Proposals for comprehensive tax reform.

Amid the turmoil of political upheaval in the current Congress, there is an increasing interest in proposals for radical reform of our tax system. Lawmakers in Washington are responding to criticisms of the current tax system with rhetoric and action that may eventually lead to a complete overhaul of the income tax structure. There are compelling arguments which suggest that taxing consumption rather than income would simplify our tax system, increase national savings, improve economic efficiency and enhance long-term economic growth. In fact, every proposal drawing attention on Capitol Hill would effectively shift, in varying degrees, the tax burden from income to consumption. If this move toward radical tax reform is real - as many believe it is - taxpayers should begin to look at what reform could mean for their bottom line. At a minimum, tax planners should be able to evaluate how these reform proposals would affect their clients.

The Unlimited Savings

Allowance tax system

The most developed of the proposals for comprehensive reform is the Unlimited Savings Allowance (USA) tax system (S. 722), introduced April 25 by Senate Budget Committee Chairman Pete Domenici and Sen. Sam Nunn. The USA tax has two integrated parts, the USA Income Tax and the business tax. The USA Income Tax base would be all wage and salary income (including employer-provided health and pension benefits currently excluded from taxable income), and rent and royalty income. The key feature of the USA Income Tax is the unlimited savings allowance that would let a taxpayer deduct the entire amount of net new savings (portfolio shifting is not allowed). In addition to the exclusion for net new savings, there would be a generous family, living allowance" - an exemption allowed on top of the current personal and dependent exemptions. Graduated rates would then apply to taxable income. Individual taxpayers would also be able to claim a 7.65% credit to offset the employee portion of payroll tax.

The USA business tax, although often described as an income tax, is a "subtraction method" value-added tax, and it allows immediate expensing of all capital investments. Generally, the business tax base would be the difference between total sales of goods and services in the U.S. and total business-related purchases, including but not limited to purchases of plant, equipment, inventory, rent, and legal and accounting fees. Interest and dividend receipts would not be taxable, but no deduction would be allowed for interest and dividend payments. Unlike current law, wages paid and indirect compensation would not be deductible, but employers would be allowed a 7.65% credit to offset the employer portion of payroll tax, which would soften the impact of the lost wage deduction. The USA business tax disallows the deduction for wages in order to make the tax GATT-legal and therefore border-adjustable for all exported goods.

The Armey-Shelby flat tax

The House Republican majority leader, Rep. Dick Armey, and Sen. Richard Shelby, will reintroduce later this year a proposal for a flat tax that would significantly broaden the individual and corporate tax bases and apply a single, lower rate to both. Generally, individuals' wages, salaries and pensions would be taxed at a flat 17% rate, with no deductions. (Sen. Arlen Specter has proposed a similar flat tax with a 20% rate, but he allows a deduction for home mortgage interest and charitable contributions.) Generous personal exemptions would be provided: $12,350 for a single person, $24,700 for a married couple filing jointly, and $5,000 for each dependent. Interest and dividend earnings would not be taxable, and there would be no credit offsetting payroll taxes.

Under the Armey-shelby business tax, businesses would pay a flat 17% rate on the amount by which gross revenue exceeds the total purchases of goods and services, capital equipment, buildings and land, plus employee wages. Corporate, partnership, professional, farm and rental earnings would be subject to the business tax. There would be no deductions for noncash fringe benefits, interest paid or dividend payments to owners and no credit to offset payroll tax. Because wages are deductible, the Armey-Shelby business tax is not likely to be GATT-legal and taxes not border-adjustable.

Transition issues

The proposals on the table appear to be simple and fair at first glance, but it is clear that "the devil is in the details," especially when looking at transition issues. For example, how would existing personal savings that had already been taxed be treated under the USA Income Tax? How would unrecovered costs of capital assets be treated under the USA and Armey-Shelby business taxes? In general, how would a new system treat taxpayers fairly while preventing some of them from "gaming" the system that would lead to large revenue shortfalls in the early transition years?

For now, only the USA tax system (because it is the most developed of the reform proposals) addresses some - but not all - of the transition issues it creates. It establishes rules for the tax treatment of accumulated savings for individuals and unrecovered basis in capital assets for businesses. Yet the USA Tax as developed so far would have no transition rules for many important existing tax attributes, such as net operating loss and loss carryovers, general business credit carryovers, foreign tax credit carryovers or prior year minimum tax carryovers. Clearly, the loss of these carryovers could pose significant problems to a number of businesses, making transition issues an important point to watch.

Beyond understanding the immediate effect these reform proposals would have on a taxpayer's annual tax bill, it is also important to evaluate how these reforms would affect the economy in which the taxpayer operates. In theory, if comprehensive tax reform achieves the goal of improving our national savings rate, it would follow that capital would be easier and cheaper to access, investment in technology to increase productivity would grow and the economy generally would be better off. But what about the short-term impact of shifting the tax burden toward consumption instead of income? It would make sense that if consumers have an incentive to save, they would also have a relative disincentive to spend. It could be assumed that consumption, especially in certain sectors of the economy (e.g., retail sales), would drop in the short term. It is possible, however, that this short-term drop in consumption is just that - a short-term drop - and well worth the long-term benefit of an increased national savings rate leading to higher levels of consumption. One thing is certain: with radical reform a real possibility in the coming years, it is in the interest of all taxpayers to consider sooner rather than later the impact of structural tax reform on their specific circumstances, individual and business.

From Darcy Bentley, Washington, D.C.