IRS

Tax Reform: What Can We Expect?

Shirley Dennis-Escoffier

President Bush recently declaredthat a major overhaul of the taxcode was a top priority of hissecond term, along with SocialSecurity reform. He stated thathe wants to make the tax systemsimpler, fairer, and more con-ducive to economic growth. Sothe U.S. Internal Revenue Codecould soon be facing its firstcomplete revision since 1986,when President Reagan reducedtax rates and broadened the taxbase by closing loopholes.

Complexity in the currenttax code results from incentivesin the form of targeted deduc-tions, credits, and exemptions.The way to make it simpler is toeliminate some or all of them.But many of these tax breakswere put into the law to make itfairer. So simplifying ourincome tax system could meanthat taxpayers who benefit fromthese incentives would payhigher taxes. In PresidentBush’s first term, there wereonly winners and no real losers,because the cost of these cutswas just added to the deficit.But this time, the President hasstated that any reform planshould be revenue-neutral,meaning the overall changeswould neither increase nor

decrease the amount of tax rev-enue generated.

President Bush has beenvague about what he has in mindbeyond naming a commission tostudy fundamental changes inour federal tax system. So thespecifics of tax reform probablywill not emerge for severalmonths. Many conservativeshave been anxiously anticipatingradical tax reform that wouldeliminate the Internal RevenueService and replace our incometax system with a national retailsales tax or other consumptiontax, while other moderatesinstead advocate a gradual movetoward a flat-rate system byreducing the rates while elimi-nating many deductions.

During the debate, it will behelpful to have a basic under-standing of the different types oftax systems that are bound to beconsidered so that you can antic-ipate what effect they could haveon you and your business.

WHICH FORM OF TAXREFORM?

Many economists prefer atax system that encouragesgreater savings and investment,which is why you will be hear-

ing much about changing froman income tax to a consumptiontax system. A consumption taxis ultimately levied on con-sumers when they purchasegoods or services. Consumptionis the purchase of goods that areused currently, while savings isthe purchase of goods that areheld for investment purposes orare capital in nature. Examplesof purchases that would be clas-sified as savings include stocks,bonds, pension plans, and realestate. In addition, the incomeon these items is also not taxedunless it is used for consump-tion. So if an individual pur-chases an investment and con-tinues to reinvest the incomeand proceeds from the sale, thetaxpayer will never pay tax onthe purchase.

A consumption tax systemshifts the tax burden away frominvestors onto consumers. Thosehit the hardest would be con-sumers with a high consumptionratio relative to their income. Forexample, an elderly taxpayerwho saves early in life and thenconsumes more than she earns inher retirement years would beconsidered to have a high con-sumption ratio. Low- and mid-dle-income taxpayers who con-

De

p a r t me

nts

89© 2005 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20109

sume almost all they earn alsohave high consumption ratios.Wealthy taxpayers who consumemuch less than they currentlyearn have low consumptionratios. A switch from an incometax system to a consumption taxsystem would mean that taxpay-ers with high consumption ratios(such as the elderly) would beara heavier tax burden than thosewith lower consumption ratios(the wealthy). This is why oppo-nents of a consumption tax arguethat it is regressive and places amuch heavier burden on the el-derly, low-income taxpayers, andlarge families that have a highconsumption ratio.

Retail Sales Tax

A retail sales tax is the typeof consumption tax Americansare most familiar with and hasalready been proposed as areplacement for all current fed-eral income taxes (both individ-ual and corporate) as well aspayroll taxes. Although mostAmericans generally prefer asales tax to an income tax, thatview could change when theysee the details of the plan. Mostcurrent state sales taxes applyonly to the purchase of goods,while services are exempt. Abroad-based retail sales taxwould have to tax services (suchas accounting, consulting, legal,and medical services) as well asgoods. The Fair Tax Act of 2003introduced by RepresentativeJohn Linder would require anational sales tax rate of approx-imately 30 percent (and thatwould be in addition to any stateand local sales tax) to raise thesame amount of revenue current-ly raised by all federal incometaxes and payroll taxes. Manysales tax systems exempt suchitems as food and medical ser-vices to minimize the regressive

impact they have on taxpayerswith high consumption ratios.Economists predict that addingsuch exemptions to a nationalretail sales tax system wouldrequire a rate that is significantlyhigher than 30 percent.

With such a high rate, therewould be a huge incentive fortax evasion. The collection of anational retail sales tax wouldfall on retailers and, thus, dispro-portionately on small businesses.Small businesses traditionallyhave a high incidence of tax eva-sion, so the principal concernswith a sales tax system are thatsmall retailers would not reportall their sales and business own-ers would purchase items forpersonal use through their busi-ness to avoid paying the tax.Administration would be moredifficult than the current incometax system because it is difficultto cross-check records of retail-ers against consumer records.These are some of the reasonswhy most other countries with aconsumption tax use a value-added tax (VAT) instead of asales tax.

Value-Added Tax

Value added is the differ-ence between the value of abusiness’s sales and its purchas-es from other businesses. A VATis a tax on business that is col-lected as goods move throughdifferent stages of production.There are two principal types ofvalue-added taxes: the credit-invoice method and the subtrac-tion method.

Almost every other industri-alized country uses a credit-invoice version of a VAT becauseit allows for cross-checking. Acredit-invoice VAT wouldimpose new compliance costs onbusinesses by requiring them tokeep detailed records of each

sale and purchase. This record-keeping improves compliancethrough cross-checking of taxespaid by sellers with creditsclaimed by buyers. It also elimi-nates the need for retailers todistinguish sales to businessesfrom sales to consumers.

An alternative to the credit-invoice method is known as thesubtraction method VAT. Individ-uals and businesses would file atax return each year determiningthe amount of expenditures thatyear and paying the appropriatetax. The subtraction method isconsidered to be simpler than thecredit-invoice method because itcould be implemented usingexisting books without the newrecordkeeping that would berequired under the credit-invoicemethod. A subtraction methodVAT can use a progressive ratesystem or one flat-tax rate.

Several different flat-tax ver-sions have already been pro-posed, with most of them impos-ing the tax on all businesses, notjust corporations. Many of thesehave two items in common: theentire cost of a new plant andequipment can be deducted infull in the first year and overseassubsidiaries of U.S. businesseswould be exempt from tax.Under one version, the businesstax base would be businessreceipts reduced by wages andpurchases from other businesses.The advantages of this systemwould be offset by the loss ofdeductions for interest paymentsand fringe benefits. Underanother version, the deductionfor wages would be replacedwith a payroll tax credit equal to7.65 percent of most wages, andall exports would be exemptfrom tax, but an import dutywould be imposed on imports.

Under the individual flattax, wages and pension distri-butions would be subject to tax,

90 The Journal of Corporate Accounting & Finance

© 2005 Wiley Periodicals, Inc.

while interest income, dividendincome, and capital gainswould be exempt. Many conser-vatives argue that any flat-taxsystem should eliminate all taxdeductions—except for possiblyallowing a standard deduc-tion—to get the rate as low aspossible. But some politiciansargue that it would not be polit-ically possible to eliminate alldeductions. One previously pro-posed version of this tax systemwould keep the deduction forcharitable contributions and forhome mortgage interest, whileadding a new deduction forincome that is saved. But thisversion would require a muchhigher tax rate than the versionwith no special deductions.

Critics fear that efforts tomove from an income to a con-sumption tax system will onlyshift taxes from the wealthy tothe middle and lower classes,making life much better forthose who live off investmentswhile increasing the burden onwage earners. To address thisconcern, Michael Graetz, a Yalelaw professor, recently proposeda combination of a VAT with anincome tax, stating that all otherindustrial nations have both aconsumption tax and an incometax system in place at the sametime. Graetz estimates thatenacting a 14 percent VAT(which is a little less than theaverage European rate) on thesale of goods and services col-lected at all stages of productionwould raise enough to eliminatefederal income taxes for anyfamily making less than$100,000. Under his plan, fami-lies making more than $100,000would still have to pay incometax at a 25 percent flat rate onincome over $100,000 afterallowing for deductions for char-itable contributions, home mort-gage interest, medical expenses,

and state and local taxes. Graetzwould also reduce the corporatetax rate to 25 percent. This sys-tem would preserve income taxincentives for employers to pro-vide health insurance and pen-sions to their employees.

Tax reform has strong sup-port in both the House of Repre-sentatives and the Senate, butthere is no agreement on theform it should take. Tom DeLay,the House Majority Leader, isamong those who want to repealthe federal income tax andreplace it with a national salestax. In the last session, hecosponsored Representative Lin-der’s bill that would have abol-ished income and payroll taxesin favor of a sales tax. SenateFinance Committee ChairmanCharles Grassley, however,favors a flat-rate income tax andopposes a national retail salestax. He believes that the salestax should be left to state andlocal governments, many ofwhich use it as their major rev-enue source.

BUSH’S PRIORITIES

President Bush has said thatwhile he is in favor of taxreform, his priority in the sec-ond term is to make the tax cutspassed during his first term per-manent. Under current law, thegeneral tax-rate cuts and theelimination of the estate taxexpire at the end of 2010. Thelower tax rates on dividends andcapital gains expire at the endof 2008. The $100,000 (indexedfor inflation to $105,000 for2005) Section 179 expensingfor small business expires at theend of 2007.

There are some serious con-flicts among these proposals.Simplifying our current tax sys-tem seems at odds with the goalof making Bush’s first-term tax

cuts and new deductions perma-nent. If these tax breaks aremade permanent, it will be farmore difficult to implement anational sales tax or other radi-cal reform proposal. Immediate-ly after the election, PresidentBush said that he was for taxreform but that he favored pro-tecting “certain incentives,” suchas deductions for mortgageinterest and charitable contribu-tions. This would suggest he isthinking in terms of individualsstill filing some tax returnsrather than a switch to a nationalretail sales tax.

Gradual Modification ofCurrent System

One way to make the switchto a consumption-based tax sys-tem is to retain the traditionalincome tax structure but contin-ue the expansion toward a sys-tem that favors investment andsavings so that eventually onlyspending (consumption) istaxed. An income tax systemcan be converted into a con-sumption-based system withoutadopting a radical changethrough three methods:

1. Allowing full or very largedeductions for capitalinvestments,

2. Excluding or imposing a sig-nificantly lower tax rate oninvestment income, and

3. Allowing a significantdeferral of taxation so thatthe tax rate on investorsapproaches zero.

When one examines the tax lawspassed by President Bush in hisfirst term, we can see that wehave already made many ofthese changes.

An example of the firstmethod is the Section 179expensing for investment in

March/April 2005 91

© 2005 Wiley Periodicals, Inc.

business equipment. The 2002and 2003 tax acts were relative-ly generous in terms of depreci-ation by increasing the Section179 expensing from $25,000 toover $100,000 and introducingfirst-year bonus depreciation.This is clearly moving to a con-sumption-based tax system inwhich capital equipment is, ineffect, expensed (not treated asconsumption). Although bonusdepreciation was essentiallyallowed to expire at the end of2004, the higher Section 179expensing has been extendedthrough at least 2007. Anexpansion of this or related pro-visions that allow businesses toclaim larger initial deductionsfor investments in plants andequipment could move us moretoward a consumption-basedtax system.

Another way to approximatea consumption-based tax systemis with a system that taxes earn-ings from an investment at zeroor close to zero. For many years,the U.S. income tax system hasfavored capital gains overincome from wages and evenover other sources of investmentincome. In 2003, the maximumtax rate on dividends and capitalgains was cut to 15 percent andthe tax rate was reduced to only5 percent for taxpayers in the 10percent or 15 percent marginaltax bracket. In 2008, the ratewill be zero for individuals in

the 10 percent or 15 percentmarginal tax bracket. In 2003,President Bush stated that hewanted to completely eliminatethe double tax on corporateprofits, so he may decide topush for a rate reduction to zerofor all taxpayers.

A third way to move to aconsumption-based system is byallowing a significant deferral oftaxation so that the tax rate oninvestors approaches zero.Retirement plans currently allowfor a significant deferral of taxa-tion. The employer receives acurrent tax deduction for thecontribution while the employeedefers income until withdrawn atretirement. Last year, PresidentBush proposed two new savingsvehicles called lifetime savingsaccounts (LSAs) and retirementsavings accounts (RSAs). Bothof those would be similar to aRoth IRA in that no deductionwould be allowed up front, withearnings and distributions tax-free. LSAs would allow taxpay-ers to contribute $7,500 a yearper person and withdraw thefunds tax-free at any time for anyreason. RSAs would also allowtaxpayers to contribute up to$7,500 a year per person;investors would be able to startwithdrawing funds at age 58.Those accounts would be avail-able to all taxpayers, with noincome limitations. These pro-posals will continue moving us

toward a consumption-based sys-tem, so it appears that the admin-istration can achieve many of itsgoals through modification of theexisting income tax system.

TIMING

One indication of whetherthere likely will be real reformis how long President Bush’s taxreform commission takes torelease its report. There is awindow of opportunity over thenext year or so during which acommission-backed reform rec-ommendation could receive realconsideration. But if the reportis not released until 18 monthsor more into Bush’s secondterm, it may be too late. Bythen, lawmakers will beginfocusing on the 2006 midtermelections and the next presiden-tial campaign. Congress may bereluctant to rescind tax breaks ithas granted to campaign con-tributors, especially as electionsnear. The special-interest lobby-ists that thrive on the currentsystem cannot be expected toquietly watch while their loop-holes are eliminated. Thus, thelonger it takes before the com-mission’s report is released, thegreater the likelihood that theresult of this tax-reform effortwill not be major overhaul, butrather incremental steps thattake us toward a single-rate con-sumption-based tax system.

92 The Journal of Corporate Accounting & Finance

© 2005 Wiley Periodicals, Inc.

Shirley Dennis-Escoffier, PhD, CPA, is an associate professor of accounting at the University of Miami atCoral Gables, Florida. She is past president of the American Taxation Association and has published numer-ous articles in tax journals.