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Wednesday, November 11, 2009

Tax Reform Reruns - What Will Change This Time?

On December 4, 2009, President Obama's tax reform group is to issue its report. It is not intended to include recommendations for major reform, but to address simplification, the tax gap and corporate "loopholes." Yet, it could easily be a starting point for larger scale reforms. Last year the Senate Finance Committee held hearings in anticipation of reform and Congressman Rangel introduced H.R. 3970 in the 110th Congress calling for significant changes to the tax law. The Tax Council Policy Institute in DC is holding its February 2010 program on Tax Reform: In Search of a 21st Century U.S. Tax System (nice title!)

I came across a 1996 report I wrote for the Tax Foundation on many aspects of tax reform (this was back when Congressmen Archer and many others were last seriously considering major federal tax reform) - here. Despite the age, the explanations and issues explained in the report are all mostly still relevant today. For example, here is an excerpt on some issues to be addressed in the tax reform process.

"What are the goals of tax reform? Various goals have been offered for why major federal tax reform should occur. Not all goals are achieved under all proposals . In addition, some of the goals, such as simplification, are achievable by "tinkering" with our current tax system . In order for effective reform to occur, Congress (and the public) should carefully identify the goals to be attained so that an appropriate and worthwhile debate can follow .

Should/can taxes be reformed without spending reforms? Current discussion focuses on government revenues and how they should be assessed . But, what is the goal from the spending side? The present income tax system includes hundreds of indirect government "subsidies" in the form of special tax rules designed to encourage certain activities, such as the research tax credit and charitable deduction . These tax preferences are also referred to as tax expenditures . If the government believes that these indirect expenditures or subsidies are worthwhile, will they be converted from indirect subsidies to direct subsidies under a new tax system or otherwise incorporated into the new system? For example, if the research tax credit is removed, will the value of that indirect subsidy be converted into direct government subsidies? If the child care credit is eliminated, will the current level of this subsidy be continued in another form, such as government funded child care centers?

Employment tax reform. Can or should federal income tax reform realistically occur without reform of employment taxes. For example, if federal income taxes are reformed first and later employment taxes are reformed by raisin g the tax rate for social security and Medicare taxes, would public outcry follow?

Simplification. Will the new system by simpler than the present system? Perhaps some complexities, such as international issues and those involving innovative financing cannot easily be removed . Another complexity that could arise is where a system requires non-cash employee benefits to be valued . For example, the Hall-Rabushka flat tax book notes that an employee would be required to include the market value of stock options received from the employer, when received, and whether or not exercised . The valuation of stock options when received is difficult and has already been a major issue with respect to financial accounting rules. Are the touted simplifications of the proposal legitimate? For example, a single tax rate does not necessarily make a tax system simple because taxpayers use tax tables and computers. Also, removal of the mortgage interest deduction is not simplification because little recordkeeping is involved . (However, removal of the deduction does remove federal income taxes from the home-buying decision.)

Efficiency. Does the reform proposal remove distortions from the current tax system that tend to affect decisions to work, invest, or spend? For example, the current tax system may affect investment decisions due to the difference between capital gains and ordinary income tax rates . Also, does the tax proposal remove distortions caused by differences in tax rates (such as where a corporation in a 35% tax bracket borrows from an individual in a lower tax bracket), preferences for different types of income (such as fringe benefits), and the double taxation of corporate income which can affect business entity decisions ?

Change in tax burden. If the proposal is intended to raise the same amount of revenue as under our current tax system, will the distribution among income groups be the same? If not, who will pay more and who will pay less ? (Who will the winners and losers be?) How easy will it be to make this determination when the tax base has changed and the distribution of the burden between individuals and businesses may have changed? For example , flat tax proponents stress that investment is taxed at the source (business level) rather than also at the individual level. However, will the incidence of that tax at the business level be shouldered by the investors/owners, or won't some also be shouldered by employees? How can this be determined? Where will the incidence of the new tax fall as between a businesses' owner and employee or individuals? Where will it appear to fall? For example, under a subtraction VAT where only businesses file tax returns, the tax would appear to fall on the businesses' owners and employees . Where does the burdens of corporate taxes fall under our current tax system? If the incidence of the tax changes, what will be the affect ? Will the incidence of the new tax fall among different types of industries similarly to our current system? If not , who will the winners and losers be? For example, some industries tend to have little debt (such as high tech) and might therefore be "winners" under a tax system where interest expense is not deductible .

Global competitiveness. How would the new system affect the ability of businesses to compete globally?"

What do you think? What is the biggest obstacle to reforming our federal system which clearly has issues of complexity, a large tax gap, hinders global competitiveness for US firms, etc.?