Restructuring the tax system.

I am pleased to be with you today to discuss a subject that is near and dear to my heart: restructuring the tax system. My views on the need for restructuring grow out of a somewhat unique set of experiences. I have practiced tax law for 20 years, and I have served as both Commissioner of Internal Revenue and Assistant Attorney General in charge of the Tax Division in the U.S. Department of Justice. I have thus participated in the tax system on the inside and the outside. My work on the outside has included planning transactions and handling tax controversies and litigation. On the inside, I served as the nation's chief tax "enforcer" and then its chief tax "administrator." In short, I have just about "seen it all" when it comes to the workings of the tax system. This experience has led me to the conclusion that we should repeal the Internal Revenue Code and start over.

Some of you may have seen a recent article in Fortune magazine entitled "Our Screwed-Up Tax Code." The article began with the following statement:

The U.S. tax system is an unwieldy, inefficient, ungodly mess--and this summer's shenanigans in Washington have just made it worse. It penalizes the very investment we need to create jobs and improve living standards. It makes U.S. companies less competitive internationally and encourages them to expand overseas instead of at home.

That statement capsulizes the problem. What can we do about it? My view is that we cannot "fix" it with more tinkering at the margin. I believe that the only solution is to repeal the Internal Revenue Code and start over.

The call for reform is not new. In the mid-1970s, Secretary of the Treasury William Simon called for fundamental reform. He said: "It is time to start over from scratch and develop a new tax system in the United States. It must be a system that is designed on purpose, based on a clear and consistent set of principles, which everyone in the United States can understand." Secretary Simon commissioned a major study of the tax system, which resulted in a report entitled Blueprints for Basic Tax Reform. Blueprints stands today as perhaps the seminal work on tax reform.

Almost 20 years after Blueprints was published, Secretary Nicholas Brady issued a similar call for fundamental reform. In December 1992, the Department of Treasury issued "Restructuring the U.S. Tax System for the 21st Century: An Option for Fundamental Reform." And, now, several Democratic and Republican Senators and Congressman are working together in a bi-partisan effort to reform the tax system. Before turning to a discussion of alternative systems, I want to give you some historical perspective on the subject.

Historical Perspective

The Sixteenth Amendment to the Constitution was ratified on February 25, 1913, and the federal income tax became effective on March 1, 1913. Thus, 80 years have passed since the income tax was first enacted. As originally enacted, the income tax applied to a relatively small portion of the population and the normal rate was one percent. The maximum rate was seven percent on income over $500,000.

Beginning in the 1940s, the number of individuals subject to tax increased dramatically. In 1941, only 45 percent of the population was subject to the income tax. By 1944, that number had increased to 80 percent, and wage withholding had been implemented.

In the 50 years since World War II, the income tax has become a "mass" tax, and the Code has been riddled with deductions, exemptions, exclusions, and credits. The system is no longer, strictly speaking, an "income" tax. The current system contains elements of both a consumption base and a comprehensive income base. One problem with the current system is that we have been unable to define "income" in a consistent manner. Moreover, the current system does not tax all income alike and that failure raises concerns about equity, efficiency, and simplicity.

During the first half of this century, Congress made periodic changes to the law, but, by and large, the Code "hung together" in a way that was logical and reasonably comprehensible. Today, changes in the tax law are driven by political considerations and revenue constraints. Wise tax policy has virtually nothing to do with it. The result is a Code that does not reflect a consistent philosophy and that is so complex that the vast majority of taxpayers find it incomprehensible.

There have been many attempts at tax reform over the past 25 years, but none of those efforts has attempted to restructure the entire Code. Rather, the so-called reforms have only added to the jumble of complexity. The Tax Reform Act of 1969 was popularly referred to as the "Lawyers and Accountants Relief Act," and that Act was followed by a series of reforms in the '70s and '80s that only added layers of additional complexity to the Code.

In my view, we have reached the point where further "patchwork" will only compound the problem. The time has come to assess the continued viability of the current system and to consider a complete restructuring of the Internal Revenue Code. I want to emphasize that my call for repeal of the Internal Revenue Code is not a flippant remark. And I am not alone in my belief that we have nearly reached the end of the road.

Dean Erwin Griswold, the former Solicitor General and Dean of the Harvard Law School, made the following statement during a recent lecture to the American College of Tax Counsel. Dean Griswold said:

...[O]ur present tax system, which worked very well during the first third of this century, and struggled along during the second third of the century, has now come to the place where it is simply monstrous. We would never accept it if it had not just crept up on us, if the tax lawyers had not done their ingeniously intricate job. Something has to be done about it. It will be very hard to do.

Why Change?

There are at least four reasons for change:

* to reduce complexity,

* to reduce burden on taxpayers,

* to eliminate disincentives for savings, and

* to enhance our competitive position in a global economy.

Reduce Complexity and Burden

The current level of complexity undermines compliance. Many people believe that "others" (such as the "rich" and foreign corporations) do not pay their "fair share of tax." They attribute this perceived inequity to the complexity of the system that permits "loopholes" for those who can afford to pay lawyers and accountants to advise them. And complexity drives some taxpayers out of the system altogether. In 1990, 10 million people in this country--although required by law to do so--did not file tax returns. 34 percent of the non-filers--about three-and-one-half million people--were entitled to refunds. Many of those non-filers fell out of the system because they simply could not cope with its complexity. Even the simplest tax forms are not simple. Would you believe that the instruction booklet for the 1040 EZ is 14 pages of fine print?

Complexity breeds disrespect for the law and for those agencies of government charged with its interpretation and administration. It encourages tax protesters who argue that they did not understand their obligations and therefore are not guilty of criminal conduct when they evade taxes. (Needless to say, I have no sympathy for those who intentionally violate the law.)

Complexity also imposes an undue burden on our citizens and on businesses, who must divert scarce resources from productive activity to tax compliance efforts. The overall cost of tax compliance has been estimated to reach into the hundreds of billion dollars annually. Surely those resources could be put to more productive use as this nation seeks to improve its competitive position in a global economy.

The burden imposed by the tax system falls on large and small alike. Indeed, some of the most obscene complexity in the Code can be found in the Earned Income Credit, which, ironically, was intended to help the working poor.

The Need to Encourage Savings

Our current tax law discourages savings. Individuals are taxed on their earnings, and they are taxed again on income from savings. Corporate profits are taxed twice: once at the corporate level and again at the shareholder level. Capital gains, including gain from inflation, is taxed, and the tax law still favors debt over equity.

The tax system thus bears some responsibility for the current low rate of savings in the United States. The Center for Strategic and International Studies recently issued a thoughtful report entitled "The CSIS Strengthening of America Commission." That Report stresses the need to encourage savings and notes that the U.S. net national savings rate is at an all-time low. It fell from an average of 9.8 percent of gross domestic product (GDP) in the 1960s to an average of 3.6 percent in the 1980s. In contrast, Japan and the EC countries save at a rate of well over 10 percent of their GDPs.

As the study points out, a low level of savings results in reduced economic growth, low productivity growth, and fewer jobs. We need to design a tax system that will--at a minimum--not discourage savings.

Competing in a Global Economy

There has been a profound change in the world in the eight decades since the income tax was enacted. Technology has made the world a smaller place. Investments and currency move at lightning speed across borders and eventually come to rest where the investment will be safe and will earn the highest return.

As I said in a recent speech at the Japanese Fair Trade Center in Tokyo, "In some respects, tax policy is trade policy. When a tax system imposes undue burdens on in* vestment, that investment will seek a more congenial climate. Unfortunately, this economic principle is not always understood by the officials who enact the tax laws."

If we are to compete effectively in a global economy, we must reduce the tax burden on investment, and we must reform the law governing multinational business activity. As Fortune magazine so aptly put it, "[A] prime source of perversity in the tax code is its treatment of the foreign income of U.S. multinationals."

Alternatives for Reform

With that background, I will turn to the various alternatives for a new system. I want to emphasize that I do not favor "adding on" new taxes. Rather, I urge the total revision of the current system. Several blueprints for reform already exist. Those blueprints have been designed by both Democrats and Republicans, and they offer a variety of options.

One alternative would be to repeal the current income tax and replace it with a vastly simplified income tax or cash-flow tax. Another alternative would substitute a value-added tax for the current income tax. In order to address concerns about regressivity, the value-added tax could be accompanied by a simplified income tax that would be imposed only upon persons having incomes in excess of, say, $50,000. Another option would replace only the existing corporate tax with some form of value-added or business transfer tax.

Before discussing the various alternatives, I want to focus on the desired characteristics of any replacement tax. They are, as follows:

* The tax should be simple.

* It should be easily understood and should be administrable.

* It should be fair.

* It should minimize opportunities for tax avoidance.

* It should not discourage savings.

* It should be neutral with respect to the economic allocation of resources.

* It should enhance the country's competitive position in a global economy.

I will begin my discussion of alternative tax systems with the 1992 Treasury Option.

The 1992 Treasury Option

In a speech before the Columbia University School of Business in December 1992, Secretary of the Treasury, Nicholas Brady, unveiled an option for fundamental reform of the tax system. Calling for restructuring of the system, Secretary Brady said, "[r]ather than rearranging the deck chairs on a sinking ship, the keel of our tax system should be raised and completely overhauled."

The 1992 Treasury Option would have significantly reduced reliance on income tax revenues by enacting a border-adjusted business transfer tax. The Treasury Option would provide a substantial increase in the individual income tax standard deduction. Indeed, the deduction would be so large that 50 percent of all individual taxpayers would no longer be subject to the income tax.

This approach would have the enormous advantage of reducing burden on individuals having relatively modest incomes. Some would question, however, the wisdom of the tax system in which half the population does not participate directly.

The 1992 Treasury Option would integrate the corporate and individual tax systems. Corporate income would be taxed only once--at the corporate level. Shareholders would exclude dividends paid out of income that had been previously taxed to the corporation, and distributions of other income would be treated as a return of capital. There would be no capital gain tax on reinvested retained earnings, but a step-up in basis of corporate stock would be provided to reflect retained savings.

The alternative minimum tax (AMT) adds immensely to the complexity and burden of the current system. It basically operates as a parallel tax system that imposes special rules for determining income and limiting deductions. The 1992 Treasury Option would repeal the corporate AMT and would remove business preferences from the individual AMT.

The 1992 Treasury Option recommends reform of the international tax rules, and it identified three options. One option is an exemption system that does not tax active foreign-source income. Another option would adopt a regime of current taxation of foreign-source income.

The centerpiece of the 1992 Treasury White Paper is a new business transfer tax (BTT). The BTT base would be all domestic sales by businesses, less purchases from other businesses. Unlike the existing income tax, the BTT would be border adjustable. The BTT would thus be imposed on imports and rebated on exports. Under the Treasury Option, small businesses would not be required to be in the BTT system and a refundable credit would be provided to low-income families.

The Treasury Option thus addresses concerns about regressivity by eliminating the income tax and providing a refundable tax credit for low and middle income families.

Treasury concluded that a BTT would increase savings rates and reduce the percentage of national income going to current consumption but, over the long term, the absolute level of consumption spending would increase as a result of increased economic growth.

Value-Added Tax

Another option for reform--and one that we surely will hear more about in the coming years--is the value-added tax (VAT). Most of the industrialized nations--except the United States--have some form of value-added tax. The VAT has not received strong political support in the United States.

The VAT has proved so controversial that it is difficult to get agreement even on definition of what it is. For purposes of this discussion, we will simply say that a VAT is a form of consumption tax that is levied on the "value added" at each stage of the production process. "Value added" is generally defined as sales minus purchases.

The tax can be calculated under either the "subtraction method" or the "credit-invoice" method. Under the credit-invoice method, the taxpayer calculates its liability by applying the tax rate to each individual sale and subtracting all taxes previously paid on purchases. Stated another way, under the credit-invoice method, a business pays value-added tax on all its purchases, charges value-added tax on all its sales, subtracts the amount paid from the amount collected and remits that balance to the government.

Under the subtraction-method VAT, the taxpayer calculates its liability by adding all its sales and then subtracting all its purchases and multiplying the balance by the tax rate. Profit is not a prerequisite to tax liability.

Most countries have chosen the credit-invoice method VAT. Japan is the only industrialized country that has adopted a different system. Japan chose the subtraction-method VAT. Japan, however, is reportedly considering changing to a European-style VAT.

Tax Executives Institute has produced a fine publication on value-added taxes that describes the various forms of VATs and identifies the arguments for and against a VAT. I do not have time here today to take you through all the variations on the theme of a VAT. The arguments for and against, however, are pretty much the same, no matter what type of VAT is under consideration.

The proponents of a VAT argue that:

* The VAT is an economically neutral tax and therefore will improve economic efficiency. The VAT does not favor corporations, partnerships or any other form of business entity. It makes no differentiation between equity and debt financing. It does not discriminate between labor and capital intensive businesses or between new and old capital.

* A VAT would improve our competitive performance in a global economy.

* A VAT would improve our savings rate and would encourage capital formation.

* A VAT could be applied to an extremely broad base.

* A VAT would be simpler to administer than the current income tax system.

The opponents of a VAT argue that:

* A VAT is extremely regressive.

* It is an invisible tax that Congress can increase without political repercussions and, therefore, will be economically harmful. It is a "money machine" that will bankrupt the country as Congress goes on a spending spree.

* It will impair state and local government revenues.

* It is costly to administer and enforce.

It is likely that we will hear a lot more about a VAT before the decade is out. Representative Sam Gibbons, who is the second-ranking Democrat on the Ways and Means Committee and who has long been a proponent of a VAT, has prepared a proposal that will serve to open the debate on a VAT. In a nutshell, the Gibbons proposal would replace the current income tax system with a subtraction-method VAT. Congressman Gibbons favors the subtraction-method, because it is simpler, and most businesses could use their existing bookkeeping systems.

The Gibbons VAT proposal is based on the "destination principle." Under the destination principle, a good or service is taxed where it is consumed rather than where it is produced. Thus, a VAT is imposed upon imports and rebated on exports. The "destination principle" is a key element of the argument that a VAT would improve U.S. competitiveness abroad. Although economists disagree on the impact of a VAT on U.S. competitiveness abroad, there is widespread feeling among taxpayers that the current tax system penalizes U.S. companies doing business abroad.

One of the major criticisms of a VAT is that it is regressive. Concerns about regressivity, however, could be addressed in a number of ways. A VAT could be combined with a progressive income tax on the very wealthy. Moreover, the estate tax is the final great leveler. Further, to the extent that necessities, such as food, were not exempted from the VAT, the problem may be better addressed by direct subsidies to those in need.

Ideally, a VAT should be applied at a uniform rate to as broad a base as possible. Unfortunately, the political reality is that any proposal for a VAT will invite pressures for exemptions and multiple rates. Exemptions create administrative and enforcement problems and would greatly reduce the efficiency of the tax. The simplest approach would be to apply one rate to all goods and services. As a practical matter, that is probably not politically feasible. My biggest concern about a VAT is that it would be placed on top of the current system. That is the most undesirable result in my view.

Consumed Income Tax

I am going to turn now from the VAT to other alternatives for reform. I will start with a consumption-based cash-flow tax. The principal difference between an income and a consumption-based tax is that the consumption tax excludes savings from the tax base. In a consumptionbased system, net savings are subtracted from gross receipts to produce the tax base while withdrawals from savings are included in the tax base.

The objective of a consumption-based tax system is to increase saving by taxing it once rather than twice. Proponents of a consumption-based tax argue that: "More saving means more funds available to finance investment. More investment means a larger and faster growing capital stock and therefore faster economic growth. Faster economic growth means a bigger economic pie to slice."(1)

Most commentators conclude that replacement of the current hybrid income tax with a consumed income tax would simplify the law. A consumed-income or cash-flow tax would avoid some of the difficult problems of measurement that arise under an income tax system. Depreciation rules, inflation adjustments, and allocation of undistributed corporate income all become irrelevant because all forms of saving are removed from the tax base.

For example, there would be no need for the capital cost recovery provisions, because all plant and equipment purchases would be expensed. Moreover, the distinction between currently deductible business expenses and capital expenditures would become irrelevant.

Most of the realization issues that exist under current law would be eliminated, because the event that triggers tax is consumption rather than realization. Basis and the indexation of basis would be irrelevant, as there would be no computation of gain or loss. Rather, under a cash-flow or consumed income tax system, we would measure the amount of cash that the taxpayer received. Since corporate earnings are a form of savings, they would not be taxed until they were distributed to and consumed by shareholders.

Notwithstanding these perceived advantages, there remains significant resistance to a consumption-based tax. Opponents urge that such a tax would be inequitable, since low-income taxpayers spend a larger share of their income than high-income taxpayers. (The equity argument, however, could be addressed through direct payments to low-income taxpayers.)

Opponents also argue that a cash-flow or consumed income tax would present formidable transition problems. One difficult question is the proper treatment of assets or savings that were acquired under the existing system and are then consumed under the new system. The transition problems, however, are not insurmountable. Blueprints for Basic Tax Reform contains proposals for "grandfathering" existing assets and phasing in new rules.

If you are still awake, you are probably saying to yourself, "This is all a fine theoretical discussion, but what relationship does it bear to the real world?" Good question. Fortunately, there are a number of Senators and Congressmen who have begun to consider serious tax reform. Senators Nunn and Domenici are preparing to introduce in Congress a proposal for an alternative tax system that would be a form of consumption-based cash-flow or consumed income tax. They announced the broad outlines of their proposal on October 5. They call it a "Savings Exempt Income Tax" (SEIT).

Senators Danforth and Boren are also working on a proposal for restructuring, which they say, would "dovetail" with the Nunn/Domenici proposal. The Danforth/Boren proposal would replace the corporate income tax with a consumption-based tax. Moreover, former Senators Paul Tsongas and Warren Rudman, who serve as co-chairs of The Concord Coalition, have endorsed restructuring the tax system. They recently released their "Zero Deficit Plan" in which they say:

The purpose behind restructuring the tax system is not to raise more revenue; rather, it is to raise revenue in a way that replaces the perverse incentives in today's tax code with a system that rewards savings and investment in America. The goal would be to have people in all income groups save more of their income over time.

The Nunn/Domenici Proposal

The Nunn/Domenici proposal would continue separate taxes on businesses and individuals but under a vastly simplified system. Imagine if you can a world without the current corporate income tax. Imagine in its place a simple low rate tax that would apply to corporations and all other businesses. The flat rate tax (they estimate a flat rate of 10 percent) would be imposed on the gross profit of the business. The Business Tax would apply to all forms of business: corporations, proprietorships, and partnerships--large and small.

Gross profit would be defined as gross receipts from sales minus amounts paid to other businesses for equipment, inventory, services, and the like. Investment in plant, equipment, and inventory would thus be deducted in the year in which the expenditure is made. There would be no deduction for dividends, interest or wages. The Business Tax would use only a cash method of accounting.

Businesses would receive a credit equal to the 7.65percent payroll tax set aside for Social Security. As you know, under present law, there is a 7.65-percent employer payroll tax on wages and salaries paid to employees. This is the FICA tax that goes into the Social Security Trust Fund. The Nunn/Domenici proposal would give businesses a credit for this employer payroll tax. This credit would offset a large portion of a business's gross profit tax under the Nunn/Domenici proposal.

One enormous potential benefit of the business gross profits tax would be simplification of the foreign provisions. Exports would not be taxed, and the foreign sales of U.S. companies would not be subject to U.S. tax.

In short, the tax would not apply to the foreign operations of a U.S. business. Receipts from strictly foreign operations would not be includible in the U.S. businesses' gross profit, and there would be no deduction for foreign costs. The Nunn/Domenici proposal would also impose an import tax. A tax equal to the Business Tax Rate (currently projected at 10 percent) would be imposed on goods and services produced outside the United States but sold in the United States.

Moving to the tax on individuals--again, the current income tax would be replaced with a simple tax that allowed a deduction for personal savings but eliminated most other deductions. Gross income would consist of wages, salary, and other forms of compensation plus financial income actually received--such as dividends, interest, rent, proceeds from the sale of property, and the like. Business income, which will be taxed under the business gross profits tax, would not be included in personal income unless it were actually received.

The key element of the Nunn/Domenici proposal is the full deduction for net savings. Purchases of savings assets and savings account deposits would be fully deductible. Withdrawals from savings that were not reinvested in savings assets would be includible in income. In short, the Nunn/Domenici proposal would provide an unlimited IRA. There would be no limit, however, on the amount of savings that would be deductible and savings could be used for any purpose--not just retirement. Also, withdrawals could be made at any time. But withdrawals would be added to the tax base. Assets purchased with borrowed funds would not give rise to a deduction.

A substantial personal exemption, say $15,000, would be provided. The tax would be imposed at a progressive rate up to about 40 percent. The rates would be set high enough to replace the revenues currently obtained from the individual income tax and the employee share of the payroll tax. As with the Business Tax, the individual income tax would provide a credit for the employee share of the payroll tax. The payroll tax would still be levied and deposited in the trust fund.

Although the Nunn/Domenici proposal has much to commend it, it will be a miracle if it makes its way through Congress in anything like its current form. Congress is unlikely to resist the temptation to do a little "social engineering" or to include provisions that favor one class of investments or expenditures over another. The treatment of charitable contributions, the cost of home ownership, medical expenses, state and local taxes, and tax-exempt bonds will generate much debate. And every exception will add complexity.

While theoreticians can debate the proper treatment of charitable contributions under a consumed-income tax system, the political reality is that any tax system is likely to retain preferential treatment for charity. Indeed, the Nunn/Domenici proposal would retain the deduction for contributions to charity. Retention of a charitable deduction will add complexity, because all of the rules relating to deductible contributions and qualified tax exempt organizations will continue to be necessary.

Another thorny question involves the treatment of gifts and bequests under a consumed-income tax system. Is a gift or bequest "consumption" by the donor and, therefore, taxable to the donor? Or should a gift or bequest be deductible by the donor and includible in the donee's tax base? In any event, it seems likely that a transfer tax system, such as the current estate and gift tax, will remain in place. Conclusion

The time has come to consider alternatives to our present tax system. In today's political climate, it is questionable whether a coherent, principled proposal for a new system could survive the political process. For that reason, I recommend that the President appoint a bi-partisan commission-and charge that Commission with responsibility for designing a new tax system having the characteristics that I outlined earlier. That is likely the only way to achieve fundamental, sensible, and principled reform.

1 John H. Makin, Income Tax Reform and the Consumption Tax, The Consumption Tax (1987).