenuesbyallowingfirmstodeductthecostoftheirinvestmentsmorerapidlyagainsttheirtaxableincome.Someindustrieswouldbenefitmorethanothersfromthistreatment: some argue that expensing would disproportionately benefit capital-intensive indus-triesthatmakesignificant investments inphysicalcapitalcomparedtohigh-techindustriesandindustriesthatprimarilyinvestinintangibleandintellectualcapital.Butitisthecapitalintensiveindustriesthatarerelativelydisadvantagedbythehighcorporatetaxrateandtheirdifferentialtaxtreatmentinthecurrentsystem.Allowingexpensingfornewinvestmentwouldlowerthevalueofexistingassetsbecauseexistingcapitalwouldnotbenefitfromexpensingandwouldhavetocom-petewithnewcapitalthatdoes.
Allowingforimmediateexpensingofnewinvestmentwhileretainingthedeductibilityofinterestwouldmaintainorcouldevenincreasetheincentivesfordebtfinancinginthecorporatetaxsys-tem.Thisdisadvantagecouldbemitigatedbyreducingthedeductibilityofnetinterestasdiscussedbelow.
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Businessownerscommonlyregardexpensingasalessattractiveorpowerfulincentiveforinvest-mentthanareductioninthetaxrateontheirbusinessincome.Expensingprovidesonlyatempo-raryreductionintaxessinceitonlyacceleratesthesameamountofdeduction.Underaccountingrules,thismeansthatexpensingwouldnotallowabusinesstoshowanyincreaseincurrentearn-ingssinceanoffsettingallowanceismadefortheadditionaltaxestobepaidlater.Inaddition,somebusinesspeoplearguethatanimportantpartoftheincentivetoinvestisthepursuitofanabove-normalrateofreturn. Whilea lowercorporate taxratewould increasethe incentivetopursueabove-normalreturns,theexpensingofnewinvestmentwouldnot.
Finally,allowingfortheexpensingofnewinvestmentoraccelerateddepreciationonnewinvest-mentsdoesnotaddressissuesrelatedtothetaxtreatmentofforeignsourceincomethewaythatratereductiondoes,becauseMNCswouldstillfacehighertaxesontheiroperationsabroadthanwouldtheirinternationalcompetitors.
c. Option Group B: Broadening the Corporate Tax BaseEliminatingorlimitingdeductions,credits,andotherbase-narrowingfeaturesofthecorporatein-cometaxwouldallowforalowercorporaterateandcouldimprovetheincentivesinthetaxsystem.Whenothercountriesreducedtheircorporatetaxratesoverthepastdecade,theyusuallyoffsettherevenuelosswithmeasurestobroadenthetaxbasethroughtherepealorreductionofvarioustaxcreditsanddeductions.(Theyalsoincreasedrevenuesfromothersources.)Asaresult,theU.S.corporatetaxbaseisnownarrowerthaninmanyothercountries.Ourdiscussionswithexpertsidentifiedseveralwaystobroadenthecorporatetaxbasethatwouldallowthesameamountoftaxrevenuetoberaisedwhileloweringthecorporatetaxrate.Inaddition,abroadertaxbasewouldmakethecorporatetaxmoreneutralacrossinvestmenttypesandsectorsofeconomicactivity,andthisisanimportantgoalinitselfbecauseitreduceseconomicdistortions.
Broadeningthecorporatetaxbase,however,ismoredifficultthansimplyeliminating“loopholes,”ortaxprovisionsthatcorporationsusetoavoidthetaxeslawmakersintendthemtopay.Infact,mostprovisionsthatnarrowthecorporatetaxbaseareintentional—deductions,credits,orotherprovisionsenactedtoreducetaxesforcertainbusinessesorindustriesorcertainactivitiesthatareoftenreferredtoas“taxexpenditures”andshouldbedistinguishedfrom“loopholes.”Incontrasttotheindividualtaxcode,whichincludesmanysizabletaxexpenditures,therearearelativelysmallnumberofpotentialchangestothecorporatetaxcodethatcouldbroadenthecorporatetaxbasesignificantly.Weconsideredafewofthelargebase-broadeningchanges(eachofwhichcouldbescaledupordowninsize).Andwealsoconsideredafewspecifictaxexpenditurestogivesomeex-amplesandtoshowhoweliminatingtheseexpendituresindividuallywouldnotraiselargeamountsofadditionalrevenueandwouldneedtobecombinedtohaveameaningfulimpactonrevenues.
i. Option 1: Provide More Level Treatment of Debt and Equity Financing
Thetaxcodeencouragesdebtrelativetoequity.Corporatedividendspaidarenotdeductibleatthecorporatelevel.Incontrast,corporationscandeductinterestpayments.Consideraninvestment
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thatrequires$1,000todayandwillpayoff$1,100inthefuture.Iffinancedbyequity,acorporationwouldpay$35intaxes(35percentonthe$100profit)andpayout$65asadividendtosharehold-ers.Iffinancedbyborrowingat10percent,thecorporationwoulddeduct$100ininterestpay-mentsmadetothedebtholderagainstthe$100profit—resultinginzerocorporatetaxes.Indeed,thecombinationofthedeductibilityofinterestanddepreciationreducesthecostofdebtcapitaltowhat itwouldbewithnocorporate tax. Whencombinedwithaccelerateddepreciationandotherprovisions,however,thedeductibilityofinterestmakesthecostofcapitalevenlessthanitwouldbewithnocorporatetax.Infact,accordingtoTreasurystudies,forcertainfirmstheeffec-tivemarginaltaxrateondebt-financedinvestmentisnegative(theinvestmentsaresubsidized)asdeductionsforinterest,togetherwithdeductionsforitemssuchasaccelerateddepreciation,morethanoffsettheincomegeneratedfromdebt-financedinvestment.Incontrast,theaveragetaxrateonequityfinancedinvestmentismuchhigherandstillpositiveevenwithaccelerateddepreciation.
The proposal and its advantages: Limitingthedeductibilityofnetinterest(i.e.,theexcessofinterestexpenseoverinterestincome)wouldbroadenthetaxbaseandprovidemoreleveltreatmentofdebtandequity.Asanillustrativeexample,oneoptionwouldbetolimitthedeductibilityofnetinterestto90 percentofexpenseinexcessof$5 millionperyear(i.e.abusinesswith$15millionofinterestexpensewouldbeallowedtodeductthefirst$5millionandthen$9million(90 percent)oftheremaining$10million).Ignor-inglikelybehavioralresponses,arough(static)computationsuggeststhatthisproposalwouldraisecorporatetaxrevenuesbyenoughtoreducethecorporateratebyabout0.7 percentagepoint.Ifthesamerulesappliedtonon-corporatebusinesses,revenueswouldbeincreasedsomewhatmore.
Alimitationonnetinterestdeductibilitywouldlessenthebiasagainstequityfinancingandcouldreducedependenceondebt,therebyreducingtheleverageoffirmsandthelikelihoodoffuturefi-nancialdistress.Limitingthedeductibilityofnetinterestwouldalsoleveltheplayingfieldtosomeextentbetweenbusinessprojectsfinancedbydebtandbusinessprojectsfinancedbyequityandbetweenfirmsthathaveeasyaccesstodebtfinancingandthosethatdonot.
Ifthedeductibilityofnetinterestexpensewerelimited,MNCswouldhaveareducedincentivetoshiftborrowingtotheU.S.toreducedomestictaxliability.Inthecurrentsystem,MNCscanraisedebtcapitalinU.S.markets,deducttheinterestexpenseatthe35 percentU.S.rateagainsttaxableU.S.earnings,andinvesttheproceedsabroad,andtheearningsfromthatinvestmentcanbede-ferredandcanavoidU.S.taxationindefinitely.
Someothercountries impose limitsonthedeductibilityof interestexpense. Forexample,Ger-manyimposesalimitonnetinterestexpense.Interestexpensegenerallyisalloweduptothelevelofinterestincomereceived.Abovethat,interestexpenseinexcessof30 percentofearningsisdisal-lowedsubjecttoanumberofexceptionsincludinga“smallbusiness”exception.
Theintroductionofalimitonthedeductibilityofnetinterestexpensewouldrequireconsiderationofthetreatmentofsmallfirms,whichrelymoreheavilyondebtfinancing;oneoptionwouldbetoimposethelimitationonthedeductibilityofinterestexpenseonlyabovesomethreshold—likethe$5millionthresholdintheexampleabove.(Iftheinterestratewere5 percent,a$5millionthresh-oldwouldexemptabusinesswithasmuchas$100millionindebt.)Furthermore,policymakers
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wouldneedtodecidewhethertoapplyaninterestlimitonallbusinessentitiesoronlyoncorpora-tions.Theadvantagesofapplyingthelimittoallbusinessesaresimilartothoseforcorporations—suchasalowerrelianceondebt,reducedriskofbankruptcy,andhigherrevenues.Inaddition,ap-plyingthesamerulestoallbusinesseswouldreducetheoptionsfortaxavoidanceortaxarbitrage,andharmonizedruleswouldbesimplertoenforce.OthertypesoflimitsoninterestdeductionssometimesproposedincludedenyingtheinterestdeductionfortheinflationarycomponentoftheinterestrateandlimitingtheinterestdeductiontotheinterestrateonTreasurysecuritiesonthegroundsthathigherinterestratesrepresentahigherriskpremiumthatismorelikeanequityre-turn.Theeffectsofdifferentkindsoflimitsoninterestdeductionswouldhavetobestudiedmorecarefullyfortheirpossibleeconomicconsequences.
Disadvantages:Limitingthedeductibilityofnetinterestwouldhavedifferenteffectsondifferentsectors,raisingtaxesmoreforsomethanforothers.Forexample,limitationsonnetinterestwouldyieldhighertaxburdensonmanufacturersandutilities,whicharefirmswithsignificantinvestmentsinphysi-calcapitalthatarefrequentlydebtfinanced.Anabruptchangethatdisallowedsomeorallinterestexpensewouldhave significant short-term impactson theprofitabilityoffirms relyingondebtfinancing.Thusthetransitionfromthecurrentsystemtoasystemwithlimitationsonnetinterestdeductionswouldbedifficultforfirmswithdebtintheircapitalstructure,andtransitionalreliefandaperiodoftimeforfirmstoadapttheircapitalstructurecouldbeappropriate.Smallbusi-nessesalsorelyheavilyondebtfinancing,andlimitinginterestexpensedeductionscouldreducetheiraccesstocapitalanddiscouragetheformationofnewfirms.Allelseequal,likeotherbase-broadeningmeasures,limitingthedeductibilityofnetinterestwouldincreasetheeffectivetaxrateoncapitalinvestmentsunlessoffsetbyalowercorporatetaxrate.Finally,limitingdeductionsforinterestexpensewouldcreateincentivesforfirmstoreplaceinterestexpensewithotherexpenseslikeleasingarrangements,whichachievethesameeffectbutwhichwouldremaindeductibleex-penses.
ii. Option 2: Review the Boundary Between Corporate and Non-Corporate Taxation
Anotherfactorthathascontributedtotheerosionofthecorporateincometaxbasehasbeenthegrowthofnon-corporatebusinesses(non-Ccorporations)includingpartnerships,LLCs,Scorpo-rations,andotherpass-throughentities.Suchbusinessespaynoseparatecorporateincometax,andtheirincomeistaxedattheownerlevel.Manyoftheseentitiesprovidethelegalbenefitsoflim-itedliability,buttheirearningsaregenerallytaxedonlyonce—onthetaxreturnsoftheirowners.12Indeed,pass-throughentitiesnowaccountfornearlyhalfofbusinessincomeintheU.S.andabout
12 Corporationscanbeandoftenarepartnersinpartnerships,thuspartnershipincomemaybesubjecttothecorpo-ratetax.WhenallpartnersareCcorporations,suchasinajointventure,allofthepartnershipincomeissubjecttothecorporatetax.Overall,asmuchas15to20percentofthepass-throughincomemayultimatelybesubjecttothecorporatetax.
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one-thirdofreceipts(seeTable8).13Changesatthefederalandstatelevelhaveallowedmorebusi-nessestooperateinpass-throughform.14Wearenowinasituationinwhichthecorporateincometaxbillispaidpredominantlybythelargestcorporations:in2006,85percentofcorporateincometaxeswerepaidbylessthan0.5 percentofallCcorporations—fewerthan10,000firms.
Table 8: Shares of Total Business Returns, Receipts and Net Income, 1980-2007
1980 1990 2000 2007
S Corporations
Returns 4% 8% 11% 12%
Total Receipts 3% 13% 15% 18%
Net Income (less Deficit) 1% 8% 14% 14%
Partnershipsa
Returns 11% 8% 8% 10%
Total Receipts 4% 4% 9% 12%
Net Income (less Deficit) 3% 3% 18% 23%
Sole Proprietorships
Returns 69% 74% 72% 72%
Total Receipts 6% 6% 4% 4%
Net Income (less Deficit) 17% 26% 15% 10%
C Corporationsb
Returns 17% 11% 9% 6%
Total Receipts 87% 78% 72% 66%
Net Income (less Deficit) 80% 62% 53% 53%
a. IncludesLLCs&LLPs.b. Includes1120-RICand1120-REIT.Source:InternalRevenueService,StatisticsofIncome,www.irs.gov/taxstats.
Agoalofreforminthisareaistaxneutralitywithrespecttoorganizationalform.Manyindividualswithwhomwemetsuggestedthatitwasneitherfairnorgoodtaxpolicyforbusinessesofsimilarsizeandengagedinsimilaractivitiestofacedifferenttaxregimesanddifferenttaxrates.Stepsto-wardneutrality—harmonizingtherulesandeffectivetaxrates—forcorporateandnon-corporatebusinessescouldbetakeninanumberofways.
The proposals and their advantages: One option would be to require firms with certain “corporate” characteristics—publicly tradedbusinesses, businesses satisfying certain income or asset thresholds, or businesses with a largenumberofshareholders—topaythecorporateincometax.Ineffect,thiswouldbroadenthecor-poratetaxbasebyapplyingthecorporatetaxtomorebusinesses.
Sinceaprimarydistinctionindeterminingwhetherabusinessistreatedasacorporationforfed-eraltaxpurposeshasbeenaccesstopubliccapitalmarkets,theconditionsunderwhichfirmscanaccesspubliccapitalmarketswithoutbeingsubjecttothecorporatetaxcouldbereconsidered.A
13 Thesefiguresdonotremovethedouble-countingthatcanresultfromtieredpartnershipsorScorporationsown-ingpartnershipinterests.
14 TheseincludetheTaxReformActof1986,theadoptionoflimitedliabilitycompanylegislationbyallstatesbytheendofthe1990s,theexpansionofeligibilityforScorporationstatusin1996,andtheadoptionof“check-the-box”bytheIRSin1997.
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straightforwardapproachwouldendthecurrentlawexemptionsforentitieswithcertaintypesofincome(naturalresourceorportfolio-typeincome)fromtherequirementthatpubliclytradedenti-tiesbetaxedascorporations.Amorelimitedversionofthis,asreflectedinseveralbillsintroducedinCongress,wouldremovethepubliclytradedpartnership(PTP)exceptionforpartnershipswithpassive-typeincomederivedfromprovidinginvestmentadviserandrelatedassetmanagementser-vices.ThischangewouldeliminatethedistortionsthatresultfromdifferenttaxtreatmentforPTPsandfrombusinessesthatprovidesimilarservicesandoperateinsimilarways.
Alternatively,companysizeorthenumberofshareholderscouldbeconsideredasabasisforcor-poratetaxation,withthecorporatetaxrateappliedtofirmsaboveacertainsizeorwithmorethanaspecifiednumberofshareholders.Theremayalsobesomeindustryorsectorsituationsinwhichimposingthecorporate taxmightbeappropriate,suchas forvery largeScorporationbanksorcreditunions.
Analternativeoptionwouldeliminatethedoubletaxationofcorporateincomeandharmonizetaxratesoncorporateandnon-corporate incomethrough“integration”withtheindividual incometax.Inoneexampleofsuchasystem,individualinvestorswouldbecreditedforallorpartofthetaxpaidatthecorporatelevelagainsttheirindividualtaxes.AnumberofOECDcountries—theU.K.,Canada,andMexicoforexample—haveusedsuchasystem.Insuchasystem,theeffectivetaxburdenoncorporatebusinesseswouldbereducedrelativetothetaxburdenonnon-corporatebusinessesandthelostcorporaterevenuescouldberecoupedattheindividuallevelthroughhigherratesondividendsorhighermarginalrates.Ifthecreditwasnotavailableforforeignshareholders,ahighercorporateratewouldnotraisethetaxonU.S.shareholders.
Disadvantages:Achievingneutralitybetweencorporateandnon-corporatebusinessesbysubjectingmorebusi-nessestothecorporatetaxwouldincreasethecostofcapitalandthusdecreaseinvestmentinthosebusinesses.Inparticular,imposinganadditionalleveloftaxonPTPswouldlikelydiscouragetheflowofequity into such investments. If corporate tax statuswerebasedonan incomeorassetthreshold,complexitieswouldbenumerous.Forinstance,ifafirm’sactivitiesfluctuatedaboveandbelowsuchthresholds,ruleswouldbeneededtoaddressfrequentconversions.Also,ruleswouldbeneededtopreventbusinessesfromavoidingsizethresholdsbysplittingintoparts—forexample,asinglepartnershipsplitting into twoormorepartnerships. Dependingonhowthenewruleswere defined and applied, they could add complexity for existing non-corporate pass-throughsthatwouldberequiredtofollowcorporatetaxrulesandfilecorporatetaxreturns.However,thiscouldreducethecomplianceburdenforlargenon-corporatebusinesseswithmanyshareholdersorpartners,eachofwhommustcurrentlyreportthebusiness-relatedincomeanddeductionsontheirindividualreturns.Theshiftofbusinessactivityfromthecorporateintothenon-corporatesectorhasresultedinmarketefficiencies(e.g.,theformationofpartnershipsthatarejointventuresinvolvingtheassetsoftwoormoreentities). Thetaxationofsuchpartnershipsascorporationsmightpreventtheformationoftheseproductiveventures.
Finally,eliminatingthedifferencesbetweenthetaxtreatmentofcorporateandnon-corporatebusi-nessesbyintegratingthecorporateincometaxsystemwiththeindividualincometaxsystemwouldcarryarevenuecosttotheextentthatcreditsforcorporatetaxespaidreducedrevenuesfromindi-
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vidualtaxes.However,thelostrevenuescouldbeoffsetbytaxingcorporateincomeatahigherrateattheindividuallevel.
iii. Option 3: Eliminate or Reduce Tax Expenditures
Anumberofprovisionsinthetaxsystemnarrowthetaxbaseforcertainbusinesses,withtheresultthathigherstatutoryratesareneededtoachievethesamerevenue.SomeofthelargestoftheseexpendituresareprovidedinTable9,whichshowsthe10-yearrevenuelossesduetoeachprovi-sion.Theestimatesdatefrom2007,andthusproviderevenuenumbersthatarenotaffectedbytherecession.
Table 9: Special Tax Provisions Substantially Narrow the Business Tax Base
Revenue, 2008-2017 (FY, $ billions)
Major Special Business Tax Provisions Corporate Non-Corporate Total
Deduction for U.S. production/manufacturing activities 210 48 258
Research and experimentation (R&E) tax credit 132 1 133
Low-income housing tax credit 55 6 61
Exclusion of interest on life insurance savings 30 0 30
Inventory property sales source rules 29 0 29
Deductibility of charitable contributions 28 0 28
Special ESOP rules 23 4 27
Exemption of credit union income 19 0 19
New technology credit 8 1 9
Special Blue Cross/Blue Shield deduction 8 0 8
Excess of percentage over cost depletion, fuels 7 0 7
Other business preferencesa 27 28 55
Total 576 88 664
Accelerated depreciation/expensing provisions 356 306 662
Total Revenue from Business Preferences 932 394 1,326
a. None of the special business tax provisions in this category exceed $5 billion over the 10-year budgetwindow.
Source:U.S.DepartmentoftheTreasury,OfficeofTaxAnalysis.
Manyoftheseprovisionsdistorteconomicactivity,increasethecomplexityofthetaxcode,andviolateprinciplesthatbusinesseswithsimilarcharacteristicsshouldbetreatedequally.Eliminatingspecificexpenditureswouldthusimproveefficiencywhilesimplifyingthetaxcode.Manyofthedisadvantagesofeliminationarespecifictotheproposals;eliminationwilldisadvantagethosewhobenefitfromthetaxexpenditure.
Adiscussionofthelargestoftheseprovisionsfollows.
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1. Eliminating the Domestic Production Deduction
In2004,theU.S.beganallowingbusinesses(bothcorporationsandpass-throughentities)todeductpartoftheirearningsfromcertainkindsofdomesticproductionfromtheirtaxableincome.ThisdeductioniscalledthedomesticproductiondeductionanditwasintroducedasasubstitutefortheForeignSalesCorporation(FSC)lawthatwasruledillegalbytheWTOin2000.ThepurposeofthedomesticproductiondeductionwastoencouragemanufacturingproductionintheUnitedStates.However,thescopeofthedefinitionof“production”issufficientlybroad—encompassingactivitieslikethewritingofcomputersoftwareandeventheproductionoffastfoodhamburgers—thatmanysectorsbenefitfromthededuction.
The proposal and its advantages: Weestimate thateliminating thisprovisionwould raisecorporate revenuesbyenough toallowareductioninthecorporatetaxrateofabout1.1percentagepoints.Thecorporateratecouldbereducedbyabout1.4percentagepointsiftheprovisionwasrepealedforallbusinessesandtherev-enueusedtoreducethecorporaterate.
Eliminatingthedeductionwouldalsoresultinconsiderabletaxsimplificationbecausethedefini-tionofqualifyingproductioniscomplexandraisescomplianceandadministrativecosts.More-over,thedeductiondoesnotapplytoalldomesticproductionsothisprovisiondistortseconomicdecisions.Sincethedeductionissimilarineffecttoaratereduction,itwouldmakethetaxsystemsimplerandmoretransparenttosimplyreducerates.
Disadvantages:Aconcernisthatthiswouldraisetheeffectivecorporatetaxrateonmanufacturingindustriesbyabout3percentagepointsifthestatutorycorporatetaxrateisnotreduced.Itwouldberevenueneutralforthecorporatesectoronlyifthecorporateratewasreduced.Additionally,non-corporatebusinessesreceiveabout20percentofthebenefitfromthededuction,sothateliminatingthepro-visionandusingtherevenuetoreducethecorporateratewouldresultinwinnersandlosersbyorganizationalform.
2. Eliminate or Reduce Accelerated Depreciation
Asdiscussedabove,accelerateddepreciationandexpensingprovisionsare the largestsingle taxexpenditure(measuredrelativetostraightlineeconomicdepreciation)forbusinesses(bothpass-throughentitiesandcorporations).Accelerateddepreciationprovidesalowerratetonewinvest-ment,similartoexpensingorbonusdepreciation.Italsoreducesthepenaltyoninvestinginplantandequipmentandcommercialrealestaterelative to investing inresearchoradvertising,or inowner-occupiedhousing.
The proposal and its advantages: Eliminatingaccelerateddepreciationwouldraisesignificantrevenuesfromcorporations—enoughtoreducethecorporateratebyaround3 percentagepoints.(Almostasmuchrevenuewouldberaisedbyeliminatingaccelerateddepreciationforthenon-corporatesector;completeelimination
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ofaccelerateddepreciationwouldraiseenoughrevenuetolowerthecorporaterateapproximately5percentagepoints.)Amorelimitedoptionthatwouldraiseproportionatelylessrevenuewouldbetoreducethedegreeofaccelerationinthedepreciationformulas.
Ingeneral,theadvantages(anddisadvantages)ofcurtailingaccelerateddepreciationarethesameasthosediscussedinOptionGroupAabove.
Disadvantages:Eliminatingaccelerateddepreciationwouldraisetaxesfornewinvestments,reducinginvestmentintheaggregate.Itwouldexacerbatethedifferentialtreatmentofplantandequipmentinvestmentsrelativetoothercorporateinvestments,likeadvertisingorresearch.Somefirmswouldseetheirtaxesrisemorethanothers—forexample,newerfirmsorfirmsincapital-intensiveindustries;ineffectthiswouldrewardexistingcapitalatthecostofnewinvestments.
3. Eliminate Other Tax Expenditures
Table9alsoenumeratesanumberofadditional,smallertaxexpendituresthatexpertshavemen-tionedaspossiblebase-broadenersinabusinesstaxreform.Afewspecificprovisionsarediscussedbelow.
A. SpecialEmployeeStockOwnershipPlan(ESOP)Rules
ESOPplansareemployer-sponsoredretirementplansthattypicallyinvestentirelyinstockoftheemployer.SpecialrulesallowemployerstodeductdividendspaidtostockinESOPsandallowem-ployeestodeferpayingcapitalgainstaxesoncertainemployer-stocktransactions.SomearguethatthespecialtreatmentgiventoESOPs,whichisevenmorefavorablethanotheremployer-sponsoredretirementaccounts,resultsinalackofdiversificationinemployees’retirementsavingsthatcanand,historicallyhas,sometimesresultedinoutsizedlossestoretirementwealth.EliminatingthesespecialprovisionsandtreatingESOPplanslikeotheremployer-sponsoredretirementplanswouldraiserevenuesandharmonizetaxincentiveswithotherretirementplans.
B. ExemptionofCreditUnionIncomefromTax
Unlikeotherfinancialinstitutionslikebanksandthrifts,creditunionsdonotpaycorporatetaxesontheirincome.Thisputsthematacompetitiveadvantagerelativetootherfinancialinstitutionsfortaxreasons. Eliminatingthisexemptionwouldraiserevenueandleveltheplayingfield,butwouldclearlyraisetaxesoncreditunions.
C. Low-IncomeHousingCredit
Thelow-incomehousingcreditencouragestheconstruction,rehabilitation,andpurchaseoflow-incomerentalhousing.Someexpertssuggestthatotherfederalaid(likehousingvouchers)would
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assist low-incomehouseholdsatalowercost. Proponentsofthecreditarguethatitencouragesinvestmentinrentalpropertiesinlow-incomeareasandhelpstorevitalizethoseneighborhoods.
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V. ADDRESSING INTERNATIONAL CORPORATE TAX ISSUES
Asnotedabove,theU.S.hasoneofthehigheststatutorycorporatetaxratesamongdevelopedecon-omies,andthedifferencebetweentheU.S.taxrateandthetaxratesimposedbyotherdevelopedcountrieshasincreasedovertimeasothercountrieshaveloweredtheirrates.TherelativelyhighU.S.taxrateisparticularlyimportantforU.S.MNCsbecausetheyaresubjecttotheU.S.corporatetaxontheirworldwideincome,regardlessofwhereitisearned.Asaresult,U.S.MNCsoperatinginlower-taxjurisdictionsfacehigherstatutorytaxratesthantheircompetitors. TemperingthisburdenisthefactthattheU.S.corporatetaxispaidonlyifandwhenacorporationrepatriatesitsforeign-earnedincome,forexampleasadividendtoitsparentcorporation.Incontrast,theincomeearnedbyU.S.corporationsdomesticallyissubjecttotheU.S.corporateincometaxatthetimeitisearned.Inpractice,mostMNCstakeadvantageofdeferralanddefertherepatriationofasignifi-cantfractionoftheirforeign-earnedincomeforlongperiodsoftime,oftenindefinitely.Deferralthereforereducestheeffectivetaxrateonforeign-earnedincome,mitigatingthetaxdisadvantagesU.S.MNCsfacewhenoperating in foreign jurisdictionscomparedto their foreigncompetitors.AnotherconsequenceisthatU.S.MNCsfacelowereffectivetaxratesontheirforeign-earnedprof-itsthanondomestically-earnedcorporateincome.
ManyexpertsandbusinessrepresentativesarguedthatthehigheffectivecorporatetaxrateintheU.S.discouragesMNCsfromchoosingtheU.S.asasitefortheproductionofgoodsandservicesorasaheadquartersfortheirglobalactivities.Moreover,weheardconcernsthattheU.S.systemplacesU.S.MNCsoperatinginothercountriesatacostdisadvantagerelativetotheirbusinesscom-petitorsinthosejurisdictions.Bothoftheseconcernsareexacerbatedbythefactthatinadditiontohavinglowerstatutorytaxrates,mostotherdevelopedcountriesalsoexemptfromcorporatetaxa-tionallormostoftheoverseasincomeearnedbytheircorporations.Incontrast,theU.S.exemptssuchincomefromtaxationonlyaslongasitremainsabroad.
OtherexpertsarguedthatthedifferenceintheeffectivetaxratesbetweenincomeearnedathomeandincomeearnedoverseasprovidesU.S.-headquarteredMNCsincentivestoshifttaxableprofitsto their foreign subsidiaries to delay taxation, and encourages costly and wasteful tax planningmeasurestodoso.Ascorporatetaxratesinothercountrieshavedeclinedandasglobalmarketshavegrown,theincentivesandopportunitiesforU.S.MNCstoshiftprofitsabroadhaveincreased,strainingthealreadycomplicatedsystemoflawsandenforcementthatattemptstoregulatetheseactivities.Expertsalsocautionedthatsuchtaxavoidanceeffortsreducethedomestictaxbaseandreducecorporatetaxrevenues.
MostexpertsemphasizedtheneedforchangestothecurrentrulesfortaxingtheforeignincomeofU.S.corporationstoaddresstheaboveconcerns.Butexpertsdifferedonwhatchangesshouldbemadebecauseoftheirevaluationofhowchangeswouldaffectthefollowing,sometimescom-peting,policygoals:increasingtheattractivenessoftheU.S.asaproductionlocationforU.S.andforeigncompanies;reducingthetaxdisadvantagesofU.S.MNCsoperatinginlow-taxjurisdictionscomparedtotheirforeigncompetitors;reducingtheincentivesforU.S.MNCstoshiftactivitiesandreportedprofitsabroadtoavoidpayingU.S.corporatetax;reducingthecostsofadministrationand
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compliance;andreducingtheerosionoftheU.S.taxbaseandthelossofcorporatetaxrevenuesthatresultfromtaxavoidancemeasures.
a. The Current U.S. Approach to International Corporate Taxation
Asnotedabove,theU.S.usesaworldwideapproachtothetaxationofcorporateincomeearnedbyU.S.companiesoverseas.ThebasicprincipleofthisapproachisthatalloftheincomeearnedbyU.S.companiesanyplaceintheworldshouldbesubjecttotheU.S.corporateincometax.ButthecurrentU.S.systemalsoallowsU.S.companiestodeferpaymentofthetaxonmostoftheoverseasactiveincomeearnedbytheirforeignsubsidiariesuntilitisrepatriated,forexampleasdividendstotheparentcorporation.U.S.taxisnotdeferredonpassiveinvestmentincome(suchasportfo-liointerest)earnedabroadoronothereasilymoveableincomeofforeignsubsidiariesundertheso-called“subpartF”anti-deferralrules.ProfitsorlossesofforeignbranchesofU.S.corporations(ratherthansubsidiaries)aresubjecttoimmediateU.S.taxjustasiftheprofitsorlossesaccrueddomestically.
TopreventthedoubletaxationofincomeearnedbyaU.S.companybyboththegovernmentofaforeigncountryinwhichtheU.S.companyisoperatingandbytheU.S.government,currentU.S.taxlawincludesprovisionstoallowacreditforforeignincometaxes. Undertheserules,aU.S.companyisallowedaforeigntaxcreditforforeignincometaxespaidbyitandbyitsforeignsub-sidiariesonearningsrepatriatedtotheUnitedStates.TheforeigntaxcreditisclaimedbytheU.S.companyonitsU.S.taxreturnandreducesitsU.S.taxliabilityonforeignsourceincome.(SeeBox1foradiscussionoftheforeigntaxcredit.)
Asaresultofdeferralandforeigntaxcredits,theU.S.corporatetaxpaidbyU.S.MNCsonforeignsourceincomein2004wasonly$18.4billion.ArelativelysmallpartofthatrevenuewasderivedfromdividendspaidbyforeignsubsidiariestotheirU.S.parents.Foreignsourceroyalties,aswellasforeignsourceinterestandincomefromforeignsubsidiariesnoteligiblefordeferralunderthecurrent system, represent a much more important source of tax revenue than dividends. Evenwithforeigntaxcredits,U.S.multinationalshaveastrongincentivetokeeptheiroverseasearningsoutsidetheU.S.asaresultoftheinterplaybetweenthehighU.S.statutorycorporatetaxrateanddeferral.In2004,whenCongressallowedcompaniestorepatriateoverseasincomeforalimitedamountoftimeatareducedcorporateeffectivetaxrateof5.25 percent,theamountofrepatriatedincomejumpedfromanaverageofabout$60 billionperyearfrom2000-2004toabout$360billionin2005.In2004,U.S.multinationalshadover$900billioninunrepatriatedoverseasincome.Evenafterrepatriatingover$360billionin2005,U.S.companiesreportedover$1trillionofpermanentlyreinvestedearningson2008financialstatements.Mostofthebusinesspeoplewespokewithpre-dictedthatasignificantportionofthisincomewouldberepatriatedtotheU.S.iftherewasanothertemporarytaxholidaywithareducedrateoriftherewasareductioninthecorporatetaxrate.
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b. Box 1: The Foreign Tax CreditTheforeigntaxcreditrulesarecomplicatedandincludeseveralsignificantlimitations.Inparticular,theforeigntaxcreditisappliedseparatelytodifferentcategoriesofforeignincome(generallydistinguishingbetween“ac-tive”and“passive”income).ThetotalamountofforeigntaxeswithineachcategorythatcanbecreditedagainstU.S.incometaxcannotexceedtheamountofU.S.incometaxthatisdueonthatcategoryofnetforeignincomeafterdeductions.Incalculatingtheforeigntaxcreditlimitation,theU.S.parent’sexpenses(suchasinterest)areallocatedtoeachcategoryofincometodeterminethenetforeignincomeonwhichthecreditcanbeclaimed.TheallocationofexpensestoforeignincomeisintendedtoassurethatcreditsforforeigntaxesdonotoffsetU.S.taxondomesticsourceincome.Theportionofexpensesallocatedtoforeignincomethereforereducestheamountofforeigntaxthatcanbecreditedthatyear.Thisforeigntaxcredit limitation,however,allowsactiveincomesubjecttohighforeigntaxes(usuallyactiveearningsofforeignsubsidiariesdistributedtoU.S.parentcorporationsasdividends)tobemixedwithactiveincomesubjecttolowforeigntaxes(includingroyaltiesorinterestfromaffiliates).Thus,ifearningsrepatriatedbyaforeignsubsidiaryhavebeentaxedbytheforeigncountryinexcessoftheU.S.rate,theresulting“excess”foreigntax(i.e.,theamountofforeigntaxontheearningsthatexceedstheU.S.taxthatwouldbeowedonthedividend)maybeusedtooffsetU.S.taxonother,lower-taxedforeignsourceincomeintheappropriatecategory.Thismethodofusingforeigntaxcreditsarisingfromhigh-taxedforeignsourceincometooffsetU.S.taxonlow-taxedforeignsourceincomeisknownas“crosscrediting.”Oneconsequenceofcross-creditingisthatifaU.S.parentcorporationdevelopsanintangibleasset,suchasapatentortrademark,andlicensestherightstoitssub-sidiariesoperatinginforeigncountries,theroyaltyincomegenerallywouldbeconsideredactiveandtheU.S.taxonthatincomemaybeoffsetbyexcessforeigntaxcreditsonotheractiveincomesubjecttohighforeigntaxes.IfaU.S.parentdoesnothaveorexpecttohaveexcessforeigntaxcreditsfromearningsinahigh-taxcountry,itmayhaveanincentivetostructureitsaffairssothattherightstosuchanintangibleareownedfortaxpurposesbyaforeignsubsidiaryinalow-taxcountry.ThismaybeaccomplishedthroughuseofanR&Dexpensecostsharingarrangement,whichallowstheU.S.parentcorporationtoretainlegalownershipoftheintangiblerightsforintellectualpropertylawpurposesbutfortaxpurposesallowstheforeignsubsidiarytobetreatedasowninganundividedinterestintheintangible.ItisnotnecessarytopayaroyaltytotheU.S.parentforanintangiblewhosecostshavebeenshared;however,theU.S.parentlosesitsU.S.deductionfortheportionofR&Dexpensethatisshared.Theforeignsubsidiarymayusetheintangibleorsub-licensetherightstoaffiliatesthatmakeuseoftheintangibleandearnreturnsattributabletothecostsharedintangible.Itgenerallyispossibletoachieveadeductioninthecountryofoperationandincomeinthelower-taxedcountry,whileavoidinganyU.S.taxunderthe“subpartF”anti-deferralrules.ProperallocationofearningsbetweenaU.S.parentcorporationandaforeignsubsidiarynecessarilyrequiresputtingappropriate fairmarketpricesonservices,productsandtransfersof intangiblerightsexchangedbe-tween the two. If these“transferprices”are toohighor too low,earningsmaybe incorrectlyallocatedandU.S.taxmaybeavoidedbyshiftingearningstoalower-taxcountry.Thisistheso-calledtransferpricingis-sue.Theincentivetomanipulatetransferpricesisrelatedtothedifferenceineffectivetaxratesbetweencoun-triesinvolvedinatransaction.Inthecostsharingarrangementdescribedabove,ifrightstoanintangiblearecost shared after the intangible has significant value, the party receiving the benefit should pay for pre-ex-istingvalue(a“buy-inpayment”). Thisisoneofthemostdifficulttransferpricingissuestoadministerandenforce, and highlights the challenges facing governments in applying national tax systems tocross-bordertransactions.
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TheUnitedStatesistheonlymajordevelopedcountryeconomythatusesaworldwide(withdeferral)approachtothetaxationofcorporateincome.Otherdevelopedcountriesusea“territorial”or“dividendexemption”approachthattaxesonlythedomesticincomeoftheircorporationsandexemptsallorasignificantportion(e.g.,95 percent)oftheiroverseasincomefromdomestictaxes.(BoththeU.K.andJapanrecentlyswitchedfromaworldwideapproachtoaterritorialapproach.)Additionally,allofthedevelopedcountrieswiththeexceptionofJapanhavealowerstatutorycorporatetaxratethantheUnitedStates.IncontrasttotheworldwidesystemusedintheU.S.,interritorialsystemsthereisno(orverylittle)additionaldomestictaximposedonexemptoverseasincomewhenitisrepatriated.AterritorialsystemthereforeprovidesanevengreaterincentiveandopportunityforacompanytoreduceitsdomesticcorporatetaxesbyreportingprofitsabroadanddeductiblecostsathomethantheU.S.approach.However,themagnitudeoftheadditionalincentiveissubjecttodebate,withsomearguingthatitisactuallyquitesmallbecausethecurrentU.S.systemalreadyprovidesterritorial-liketreatmentforunrepatriatedearnings.OtherspointtothewillingnessofU.S.corporationstorepatriatesubstantialforeignearningsin2005inresponsetoatemporary5.25 percenteffectiverateasevidencethattheimplicitcostsofdeferralaremoresizable.
AsimpleexampleshowsthedifferencebetweentheworldwideapproachusedbytheUnitedStatesandaterritorialapproach.AU.S.companywithasubsidiaryinIreland,wherethecorporatetaxrateis12.5percent—amongthelowestintheOECD—paysU.S.taxontheprofitsearnedfromactivebusinessoperationsinIreland,adjustedbyaforeigntaxcreditsforforeigntaxespaidinIre-land(toensuretheearningsarenotdoubletaxed),whentheprofitsarerepatriatedintotheUnitedStates.Thus,iftheincomeearnedbytheIrishsubsidiaryisrepatriated,thetaxrate,adjustedforapplicableforeigntaxcredits,isincreasedfrom12.5percenttothestatutoryU.S.corporaterateof35percent.AFrenchcompanywithanIrishsubsidiaryalsopaystheIrishtaxof12.5percentonincomefromactivebusinessoperationsofitsIrishsubsidiary.IncontrastwiththeUnitedStates,iftheincomeearnedbytheIrishsubsidiaryisrepatriated,theFrenchcompanyonlypaysFrenchtaxon5 percentoftherepatriatedprofitswhentheseprofitsarerepatriatedtoFrance.Insuchacase,thetaxrateontheFrenchsubsidiaryistheIrishrateof12.5percentplusasmalladditionalFrenchtax.
Astheprecedingexampleindicates,theafter-taxresultoftheU.S.worldwidewithdeferralsystemandaterritorialsystemissimilarifforeignearningsarenotrepatriated.Indeed,someexpertssug-gestedthatwithdeferraltheU.S.systemisverysimilartosometerritorialsystemsusedelsewhere.FinancialaccountingrulespreservethispatterninthattheydonotrequireaccrualoftheU.S.taxonrepatriationofearningsifthecompanymakesanelectiontotreattheearningsaspermanentlyreinvested,butthatsimilaritydisappearsiftheU.S.companywantstopaydividendsfromtheforeignsubsidiarytotheparentinordertofinanceinvestmentintheU.S.orpaydividendstoshareholders.
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c. Economic Effects of the Current U.S. Approach
i. Effects on the Location of the Economic Activities of U.S. Multinationals
TherearetwocontrastingviewsabouthowU.S.internationalcorporatetaxrulesaffecttheproduc-tionandemploymentofU.S.MNCsathome.Oneviewrestsonthebeliefthattheforeignopera-tionsofU.S.multinationalsareasubstitutefortheirdomesticoperations,inthesensethatincreasesinforeignoperationscomeattheexpenseofdomesticoperations.Accordingtothisview,factorsthatreducethecostofforeignoperations,includinglowertaxesonforeignsourceincome,increasetheincentiveforAmericancompaniestoshiftproduction,investmentandemploymenttolower-costforeignlocations.Underthisview,reducingtherelativetaxburdenontheforeignsourcein-comeofU.S.MNCsincreasestherelativecostadvantageoftheiroverseasactivityandencouragesthemtomoveinvestment—andjobs—abroad,reducingemploymentandproductionathome.Bythislogic,increasingtherelativetaxburdenontheforeignsourceincomeofU.S.multinationalswouldencouragethemtorelocateproductionandjobsbacktotheU.S.
There isevidencethatsupports theviewthatcostdifferencesaresometimesasignificant factorbehind MNC decisions to substitute overseas employment for domestic employment. StudieshavefoundthatU.S.employmentcorrelatespositivelywithforeigncountrywages,indicatingthatdomesticandforeignlaboraresubstitutes,andthathigherforeigncostsincreaseemploymentathome.OtherstudiesfindthatthesignoftherelationshipvariesbycountryandlikelydependsonthetypeofforeignactivitybeingundertakenbytheU.S.company.
AcontrastingviewisthattheforeignoperationsofU.S.multinationalsareacomplementtotheirdomesticoperations—thatis,thatemploymentandothereconomicactivityatforeignsubsidiariescorrelatepositivelywithdomesticemploymentandactivity. Accordingtothisview,theforeignsubsidiariesofU.S.multinationalsincreaseemployment,output,investmentandR&DintheU.S.bothbyenhancingtheefficiencyandcostcompetitivenessofU.S.multinationalsandbyincreasingtheirsalesinforeignmarkets,manyofwhicharegrowingmuchmorerapidlythantheU.S.market.Inthisview,theforeignoperationsofU.S.companiesgeneratejobsandactivityattheirdomesticoperations.Accordingtothisview,factorsthatincreasetheattractivenessofforeignoperations,includinglowertaxesonforeignsourceincome,willincreasetheeconomicactivityofU.S.MNCsbothoverseasandathome,andalsoincreasetheuseofequipmentandinputsproducedbyU.S.suppliers.
ThereisalsoevidencethatsupportstheviewthattheforeignoperationsofU.S.MNCscomplementtheirdomesticactivities.Recentstudieshavefoundpositiverelationshipsbetweenboththedo-mesticandforeignemploymentofU.S.MNCsandbetweentheirdomesticandforeigninvestmentlevels.
Onafirm-by-firmandindustry-by-industrybasis,thereislikelytobesignificantheterogeneityintherelationshipbetweendomesticandforeignactivity.Formanybusinesses,theabilitytosubsti-tutedomesticactivitiesforforeignactivitiesinordertoserveforeignmarketsislimitedbywhat
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theyproduce. Forexample,firmsthatrequirealocalpresencetoexploitU.S.innovationorex-pertisetoserveforeignmarkets,firmswhosebusinessrevolvesaroundnaturalresourceslocatedabroad,firmsthatrequirearetailpresenceorwhosebusinessrequiresface-to-facerelationshipswithconsumers,andfirmsthatproducegoodsthatarecostlytotransportareoftenunabletoserveforeignmarketsfromtheirdomesticlocationsandtosubstitutedomesticemploymentandinvest-ment for overseas employment and investment. Indeed, in 2007, 19 percent of U.S. exports ofgoodswereintra-companyexportsfromaU.S.parenttoaforeignaffiliate.FirmsinsuchsectorsandcarryingonsuchactivitiesoftenhavesignificantadministrationandR&DactivitiesintheU.S.tosupportorcomplementtheirforeignoperations.Incontrast,firmsthatproducehighvalue-to-weightgoodsandgoodsthatareeasytotransportarebetterabletoserveforeignmarketsthroughexportsfromU.S.locations.Forsuchcompanies,therelativecostofinvestingabroad(includingtaxes)islikelytobeamoreimportantdeterminantofdecisionsaboutwhethertolocateproductionandemploymentintheU.S.oroverseas.
ii. Effects on the Costs of U.S. Companies and their Foreign and Domestic Competitors
Thecombinationoflowerforeigncorporatetaxratesandtheterritorialsystemofcorporatetaxa-tionusedbyothercountriesreducesthecostofproductionforforeignfirmscompetingwithU.S.companies outside of the U.S.—thus raising the relative cost of U.S. MNCs operating in lower-taxforeignjurisdictions.Althoughdeferralreducesnationaldifferencesineffectivecorporatetaxrates,suchdifferencesmaystillplaceU.S.MNCsatarelativedisadvantageininternationalmarketsandmaybeinfluencingcompanysharesinglobalmarketsandpreventingglobalproductionfrombeingallocatedtothemostefficientcompanies.
TheU.S.worldwide/deferralapproachtocorporatetaxationfavorsforeignfirmsoperatingintheirowncountrycomparedtoU.S.firmsinthatcountry.ForeignandU.S.firmsbothpaycorporatetaxesinthatcountry—onaverageatlowerratesthanintheU.S.—butU.S.firmspayanadditionaltaxonrepatriationofthoseprofits.ThesameistruewhenU.S.andforeigncompaniescompeteinalow-taxthirdcountry;foreignfirmsoperatinginsuchacountry(e.g.,aFrenchfirminIreland)paythethirdcountryrate,buttheU.S.firmpaysanadditionaltaxwhenitrepatriatesitsearningstotheU.S.Overall,theterritorialsystemlowersthecostofdoingbusinessbyforeignfirmsinlow-taxthirdcountriescomparedtoU.S.firms. However,becauseU.S.MNCshavebeensuccessfulinreinvestingtheirincomeabroadanddeferringU.S.taxes,thistaxdisadvantagemaybesmall.Nevertheless,U.S.companiesthatdonotremitforeignearningsduetotheU.S.repatriationtaxbearcoststhatarisefromtax-inducedinefficienciesintheirfinancialstructure—coststhattheircompetitorsbasedinterritorialcountriesdonotbear.
TheU.S.worldwide/deferraltaxapproachalsoputsU.S.MNCsatadisadvantageintheacquisitionandownershipofbusinessesinothercountriescomparedtoforeigncompaniesthatoperateunderaterritorialapproach.Forexample,aforeigncompanycanpaymorethanaU.S.companytoac-quireafirminEuropeorinalow-taxthirdcountrybecausethenet-of-taxprofitsresultingfromtheacquisitionwillbehigherfortheforeigncompanythanforitsU.S.competitor.
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Indomesticmarkets,however,bothU.S.MNCsandtheirforeigncounterpartsbenefitfromthelowereffectiveratesapplied to their foreign-source incomeanda lowercostofcapital,andcanspreadtheiroverheadcostsoverabroaderbaseofsalesthancanpurelydomesticfirms.Moreover,multinationalfirmsmayalsobenefitfromreduceddomestictaxesthroughtaxplanningandtrans-ferpricingtoshiftdomestically-earnedprofitstolower-taxforeignjurisdictions.Suchtaxavoid-anceopportunitiesarenotavailabletopurelydomesticfirms.
iii. Erosion of the Business Tax Base through Transfer Pricing and Expense Location
BecauseoftherelativelyhighU.S.corporatetaxrateandtheabilitytodeferforeign-earnedincomeindefinitely,U.S.companieshaveastrongincentivetoshiftprofitsabroadtodelaypaymentoftheircorporatetaxes,andtodeductthedomesticbusinessexpensesincurredinsupportoftheirforeignoperationsagainsttheircurrentdomesticearnings.Forexample,twoofthemostimportantmeth-odsthatU.S.MNCsusetoavoidtaxesrelatetothelocationofdebtandtothelocationofvaluableintangibleproperty.Inthefirstexample,acorporationissuesdebtinahigh-taxlocation(e.g.theU.S.)andusesthecapitaltogenerateactiveincomeabroad,whichisthendeferred.Thispracticeal-lowsbusinessestoreducetaxableincomefromtheirdomesticoperationsimmediatelywhiledefer-ringthepaymentoftaxesontheirforeignprofits.Inthesecondexample,acorporationtransfersavaluableintangibleasset,likeapatentorcopyright,toasubsidiaryinalow-taxjurisdictionwithoutappropriatecompensation.Thecompanythenexploitstheintangibleassetthroughthesubsidiarywithoutappropriateroyaltypaymentstothedomesticparent.Thecompanybenefitsfromdeduct-ingthecostsofdevelopingtheintangibleintheU.S.,thehigh-taxcountry,andreportingprofitsfromexploitingtheintangibleinthelow-taxcountry.U.S.MNCsalsohaveastrongincentivetoclassifypassiveincomeearnedoverseasasactiveincomebecausedeferralappliestothelatterformof incomeandnottotheformer. Furthermore,thecurrentsystemofforeigntaxcreditsallowsfirmstouseforeigntaxcreditsreceivedforprofitsearnedinhigh-taxcountriestooffsettaxesdueonprofitsearnedinlow-taxcountriesortooffsettaxesdueonotherkindsofincome,likeroyalties.Thissystemprovidesadditionalincentivestomanipulatethelocationofprofits(andthetypeofearnings)attainedabroadtoqualifyforforeigntaxcredits.
Policingtransferpricingischallengingbothbecauseoftheintrinsicdifficultyofassigningpricestointra-firmsalesthatarenotobservedthewayarm’slengthtransactionscanbeandbecauseofthecomplexityandnumberofrelated-partytransactionsthatoccurwithinMNCs.Thus,changesinthetaxsystemmotivatedbythegoalofimprovingthe“competitiveness”oftheforeignsubsidiariesofU.S.multinationalswithrespecttotheirforeigncompetitorsmayalsohavetheeffectofincreas-ingtheincentiveforU.S.MNCstoreducethetaxestheypayontheincometheyearnintheU.S.Indeed,apartofthetaxexpenditureformaintainingdeferralinthecurrentsystemorforshiftingtoaterritorialsystemisthereductionintaxespaidbyU.S.MNCsontheirdomestically-earnedincome.
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iv. The Costs of Administering and Complying with the Current U.S. System
MostexpertsagreethatthecurrenthybridU.S.systemthatcombinesaworldwideapproachwithdeferralembodiestheworstfeaturesofbothapureworldwidesystemandapureterritorialsystemfromtheperspectiveofsimplicity,enforcementandcompliance.Inapureworldwidesystem,allincomeissubjecttothesametaxrate,eliminatingthenecessityofdistinguishingactivefrompas-siveincome(andthecomplexityofsubpartF)andofdistinguishingdomesticandforeignsourcesofprofits(andthereforetheneedtopolicetransferpricing).Hence,costlytaxplanningtoshiftincometolow-taxhavensortore-characterizepassiveincomeasactiveincomeissignificantlyre-duced.Andsoistheneedforenforcement.However,eveninapureworldwidesystem,aforeigntaxcreditsystemisstillrequiredtoensurethatcompaniesarenotsubjecttodoubletaxation.(Andtheforeigntaxcreditsystemiscomplicated.)Moreover,inapureworldwidesystemwithoutdefer-raltherewouldbeagreaterincentiveforU.S.multinationalstoshifttheirheadquartersabroadandreorganizeasforeigncompaniestoavoidthehighU.S.corporatetaxrateonforeignincome.
Inaterritorialsystem,foreignactiveincomeisgenerallynotsubjecttodomestictaxbutforeignpassiveincomeis. Thelocationofprofitsandthesourceof incomeareveryimportantbecausesomeincomeistaxedatthefulldomesticrate(35percentintheU.S.)andsomeincomeistaxedpotentiallyatzero.Thus,inaterritorialsystem,theretypicallyarerulestodifferentiateactivefrompassiveincome(likesubpartFunderpresentlaw),andrulestodifferentiateprofitsearnedathomefromprofitsabroad(includingtransferpricingrules).Aforeigntaxcreditsystemisrequired,butonlyforpassiveincomeandotherforeignincomenoteligibleforexemption(e.g.,royalties).Inapureterritorialsystem,dependingonthedifferenceineffectivetaxratesondomesticincomeandforeignincomeeligiblefordividendexemption,firmshavestrongincentivesfortaxplanning,andspendtimeandmoneydoingit.
TheU.S.hybridapproach,likeapureworldwideapproach,requiresabroadforeigntaxcreditsys-temtoavoiddoubletaxation.Butdeferraleffectivelyprovidesterritorial-liketreatmenttoactiveearnings until repatriated, generating the same incentives for tax planning and transfer pricingasaterritorialsystem.Plus,onlyactiveincomemaybedeferredwhilepassiveincomemaynot.Therefore,thecurrentU.S.systemrequiresacompleteforeigntaxcreditsystem(includingexpenseallocation rules), subpart F anti-deferral rules for passive income, and onerous transfer pricingenforcement,whilegeneratingstrongincentivesfortaxplanningandavoidancebybusinesses.Inshort,thecurrentU.S.systemcombinessomeofthemoredisadvantageousfeaturesfrombothpureworldwideandpureterritorialsystems.
TheincentivesgeneratedbythecurrentsystemencourageagreatdealofcostlytaxplanningbyfirmsandnecessitateasignificantamountofcostlyenforcementandcomplianceactivitiesbytheIRS. Moreover, the provisions to address problems created by deferral, foreign tax credits andexpenseallocationrules,andtodifferentiatepassiveandactiveincomecontributesignificantlytothecomplexityofthecorporatetaxcode.Accordingtoonestudy,largecompaniesreportedthat40percentoftheirtaxcomplianceburdenarisesfromthetaxationofforeignsourceincome.AndtheIRSmaintainsthattheinternationalprovisionsfortaxationofcorporateincomeareamongthehardesttoadministerandenforce.
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MostexpertsagreethatthecurrentrulesfortaxingtheforeignincomeofU.S.corporationsshouldbereformed,butthereisdisagreementabouthow.Intheremainderofthissection,wesummarizetheprosandconsofthreebasickindsofreformsthatwediscussedwithexpertsduringourworkoninternationalcorporatetaxation:movingtoaterritorialsystemsimilartothoseofotherdevelopedcountries;maintainingaworldwideapproachbutatalowercorporaterateandwithoutdeferral;andtighteningorendingdeferralwithnochangeinthecorporaterate.Wealsodiscusstheimpli-cationsofmaintainingthecurrentsystemwithdeferralandalowercorporatetaxrate.
v. Option 1: Move to a Territorial System
The proposal and its advantages:TheUnitedStatescouldadoptaterritorialapproachsimilartothoseusedbymostotherdevelopedeconomiesandexemptfromU.S.taxationtheactiveforeignincomeearnedbyforeignsubsidiariesorbythedirectforeignoperationsofU.S.companies.(Transitionrulesmightbeimposedtolimitthepotentialwindfallfromeliminatingthetaxthatwouldhavebeenpaidwhenandifaccumulatedanddeferredprofitscurrentlyheldabroadarerepatriated.)
MovingtoaterritorialsystemwouldeliminatetheincentivesofU.S.MNCstokeepincomeearnedfromforeignoperationsabroadratherthanrepatriatingthisincometotheU.S.,reducingtheim-plicitcostscompaniesincurtoavoidrepatriation.Movingtoaterritorialsystemwouldthereforeimprovetheefficiencyofcorporatefinancedecisions.
AdoptingaterritorialsystemwouldmeanthattheforeignsubsidiariesofU.S.MNCswouldfacesimilareffectivetaxratestothosefacedbytheirforeigncompetitorsheadquarteredincountrieswithterritorialsystems.ThiswouldreducethecostofdoingbusinessincountriesthathavelowertaxratesforU.S.multinationalsrelativetotheirforeigncompetitorsinthoseforeignmarkets.
AterritorialsystemwouldalsoenhancetheabilityofU.S.multinationalstoacquireforeignfirmsandwouldeliminatetheincentivesforU.S.multinationalstomergewithorselltheirforeignop-erationstoforeigncompaniesfortaxreasons.Eliminationofthesedistortionstotheownershipofcapitalassetswouldhelpensurethatthoseassetsweremanagedbythemostproductivebusinesses.
TotheextentthatforeignoperationscomplementthedomesticoperationsofU.S.MNCs,movingtoaterritorialsystemthatreducestheircostsandincreasestheirsharesinforeignmarketswouldboosttheirproduction,investment,andemploymentintheU.S.
Movingtoaterritorialsystemcouldalsoprovidesomesimplificationbenefitsbyeliminatingtheneedforforeigntaxcreditprovisions(exceptthosethatapplytopassiveincomeandothernon-exemptincome).
Disadvantages:Theprincipaldisadvantagesof adoptinga territorial systemderive from the fact that in suchasystemthedifferencesintaxratesappliedtorepatriatedforeignearningsversusdomesticearningsandactiveversuspassiveincomewouldincrease,strengtheningtheincentivesforfirmstoshiftin-comeoffshorethroughtransferpricingandexpenseshifting,andencouragingactivetaxplanning
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(aslongastheU.S.corporatetaxrateremainssignificantlyhigherthantheratesimposedbyothercountries).Asnotedabove,however,theincrementaleffectoftheseincreasedincentivescomparedtothecurrentsystemwithdeferralmaybemodest.AddressingthesedisadvantagesofaterritorialsysteminordertoprotecttheU.S.domestictaxbaseandmaintaintaxrevenueswouldplacepres-sureonthecurrenttaxadministrationandcomplianceregimeandcouldrequirerulesandregula-tionsthatdifferedsignificantlyfromthoseofothercountries.
Inparticular,tomaintaincorporatetaxrevenues(frombothdomesticandinternationalprofits)underaterritorialsystem,critical(andtechnical)detailswouldneedtoberesolved,including:theshareofforeigncorporateincomeexemptedfromU.S.taxes;theU.S.taxtreatmentofU.S.businessexpensesincurredbyU.S.companiestosupporttheirforeignoperations;andtheU.S.taxtreat-mentofroyaltyorpassiveincomeearnedabroadbyU.S.corporations.
Therevenueconsequencesofthesedesigndecisionsarematerial. AccordingtoroughestimatesfromtheTreasury,asimplifiedterritorialsystemwithoutfullexpenseallocationruleswouldloseapproximately$130billionoverthe10-yearbudgetwindow.Incontrast,aterritorialsystemwithfullapplicationofexpenseallocationrulescouldberevenueneutralorcouldraiserevenuedepend-ingonthebehavioralresponsesofcorporationsandtheabilityoftheIRStopolicetransferpricingandexpenseallocations. Indeed,earlier studies fromthe JCT,Treasury,and theCongressionalBudgetOffice(CBO)havescoredterritorialtaxsystemswithexpenseallocationrulesbasedonthecurrentrulesusedfortheforeigntaxcreditasraisingbetween$40 billionand$76billionover10years.Differencesintheseestimatesresultfromdifferencesinbehavioralassumptions,thedetailsoftheproposals,andthedatausedtomaketheseestimates.Thewidevariationinrevenueeffectshighlightstheimportanceofcomplexspecificationdetailsandtheincentivescreatedunderdiffer-entregimes.
Areformthatmaintainedthecurrenteffectivetaxrateonthedomestically-earnedincomeofU.S.MNCswouldrequireincreasedattentiontotransferpricingenforcementandtherulesregardingthelocationofexpenses.Forexample,tomaintainrevenueneutrality,taxdeductionsforinterestandotheradministrativeexpensesofU.S.MNCsusedtofinanceoperationsabroadwouldneedtobedisallowedsothattheycouldnotbeusedtoreducedomestictaxableincome.Thiswouldlimitanysimplificationbenefitsofreform.Moreover,aterritorialsystemthatincludedexpensealloca-tionruleswithrigorousenforcementwouldremainverydifferentfromtheterritorialsystemsofotherdevelopedcountries.Mostcountriesusingterritorialsystemsdonot“allocateanddisallow”domesticbusinessexpensesinthiswayeitherbydesignorbecausetheirrulesareundeveloped.Inasystemwithstringentallocationrules,manyU.S.firmscouldstillfacehighercostsofdoingbusi-nessinforeignjurisdictionsthantheirforeigncompetitors.Similarly,shiftingtoaterritorialsys-temwhileretainingthecurrentrulesonroyaltyincomewithoutareductionintheU.S.corporatetaxratewouldmeanthatroyaltyincomefromforeignsourceswouldbetaxedatahigherratethanroyaltiespaidtoforeignfirmsoperatingfromlower-taxjurisdictions.15
15 AterritorialsystemwouldimposeahighereffectiveU.S.taxrateonforeign-sourceroyaltyincome,providingfirmswithagreaterincentivetoreclassifyroyaltypayments(andothernon-exemptincome)asexemptactivein-come.Currently,royaltiesaremostlyshelteredfromtaxusing“excess”foreigntaxcredits.Shiftingtoaterritorialsystemwouldeliminatetheseexcessforeigntaxcredits.
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Anumberof foreigngovernmentswith territorial systemsattempt to recouprevenueby taxingasmallportionoftheforeignsourceactiveincomeoftheircorporations(typicallybyexemptingaround95 percentofrepatriatedearningsfromtax). TheU.S.couldadoptsuchanapproachtorecoupsomeofthelostrevenuefrommovingtoaterritorialsystem.Thiswouldreducethead-ministrativeandcompliancecostsofaterritorialsystemcomparedtoonethatusedacomplicatedexpenseallocationsystemlikethatcurrentlyusedfortheforeigntaxcredit.Revenuelossescouldalsobereducedbydenyingexemptionforincomeearnedinalow-taxcountry(a“taxhaven”)thatdoesnothaveaminimumeffectivecorporatetaxrate.
Aterritorialsystemthatresultedinlowereffectiveratesonforeign-earnedprofitscouldalsoaf-fectthelocationdecisionsofU.S.multinationals.Totheextentthatproductionoverseasisasub-stitutefordomesticeconomicactivity(orinindustrieswherethisistrue),adoptingaterritorialsystemcouldencouragethemovementofproduction,employmentandinvestmentoutoftheU.S.tolower-taxjurisdictions.AterritorialsystemthatraisedeffectiveratesonroyaltyincomefromU.S.-domiciledintangiblescouldencouragefirmstoshiftintellectualpropertyandresearchanddevelopmentabroad.
Finally,aterritorialsystemwouldretainorexacerbatemanyoftheincentivesforinefficientbehav-iorinthecurrentworldwidesystemwithdeferral:incentivesforshiftingincometolow-taxloca-tionsbydistortingtransferpricesorpayinginadequateroyalties;incentivesforusingrelated-partytransactions(wheretransferpricingcanbeusedtoreducetaxes)ratherthanarm’slengthtransac-tions;andincentivesforalteringthelocationoftangibleandintangibleassets.
vi. Option 2: Move to a Worldwide System with a Lower Corporate Tax Rate
The proposal and its advantages: Thisoptionwouldimposeapureworldwidetaxsystemandenddeferralaspartofalargercorpo-ratetaxreformthatloweredtheU.S.corporatetaxratetoalevelcomparabletotheaverageofotherdevelopedcountries.Ifthestatutorycorporateratewereloweredtoarateatwhich,onaverage,U.S.MNCsexperiencednochangeintheeffectivetaxratetheycurrentlyfaceonincomeearnedabroadthereformwouldbe“burdenneutral”forthiscategoryofincome(thoughasdiscussedbelowtherewouldprobablybeindividual“winnersandlosers”).Oneestimateoftherequiredburdenneutralcorporaterateforthisreformis28 percent.Thisoptionwouldresultinasignificantoverallrev-enuelossbecausethelowercorporateratewouldapplytobothdomesticandforeignincomeandtoallU.S.corporationsregardlessofwhethertheyhaveforeignoperations.Toreduceoravoidthisrevenuelosswouldrequirerevenueincreaseselsewhere,forexamplebybroadeningthedomesticcorporatetaxbaseasdescribedaboveunderOptionGroupB.(Loweringthecorporatetaxratewouldalsohaveefficiencybenefitsinthedomesticcontext,asdescribedinOptionGroupA.)
Movingtoaworldwidesystemandendingdeferralwouldhavesignificantbenefitsforsimplifica-tion,compliance,enforcement,andefficiency.Byeliminatingdeferralforactiveforeignincome,allincomewouldbetaxedatthesamerateregardlessofwhereitisearned(domesticallyorinter-nationally),orwhetheritispassiveoractiveincome.Thesubpart-Fanti-deferralprovisionsand
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mostrulestodifferentiatepassiveandactiveincomecouldbesimplifiedoreliminated.Thesystemofforeigntaxcreditswouldbemaintainedtoavoidthedoubletaxationofforeign-earnedincome,butitwouldbepossibletosimplifythesystembyeliminatingtheallocationofexpenses.
Movingtoaworldwidesystemwithoutdeferralwouldalsoreducemanyoftheincentivesfortaxplanningandtaxavoidance,andthereforewouldrequirelesscomplexandonerousanti-abusepro-visionsandlessenforcement.Incentivestoengageinincomeshifting,forexamplethroughtransferpricing,wouldbeeliminated,reducingplanningandcompliancecostsatbusinessesandrequiringlessoversightfromtheIRS.
Anotheradvantageofthisproposalisthatitremovesincentivesforanumberofinefficientbehav-iors.First,becauseallincomeistaxedcurrently,firmswouldnolongerhaveaU.S.taxincentivetokeepcashabroadtoavoidrepatriation,improvingtheefficiencyofcorporatefinancingdecisions.Second,asmentioned,thereisnoincentiveforU.S.multinationalstoengageinincomeshiftingthroughexpenselocationortransferpricing,andthiswouldreducethedistortionsthatarisefromincentivestouserelated-partytransactions,tolocatetangibleandintangibleassetsinalternativelocations for taxpurposes,or to favorcertainfinancingchoices (likedomesticdebt)overotherchoices.
FinallytotheextentthattheforeigneconomicactivitiesofU.S.MNCssubstitutefortheirdomesticeconomicactivities,thisoptionwouldencourageproduction,investmentandemploymentintheU.S.
Disadvantages:Adifficultywiththisapproachisthat loweringthetaxratetotherequiredburden-neutral level(around28 percent)wouldeithernecessitatesignificantbasebroadeningthroughtheeliminationofothercorporatetaxcreditsandtaxdeductions,orasubstantial lossofcorporatetaxrevenue.Ending deferral would itself permit a revenue-neutral reduction in the corporate rate by about1.5 percentagepoints.
Althoughcuttingthecorporateratetotheburden-neutrallevelwhileendingdeferralwouldresultinnochangeintheaveragetaxrateonforeignincome,somefirmswithsuchincomewouldfacetaxincreasesandotherstaxreductions.Forexample,firmsoperatingprimarilyinlow-taxcoun-triesbenefitmorefromdeferralthancompaniesoperatinginhigh-taxcountries,soendingdeferralwouldraisetaxesmoreontheformergroupoffirms.Thus,thisoptionwouldintroducegreatercountry-by-countryheterogeneityinthecompetitivenessofU.S.firmsdependingonthetaxratesof thecountries inwhichtheyoperate,andU.S.MNCswould facegreater taxdisadvantages inlower-taxcountriescomparedtotheircompetitorsheadquarteredincountrieswithlowercorpo-ratetaxratesand/orwithterritorialsystems.Otherfirmslikelytobenegativelyaffectedbyendingdeferralevenwithaburden-neutralreductioninthecorporatetaxrateincludethoseabletousetransferpricingtomoveprofitsabroad—forexample,thosetransferringhard-to-valueintangibleassetsorservices.
Underthisoption,U.S.MNCswouldstillfacecompetitivedisadvantagesonforeignoperationsinjurisdictionswithcorporatetaxratesbelow28percent.Thisoptionwouldalsoretaintheincen-tivesforforeignfirmstoacquireU.S.companiesortheirforeignsubsidiaries.Althoughthesein-
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centiveswouldbelimitedtosomeextentbecausethegainsfromthesalesofsubsidiariesaresubjecttoU.S.taxation,thisoptionwouldreducetheabilityofU.S.firmstocompeteintheacquisitionofforeignfirmsthatfacelowereffectivetaxrates.
Indeed,theincentiveforforeignfirmstoacquiretheforeignsubsidiariesofU.S.MNCswouldlikelyincreasebecausethoseforeignsubsidiarieswouldbemorevaluableinthehandsofforeignfirmsthaninthehandsoftheU.S.MNCs.Further,thisproposalwouldincreaseincentivesforforeignfirmstoacquireU.S.MNCsoutrightandthenusetransferpricingtoshiftprofitstolower-taxjuris-dictions,raisingconcernsovertransferpricingenforcementofforeignMNCsoperatingintheU.S.Preventingthisoutcomewouldrequirecontinuedenforcementeffortsunderthetransferpricingrules.Thus,transferpricingruleswouldremainimportantforthesefirmsand,toalesserextent,forU.S.taxadministrators.
vii. Option 3: Limit or End Deferral with the Current Corporate Tax Rate
GiventhehighU.S.corporatetaxrate,underapureworldwidetaxsystemwithoutdeferral,U.S.MNCswouldfaceahighereffectivetaxratecomparedtoforeignMNCsheadquarteredincoun-trieswithlowercorporatetaxrates,territorialtaxsystemsorboth.Deferraloffsetsmuchofthisdisadvantagebyapproximatingtheeffectiveratesfacedinforeignjurisdictions.WithdeferraltheforeignoperationsofU.S.corporationsaretaxedcomparablytotheforeignoperationsoftheirfor-eigncompetitorsoperatinginthesameforeigntaxjurisdictions.Asaresultofthe“timevalueofmoney”advantageofpostponingtaxpayments,deferralallowstheforeignsourceincomeofU.S.corporationstobetaxedatalowereffectiveratethanitwouldbeifitwereearnedintheU.S.ThiscreatesanincentiveforU.S.corporationstokeeptheirforeignearningsabroadaslongaspossibleanddistortstheirinvestmentandbusinessdecisions.
The proposal and its advantages: MaintainingthesystemofdeferralforU.S.MNCstoallowthemtoenjoysimilartaxratestocom-petitorswhenoperatinginforeignjurisdictionscomesatasignificantrevenuecost—approximately$180billionovertenyears.Endingthistaxexpenditurewouldraiseconsiderablerevenues,enoughtoreducethecorporateratebyabout1.5percentagepoints,relievingtheeconomicdistortionsofthecorporatetaxalonganumberofmargins.
ForthosewhoseetheforeignactivitiesofU.S.MNCsasasubstitutefordomesticactivities,defer-ralbothreducesjobs,productionandinvestmentbyU.S.companiesathomeandencouragestheseactivitiesabroad,aswellasallowingU.S.companiestoavoidtaxes.Bythislogic,limitingorelimi-natingdeferralwouldcauseU.S.MNCstosubstitutedomesticforforeignactivities,wouldreducetaxavoidance,andwouldincreasetaxrevenues.
Like theburden-neutral reformdiscussedabove, thisoptionwouldsimplify the tax system, re-duceincentivesforincomeshiftingandtaxplanningandavoidance,andwouldthereforeimproveinternationalenforcementandreduceadministrativeandcompliancecosts.Itwouldbeeasierto
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enforcethanthecurrentsystembecauseitwouldleavelittleincentivefortransferpricingortheuseoftaxhavens.
Disadvantages:WithoutasubstantialreductionintheU.S.corporateincometaxrate,however,thisoptionwouldimposeasignificantburdenonU.S.multinationals,raisingtheeffectivetaxratesonincomeearnedattheirforeignsubsidiariesrelativetotheratesthatapplytotheircompetitorsinlower-taxcoun-tries,andhamperingtheirabilitytobidforandpurchaseforeignassetsinlower-taxjurisdictions.Atthesametime,endingdeferralwouldmakeitmoreattractiveforforeignfirmstoacquiretheforeignassetsofU.S.companies.TotheextentthattheforeignactivitiesofU.S.MNCscomplementtheirdomesticactivities,deferralincreasesjobs,productionandinvestmentathomeandlimitingoreliminatingdeferralwouldreducethecompetitivenessofU.S.companies,woulddecreasejobs,productionandinvestmentintheUS,andwouldreducecorporatetaxrevenuesovertime.
viii. Option 4: Retain the Current System but Lower the Corporate Tax Rate
The proposal and its advantages: ThisoptionwouldlowerthecorporaterateasinOption2,butwithinthecurrenttaxsystem,whichtaxestheactiveforeignearningsofU.S.MNCsonlyuponrepatriation.TheefficiencybenefitsofalowercorporatetaxrateforallU.S.corporationsregardlessofwheretheyearntheirincomearedis-cussedintheearliersectionofthisreportoncorporatetaxation.Atthesametime,deferralwouldoffsetmuchofthedisadvantageU.S.firmsfacewhenoperatinginlow-taxcountries.Becauseofthelowercorporaterate,thedifferenceintaxratesbetweenincomeearneddomesticallyversusincomeearnedabroadwouldbereduced,reducingtheincentivesfortransferpricingandexpenselocationandthedisincentivetorepatriateforeignearnings.
Disadvantages:Thisoptionwouldreducerevenuesbyloweringtherateandwouldretainthetaxexpenditureofdeferral(atalowercost),butwouldnotprovidemanyofthesimplificationandefficiencybenefitsofOption2.Boththecomplexityofthecurrentsystemandtheincentivestolocateprofitsabroadanddeferrepatriationfortaxavoidancewouldberetained.
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VI. ACKNOWLEDGMENTSAllofusonthePresident’sEconomicRecoveryAdvisoryBoardwouldliketoexpressourutmostgratitudetotheBoard’sTaxReformSubcommitteeandstafffortheirtirelesseffortsinproducingthisreport.Inresearching,revising,coordinating,andorganizinginputfromhundredsofpeoplearoundthecountry,theyappliedtheiradmirablediligenceandpublic-spiritednesstothisformida-bletask,andthisreportisareflectionoftheirdedication.ThemembersofthesubcommitteewerePaulVolcker,WilliamDonaldson,MartinFeldstein,RogerFerguson,andLauraD’AndreaTyson.
Wewanttothankthestaffthathelpedassistintheworkofthereport:AustanGoolsbee,theStaffDirectorandChiefEconomistofthePERAB;EmanuelPleitez,theDesignatedFederalOfficer;andespeciallyAdamLooney,senioreconomistatCEAandthePERAB,withoutwhosehardworkanddiligencethisreportwouldneverhavebeenpossible.Adam’sknowledgeofthecomplexitiesofthetaxcodewasindispensable,andheoversawalargemountainofworkontheproject.Weowehimaspecialdebtofgratitude.WewouldalsoliketothankPERABstaffers:EmilyAngulo,LauraBlum,RonnieChatterji,TonyDowd,WendyEdelberg,ArielGold,JoshuaGoldman,MaxHarris,BrittanyHeyd,AdamHitchcock,MerylHolt,ArikLevinson,AndrewMetrick,ReneMoreno,JohnOxtoby,JesseRothstein,PaulSmith,IrinaVarela,CatherineVargas,andJacquelineYenfortheirworkontheproject.
WearealsoindebtedtothesupportoftheDepartmentoftheTreasury,theInternalRevenueSer-vice,theDepartmentofCommerce,theCouncilofEconomicAdvisers,theFederalReserveSys-tem,andtheNationalEconomicCouncil.Themenandwomenstaffingtheseagenciesgracefullyloanedustheirdecadesofexpertisethroughouttheprocess.
Mostofall,wewouldliketothankthepublic.Thosewhotestifiedinperson,spoketousonthephone,submittedtheir ideas inwriting,andthosewhoparticipatedinourpublicmeetingson-line—eachcontributedinanimportantway.Intheend,wereceivedhundredsandhundredsofideasandsuggestionsandtorecognizetheircontributions,wehavelistedallthedirectcontributorsintheappendixtothereport.
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VII. APPENDIXThePresident’sEconomicRecoveryAdvisoryBoard(PERAB)metwithorganizationsandrequest-edpubliccommentsforideasontaxreform.Uponsubmission,suchcommentsbecamepartofthepublicrecordandsubjecttopublicdisclosure.Wemakenorepresentationregardingthena-tureofthecommentsastheywereself-reportedbythepublic.Thepublishingofthislistdoesnotconstituteendorsement,recommendation,orfavoringbythePERAB.Thestateslistedforcertainindividualswerederivedfromtheareacodesofthephonenumbersthattheyprovided.
Last First Organization
Abraham Terri Individual from Georgia
Abramson Steve Individual from New York
Ackerman Deena U.S. Department of the Treasury
Ackman Sheldon Fair Tax Organization
Aitken David Individual from Colorado
Al-Bakri Abdel Ilah None provided
Alfera Donald AlfsDogs
Almand Charles Georgians for Fair Tax
Altshuler Rosanne Urban-Brookings Tax Policy Center
Anderson Dave Honeywell
Anderson Melva Individual from Missouri
Annee Carl Individual from Georgia
Arias John Individual from New York
Arnett Charles Individual from Georgia
Arnold Steve Individual from Georgia
Arnold Stephen M. Tax Payer, Citizen, and a FAIRTAX supporter
Arslan Kristie National Association for the Self-Employed
Ashbaugh Margaret Individual from Missouri
Asnip Andrew Individual from Georgia
Atkinson Larry Individual from Georgia
Auerbach Alan UC Berkeley
Augustine Alexander Individual from Pennsylvania
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Last First Organization
Auten Gerald U.S. Department of the Treasury
Avi-Yonah Reuven S. University of Michigan Law School
Baehr Ted Individual from Louisiana
Bain Stuart None provided
Baker Teal Podesta Group
Baker Mary U.S. Senate Finance Committee
Baldassari Gene Baldassari for Assembly 2009
Ballard Mark Individual from Illinois
Bankman Joe Stanford University
Barba Chris Individual from Colorado
Barker, Professor William Penn State Law School
Barnes Scott Individual from Florida
Barrett William C. Applied Materials
Bean Elise U.S. Senator Carl Levin
Beard Bill None provided
Beaumont Simon IBM
Bedford Daniel Individual from Virginia
Bedingham Ann Individual from Arizona
Beharelle Lisa Individual from Georgia
Behler Jr. George F. None
Belson Goluboff Nicole Individual from New York
Bennett Jim Americans for Fair Taxation
Beran Robin Caterpillar
Betz Joseph Individual from Pennsylvania
Biddison Bonnie None provided
Binder Michael None provided
Bindner Michael Individual from Virginia
Bisson Joe Individual from Georgia
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Last First Organization
Black Rachel Bread for the World
Blakley III David W. Individual from Missouri
Blanchard Kimberly S. Weil, Gotshal & Manges LLP
Bontrager Jason Blinn College
Borom Andrew Individual from Florida
Bostick George U.S. Department of the Treasury
Bouma Herman B. Buchanan Ingersoll & Rooney PC
Boyd Janet Dow
Bradshaw Stephen None provided
Brady Woods Elizabeth Individual from California
Brannon Craig Individual from Georgia
Brock Bob Individual from New Mexico
Brothers Jeremy Individual from Ohio
Brown Fred B. University of Baltimore School of Law
Brown Becky The Information Factory
Brown Tom Retired scientist
Brown Jason Individual from Arizona
Brown Ketron Individual from Florida
Brown Gerald Individual from Georgia
Brown Jim Individual from Georgia
Bruce Paul None provided
Buel Estelle Individual from Texas
Burchill John FairTax.org
Burger Frank Jos. Individual from New York
Burnley Kristin Individual from Georgia
Burns Kevin Individual from Georgia
Burns William A. Individual from South Carolina
Burritt Dave Caterpillar
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Last First Organization
Buttonow Jim New River Innovation, Inc.
Calianno Joseph M. Georgetown Law School
Callihan Jesse W. Individual from Georgia
Campbell Speedy Bonnie AARP Tax-Aide
Cannoles, CPA/PFS Gordon Individual from Texas
Cardaropoli, Jr Anthony J. Individual from California
Carrigg Daniel University of Rhode Island
Castro Juan A. Individual from Florida
Caswell Steven Individual from Georgia
Chambers Lisa Individual from Georgia
Chetty Raj UC Berkeley
Chew Thomson None provided
Chwee Monica None provided
Clay Alex Individual from California
Clemens Jeff Harvard University
Coleman Dorothy National Association of Manufacturers
Colgan Daniel R. Individual from Minnesota
Colon Elizabeth None provided
Comeaux Kim Alliance Realty Team
Cooper Michael U.S. Department of the Treasury
Coratolo Giovanni U.S. Chamber of Commerce
Coussoule John Individual from Florida
Crago Chris Winston & Cashatt
Crain Jack L. Individual from Louisiana
Crandall Ted Rockwell Automation
Crider Oakey Individual from Indiana
Croft Charles R. Individual from Georgia
Cullinan Ronald Individual from Texas
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Last First Organization
Cummings, Jr. Jasper L. Alston & Bird
Curtin Ashley None provided
Curtiss Alison Individual from Florida
Dahl Sr. Jeffrey T. Individual from Arizona
Dale Emily Macon Organizing for America
D’Arrigo Emanuele Individual from the UK
David Ryan M. Individual from Texas
David Forte Sydney Citizen of the Corporate States of America
Davidson Charles Taxpayer Advocacy Panel
Dawson Shirley Individual from Missouri
de Grandis G. Individual from Pennsylvania
Debes Harry None provided
Deck Christopher Self Employed Accountant/Governmental Auditor
Desai Mihir Harvard Business School
DeTate Jack Individual from California
Devlin Peter Individual from Mississippi
Dey Dan Individual from Missouri
Dickel Ronald Alcoa
Dicker Eli J. Tax Executives Institute
Dilworth Robert McDermott Will & Emery LLP
DiStefano Theresa Individual from Georgia
Distefano Anthony Fairtax supporter
Dodd Randall AARP MEMBER
Dolezal Uva B. Individual from Georgia
Dosmann Todd Individual from Florida
Driggers Jacqueline Individual from Kentucky
Dukes Rita Individual from Colorado
Duperon Theresa Individual from California
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Last First Organization
Dwyer Terence Individual from Minnesota
Early Sheila Individual from Georgia
Earnest Diane Individual from Georgia
Earnest Patrick Individual from Illinois
Edwards Chris Cato Institute
Edwards Shannon None provided
Eichner Jesse M. JMEArtists.com
Eldridge Matthew Individual from Vermont
Elias Les Individual from Kansas
Elkins Stephen American Chemistry Council
Ellis George Individual from Florida
Engle Kyley Individual from Washington
Engler John National Association of Manufacturers
Engwall Randy Individual from Georgia
Ettlinger Michael Center for American Progress
Evangelist Michael Center for Economic Progress
Fabii Reno Individual from Florida
Fairbanks Steve None
Fath Meredith Tax Analysts
Faust Ed None provided
Fearon Rick Eaton
Feenberg Dan NBER
Feeney Michael Marks Building Systems
Femia Rocco V. Miller & Chevalier
Feraios Thomas Individual from Pennsylvania
Fige David Individual from Georgia
Finch Mike Individual from Virginia
Finis Carla J. Individual from Idaho
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Last First Organization
Finkelstein Amy MIT
Finnell Stephen C. Individual from Georgia
Fisher Carey Individual from Georgia
Flach Robert D. Taxpro Services Corporation
Ford Fred fwf inc
Fox Rockey Individual from Georgia
Frank Jeremie None provided
Freeman Art None provided
Friesen Corey Individual from Oregon
Froelich Daniel Individual from Pennsylvania
Fry Carol Individual from Georgia
Fulton Kathryn H&R Block
Furman Jason NEC
Gailey Scott Individual from California
Gale Bill Brookings
Galvin Walt Emerson
Garcia James Individual from New Mexico
Garmon Andrea Individual from New Jersey
Gaspard Michael Individual from California
Gastler Shirley Individual from Missouri
Gavalis Albert Individual from NY
Geeting Jonathan Individual from Pennsylvania
Gellasch Tyler U.S. Senator Carl Levin
Gerardi Geraldine U.S. Department of the Treasury
Germann Christine Individual from New Jersey
Gibson L. None provided
Gilbert Karl Individual from Maryland
Gilbert Frank Individual from Ohio
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Last First Organization
Godwin Robert Century Homes
Goluboff Nicole Individual from New York
Gordon Roger UC San Diego
Gordon Jane None
Goulder Robert Tax Analysts
Graham John F. Ansett
Grantham Doug Individual from Georgia
Grantham Douglas None provided
Granwell Alan W. DLA Piper
Gray Victor E. Individual from Nevada
Greco Cal Individual from Pennsylvania
Green Bradley Individual from California
Green Jason Individual from Georgia
Greenstein Robert Center on Budget and Policy Priorities
Greer Lisa Individual from Georgia
Gropper Adam Baker Hostetler
Gross Drew Individual from North Carolina
Grubert Harry U.S. Department of the Treasury
Grumet Louis New York State Society of Certified Public Accountants
Guerard Teresa Individual from Florida
Gustafson Susan Princess House, Inc
Gwyn Brigitte Business Roundtable
Hadstate James Individual from South Carolina
Hahn BruceAmerican Homeowners Grassroots Alliance/American Homeowners Foundation
Hakim Joseph B. Individual from Iowa
Halber Barry Individual from Florida
Hamden Robert Individual from Florida
Hammett Eugene None provided
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Last First Organization
Hamor Kathy The Savings Coalition of America
Harper Jonathan Individual from South Carolina
Hasset Kevin AEI
Hatano Daryl Semiconductor Industry Association
Hausner Tony Individual from Maryland
Hay Christopher Individual from South Carolina
Hayes Gregory United Technologies
Haynes James Individual from Ohio
Hazelwood Dennis The Gates Corp.
Heil Mary Individual from Michigan
Heller Ken National Small Business Association
Herzig, Professor David Valparaiso University School of Law
Heter Thomas Individual from Kansas
Hightower Mark A. Mark A. Hightower, CPA, P.C.
Hines Jr. James R. University of Michigan Law School
Hodges James Individual from Kansas
Holbrook Anthony Georgians for Fair Taxation
Holland Rebecca Individual from Georgia
Holzer HarryGeorgetown Center on Poverty, Inequality and Public Policy
Hooper Jeff None provided
Hoover Brandy Leigh Individual from West Virginia
Horvath David Individual from Michigan
Hoxby Caroline Stanford University
Hu Wendy Individual from Florida
Hu Jon Individual from Florida
Hubbard Frankie Individual from Georgia
Huckle Mike None provided
Huddleston Joe Multistate Tax Commission
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Last First Organization
Huffman Sam Individual from Oregon
Hughes Davis U.S. Senate Finance Committee
Hughes Greg Individual from Georgia
Hume John None provided
Hunt James Individual from Georgia
Hunt, Jr. Marshall Accounting Aid Society
Irons John Economic Policy Institute
Iwan David Small business owner
Iwry Mark U.S. Department of the Treasury
Jacobowitz Gerald N. Jacobowitz and Gubits, LLP
Jaeger Mike Individual from California
James Jonathan Individual from Tennessee
Jens Dean Individual from Illinois
Johnson Calvin H. Texas Law School and Shelf Project
Johnson Pamela Individual from Georgia
Jones Teresa None provided
Jones Robert Individual from Georgia
Jones Robert A. Individual from Georgia
Jones Trevor Individual from Utah
Jones Billie ACORN
Kaplan David Individual from Massachusetts
Kappler Jim Community Metrics, LLC
Karas Matthew Individual from Connecticut
Karl Ed AICPA
Karobonik Sheri Individual from Arizona
Kayal David Nicholas Individual from California
Kebschull William David Individual from Maryland
Keefer Jeff DuPont
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Last First Organization
Keeling J. Michael The ESOP Association
Kelley Paul FairTax
Kellner Richard Individual from New York
Kelly Barry Individual from Missouri
Kelly Kevin Individual from Virginia
Kesselman, Professor Jonathan R.Simon Fraser University, Graduate Public Policy Program, Vancouver, BC, Canada
Kieffer Mike Individual from Utah
Kilgallen Kim Individual from Georgia
King Larry Individual from Georgia
Kinyon Richard S. Morrison & Foerster LLP
Kitchen John U.S. Department of the Treasury
Kleinbard Edward USC Gould School of Law
Klepinger David None provided
Klopping Randall None provided
Knakmuhs Sarah Altria
Knittel Mathew U.S. Department of the Treasury
Koch Cathleen U.S. Senate Finance Committee
Korth Christopher M. Western Michigan University
Koschik Julie Individual from Ohio
Koutoulas Pete Individual from Kentucky
Krueger Alan U.S. Department of the Treasury
Kukreja Michael None provided
Kupfer Jeff President’s Advisory Panel on Federal Tax Reform
Laforme Bill Individual from Massachusetts
Laing David Individual from Maine
Lane Shirley Individual from Georgia
Lang Helen Individual from Florida
Lanton Ron H. D. Smith
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Last First Organization
Lara David Office of Governor David Paterson
Larson Paul None provided
Lau Gibian Karen Investment Company Institute
Lee Marie TechAmerica
LeMaster, Executive Director
Roger The Tax Council
Lenard Thomas M. Technology Policy Institute
Lenney Cheryl Individual from Georgia
Lenzi Tony Individual from Virginia
Lerman Allen U.S. Department of the Treasury
Levitsky Brion Individual from California
Lewis Claudia Individual from Ohio
Libin Jerome B. Sutherland Asbill & Brennan LLP
Lifson, CPA David A. NY State Society of Certified Public Accountants
Linbeck, Jr. Leo E. Americans For Fair Taxation
Livingston Peg Individual from Oklahoma
Lobel Martin Lobel Novins & Lamont, LLP
Loberger Patrick None provided
Locke Jeffrey Individual from Kansas
Lockwood David Strategy Management, Inc.
Lokpez Midiala Individual from Florida
Looker, CPA Michael Individual from New York
Looney Steve Tax Attorney
Lowrey Lee Individual from Georgia
Lykken Matt SharedEconomicGrowth.org
Lyon Andrew PwC
M David None provided
Macker Brian Individual from New York
Manieri Marc AFFT
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Manners Jahmaal Individual from Maryland
Mansell Bev None provided
Marr Charles Center on Budget and Policy Priorities
Martin Riley D. Individual from Georgia
Martin Robert Individual from Wisconsin
Massie Roy None provided
Matthews, JD/CPA Robert (Chip) Sam Houston State University
Maxwell Gary Individual from California
Maydew Ed UNC Kenan-Flagler Business School
Maynes Bruce Individual from Georgia
Mazur Mark U.S. Department of the Treasury
McAdory Henry Individual from Georgia
McCarthy Jim Procter & Gamble
McConnell Bill Individual from Tennessee
McCrady Howard Individual from Arizona
McDonald Rob Emerson
McDonald Timothy Procter & Gamble
McGinnis Richard PwC
McGuire Monica R&D Credit Coalition
McIntyre Robert S. Citizens for Tax Justice
McKay Bernard Intuit
McLane Charles Alcoa
McMillion John None provided
Meier Ron Individual from Nebraska
Melancon Barry AICPA
Menke Roger Individual from Missouri
Merrill Peter PwC
Merszei Geoffrey Dow
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Meyrow Sarah National Retail Federation
Michaelson Robert Individual from New
Miller Matthew M. Financial Executives International
Mioli Dean Individual from Pennsylvania
Miran Steve Harvard University
Moeller Jon Procter & Gamble
Mole Alan Individual from Colorado
Molnar Anna Individual from Illinois
Mongiello Stormy The Inn of the Patriots Bed and Breakfast
Montague Rachael Individual from California
Montgomery James Individual from Georgia
Moore Theresa M. None provided
Moore Allen Individual from Illinois
Mullis Sharon Individual from Georgia
Mundaca Michael U.S. Department of the Treasury
Mundy Kimbo Individual from New Mexico
Murray Fred F. Georgetown Law School
Nader Bertte greensceneshop.com
Najour Larry Azar Electric, Inc.
Najour Judy Individual from Georgia
Nellen Annette San José State University
Nelson Susan U.S. Department of the Treasury
Nelson Suzanne Individual from Georgia
Netzley Matthew Individual from Indiana
Neubig Thomas Ernst & Young
Newman Thomas None provided
Newman Dan Individual from Colorado
Ninovski Stanimir None provided
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Nissen Matt None provided
Nobles Jerry Individual from Mississippi
Nowland Anne Individual from Massachusetts
Nowland Ian Individual from Massachusetts
Noyes Paul M. Individual from Georgia
O’Brien Jim Fair Tax
Oh-Willeke Andrew Individual from Colorado
Olander David U.S. House Ways & Means Committee
Olson Jim Individual from Georgia
O’Melia John M. None provided
Orme Vickie Individual from Georgia
Orszag Peter OMB
Ozanne Larry Congressional Budget Office
Parr Curtis Individual from Oklahoma
Patterson Stephen None provided
Peacock Philip J. ExaTech Solutions, Inc.
Perez Ruth IRS
Perez-Fox Prescott Starship Design LLC
Perrone Anthony Individual from Florida
Peters Jeremy Individual from Michigan
Pettingill Eric Mental Wellness Center
Petzold Charles Individual from New York
Pfost Bodie Individual from California
Phillipine Louis Individual from New Jersey
Phillips Richard INFRADANT LLC
Phillips John Phillips & Cohen LLP
Pinkerton Lorilyne None provided
Place Bob Individual from Georgia
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Plattner Robert None provided
Ponder Kendall Individual from Missouri
Poot Hu None provided
Poterba Jim MIT
Prater Mark U.S. Senate Finance Committee
Putz Nancy Individual from Illinois
Quinn Ronald Individual from Florida
Radlo Lee Individual from Massachusetts
Rakes Richard Individual from Colorado
Rauls Venecia Individual from Oregon
Ravitch Richard Office of Governor David Paterson
Ray Suzanne Individual from Georgia
Recob Joseph Individual from Missouri
Regalia Martin U.S. Chamber of Commerce
Reister William L. None provided
Reister Bill Individual from Georgia
Rice Derica Eli Lilly
Richards Shan Individual from California
Rish Paul Individual from Georgia
Roach Robert U.S. Senator Carl Levin
Robb Jeremy Individual from Utah
Roberson Graham Individual from North Carolina
Roberts Bill AICPA
Rodriguez Edward Individual from California
Roesser Tom Microsoft
Rosenbloom H. David Caplin & Drysdale
Ross Jeanne U.S. Department of the Treasury
Ross Samuel Individual from New Jersey
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Ross Chip None provided
Rossotti Charles Carlyle Group
Rough John E. None provided
Roxx Kimillion Robertson Properties
Rutherford Ken Individual from Georgia
Rutledge Jacob Individual from Georgia
Rys William National Federation of Independent Business
Sama Rob Individual from Massachusetts
Sammartino Frank Congressional Budget Office
Samuel Randall Individual from Ohio
Samuels John GE
Samwick Andrew Dartmouth College
Satagaj John Small Business Legislative Council
Savage Jeffrey Individual from Missouri
Sawyer James Praxair
Sayler Joy Individual from Nevada
Schenk Deborah H. NYU Law School
Scheppers John Individual from Missouri
Schiavo Pete Individual from California
Schifferl Donald Individual from Indiana
Schilling Juli Computer & Communications Industry Association
Schmid Heinrich O.E. Individual from Austria
Schoewe Thomas Walmart
Sears Brayden Individual from Kentucky
Seden Michael Individual from Georgia
Sedlak Sophie Individual from Georgia
Sepp Pete Taxpayers Union
Seto Theodore Loyola Law School Los Angeles
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Shahi Hurshbir None provided
Shannon Guy None provided
Sharaf Eldin Aref Ahmed BUSINESS
Shaviro Daniel N. NYU Law School
Shay Stephen U.S. Department of the Treasury
Shear Anissa M. Andyrsco & Associates, Inc.
Sherman Jillian L. Virginia College Savings Plan
Shimandle Adie Fair Tax
Shlaes Amity NYU Stern School of Business
Shulin J. None
Shulman Doug IRS
Shultz Ronald Individual from Pennsylvania
Shumans Diane Individual from Georgia
Sica Bob Individual from Georgia
Silverman Mark Steptoe & Johnson LLP
Singer Paula N. Vacovec, Mayotte & Singer, LLP
Skipton F. Individual from Oregon
Slater Kim Individual from Georgia
Slemrod Joel University of Michigan
Slot Bryan G. Individual from Illinois
Smith Frederick W. FedEx Corporation
Smith Tiffany U.S. Senate Finance Committee
Smith Robert Individual from Florida
Smith Joshua Individual from Florida
Smith Darrel E. Individual from Indiana
Smith, Jr. F. Houston Individual from North Carolina
Sparkman Don Individual from Georgia
Spradley Chip Individual from Georgia
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Spradling Gregory B. Individual from Tennessee
Starkman, CPA Jay Jay Starkman, PC
Stauffer John None provided
Stegner Bill Individual from Georgia
Stephens Terrell Individual from North Carolina
Steuerle C. Eugene Peter G. Peterson Foundation
Stresing Matthew None provided
Stretch Clinton Deloitte Tax LLP
Strickland Brent Yale University
Strier Robert Individual from Florida
Suez Emmanuel UC Berkeley
Sulcer Tom Individual from New Jersey
Summers Larry NEC
Sutter Matthew Individual from Georgia
Szrejter Timothy Individual from Georgia
Taiwo Olufemi Indiana University
Talbert Michael A. IRS - retired
Talisman Jonathan Capital Tax Partners
Taney Eric Individual from Texas
Taperman Rolnick Thala National Small Business Network
Tauro Richard Individual from Ohio
Taylor Rusty San Juan Financial
Taylor Dillon SBA Office of Advocacy
Taylor Richard Individual from Georgia
Taylor Jim Individual from Georgia
Taylor Sharon Individual from Pennsylvania
Thaxton James Individual from Georgia
Thomas Dawn Individual from Texas
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Thomas Donald Individual Taxpayer Advocacy Panel Member
Thompson Todd Individual from Florida
Threadgill Jeremy Eco Concepts of Mississippi/AMMO
Throckmorton Charles D. Voting US Citizen
Thuronyi Victor Individual from Maryland
Tiedemann John @homecomputers
Tilton Sandy 9-12 Project
Toder Eric Urban Institute
Townsend Jr. Alvin Individual from Georgia
Treml Rudy Individual from Florida
Trimble Ray Individual from Georgia
Tuck Lee None provided
Tuszynski Tyler Individual from Florida
Vallee Jean None provided
Vande Guchte John None provided
Vaughn Latricia Individual from Missouri
Vazquez Alex None provided
Viard Alan AEI
Vincent Joshua Center for the Study of Economics
Vodanovich Adam Individual from Louisiana
Vogelman Mike AB Courier
Walker Robert None provided
Waller Alex Individual from Georgia
Walser David None provided
Walter Robert Individual from Georgia
Walter Carolyn Fair Tax Grassroots
Warlick Mike and Marian Americans for Fair Taxation
Warlick, Sr. Michael D. Americans for Fair Taxation/Georgians for Fair Taxation
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Warren Mark Retail Industry Leaders Association
Washington Dianne Individual from New York
Waters Jack Individual from Pennsylvania
Weaver Debra Internal Revenue Service
Weinburg Mark Individual from Massachusetts
Weiner Joann M. George Washington University
Wells Kenneth Individual from Alaska
Wells Steve Individual from Georgia
Welsh Walter ACLI, AALU, GAMA, NAILBA, and NAIFA
West Jade The LIFO Coalition
West Philip Steptoe & Johnson LLP
Westover-Kernan Tiffany Corporate Voices for Working Families
Whalen Richard None provided
Whitehead Lois NY State Society of Certified Public Accountants
Whitson Herb Individual from Georgia
Wilkerson Matt None provided
Wilkerson Matt Americans for Fair Taxation
Williams Michael North American Equipment Dealers Association
Williams Lyn AFFT
Wilson John Meredith College
Wilson Leslie Wilson & Associates Architects, Inc.
Wilson Logan Individual from Arizona
Wilson Charles Individual from Ohio
Witt David Individual from Ohio
Wolf Maurice A. Individual from California
Wrick Nancy Individual from Pennsylvania
Wright Arthur W. University of Connecticut
Wright Sam None provided
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Wyden Ron U.S. Senator Ron Wyden
Yin George K. University of Virginia School of Law
Young Mary Ann Fair Tax
Zagaris Bruce Berliner, Corcoran & Rowe, LLP
Zieburtz Wiliam None provided
Zobel Kenneth Individual from New York
Zolt Eric M. UCLA
Beckham None provided
Burrton Individual from Georgia
Chris Individual from Georgia
Colin Individual from Missouri
Ed Individual from Pennsylvania
Edward Individual from France
Froggy Individual from Colorado
Glenn LU 803
Greg Illinois State University Graduate Student
Harry None provided
Indigent Salvation Army
J None provided
Jess None provided
Jill Individual from Utah
Jim Individual from Georgia
John None provided
Joy Individual from Arizona
Kalanda Individual from Florida
Karen Fair Tax
Kristina Individual from Florida
Nancy None provided
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Peter Self-Employed
Peter Self-Employed
Tasha Individual from Michigan
Ted Individual from Florida
National Tax Association
IRS Research Conference
NBER Tax Policy and the Economy Conference