[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]
THE IMPACT ON INDIVIDUALS AND FAMILIES OF REPLACING THE FEDERAL INCOME
TAX
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
__________
APRIL 15, 1997
__________
Serial 105-15
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
47-448 CC WASHINGTON : 1998
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
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C O N T E N T S
__________
Page
Advisory of April 8, 1997, announcing the hearing................ 2
WITNESSES
______
Armey, Hon. Richard, K., a Representative in Congress from the
State of Texas................................................. 6
Family Research Council, Martin J. Dannenfelser, Jr.............. 46
Hubbard, R. Glenn, Columbia University........................... 31
Mitchell, Daniel J., Heritage Foundation......................... 43
National Center for Policy Analysis, Barry Asmus................. 37
Steuerle, C. Eugene, Urban Institute............................. 21
Tax Analysts, Martin A. Sullivan................................. 41
SUBMISSIONS FOR THE RECORD
Center for the Study of Economics, Columbia, MD, Steven Cord,
statement...................................................... 65
Ramstad, Hon. Jim, a Representative in Congress from the State of
Minnesota, statement........................................... 5
Schaefer, Hon. Dan, a Representative in Congress from the State
of Colorado, statement......................................... 66
Tauzin, Hon. W.J. ``Billy,'' a Representative in Congress from
the State of Louisiana, statement.............................. 67
THE IMPACT ON INDIVIDUALS AND FAMILIES OF REPLACING THE FEDERAL INCOME
TAX
----------
TUESDAY, APRIL 15, 1997
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:08 a.m., in
room 1100, Longworth House Office Building, Hon. Bill Archer
(Chairman of the Committee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
FOR IMMEDIATE RELEASE CONTACT: (202) 225-1721
April 8, 1997
No. FC-6
Archer Announces Hearing on the Impact
on Individuals and Families
of Replacing the Federal Income Tax
Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
and Means, today announced that the Committee will hold a hearing on
the impact on individuals and families on replacing the Federal Income
Tax. The hearing will take place on Tuesday, April 15, 1997, in the
main Committee hearing room, 1100 Longworth House Office Building,
beginning at 10:00 a.m.
Oral testimony at this hearing will be from invited witnesses only.
However, any individual or organization not scheduled for an oral
appearance may submit a written statement for consideration by the
Committee and for inclusion in the printed record of the hearing.
BACKGROUND:
In the 104th Congress, the Committee held five days of hearings on
problems caused by the current Federal income tax system and proposals
to replace the Federal income tax. The Committee then began to examine
how the proposed replacement systems would affect specific segments of
society and the economy, holding hearings on the impact of replacing
the income tax on small businesses, State and local governments, tax-
exempt entities, international competitiveness, domestic manufacturing,
energy and natural resources.
In announcing the next hearing, Chairman Archer stated: Two years
ago, this Committee began a careful examination of how we could
replace--in its entirety--our current income tax system. Now the
Committee picks up on where it left off last year. Following this
hearing, the Committee will continue to examine the impact of proposed
alternatives, including the effects on employee benefits and retirement
and personal savings incentives; home ownership and real estate
generally; agriculture; retail sales; financial services; service
industries; and health care.'' Dates for hearings on these topics will
be announced in future advisories.
FOCUS OF THE HEARING:
The focus of this hearing will be on the impact on individuals and
families of replacing the Federal income tax with one or more of the
proposed alternative tax systems. The basic alternatives are an income
tax (with one or more rates); a flat tax (such as the one introduced by
House Majority Leader Dick Armey); a national sales tax (such as the
one introduced by Reps. Schaefer and Tauzin); a value added tax (both
invoice-credit and subtraction methods); and an income tax system with
an unlimited savings deduction (such as the USA tax system introduced
by Senator Domenici and former Senator Nunn). The witnesses should
assume that any new tax system would replace, on a deficit-neutral
basis, the individual income tax, the corporate income tax, and estate
and gift taxes.
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ASCII format, with their address and date of hearing noted, by the
close of business, Tuesday, April 29, 1997, to A.L. Singleton, Chief of
Staff, Committee on Ways and Means, U.S. House of Representatives, 1102
Longworth House Office Building, Washington, D.C. 20515. If those
filing written statements wish to have their statements distributed to
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Chairman Archer. The Committee will come to order. Today
I'm pleased to continue our series of hearings on alternative
tax systems for structural reform of our current income tax.
Over the past 2 years, the Committee has heard expert testimony
on the shortcomings of the current income tax and the impact of
proposed alternative tax systems on various sectors of our
economy.
We covered a lot of ground in the 104th Congress, but we
still have much work ahead of us. Today, April 15, is a fitting
day to examine the impact of fundamental tax reform on
individuals and families.
As most people by now in this country know, I continue to
do my own income tax, so I understand first hand the
frustrations of millions of taxpayers as they struggle to
figure out their income tax forms.
That's why it's so important that Congress respond when
public sentiment about our tax system turns critically
negative. If our income tax is perceived as unfair, inefficient
and complex, it's time to reevaluate how we fund government.
Without public confidence in our tax system and the
administration of pertinent laws, our system of voluntary
compliance cannot survive.
I've come to the conclusion that the Tax Code is so broken
that it can't be fixed. I don't think better management at the
IRS will do the trick, and I don't think minor reforms of the
Tax Code will work. Instead, I believe we need to fundamentally
overhaul and simplify the Federal Tax Code.
The current code is unfair, riddled with loopholes,
excessively complicated, overly intrusive and antigrowth. We
can and we must do better. I think we should pull the income
tax out by its roots and throw it away so that it never grows
back, and remove the Federal tax collector, the IRS, from any
direct contact with every individual American citizen, that is,
to get the IRS completely and totally out of the lives of every
individual American.
I favor replacing the income tax with a tax on consumption
that is fairer and simpler and more conducive to economic
growth.
Our witnesses today will address the many key questions
about how families and individuals fare under current law, and
whether alternative tax proposals may improve or worsen their
lives.
I'm also extremely pleased that our Majority Leader, and my
very close friend, Dick Armey, has joined us today to discuss
the merits of his bill, H.R. 1040.
I am now pleased to yield to Barbara Kennelly, the Acting
Ranking Democrat on the Committee for any comments she might
like to make.
Ms. Kennelly. Thank you, Mr. Chairman. Good morning. This
morning, the Committee is scheduled to hear testimony on the
possibility of reforming the income tax and the impact on
families. We would do well to recall that for all the
complexity of the Code, the majority of all individual filers
are in the 15 percent tax bracket, or pay no income tax at all.
First and foremost, any serious tax reform proposal should
do no harm, and not leave these American families any worse off
than they are today. It would be a cruel hoax to tell citizens
a flat tax is possible, and not highlight the loss of a
progressive tax system or the transition costs involved.
The second tax reform test ought to be deficit neutrality,
or at least not increasing the deficit. There are those who
would advocate a flat tax, which the Treasury Department
projects would lose on average $138 billion annually. When the
Federal budget deficit has come down in each of the last 4
years, such an approach borders on the irresponsible if this
loss of progress is not factored in.
This Committee has a longstanding interest in tax fairness
and simplicity. After careful thought and thousands of hours of
work, we enacted the Tax Reform Act of 1986 which reduced taxes
on individuals by $280 billion over 5 years, and took 6 million
low- income families off the income tax rolls. The country is
certainly very different economically than it was then, we have
to admit today that we are dealing in a truly global economy.
And so I would say, yes, it is time to conduct another
thorough review. However, we would do well to recall that the
largest deductions are home mortgage, state and local taxes,
and charitable contributions, and that the largest exclusions,
employer provided health and pension benefits, dwarf the
largest deductions.
Taken together, these items account for the bulk of tax
preferences in dollar terms. The Members, Democrat and
Republican, House and Senate, were well unwilling to tackle
these items in 1985 and 1986.
I do not see any reason to believe that any legislation
that would reach the President's desk in 1997 or 1998 would be
any different.
In the absence of such action, fundamental reform is
unlikely in this session. I, however, feel that we should
continue to look for possible doable tax reform, and obviously
listening to the Chairman's remarks, I agree with him on
simplicity.
It is also agreed that the 1986 Tax Reform Act, while
dropping people from the rolls, also made business taxation
even more complicated with the Alternate Minimum Tax, AMT, and
passive loss changes. We should learn from these actions.
Having said that, I would welcome proposals to simplify the
Internal Revenue Code, correct errors or rid the Code of
outdated, unworkable provisions. In that vein, I am hopeful
that the witnesses before us today will offer us constructive
suggestions to do just that.
Thank you, Mr. Chairman, and, I, too, welcome the Majority
Leader who is appearing before us, and who is so active in this
question. Thank you.
Chairman Archer. Thank, you, Ms. Kennelly.
[The opening statement of Mr. Ramstad follows:]
Opening Statement of Hon. Jim Ramstad
Mr. Chairman, thank you for your continued leadership in
exploring fundamental reform of our deeply flawed tax system.
Last year this committee had the opportunity to examine the
impact of replacing our current system on several segments of
society--from local governments, to large and small businesses,
to tax-exempt organizations. But no group is more fundamental
to our nation's well being than the one we are highlighting
today--individual Americans and their families.
Providing relief to American families is what major tax
reform should be all about.
Our current system hurts families by being overly complex,
costing billions of dollars and billions of hours to comply.
Our current system also hurts families by creating
disincentives to work, save and invest for their futures.
Replacing our present tax system could mean a much lower
tax burden for American families, allowing them to keep more of
what they earn. Tax reform could also help us reach our
economic potential, which would mean more jobs and a better
standard of living for American families.
Again, Mr. Chairman, thank you for this opportunity to
examine how American taxpayers and their families could be
affected by fundamental tax reform.
Chairman Archer. I would like to invite our honored
Majority Leader to take the witness chair, and to tell him that
the reception will be warm here, in spite of our minor
differences on this issue, and welcome to the Committee.
Without objection your entire printed statement will be put
into the record, and you may summarize in any way that you see
fit verbally, and you may proceed.
STATEMENT OF HON. RICHARD K. ARMEY, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF TEXAS, AND MAJORITY LEADER, HOUSE
OF REPRESENTATIVES
Mr. Armey. Thank you, Mr. Chairman. First of all let me
thank you for holding these hearings. You alluded to our minor
differences, and I would say, Mr. Chairman, they are minor. I
think on the big things you and I are in perfect agreement.
We do find ourselves in agreement with the proposition that
the current Tax Code is no longer acceptable to the American
people. That proposition gets increasingly more verified each
time we take a poll on the matter.
I first engaged this subject in January 1994 when I became
convinced that the American people were fed up with the Tax
Code, and would not tolerate a continued Tax Code of this type
very much longer.
I should tell you, looking at some of the reasons why I
found that they are fed up with it, the first is its
complexity. And I was laughing at myself this morning. Mr.
Chairman, my mother, who had only a high school education,
spent most of her time, most of the years when I was a
youngster at home, doing taxes for people throughout the
community--individual taxes, taxes often for farmers and small
businesses.
And in those days she was able, even with a high school
education, to help people do their taxes, and they would then
feel that they had some opportunity for things to come out
right.
Today we find that the Tax Code is so complex that in a
recent poll of IRS agents, the agents themselves answered only
78 percent of the questions correctly. The people that are
mandated to enforce the Code can't get it right. This is a new
story.
But here's my latest iteration of that story, Mr.
Chairman.As you know, I have a Ph.D. in economics. I've been
studying these sorts of things all my life, and I, too, do my
own taxes. My own taxes are somewhat simple. I am not a wealthy
person. And one would think that I could do my taxes.
I have here today my tax refund check--$400 less than what
I thought it would be when I sent my forms in to the IRS. I
meticulously worked my way through the 1040 form, and the
instructions. I thought I had covered all my bases. I filed my
taxes a month and a half ago, and just 2 days ago I received a
notification from the IRS that I had failed to decrease the
value of my itemized deductions relative to my adjusted gross
income, and they were making the adjustment on my behalf, and
that I would get my refund check at some amount.
I can't imagine having to go to heaven some day and face my
mother and explain how I could make a mistake like that,
especially when she's sure to remind me that that requirement
in the Tax Code was put into effect during a period of time in
which I was a Member of Congress. My only plea can be, Well,
Mom, I didn't vote for it.
But at any rate, this shows me, I think, on a daily basis,
the complexity is too much. We have all kinds of statistics on
that which you'll find in my statement.
Seventy percent of people recently polled said they want a
new Tax Code. Only one out of ten people said that they felt
the current Tax Code could be repaired.
Taxes as we have them today are too high. There's no doubt
about it. And, quite frankly, we believe that you can lower
people's taxes and still retain the aggregate earnings.
Taxes are not neutral, and they do hinder economic
opportunity. Taxes undermine good government. Now, I started
studying this in January 1994. At that time, the unrest among
the public had been consolidated primarily and almost
singularly into an organization called Citizens for an
Alternative Tax System. Mr. Chairman, you know them as
principal advocates of a national sales tax.
I, naturally, in 1994 began to study the sales tax as an
alternative to the existing Tax Code. And I felt frustrated in
my efforts to respond in that way. At that point I rediscovered
the work of Professors Hall and Rabushka, and began to restudy
the flat tax, and as you know, I settled on the flat tax as a
solution.
The problem is simple: the current Tax Code will not work.
It is no longer acceptable to the American people. The solution
is to replace it, and replace it altogether.
Why the flat tax? You get the simplicity that we're looking
for, you get fairness, in that everybody's treated the same as
everybody else. You will get an encouraged growth rate, because
we end the double taxation of savings and investment that you
have under the current Tax Code, and virtually everybody who
has studied the flat tax is in agreement on that.
There will be lower taxes. There is a de facto
progressivity that's due to the generous family allowance that
for a family of four is $33,800. This means that if you earn
$25,000 you owe no tax. A family of four earning $50,000 will
pay only 6 percent of its income in taxes, and a family earning
$200,000 would pay 14 percent.
The flat tax is profamily in many ways, not the least of
which, it relieves the family of the burden of just dealing
with this complexity which if you do your own taxes you know
can be a difficult thing.
It is an honest way to tax. I have to tell you, Mr.
Chairman, I believe that in the end all taxes are paid by
people, and all taxes are paid out of current income. And the
flat tax, as a direct, honest income tax, accepts that
proposition.
We are told by even the Federal Reserve Bank of Kansas City
that the flat tax will lower interest rates by as much as 25
percent, and nobody that has examined the flat tax disputes
that it will lower interest rates. The only dispute is in the
estimators view of how much.
And let me just say very quickly that I believe very
profoundly that in a flat tax world, charitable giving will go
up because I think charitable giving is first a function of
what charity is in your heart, and second, a function of what
you have to give.
And in a flat tax world, where more people have better
jobs, with more promotions and more take-home pay, they will
give more. That is what happened in the eighties, where the tax
value of charitable deductions went down, charitable deductions
more than doubled, and charitable deductions to faith-based
institutions more than tripled.
Those are my comments, Mr. Chairman, and I'll be happy to
answer any questions.
[The prepared statement follows:]
Statement of Representative Dick Armey
Mr. Chairman, I appreciate you affording me the opportunity
to testify before the committee today on the subject of tax
reform. I would also like to commend you for holding these
hearings and focusing attention on the need to end the tax code
and the IRS as we know it.
The Tax Code is Broken
As you have stated so many times yourself, Mr. Chairman,
our current tax system is broken and needs to be scrapped and
replaced with a system that is fair, simple and honest. The
current tax code is complex; unfair; inhibits saving,
investment and job creation; imposes a heavy burden on
families; and undermines the integrity of the democratic
process. It must go.
I'd like to focus my remarks today on the effect government
taxation has had on America's families. Unfortunately, during
the past few decades the tax system has become more complex,
less fair, more destructive to the economy, and, in the
process, more of a burden on American families.
Complex
The complexity of the tax system is incomparably worse than
when I was growing up. When I was a child, during tax season my
mother prepared tax returns for farmers and other small
businessmen in Cando, North Dakota. Though she only had an
eighth grade education, she was able to prepare tax returns and
feel comfortable that they were correct.
Today, even the best-trained tax attorney must question his
ability to accurately complete a tax return. During the past
forty years, the tax code has grown mind-numbingly complex. The
number of words in the income tax code has increased more than
four-fold to 800,000. There are more than 6,000 pages of
accompanying tax regulations for the income tax.
Each year Americans devote 5.4 billion hours complying with
the tax code, which is more time than it takes to build every
car, truck and van built in the United States. The IRS sends
out more than 8 billion pages of forms and instructions which,
if laid end to end, would circle the earth 28 times.
In my own family we have experienced the costs of
complexity. Like so many other American families, time we spend
searching for receipts and studying tax law could be spent with
our children.
Unfair
The main reason the tax code is complex, of course, is the
proliferation of deductions, credits and other special
preferences in the law. Because of these loopholes, taxpayers
with similar incomes can pay vastly different amounts in taxes.
This uneven treatment of taxpayers is fundamentally unfair and
is at odds with the American value of equality before the law.
According to a recent poll by Luntz Research, three-
quarters of Americans believe it is common for taxpayers with
similar incomes to pay vastly different amounts in taxes.
Perhaps this is why more than two-thirds support a fundamental
overhaul of the tax system.
Heavy Taxes
The American people are beleaguered by the highest tax
burden in American history. Taxes represent a larger share of
the economy than ever before. As a result, American families
now pay more in taxes than they spend on food, clothing and
shelter combined.
According to the Tax Foundation, in 1955 the typical family
paid about 27 percent of its income in total taxes. Today, the
typical family pays about 38 percent of its income in taxes--a
40 percent increase in the tax burden.
The Tax Foundation data reveal the key truth to why so many
families feel as though two incomes are needed to do what one
income accomplished a generation ago. While per capita income
has doubled in the past generation, a majority of the higher
income families have earned has gone to pay taxes.
Since 1955, 52 percent of the growth in wages for the
typical single-earner family has gone to the government. For a
two-earner family, 59 percent of the growth in wages has gone
to pay higher taxes. The fact is, the second earner today works
not to support the family, but to support the government.
But the tax code's anti-family bias doesn't stop there. The
code often places a stiff cost on marriage through the so-
called marriage penalty, under which people getting married
face a tax increase. In addition, for years the value of the
personal exemption, which includes the exemption for children,
fell as inflation slowly but, over time, dramatically
diminished the value of the personal exemption.
As you know, Mr. Chairman, most of the growth in the tax
burden has come from higher payroll taxes and higher taxes at
the state and local level. The only good news for families came
in 1981. Were it not for President Reagan's 25 percent
reduction in income tax rates and indexing of personal
exemptions and the tax brackets to inflation, Americans would
be paying significantly more in taxes than they do today.
Hinders Economic Opportunity
While the economy has been generally healthy, it is not
growing at its potential because of a tax policy that is biased
against work, saving, investment and entrepreneurial activity.
In fact, recent growth has sparked fears of inflation. When
Alan Greenspan raised interest rates last month, he was
indicting our current tax code, which prevents our economy from
sustaining robust growth levels. By placing multiple layers on
saving, the tax code reduces the amount of investments in new
machines and technology that make American workers more
efficient and competitive. By favoring certain economic
activities over others, the tax code distorts financial
decisions and reduces economic efficiency.
According to a study by Jane Gravelle, an economist with
the Congressional Research Service, and Larry Kotlikoff, an
economist at Boston University, the corporate income tax costs
the economy more in lost production than it raises in revenue
for the Treasury. Dale Jorgenson, the chairman of the Economics
Department at Harvard University, found that each extra dollar
the government raises in revenue through the current system
costs the economy $1.39.
Undermines Good Government
In 1956, then Senator John F. Kennedy said, ``The lobbyists
who speak for the various economic, commercial and other
functional interests of this country serve a very useful
purpose and have assumed an important role in the legislative
process.'' Today, the lobbying industry is more than three
times as large as it was when John Kennedy was President.
But as the government has grown and tax burdens and tax
favoritism has proliferated, the lobbying industry has
flourished. Today, the lobbying industry is the largest private
sector employer in Washington. One out of every six private
sector workers--62,072 people--work in the lobbying industry.
The lobbying industry generates $8.4 billion in revenue
each year, making it larger than the entire economies of 57
countries. Data from the Clerk of the House show that more
lobbyists work on taxes than any other issue. The lobbying
industry is no longer as innocuous as in John Kennedy's day. As
tax favoritism has increased, so has the number and influence
of lobbyists. As I have said many times before, it is not
healthy for our economy or our democracy that so much talent,
energy and resources are diverted toward securing special
consideration under the tax system.
The Flat Tax Solution
Last month I introduced with Senator Shelby H.R. 1040,
which would scrap the entire income tax code and replace it
with a flat-rate income tax that treats all Americans the same.
This plan would simplify the tax code, promote economic
opportunity, and restore fairness and integrity to the tax
system. The flat rate would be phased-in over a three-year
period, with a 20 percent rate for the first two years and a 17
percent rate for subsequent years.
Individuals and businesses would pay the same rate. The
plan eliminates all deductions and credits. The only income not
subject to tax would be a generous personal exemption that
every American would receive. For a family of four, the first
$33,800 in income would be exempt from tax. There are no breaks
for special interests. No loopholes for powerful lobbies. Just
a simple tax system that treats every American the same.
What a Flat Tax Means for America
Simplicity
The flat tax replaces the current income tax code, with its
maze of exemptions, loopholes, and targeted breaks, with a
system so simple Americans could file their taxes on a
postcard-size form. The Tax Foundation estimates that a flat
tax would reduce compliance costs by 94 percent, saving
taxpayers more than $100 billion in compliance costs each year.
Fairness
The flat tax will restore fairness to tax law by treating
everyone the same. No matter how much money you make, what kind
of business you're in, whether or not you have a lobbyist in
Washington, you will be taxed at the same rate as every other
taxpayer.
Prosperity
Because the flat tax treats all economic activity equally,
it will promote greater economic efficiency and increased
prosperity. When saving is no longer taxed twice, people will
save and invest more, leading to higher productivity and
greater take-home pay. When marginal tax rates are lower,
people will work more, start more businesses and devote fewer
resources to tax avoidance and evasion. And because tax rules
will be uniform, people will base their financial decisions on
common-sense economics, not arcane tax law.
As you know, Mr. Chairman, the Joint Committee on Taxation
hosted a conference in January at which a broad group of
economists forecasted the results of tax reform proposals.
Every economist who attended reported that a flat tax would
result in a larger economy. Economists affiliated with the
Brookings Institution, Federal Reserve, CBO, Coopers & Lybrand,
DRI/McGraw-Hill, Harvard University and others all found that a
flat tax would lead to higher living standards. The unanimous
finding of such a diverse group of economists shows that there
is virtually no debate as to whether the flat tax would
increase economic growth, but only by how much.
According to one study by a former chief economist for
Congress' Joint Committee on Taxation, under the flat tax the
economy would be 5.7 percent larger after five years than under
the current system. That translates into $522 billion in higher
output, or $3,000 in higher income for the typical family of
four. Michael Boskin, a former chairman of the Council of
Economic Advisors, estimates that the flat tax would increase
the size of the economy by ten percent.
Lower Taxes
According to data by the U.S. Treasury Department, the bill
would cut taxes by about $30 billion in the first year of
enactment. When the rate is reduced to 17 percent in the third
year of the proposal, there would be significant further tax
reduction. The bill is carefully designed, however, to
safeguard taxpayers against higher deficits. Rigid spending
caps are included in the plan. Coupled with the additional
economic growth the flat tax will spur, the tight spending
controls will ensure that the budget reaches balance by 2002.
Progressivity
Under the flat tax, the more you earn, the more you pay. In
fact, because of the high family exemption, the more a taxpayer
earns, the greater the share of his income he pays in tax. A
family of four earning $25,000 would owe no tax under the
proposal. A family of four earning $50,000 would pay only six
percent of its income in income taxes, while a family earning
$200,000 would pay 14 percent.
Pro-Family
The flat tax eliminates the marriage penalty and nearly
doubles the deduction for dependent children. By ending the
multiple taxation of saving, the flat tax provides all
Americans with the tax equivalent of an unlimited IRA. This
will make it easier for families to save for a home, a family
vacation, a college education for their children, or for their
retirement years.
Pro-Taxpayer
The flat tax trusts average Americans by giving them the
freedom to make their own economic decisions. In addition, the
flat tax includes a special safeguard against higher taxes. It
requires a three-fifths supermajority vote of Congress to raise
the tax rate, lower the family allowance or add loopholes.
Honesty
By eliminating itemized deductions and special breaks, the
flat tax would have a chilling effect on special-interest
lobbying and transform the political culture in Washington.
Under a simple, transparent system that taxes all income one
time at one rate--and requires a supermajority vote to add a
loophole--there will be far fewer lobbyists than under today's
system. Instead of being divided into numerous special-interest
groups, the flat tax will make every American equal under the
tax code with a shared interest in lower rates and continued
fairness.
Lower Interest Rates
According to a study by an economist at the Federal Reserve
Bank of Kansas City, published in the Kansas City Federal
Reserve's Economic Review, the flat tax would reduce interest
rates by 25 percent, or about two percentage points. Lower
interest rates under the flat tax will not only reduce the
costs of student, car and credit card loans, they will also
offset the loss of the home mortgage interest deduction.
According to reports by the Congressional Research Service and
the Tax Foundation, the flat tax will have no meaningful effect
on home values.
Consider how a sharp reduction in interest rates would
affect the average family that earns $50,000 and deducts $5,000
in mortgage interest. The home mortgage deduction saves this
family $750 in taxes, where a 25 percent drop in interest rates
saves it $1,250 in lower interest payments. That family is $500
better off under the flat tax with lower interest rates--even
without the home mortgage interest deduction (and not counting
the higher personal exemptions).
More to Give
As incomes rise under the flat tax, so too will donations
to America's charities. Over the past several decades,
increases in giving have closely tracked increases in personal
income. This trend continued during the 1980s when, even as the
tax value of the deduction declined and fewer taxpayers were
able to take the charitable deduction, charitable giving
increased. Because incomes will increase significantly under
the flat tax, giving will rise in the long run as well, even
without the charitable deduction.
I believe the flat tax would represent a tremendous step
forward for American families. It would simplify the tax
system, saving taxpayers countless hours and resources, freeing
up time and money to meet more important family needs. A flat
tax would also lead to increased prosperity and higher wages.
Coupled with a tax cut, the higher incomes under the flat tax
would significantly increase the take-home pay, allowing
parents to meet the important needs of their family.
Perhaps most importantly, a flat tax would be true to our
values. A tax system under which every American is treated the
same and special-interest provisions are removed would do a lot
to increase the American public's faith in their government.
Chairman Archer. Thank you, Mr. Majority Leader. Have you
done your income tax for this year?
Mr. Armey. Yes, I have.
Chairman Archer. Because I was going to volunteer to help
you work through the work table on how you lose your itemized
deductions, in the event you needed any consultation or help.
Mr. Armey. Well, I'm going to go back and review that part,
because I certainly don't want to suffer this embarrassment
next year.
Chairman Archer. It's so typical of what we have in the Tax
Code today, you're given something with one hand and it's taken
away with the other hand. And we see that over and over in the
Code.
You and I both agree that we need to do that. We need to do
something about that and change it.
Could you tell the Committee what the maximum tax rate
would be under your flat tax proposal?
Mr. Armey. If we were to implement the flat tax today, Mr.
Chairman, we would start with a 20-percent rate. We would hold
that rate for 2 years, and on the third year it would be
lowered to 17 percent.
We believe that gives the growth effect of the flat tax
time to work its way into the economy and allows us to move to
the 17 percent and stay there indefinitely.
Chairman Archer. Do you have revenue estimates on your
proposal? Will a 20-percent rate in the first 2 years duplicate
the revenue from the current code?
Mr. Armey. I believe the 20-percent rate, given the family
allowance at the level we have it, gets us within $30 billion
of current revenue.
Chairman Archer. $30 billion?
Mr. Armey. $30 billion.
Chairman Archer. Per year. Because the comments that were
made by Ms. Kennelly early on were that you would lose $138
billion in the first year.
Mr. Armey. My bill, as I've written it, does not score that
way. I know a lot of people have raised their eyebrows about
the $30 billion, but I have to tell you, Mr. Chairman, if I
were to endorse revenue neutrality I would be endorsing
spending at its current levels, and I believe spending must
come down anyway, so the flat tax as I've written it would
provide further incentive for that.
And we have written in there spending caps to see to it
that we would not worsen the deficit.
Chairman Archer. I have just one last question. In the
event that your proposal were considered by this Committee, and
in the event that a majority on the Committee believed that it
would be appropriate to add some limited number of deductions,
like charitable contributions, or home mortgage interest, would
you be able to support such a bill, as a final package?
Mr. Armey. One would never want to turn their back on it
altogether. I would resist that. I believe that the way you get
simplicity and you make it stick is that you eliminate the
whole playing field for special exemptions and itemized
deductions.
Once you've done that, then you've broken the Code. If you
put in the homeowners' deduction, you've got now in place the
first best reason to add charitable deductions. Once you have
that in place, you've got two good first best reasons to do
something, you're back in the same game.
If the Committee were to report a bill to the floor that
reinstated in the new flat Tax Code these deductions--they
would obviously have to adjust the rates to compensate for the
revenue loss that would attend that--and I would petition the
Rules Committee for the opportunity to offer an amendment in
the form of a substitute that would give me a chance to have a
vote on the flat tax written as I wrote it.
Chairman Archer. Well, you have just confirmed what you and
I have privately talked about and confirmed my respect for you,
in that you believe that this should be a pure flat tax, and
not be dolled up with any kind of additional deductions, no
matter how appealing, nor be extended to tax dividends,
interests, or what we might call unearned income. And I greatly
respect you for that.
Mr. Armey. Let me just say, Mr. Chairman, that I developed
this model while making a trip to New Hampshire, not as a
candidate last year, where having read their license plates, I
decided to say the motto is Stay Flat or Die. But if you want
tax reform to stick, you better stick with it.
Chairman Archer. Ms. Kennelly.
Ms. Kennelly. Thank you, Mr. Chairman. And I salute your
mother for doing those tax returns. I think, though, probably
the fact that she got a good high school education had as much
to do with it as the simplicity of the Tax Code, and that's
something we'd like to get back to.
Mr. Armey, I'm still interested in the $138 billion figure,
because I know that last year we had a lot of trouble getting
the cuts we were looking for to balance the budget. I think we
have to be realistic.
I respect both of your opinions--the Chairman and the
Majority Leader. But I have to say to you, though, that the
American people have to understand very, very much up front
that they could lose their home mortgage deduction and they
have structured their finances based on that. They could lose
other deductions, and that's why we have to make sure that the
public understands.
But I am very interested in the charitable deduction. I
come from a town, Hartford, that used to be well off. It's now
on the list of the poorest cities in the United States of
America, and I have met with people in the charitable world.
And they deal with the goodness of people's hearts
constantly. As you mentioned, that's how people give to
charity. But I have to tell you something, Mr. Majority Leader,
a lot of it has had to do with the Tax Code.
And I would like you to explain once more what you just
said, that when the tax rates go down the giving doubled, is
that what you said?
Mr. Armey. Let me just relate, I believe the $138 billion
figure you have comes from someone who scored me at 17 percent
in the first year. I'm at 20 percent in the first year.
Ms. Kennelly. Somebody at Treasury.
Mr. Armey. The home mortgage deduction is a worry to
people, and what I have done, and people have done it by as
many as 180,000 hits on the flat tax home page in a single
month, when people try the current Tax Code with their home
mortgage deduction and try the new Tax Code without it, more
often than not they'll say I'd rather change.
In fact, I think in a recent poll, 54 percent of new
mortgage holders said that for the other advantages they would
get in a flat tax, they would happily give up their home
mortgage deduction. That, I think, is quite manageable by
education.
Now, the charitable thing, I think you have to rely on the
empirical observation and some common sense. First of all, no
intelligent, rational person is going to be willing to give
$100 in order to gain a $33 reduction in their taxes.
So clearly they're not making charitable contributions for
the tax advantage. They make the contribution out of their
belief in the purpose at hand, and how much money they have
available.
What we saw in the eighties, when the tax value of a
charitable contribution was cut to one third of its prior
level, we saw that in fact charitable contributions doubled
nationwide in the eighties, and tripled for faith-based
organizations.
Faith-based charities, I think, are perhaps more often more
reliant on the smaller denomination gifts of low-income people
and clearly as they had more they gave more.
Ms. Kennelly. Mr. Majority Leader, I still think the jury
is out on that mortgage interest question, and we're going to
have to be discussing this more, but you and I both know that
we don't have a simplified tax system yet. And no, someone
doesn't give $100 to get $33. But when someone earns $50
million and they would rather give to a charitable institution
than give to the government, other things come into play.
And so that's another area I think we have to continue to
look at. I'm not arguing with you that the system is not too
complicated. It's much too complicated. It's antiquated. So I'm
not here saying we don't need tax simplification, we don't need
more tax fairness. I just want to make sure that the American
people know what they're getting into when they give up a
progressive tax system.
Mr. Armey. I agree. They should. That's why I wrote the
book. That's why I put it on the home page.
Ms. Kennelly. I bought it.
Mr. Armey. And that's why I invite people, try it for
yourself.
Ms. Kennelly. Thank you, Mr. Chairman.
Chairman Archer. Thank you. Mr. Collins.
Mr. Collins. Thank you, Mr. Chairman. Thank you, Mr. Armey
for your comments and the proposals you've put forward, because
it does give us some interesting data to talk about.
My area of concern is that of small business, and how small
businesses may be affected by either the consumption tax or by
the flat tax. What have you determined or what have your
studies shown a small business with profits between $75,000 and
$150,000, how would they be affected? That seems to be a major
concern of small businesses.
Mr. Armey. Mr. Collins, the first reaction I have is that
under the flat tax we would expense inventory and capital
expenditures. So obviously the simplicity of the Code shows up
right away for a small business.
I have not worked out anything in particular, but the long
and the short of it is that they would take any legitimate,
necessary business expense, deduct that from gross earnings,
and then pay the flat rate on the net earnings of the business,
while they expense capital and inventory.
At this point, that's the best answer I can give you. I
can't resist saying, by contrast, the small business
organization in a flat tax world is not asked to be the tax
collector for the State as a retailer, and they would hold no
responsibility for any taxes other than their own, as opposed
to a national sales tax, where they would be asked to collect
taxes on behalf of the government.
Mr. Collins. But in contrast, a lot of small businesses do
collect consumption tax on behalf of State government or local
government. So that would be just adding one more entity line
to the collection there.
But on the small business, and the difference seems to be,
the concern is between the graduated tax rates on the smaller
profits, versus the competitive edge that larger business may
have with the flat tax. Now they will have the same flat tax
rate as the larger business.
Mr. Armey. They would have the same rate. And obviously
their business expenses are enumerated, but whether you're a
small business or a large business, you must get to net
earnings, and then you pay the same rate as anybody else.
The object of the flat tax is to tax each dollar earned in
the country in a tax year irrespective of its source at exactly
the same rate as every other dollar that's earned.
Mr. Collins. In the area of small business--and I've been
in small business--I'm still a small business man. I've had
some type of small business for 35 years. I know I don't look
that old. But I have.
But, you know, with the incentives that are there for the
small investor to take a risk, and with the graduated tax rates
and then of course the competitive edge that a lot of people
with the resources and wherewithal that are in bigger
businesses trying to compete with, I have some concern, too,
that the flat rate may impose a higher or larger tax liability
on small business.
Now, one thing I do like is your loss carry forward,
because I've suffered some of those years when I had some loss
carry forward that would not have been beneficial to me.
Now, under the individual taxpayer under the flat tax, what
are your deductions there?
Mr. Armey. Well, let me just again remind you that any time
you have high marginal rates you punish success and you
discourage people from growing. The rates being the same,
people would have all the incentive in the world to grow.
If you file the flat tax as an individual, it's a very
simple calculation. You take your personal or your family
exemption. For a family of four it's $33,800. You deduct that
from your gross earnings, you get then your adjusted gross
earnings, you apply the flat rate of 17 percent times that. In
two simple calculations you're out of there and you go on, and
you don't need to have all of the IRS records to find out what
your brother-in-law is paying. All you have to know is the size
of his income, and the size of his family, and you can
calculate his taxes, and know that he's paying the same as you,
and therefore you feel like there's justice in the world.
Mr. Collins. Well, I can appreciate the simplicity. I am
concerned that there may be a higher tax liability on small
business, and that's one of the areas that I really want to
focus in on.
I'm filing today. This is the first time. I told my
brother, who is my CPA, that we're making history this year. I
am actually filing on time. I will be sick at midnight tonight,
but I'm still filing.
Mr. Armey. Well, I appreciate that, and you know, in the
old days when you first started your business, it was easier to
file on time.
Chairman Archer. Mr. Christensen.
Mr. Christensen. Thank you, Mr. Chairman. And thank you,
Mr. Armey, for your testimony and also for the fact that you've
been leading the charge with our Chairman on this whole issue
of restructuring the Tax Code.
I'm interested in hearing your opinion on whether or not
tax policy should have any affect on social policy. You know,
our code obviously plays a large role in the development of
social policy, everywhere from tax credits for low-income
housing to myriad deductions, for home mortgage, charitable and
life insurance and everything else.
Let me ask you specifically, though, there's a lot of
momentum right now on the Senate side in terms of some of the
sin taxes, and also trying to affect the way some of the
cigarette companies are targeting our children, and especially
women.
I mean, it's deplorable what I see Philip Morris doing
right now in a campaign to go after the younger females in an
ad campaign. I really struggle with it, and I really am
frustrated.
I am not of the opinion right now though that the way to
effect change is through tax policy, but a lot of people are
jumping on that band wagon. How do you feel about the social
policy aspect?
Mr. Armey. Well, as often I do, I take my instruction from
Milton Friedman who once made the observation that once you set
the rate everything else is social policy. I believe that the
object of a Tax Code should be to raise that necessary revenue
for the government in that manner which is the least meddlesome
against the freedom of individuals.
I do not believe you ought to use the Tax Code in order to
try to direct human action and human behavior in one way or
another. Now, when you get down to the so called sin tax
doctrine, that is, of course, a very heavy decision that
carries with it a tone of morality, and often plays against
some of our very heartfelt concerns, such as children and
cigarette consumption, and so forth.
But in the end, we have discovered that the States and
other areas tend to levy higher excise taxes in these areas of
consumption precisely because they are price inelastic, that
the principal motivation for the consumption is so compelling
that they are hardly mitigated against by pecuniary influences.
So insofar as you say, for example, we're going to raise
revenue and decrease smoking, you can't do both. It's going to
be one or the other. And we have found that in many of these
areas, there's just a lack of responsiveness.
Now there may be, and certainly must be things to address
there, but I don't think that you--should I say, compromise the
integrity of your Tax Code with respect to the question of
neutrality in order to fulfill social objectives that might
otherwise in fact be better fulfilled with other measures.
Mr. Christensen. Thank you. Thank you, Mr. Chairman.
Chairman Archer. Mr. Jefferson.
Mr. Jefferson. Thank you, Mr. Chairman. Good morning, Mr.
Armey. I want to ask you a question that I've run across in
some of the studies that I have been provided which suggests
that a totally flat rate, although it simplifies the Code,
would involve a substantial shift of the tax burden from those
in the highest income tax brackets to lower and middle income
tax payers.
The flat rate would raise the share of taxes paid by low-
and middle-income tax families, and sharply reduce the share of
taxes paid by the wealthy. And the reason for it is that for
those people who are characterized as the working poor, this
eliminates the Earned Income Tax Credit or EITC.
Now, I recognize that you have a higher floor where your
taxation would start, but still above the limit that you're
dealing with, that presents something of a problem. Is your
limit now $33,000?
Mr. Armey. $33,800 for a family of four.
Mr. Jefferson. OK. The other is with respect to the effect
on Federal Insurance Contributions Act, FICA, on employer paid
health policies, and on other employee benefits that an
employer may now exempt. Am I correct in thinking there may be
a problem with this shifting, or do you have another answer for
it?
Mr. Armey. Any time you're examining any change in the Tax
Code, the redistribution charts are always the most difficult
thing to measure out. You can say that anybody today who files
a standard deduction, irrespective of the size of their family
and the number of dependents, is going to be better off in a
flat tax world than they are in today's world by virtue of the
lower rate and the higher relative family exemption.
Many people at the low-income bracket would find their loss
of earned income tax credit compensated for by that gain.
Insofar as they're not compensated, then if you're engaging in
a program of income maintenance for the low income, we think
that should be transferred to the spending side of the ledger,
not to the taxing side of the ledger. It's just a value
judgment we make.
We know that as many as 10 million low-income families, or
low-income individuals will be taken off the tax rolls in the
flat tax world by the analysis that's been made of it. And,
finally, what we've seen is, for example, Ross Perot last year
who only paid 9 percent of his income in taxes, under the flat
tax he would pay 17 percent of his income.
If, in fact, as it is generally alleged, loopholes and
exemptions are things that are most advantageous to the
wealthy, then, of course, a Tax Code that eliminates them
should have its greater impact on the wealthy. I believe the
flat tax as I've written it is at least as fair as the current
Tax Code relative to the question of progressivity, and I
believe it is clearly more fair relative to a more widely held
view of fairness, that fairness is when everyone is treated the
same as everyone else.
And so I am perfectly willing to advance the flat tax as
I've written it, on the fairness question, with great
confidence that it holds up under scrutiny by individuals.
Mr. Jefferson. It appears that there is some question about
it, because most of the loopholes, things we characterize as
loopholes are really enjoyed by taxpayers who are not in the
upper brackets, as it turns out.
Let me ask you one other thing, if I might. On the issue of
shifting the way we characterize income, there's been a problem
under previous codes that when you have a class of income that
has a lower tax rate, or no tax rate, and it can be
characterized from the type of income that has a higher rate to
that which has a lower. That's when the escaping of the tax
liability takes place.
If you have a system where you have no income tax on
capital gains, no capital gains tax, and no tax in a few other
areas, but that taxes everything that comes in wages and
salaries, won't that be a powerful incentive to mischaracterize
or to recharacterize the title you put on the income source to
avoid paying tax altogether? Won't we have more tax avoidance
problems under something like that?
Mr. Armey. Frankly just quite the contrary. Since the rate
applies the same to every dollar irrespective of the source,
there would be no reason to say I got it from this source
versus that source. What we do with capital gains taxation is
very important. We do not double tax that income.
That income right now is doubled taxed at a very
prejudicial rate. We would collect the taxes on capital
earnings at the source in the same way as they are collected at
their source now.
And I can give you a quick illustration. I have been filing
my taxes with the IRS every year of my life since I was 16. I
have never in all those years written a check to the IRS. The
reason being my taxes were collected at the source, they were
held on my account by the IRS, and at the end of the year I
filed in such a way as to clean up my account with them, and
they gave me, sometimes grudgingly, a refund of that extra
money with no credit for interest earned during the time they
were holding what is my savings.
Now, we're doing the same thing with investment earnings.
We'll collect the tax at its source. We'll make the remittance
at its source, but we won't ask you to suffer taxation on that
same earnings a second time.
Mr. Jefferson. Thank you, Mr. Chairman.
Chairman Archer. Thank you. Dick, I understand that you've
got an 11 o'clock appointment. Is that correct?
Mr. Armey. I imagine. I don't know.
Chairman Archer. Could you take two more questions before
you have to leave?
Mr. Armey. Yes, I could.
Chairman Archer. Ms. Dunn.
Mr. Armey. As long as they're not too tough.
Ms. Dunn. I'll give you a couple of easy ones, Mr. Leader.
Thank you, Mr. Chairman. I'm interested on behalf of the
taxpayers in my district, and as a small business owner and the
owner of a small family business in several areas.
And I am wondering if you could briefly tell us the effect
of the flat tax, your flat tax with regards to what happens to
the IRS, and estate taxes and savings.
Mr. Armey. The IRS, I think--there's been an analysis. I
forget where it was done--that as much as 94 percent of the
current compliance costs with the IRS would be eliminated under
the flat tax. I would guess--and I know I've heard the Speaker
talk about a goal of reducing the size of the IRS by 60
percent. I would guess the flat tax would more than fulfill
that goal.
Now, obviously, you will always have an enforcement agency
any time you have a Tax Code. The question is, if you have a
minimal code and a civilized code, can you have a minimal and a
civilized IRS? I think you can accomplish that with a flat tax.
Ms. Dunn. And estate tax, and savings.
Mr. Armey. Under the flat tax, there is no estate tax.
Again, we're trying to end double taxation. You should collect
every dollar, gather every dollar into the tax base, tax it
once in the year it's earned, and it should never be taxed the
second time.
Savings, again, you paid taxes on your earnings in this
year, you save them in any multiple number of ways, and you
would not be taxed on that a second time.
Ms. Dunn. Thank you, Mr. Chairman.
Chairman Archer. Mr. Portman.
Mr. Portman. Just a quick question, Mr. Leader. First,
thank you for being here today, and thank you for testifying
before the Commission to Restructure the IRS. That was very
helpful to us.
We spent, as you know, about the last year looking into the
problems at the Internal Revenue Service, and there is a
consensus now, I think it's fair to say, among our 17
Commissioners, including Senator Kerry and myself, who are the
cochairs, that until you simplify the Tax Code, you're really
not going to be able to ultimately improve the IRS in the way
all of us would like to see.
As long as you have the current Tax Code, it will be very
difficult to administer it. That being said, there are things
we should do with the IRS to make it work better, and we
appreciate your testimony on that, and your giving us some
pointers on simplification.
One of the concerns that we have focused on with this
commission is the EITC, and the degree to which that causes
problems of administration at the IRS. Of course, there's a
good deal of fraud with the program as well. And in our
interviews with over 300 online IRS employees, the EITC came up
time and time again as a problematic part of what they have to
do.
In response to the question of Mr. Jefferson, you talked
about the fact that with a more generous exemption, up to, I
think, $33,800, you wouldn't be having an EITC. There wouldn't
be the process of taxpayers filing and receiving a refund.
But that doesn't pick up everybody among the working poor.
And you mentioned on the spending side addressing it. Is your
thought that the tax system might not be the best place to
address some of those problems, but rather you'd do it in terms
of new spending from Congress? How do you respond to that?
Mr. Armey. That is my thought. I mean, we're basically
making a decision that we have certain levels of income, given
certain family sizes and so forth, that are insufficient to
achieve an acceptable level of living for that family, and that
we want to supplement that family's income.
Now, there are two ways you can do that. You can either do
it directly through the expenditure way, which I think is the
more clear, direct and honest way to do it, or you can do it
through the Tax Code. We tried that with the EITC, and I think
one of the heartbreaking things about our effort to work that
way is the fact that it's resulted in an enormous amount of
fraud, and has driven up the compliance frustrations of the
agency enormously.
But it's also fed a certain cynicism among the taxpayers.
When, you know, people frankly don't need to read your tax
forms, like the IRS has been doing quite frankly
illegitimately, but they know, the word goes through a
community that somebody is getting away with something, and
there's a resentment from that.
Either somebody resents it or they mimic it. And when those
things happen I think that creates a cynicism throughout the
country. We pride ourselves with the concept of a voluntary tax
system. I think if you're going to have a system of voluntary
compliance, people are going to have to believe it's simple,
it's fair, it's honest, and nobody has an opportunity to game
it.
And if I don't believe somebody else is doing it, then I
will restrain myself from doing it. But once you allow that
cynicism to creep in, I think you have a self-defeating
process.
Mr. Portman. Thank you. Thank you, Mr. Chairman.
Chairman Archer. Dick, one last question, and then we will
release you. Mr. Hayworth.
Mr. Hayworth. I thank the Chairman, and the Leader. Thanks
for coming by to see us today, and I appreciate this preview of
the great debate that will take place in terms of tax reform.
You touched earlier on a subject of great concern to me,
especially on April 15, in your response to the question from
our colleague from Washington State, in terms of the flat tax
and its impact on the IRS.
One of the stated goals of the new majority in Congress is
to end the IRS as we know it. Indeed, Chairman Kasich of the
Budget Committee this weekend on national television talked
about abolishing the Internal Revenue Service as it exists
today.
And while you offered a projection that seemed to align
with the estimation of the Speaker, in terms of reducing the
size of the Internal Revenue Service by some 60 percent, or
perhaps in excess of that, one of the criticisms of the flat
tax I am hearing is that perhaps it would not alter the role of
the IRS enough in terms of its intrusive nature.
Indeed, some of the work done by Raymond Keating of the
Center for Small Business Survival as reported in the Journal
of the Foundation for Economic Education, talked about the
institution of the income tax and how it has grown to this
leviathan stature in our society.
What safeguards should we take if we end up with a flat tax
to in fact make sure that the system does not grow back again
at some future date for future generations?
Mr. Armey. I think it goes back, frankly, to the question
asked earlier by Chairman Archer. It seems to me you have to
write the flat tax with enormous discipline. I mean, make it as
simple as you can make it. And I think we've done that. And
then stick by your guns. Resist all the temptations.
Ninety-nine percent of all the enemies of the flat tax make
their living in Washington, DC. A great many of them are tax
lobbyists, and they make their living making it more complex.
And so somebody is going to have to be stubborn about this.
I am stubborn about it, because I think you have to be.
Then you have to write in safeguards. For example, we said
it takes a three fifths vote in either house to either raise
the rate, reduce the family exemption, restore any itemized
deductions, or create multiple rates.
Now, no Congress can completely protect America from a
future Congress. But you can write in those safeguards that
will make it as difficult as can be. And I think anybody,
whether it be my plan or any other plan, that got enacted into
law, you would have to have those safeguards in place.
Trust me on this: you can write a national sales tax, and
if you don't have that discipline, vigilance, it, too, can grow
into the same kind of horrible monstrosity that we have today.
Any Tax Code can grow that way unless you put in the
discipline at its outset, and then the safeguards against easy
change.
Mr. Hayworth. I thank the Leader. And that certainly points
up the importance of today's vote later, when we talk about a
two-thirds majority needed to increase taxes.
Again, thank you, Mr. Leader. And I thank the Chairman.
Mr. Armey. Thank you.
Chairman Archer. Thank you, Mr. Armey.
Mr. Armey. Thank you, Mr. Chairman.
Chairman Archer. I told you that you would have a warm
reception, and I think that you have left unscathed.
Mr. Armey. I thought you were referring to the hot seat. I
do appreciate it. Thank you all.
Chairman Archer. Our next witnesses are in a panel. Messrs.
Steuerle, Hubbard, Dr. Asmus, Dr. Sullivan, Mr. Mitchell and
Mr. Dannenfelser. If you could come to the witness table
please.
Welcome, gentlemen. Most of you, I'm sure, are aware of the
rules of the Committee, that we're going ask you to limit your
oral testimony to 5 minutes, and the little lights there will
tell you how you're proceeding.
The yellow light comes on, that means you have 1 minute
left, and the red light means, as is always the case in our
society, stop.
Your entire printed statements, without objection, will be
inserted in the record. And we're most pleased to have you with
us this morning, and, Mr. Steuerle, if you would lead off, we'd
be pleased to receive your testimony. If you would each
identify yourselves for the record, then you may get into your
oral testimony.
Mr. Steuerle.
STATEMENT OF C. EUGENE STEUERLE, SENIOR FELLOW, URBAN INSTITUTE
Mr. Steuerle. Good morning. Thank you, Mr. Chairman. My
name is Gene Steuerle, and I'm a senior fellow at the Urban
Institute here in Washington, DC.
When it comes to tax reform, family issues are often among
the last to be considered. In practice, however, these issues
often dominate the revenue adjustments that might be required
in moving to any different type of system.
I should indicate, by the way, that my testimony deals
primarily with family issues defined as those adjustments that
are required according to such things as family size and the
distribution of income and resources within the family.
Having served as economic coordinator of the Treasury's
1984 to 1986 tax reform effort, I can warn anyone trying to
redesign tax reform that these types of family issues at times
will drive the process, if for no other reason than that so
much money is involved.
Now, many provisions of the current Federal income tax are
specifically designed to take into account the economic
circumstances of the family. My testimony deals with the
dependency exemption, a child credit such as proposed by both
political parties, but not enacted; the earned income credit;
the child dependent care credit; the so-called kiddie tax; the
standard deduction; the special rate schedule for heads of
household; marital income splitting, and the treatment of
alimony and child support.
All of these are the family type issues which I am going to
try to deal with briefly. However, I will speak only to the
first three of these issues, given the time constraint, and the
rest of the issues are discussed in my testimony.
Over the 48-year period from 1948 to 1996, the dependency
exemption has grown four fold. During that same period,
however, per capita personal income has grown sixteen fold. As
a consequence, the dependency exemption fell from about 42
percent of per capita personal income in 1948 to less than 11
percent by 1996.
The dependency exemption for 1996 would need to be set at
about $10,000 for it to represent the same percentage of per
capita income as it represented in 1948. If converted to a
credit that offset taxes, the exemption would need to be about
$1,500 per child.
This decline in the dependency exemption, along with
increases in Social Security taxes, has increased the tax
burden of families with children relative to almost all other
taxpayers. It is one of the major reasons for consideration
today of a child credit.
Now, a child credit is a possible alternative mechanism for
delivering tax relief to families with dependent children. And
although both political parties have proposed such child
credits, none has been enacted to date.
Significant simplification gains are possible if tax relief
for dependent children is provided through one mechanism rather
than several. A credit mechanism that combined the benefits of
an earned income credit and the dependency exemption could be
coordinated better also with rules for phasing out welfare
benefits.
Congress may also have a very unique opportunity today to
link some unified child credit with a requirement that a credit
is available only to families who purchase health insurance for
their children. That is, in one combined effort, Congress could
partially reverse the historic trend toward increasing the
relative tax burden on families with children, could reduce
dramatically the lack of health insurance among children and
among some adults as well, and reduce some of the very high
implicit tax rates on those who decide not to go on welfare in
the first place.
Proponents of any type of tax reform have a major difficult
issue to deal with when dealing with the earned income credit,
some of which came up in the previous questions and answers.
For example, it is impossible to remove many low-income
families from filing returns as long as the earned income
credit is designed in its current form.
For those who favor many types of consumption taxes, the
earned income credit also affects dramatically the
simplification gains they hope to achieve because the earned
income credit is necessarily income based, that is, it's phased
out for high income individuals on the basis of their income,
not on the basis of their wages or consumption.
The problem is not solved by making the issue of relief for
low-income workers a problem for the welfare system, because
those systems also contain implicit income taxes that require
income reporting.
My testimony today had dealt with the many family sensitive
issues that must be dealt with in major tax reform. Several of
these issues affect large numbers of taxpayers and affects
significant amounts of revenues. While certain types of reform
efforts technically may be beyond an income tax, you really
cannot bypass these family issues.
Thus, earned income credits and welfare programs have
income phase outs that operate like income taxes, even in the
presence of a consumption tax. And a consumption tax, or a
value-added tax or retail sales tax that did not allow for a
child care deduction, a decision would still have to be made as
to whether child care expenses will be taxable as consumption
services.
Some divorce settlements would have to be renegotiated
under any major tax reform, even though they might be based on
an allocation of tax benefits under former law.
Of all the issues I've raised, perhaps the largest and the
most important are those that relate to the way the tax system
adjusts for the presence of children through tax credits,
dependent exemptions and the earned income credit.
Recent bipartisan support for child credits, and the push
for tax reform create a unique opportunity to lessen the
increasing reliance of our tax system on families with
children, to expand significantly health insurance for
children, and at the same time to reduce the extraordinarily
high tax rates and marriage penalties on many low-income
individuals. Thank you.
[The prepared statement follows:]
Statement of C. Eugene Steuerle, Senior Fellow, The Urban Institute
Any opinions expressed herein are solely the author's and
should not be attributed to The Urban Institute, its officers
or funders.
The family is the primary social structure in the United
States for nurturing, raising and paying for the needs of
children. Support for families, however, has long been an
expressed policy goal of both major U.S. political parties.
Whether U.S. tax policy--as opposed to expenditure policy--
should be designed specifically to benefit families is an issue
of legitimate debate. In a recent article with Professor
Michael McIntyre of Wright State University, we subscribed to
the traditional view that a personal tax system should be
designed primarily to distribute tax burdens in a way that is
fair to all individuals, irrespective of their family
circumstances. At the same time we concluded that a tax system
cannot be fair to individuals unless it takes into account the
differences in ability to pay that result from the way that
resources are shared within families of different sizes and
types.
When it comes to tax reform, ``family'' issues are often
among the last to be considered. In practice, however, these
issues often dominate the revenue adjustments that might be
required in moving to any different type of system. Having
served as the Economic Coordinator for the Treasury
Department's 1984 to 1986 tax reform effort, I can warn anyone
trying to redesign the tax system that ``family'' issues at
times will drive the process if for no other reason than that
so much money is at stake. Congress' recent debate over a child
credit demonstrates just how expensive changes here can be. One
reason is that decisions over how to treat children or spouses
in the tax Code typically involve millions, tens of millions,
or even hundreds of millions of people. A change of $500 for 50
million taxpayers, for instance, might require that $25 billion
in tax liabilities be shifted annually. By way of contrast,
most other reform issues involve far smaller numbers of
taxpayers.
Many provisions of the current federal income tax are
specifically designed to take into account the economic
circumstances of the family. Examples of some family-sensitive
tax issues follow:
the dependency exemption;
a child credit (proposed by both major political
parties, but not enacted);
the earned income tax credit;
the child and dependent care credit; the
``kiddie'' tax;
the standard deduction and tax-free levels of
income that vary in amount for different types of households;
the special rate schedule for heads of
households;
marital income splitting and the rate schedule
for single taxpayers; and
the deduction for alimony payments and the
nondeductibility of child support payments.
Obviously, all tax issues affect the family in some manner
or another. For instance, the home mortgage interest deduction
and the charitable contributions deduction affect families in
different ways. However, I will confine my discussion today
mainly to those issues where adjustments in tax burden are made
according to the size of the family--in particular, the
presence of children.
One major source of complication must be admitted up front.
Current tax law includes several measures designed to benefit
low-income families. Some of these measures are defended on tax
policy grounds, whereas others are defended on spending policy
grounds. A major objective of family taxation reform--indeed,
one that has become unavoidable--should be to coordinate the
tax measures that are designed to benefit low-income families
with children with the various direct expenditure programs
targeted at such families. Indeed, as I will demonstrate, tax
administration often requires this coordination whether we
desire it or not.
A. Dependency Exemption
The dependency exemption is a major mechanism for adjusting
tax burdens for the costs of supporting children and is the
only mechanism that provides tax benefits to all middle-income
families with dependent children. The dependency exemption for
1996 was $2,550 per dependent child. Since 1987, it has been
phased out for high-income taxpayers. For tax year 1994,
taxpayers claimed a total of approximately 70 million
dependency exemptions.
Few changes in federal income tax laws over the past four
decades have had as far-reaching effects on the distribution of
federal tax burdens as the shift in the relative tax burdens
from taxpayers without dependent children to taxpayers with
dependent children. The increase in relative tax burdens has
been particularly marked for middle-income taxpayers with
children.
The increase in relative burdens on families with dependent
children did not occur because policymakers, after careful
study, concluded that parents with dependent children were
being taxed too lightly. Instead, it happened primarily because
the chief mechanism for granting tax relief to families with
dependent children--the dependency exemption--was not adjusted
sufficiently to keep up with economic growth.
Over the 48-year period from 1948 to 1996, the dependency
exemption has grown from $600 to $2,550--slightly more than a
four-fold increase. During that same period, per capita
personal income has grown from $1,425 to $23,882, which is more
than a sixteen-fold increase. As a consequence of economic
growth, the dependency exemption fell from about 42 percent of
per capita personal income in 1948 to less than 11 percent by
1996.
The dependency exemption for 1996 would need to be set at
approximately $10,000 for it to represent the same percentage
of per capita income as it represented in 1948 (Figure 1).
Simply to adjust the dependency exemption for post-1948
inflation would require that it be increased to nearly $4,000.
If converted to a credit that offset taxes, the exemption would
need to equal $1,500 or more per child to reduce taxes for the
same proportion of income as in 1948.
This decline in the dependency exemption, along with
increases in Social Security taxes, has increased the tax
burden of families with children relative to almost all other
taxpayers and is one of the major reasons today for the
consideration of a child credit.
B. Tax Credit for Dependent Children (Child Credit)
A child dependency credit, generally referred to as a child
credit, is a possible alternative mechanism for delivering tax
relief to parents with dependent children. The credit might be
a fixed amount per dependent child, or the amount of the credit
might vary with family size. It could be fixed in amount at all
income levels; some would phase out at middle-or high-income
levels, although phase outs by their very nature involve
implicit rather than explicit tax rates. Although both
political parties have proposed child credits, most major
reform proposals do not deal with this issue.
Significant simplification gains are possible if tax relief
to families with dependent children is provided through one
mechanism that integrates the benefits of current law and any
new benefits that policymakers are prepared to give to families
with dependent children. Under current law, relief is now
targeted at families with children through the dependency
exemption and, for low-income families, through the earned
income tax credit (EITC). Adding a third relief mechanism with
a different set of eligibility rules appears needlessly
complex. Nonetheless, rolling two and perhaps all three
mechanisms into a single mechanism would require some changes
in policy--for example, a uniform definition of ``dependent''
would probably be required. Such changes may create some
additional winners and losers in order to achieve gains in
administrative economy.
In tax theory, there is no strong case in favor of a credit
over a deduction or vice-versa. Indeed, as a technical matter,
for families of one size but different incomes, it is possible
to develop a credit-based system that would replicate exactly
an exemption-based system. Assuming the continuation of the
EITC and the commitment of the nation to provide minimal levels
of support to many low-income individuals, the use of a unified
credit would seem to be the preferred approach. In addition, a
credit mechanism that combined the benefits of the EITC and the
dependency exemption could be coordinated better with various
rules for phasing out welfare benefits than is possible under
current law.
Finally, I have also suggested that Congress may have a
unique opportunity today to link some unified child credit with
a requirement that the credit is only available to families
that purchase health insurance for their children. In one
combined effort, Congress could partiality reverse the
historical trend toward increasing the relative tax burden
placed on families with children, reduce dramatically the lack
of health insurance among children (and among some adults as
well), and reduce some of the high implicit tax rates imposed
on those who decide not to take welfare or who move off of
welfare.
C. Earned Income Tax Credit
Current law provides low-income workers with a refundable
tax credit--that is, besides reducing the tax liability for
low-income families, the government sends a check to the
taxpayer for any amount by which the allowable credit exceeds
that taxpayer's liability for taxes payable on his or her
income tax return. This earned income tax credit (EITC)
provides significant benefits to low-income families with
dependent children and more limited relief to other low-income
individuals. Taxpayers with income over specified income
thresholds are not eligible for the EITC.
The EITC began as a limited program in 1975 during the Ford
administration and has been expanded several times since then,
with large increases enacted in 1986, 1990, and 1993 and some
modest adjustments in 1996. The 1993 additions were only
scheduled to become fully effective in 1996. Most of the
credits represent amounts refunded to households.
Historically, the EITC has been promoted as a useful
mechanism for lowering income taxes and offsetting FICA (Social
Security) taxes for low-income individuals with dependent
children; for some it also offset the work disincentives
associated with welfare. Both of these goals continue to be
invoked to justify the EITC. Today, the EITC probably should be
considered primarily as an extension of a combined welfare/tax
system. That is, it has important tax and welfare features that
to some extent are inseparable.
Proponents of many types of tax reform have many difficult
issues to face with the EITC. For example, it is impossible to
remove most low-income families from filing returns as long as
the EITC is designed in its current fashion. For those who
favor many types of consumption taxes, the EITC also affects
the simplification gains that they hope to achieve by
eliminating requirements to measure capital income for tax
purposes. The EITC is necessarily income-based, unless high-
income individuals with low wages or low levels of consumption
are to be made eligible for the EITC. To administer the EITC,
therefore, the tax authorities must obtain substantial
information about the capital income of prospective recipients
of the EITC. A similar constraint applies to welfare
authorities administering Food Stamps, Supplemental Security
Income, and other programs. The problem is not solved by making
the issue of relief for low-income workers a problem for the
welfare system. Those systems contain implicit income taxes
that affect millions. Meanwhile, businesses, banks, and other
institutions would still need to perform income reporting even
if the main body of the income tax were converted to a
consumption tax.
Revision of the EITC is likely to be a topic on the public
agenda for some time, whatever the political fate of the major
reform plans. The EITC has received political support from many
sources, including, at various times, from the leadership of
the two major political parties. In my view, it represents an
intermediate step as the nation searches for a way to convert
welfare into work support. It has been favored both because of
the work incentives that it provides compared to welfare, as
well as the relief that it delivers to low-income families.
Some supporters have seen it as a politically viable
alternative to an increase in the minimum wage. The EITC,
however, has also received criticisms from a range of sources,
partly because of problems with its implementation and partly
because it is not well integrated with income-tested welfare
programs. Congress and the IRS have attempted to deal with the
problem of ineligible participants receiving the credit by
reforming eligibility criteria and by checking more closely
with taxpayers over the existence of dependents. Error rates,
however, remain very high.
An additional problem in the EITC remains to be addressed:
the ability of taxpayers to overdeclare income to receive
higher credit amounts. This problem, which I have labeled the
``superterranean economy'' (as opposed to the underreporting of
income in the subterrranean economy), does not require
cheating. Two neighbors could baby-sit for each other and
generate significant EITCs as a consequence.
Coordination of Tax Provisions with Implicit Taxes Embedded in
Welfare Programs.
I recognize that your focus today is on tax reform, while a
focus on family issues keeps pulling us toward discussion of
transfer programs as well. For low and moderate income
individuals, however, tax and transfer issues simply can no
longer be separated. An important objective of public policy,
whether characterized as tax policy or welfare policy, should
be to substantially reduce the high marginal ``tax'' rates that
low income individuals typically face when they attempt to
enter the workforce or the effective tax rates that low income
workers face simply by choosing never to go on welfare. A
reduction in those rates presumably would discourage long-term
dependence on welfare. It would also reduce the extent to which
low-income workers perceive that they are being treated
unfairly.
Figure 2 shows the combined tax rates derived from tax and
welfare programs just before the enactment of welfare reform--
although it is doubtful that these rates have changed much
since then. In effect, welfare recipients who worked faced
combined tax rates of 70 percent not just when they went to
work at minimum wage but all the way up toward three times the
minimum wage (the effective marginal rate on additional work is
often even higher than this ``average'' rate on all earnings).
At one to three times minimum wage for a full-time worker, few
individuals receive much in what is commonly thought of as
welfare: AFDC or its replacement, TANF (Temporary Assistance to
Needy Families). The high tax rates at those income levels
derive from federal income tax, phase out of the EITC, state
income tax, phase out of housing benefits for those who receive
them, phase out of Food Stamps, and phase out of eligibility
for Medicaid. All phase outs, remember, basically take away
benefits as income increases. Avoidance of such poverty traps
should be an important, long-term, objective of any major tax
reform.
In addition to the large tax rates on work, marriage
penalties are enormous for low-income individuals. For a
typical welfare recipient who married someone with a modest
paying job, their combined income would fall by an additional
30 percent or so just from marriage alone. Many marriage
penalties are caused by welfare, but some are in the tax code
itself due to the earned income tax credit and the standard
deduction. Thus, another potential advantage of a unified
approach to tax and welfare issues is the opportunity provided
for reducing marriage penalties. Although, as discussed later,
there are also marriage penalties for higher income individuals
due to the rate structure, but these are smaller relative to
income than those faced by low income individuals.
Let me return briefly to how a child credit provides a
means of linking together these concerns between the welfare
system and the tax system. Just as a welfare payment operates
as a refundable tax credit that is phased out as income
increases, so also a child credit could be designed to be there
when the welfare payment was no longer available. Once the
credit is fully phased in, it can be allowed to remain constant
throughout the low-and middle-income ranges, thereby avoiding
the implicit taxes that result under current law from the
phase-out of the EITC or welfare credits.
In effect, a child credit can be explicitly designed to
reduce, although not eliminate, some of the poverty traps and
marriage penalties faced by low income individuals. As far as I
can tell, none of the major tax reform proposals on the
national agenda attempt to address the poverty traps created by
the interplay of tax and welfare policies. Several of them
attempt to replicate the distribution of taxes at low-income
levels and simply to leave these issues to another time and
place.
D. Child-Care Credit
Parents with one or more children under age 13 may claim a
tax credit under current law for a portion of the expenses for
child care and household services that they incur in pursuing
gainful employment outside the home. The allowable credit is a
percentage (30 percent at low-income levels, phased down to 20
percent) of qualifying expenses. Qualifying expenses are capped
at $2,400 (one qualifying dependent) or at $4,800 (two or more
qualifying dependents). In the case of a two-job married
couple, the expenses eligible for the credit generally cannot
exceed the income of the lower-earner spouse. Taxpayers
claiming the credit must provide the Internal Revenue Service
with the name, address, and taxpayer identification number of
their provider.
A deduction for child-care expenses was introduced in 1954,
during the Eisenhower administration, primarily as a mechanism
for encouraging mothers on welfare to work outside the home.
The deduction was capped at $600 and was phased out at rather
low income levels. The allowance has been expanded several
times and was converted into a credit in 1976. The child-care
credit was claimed in 1995 by just over 6 million taxpayers for
total credits of under $3 billion. For a taxpayer with adjusted
gross income of $10,000 or less and two qualifying dependents,
the maximum credit is $1,440. The maximum credit is $960 for
parents with income of $30,000 or more.
The case for repeal on efficiency grounds is at best mixed.
An initial and continuing purpose of a child-care allowance has
been to mitigate the tax and welfare disincentives that some
parents face in taking a job in the labor market. The
efficiency problem arises if the tax system tries to be neutral
between child care provided in the home and child care provided
outside of the home. The current credit generally favors child
care outside of the home for those with low and middle incomes,
but favors child care in the home for taxpayers with above
average incomes. Eliminating any adjustment for child care
clearly would favor child care in the home, as can be seen most
readily by examining the circumstances of a single parent who
must obtain child care in order to work. Maintaining an
adjustment, on the other hand, would cause some modest increase
in the tax rate, which could have some efficiency costs.
The case for a child-care allowance on fairness grounds
also is mixed. One argument for a child-care allowance is that
it constitutes a legitimate cost of earning income and ought to
be deductible in a tax system seeking to measure net income (or
net consumption). Those arguing that child-care expenses
constitute a business cost can show that the costs of child
care are closely analogous to certain expenses, such as the
costs of travel away from home, that are deductible as a cost
of earning income. On the other hand, those costs are also
analogous to certain other expenses, such as the cost of most
types of personal clothing, that are not deductible,
notwithstanding a close relationship to business. Because
child-care costs arise from the quintessentially personal
decision to have and raise children, a case for the deduction
on business-expense grounds can never be conclusively made.
As a practical matter, I believe that some adjustment is
appropriate but needs to be limited and kept simple.
Nonetheless, any reform proposal that attempts to eliminate
filing requirements cannot maintain a child care credit or
deduction unless these could be channeled directly through
employers.
E. Kiddie Tax
Under current law, as amended in 1986, children under the
age of 14 are taxable on their unearned income at the marginal
tax rate of their parents. This rule is popularly, if
inexactly, referred to as the ``kiddie tax.'' Its point is to
prevent parents from avoiding the bite of the graduated rate
structure by shifting investment income to their children. Its
initial purpose was to simplify tax planning costs. Its
adoption, indeed, did reduce the tax planning benefits
obtaining from establishing certain family trusts, thereby
reducing the complexity for the taxpayer and the tax
authorities that is associated with such tax planning. Earned
income--e.g., income that children earn from babysitting or
delivering newspapers--is not subject to the kiddie tax rule.
Nonetheless, in 1986 Congress went much further than the
initial ``kiddie tax'' goals when it dramatically reduced or
eliminated the personal exemption for children with earnings
who were also claimed by their parents. This created much
additional filing complexity and a significant increase in
children required to file. Simplification requires a
restoration of something like an additional personal exemption
for children, even though on strict equity grounds some
children would thereby generate more personal exemption than
others.
F. The Standard Deduction and Tax Free Levels of Income
The tax-free level under current law is determined by two
mechanisms: the taxpayer exemption and the standard deduction.
For 1996, the taxpayer exemption was set at $2,550. This is the
same amount as the dependency deduction. These personal
exemptions were set at $2,000 after the phase-in of the 1986
tax act (1989) and have been adjusted upwards for inflation
since then.
Each type of filing unit has its own standard deduction
level. For married couples in 1996 it was $6,700 for a per
capita standard deduction of $3,350. Heads of household
received a standard deduction of $5,900, while single
individuals could claim a standard deduction of $4,000.
Relative to being single, the standard deduction creates a
modest marriage penalty for many moderate income couples
typically amounting to $195 in extra tax liability.
Personal exemptions, on the other hand, are of equal size
for all persons. Together with the standard deduction they
provide for a tax-free level of income of $6,550 for a single
individual, $8,450 for a head of household, and $5,900 for each
member of a couple (Table 1). Excluding the earned income tax
credit (EITC), most reform proposals would increase this tax
exempt amount. Only flat and retail sales tax proposals usually
remove marriage penalties from this source, although there is
no reason that other reforms could not also achieve that goal.
Table 1
Family-Sensitive Provisions Relating to Marital Status of Parent: Current Law, Flat Tax, USA Tax and 10-Percent
Tax
----------------------------------------------------------------------------------------------------------------
USA Tax
Current Flat Tax (personal 10-Percent
Features of Tax Regimes Law (1996) (wage tax tax Tax
component) component)
----------------------------------------------------------------------------------------------------------------
Tax-exempt amounts for adult individuals:
married (per capita)........................................ $5,900 $10,700* $6,250 $6,925
single...................................................... 6,550 10,700 6,550 7,750
head of household........................................... 8,450 14,000* 7,950 10,100
Total Exempt amount, 2-parent family of four (husband, wife, 2
children)...................................................... 16,900 31,400* 17,600 19,350
Total exampt amount, 1-parent family of three (parent, 2
children)...................................................... 13,550 24,000* 13,050 15,600
Marriage penalty from rate structure............................ yes no yes yes
Marriage penalty from exemptions................................ yes no yes yes
Alimony deduction............................................... yes no yes yes
Child-support deduction......................................... no no yes no
----------------------------------------------------------------------------------------------------------------
* Exemption does not appy to in-kind fringe benefits or employer share of FICA payroll tax, although both are
fully taxable under business tax.
NOTE: The tax-exempt amounts do not include the amounts that would be exempt to low-income familes on account
of the earned income tax credit.
Source: Michael J. McIntyre and C. Eugene Steuerle, Federal Tax Reform: A Family Perspective (1996, p. 44).
G. The Head of Household Schedule
The head-of-household schedule was introduced into the tax
code in 1951. Its purpose was to extend to one-parent families
some portion of the tax benefits that two-parent families
received under the marital income splitting regime adopted
nationally in 1948. Under that regime, marital partners were
allowed to report one-half of the total income of their marital
partnership on the same rate schedule used by single
individuals. In contrast to the head of household schedule, the
benefits of marital income splitting were available to all
marital couples, whether or not they had dependent children.
The purpose of the head-of-household schedule is to take
account of the differences in ability to pay of heads of
households relative to equal-income single individuals due to
the difference in their support obligations. In effect, the
head of a one-parent family is allowed to split income with a
dependent child, with the child's portion of the parent's
income being taxed at a low or zero rate. The head-of-household
schedule operates like a dependency exemption that increases in
value with increases n the total income level of the one-parent
family.
The special rate schedule for one-parent families creates
the potential for marriage penalty because a husband and wife
with children could reduce their taxes under current law by
getting a divorce, using the deduction for alimony to equalize
their individual incomes, and then having one former spouse
file as a head of household and the other spouse file as a
single person. The former spouses cannot both file as a head of
household under current law and still live together, because a
head of household is defined as a person providing more than
half of the cost of maintaining the household. It does not
appear that significant numbers of married couples have availed
themselves of this tax-avoidance opportunity.
Heads of household bore significantly higher tax burdens
because of the decline in dependent exemptions noted above. If
child allowances were raised significantly, this would reduce
the need for a separate head of household rate schedule.
H. Marital Income Splitting
The modern history of the current federal system of marital
taxation begins in 1948, when Congress adopted marital income
splitting as a conscious federal policy. Before the 1948
reform, federal family taxation policy was in disarray.
In a tax system that provides for full marital income
splitting, each spouse is taxable as an individual on one-half
of the total income of their marital partnership. Such a system
is not designed primarily to benefit dependent children. It is
available, after all, to childless couples and to couples with
adult children no longer dependent on their parents. Its
purpose is to tax each spouse on that share of the total income
of their marital partnership that is used to enhance their
material well-being. It can be viewed as implementing the
traditional income tax policy goal of relating the burdens of
taxation to the consumption and net savings of individual
taxpayers.
In 1969, Congress adopted a special tax rate for single
individuals that guaranteed that they would pay no more than
120 percent of the tax imposed on marital partners having the
same aggregate income. This 120-percent rule reflected a
political compromise between those who contended that equal-
income marital couples should bear equal taxes and those who
contended that individuals with equal income or equal earnings
should pay equal taxes notwithstanding differences in their
marital status. The revenue cost of introducing the ``singles''
rate schedule was modest--on the order of $200 million per year
in forgone revenue. Despite the low cost, the implications of
this change for federal tax policy were very large, for reasons
explained below.
Under the system adopted in 1969, marital partners became
taxable on their aggregate incomes as a unit, under a rate
schedule with brackets exactly twice as wide as the brackets
under the rate schedule of prior law. The tax brackets on the
marital unit schedule, however, were less than twice as wide as
the brackets on the newly created schedule for single persons.
The effect was that two marital partners having approximately
equal separate incomes would pay less in tax if they were
allowed to file separate tax returns and to compute their
separate tax liabilities on the new singles schedule. The only
way to do so, however, was to terminate their marriage. The tax
savings that marital partners could obtain from getting a
divorce and filing separately came to be called a ``tax on
marriage'' or a ``marriage penalty.''
Congress has adopted legislation from time to time to
reduce the marriage penalties created by the 1969 act. Other
legislation, unfortunately, has increased those penalties.
Marriage penalties were reduced sharply under the 1986 tax act,
due to the flattening of the rate structure and the
introduction of fuller income splitting at middle-income
levels. Marriage penalties were increased significantly by the
way that the 1993 tax act increased tax rates for high-income
individuals. No changes have been made in the basic system of
multiple graduated rate schedules introduced in 1969, which
necessarily produces marriage penalties. Plans that attempt to
replicate the existing distribution of tax burdens, such as the
USA plan and Gephardt 10-percent tax, tend to continue that
basic structure.
A perfectly flat tax would eliminate all marriage penalties
created by the graduated structure. This approach, combined
with the equal per capita standard deductions provided to
single and married persons, would eliminate almost all marriage
penalties created by the rate structure, although not--as
mentioned above--the very large penalties due to welfare and
EITC type of provisions. To eliminate marriage penalties, one
also needs to eliminate phase-outs such as the phase out of
itemized deductions and the personal exemption phase out.
I. Alimony and Child Support Payments
Under current law, alimony is deductible to the payor and
taxable to the recipient. The effect of this arrangement is to
extend some degree of income splitting to formerly married
individuals. Thus, the treatment of current law is consistent
with the income splitting approach to family taxation.
In the typical case, alimony flows from the higher-earner
taxpayer to the lower-earner taxpayer. In a tax system having
graduated rates, therefore, taxing the recipient of alimony
rather than the payor results in a net reduction in the
aggregate tax burdens of the two former spouses. If the tax
savings to the payor and the tax detriment to the recipient are
properly taken into account in setting the level of the alimony
payments, the alimony recipient should obtain a net benefit
from having been made taxable on the alimony payments. That is,
the recipient would receive an additional alimony payment
sufficient to pay the tax and to give that individual some fair
share of the resulting tax savings. Divorce settlements that
provide for the payment of alimony are typically structured so
that they deflect some or all of the tax savings from the
alimony deduction to the alimony recipient.
The proper tax policy treatment of child-support payments
is unclear. Those who hold that the earner is the proper
taxpayer on earned income presumably would oppose the deduction
of support payments. The earner rule, however, is inconsistent
with marital income splitting--an approach endorsed under
current law and under several reform proposals. If an income
splitting approach is carried over to children, then child-
support payments would be deductible to the payor and taxable
to the child, not to the custodial parent. It certainly would
be an odd result, however, to allow income splitting between
separated parents and their children and to not allow it within
fully intact families.
As discussed above, the dependency exemption can be
understood as a mechanism for allowing limited income splitting
with children. If the dependency exemption, or a child credit,
is generous, then the issue of who to tax on support payments
has reduced importance, because the parent taxable on the
support payments presumably would be the one who would be
allowed to claim the dependency exemption or credit.
Despite all of these arguments, perhaps the simplest system
administratively, and the one with the fewest enforcement
problems, is to tax income to the earner and to grant
exemptions and credits primarily upon the basis of with whom
the child lives most of the year. In a tax system with
graduated tax rates, a rule that taxed child-support payments
to the recipient parent and made them deductible by the payor
parent typically would result in lower aggregate taxes on those
parents, assuming that the payments flow from the higher-
bracket taxpayer to the lower-bracket taxpayer. The point is
similar to one that can be made with respect to alimony
payments. Both parents would be better off under a deduction
rule as long as some mechanism was in place that would require
them to share fairly the net tax savings. Even in a single-rate
system, such as a flat tax, divorced or separated parents would
obtain a net benefit from the deduction rule whenever the
recipient parent's income otherwise would have been below the
tax-exempt level. For simplification purposes, however, most
flat and consumption-based taxes would assume that the flat
rate structure eliminated most concerns over who paid tax and
would rely upon withholding of the tax at the source of
payment, such as the employer or business.
Conclusion
My testimony today has dealt with the many family-sensitive
provisions that must be dealt with in any major tax reform
effort. Several of these family related issues affect very
large numbers of taxpayers and involve significant amounts of
revenues. While certain types of reform efforts technically may
move beyond an income tax, they often cannot bypass these
family issues. Thus, earned income tax credits and welfare
programs have income phase outs that operate like income taxes
even in the presence of a consumption tax. In a consumption tax
or value-added tax or retail sales tax that did not allow for a
child care deduction, a decision would still have to be made as
to whether child care expenses were to be taxable as
consumption services. Some divorce settlements would have to be
renegotiated under major tax reform, especially when they were
based on the allocation of tax benefits under current law.
Of all the issues I have raised, perhaps the largest and
most important are those that relate to the ways that any tax
system adjusts for the presence of children through child
credits, dependent exemptions, and the earned income tax
credit. Recent bipartisan support for child credits and the
push for tax reform create a unique opportunity to lessen the
increasing reliance of our tax system on families with
children, to expand significantly health insurance for
children, and, at the same time, to reduce the extraordinarily
high tax rates and marriage penalties on those low-income
individuals who decide to work rather than rely on welfare.
Chairman Archer. Thank you, Mr. Steuerle. Our next witness
is Mr. Glenn Hubbard.
STATEMENT OF R. GLENN HUBBARD, RUSSELL L. CARSON PROFESSOR OF
ECONOMICS AND FINANCE, COLUMBIA UNIVERSITY, NEW YORK, NEW YORK;
RESEARCH ASSOCIATE, NATIONAL BUREAU OF ECONOMIC RESEARCH; AND
DIRECTOR, TAX POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE
Mr. Hubbard. Thank you, Mr. Chairman. My name is Glenn
Hubbard. I am an economics professor at Columbia University in
New York.
I have on the wall in my office at Columbia a framed copy
of the four pages of the original income tax form, including
both the instructions and schedule. Compared with the stack of
papers that was on my desk as I prepared my 1040 this year, I
observe that the tax system has obviously gone through a stark
and twisted change.
The most vocal discussion about which you have been hearing
on fundamental tax reform has to do with changing the tax base
from an income tax to a consumption tax. Many economists
support such a move, based on economic efficiency, fairness,
and simplicity.
Perhaps less vocal but, I would argue, also quite important
are voices for fundamental income tax reform--that is, taxing
broad measures of income, but tax them only once, as Mr. Armey
was suggesting.
An example of this debate is the discussion of corporate
tax integration. The U.S. Treasury has put forth a proposal
forward that end in 1992.
An interesting point--to which I will return in a moment--
is that many of the improvements that economists identify for
consumption taxation could be achieved with fundamental income
tax reform. I would encourage you to step back from labels
except one--``radical.''
The current tax system is widely and properly regarded as a
patchwork quilt of incentives and disincentives. It is tempting
to call the current tax an ``income tax,'' and, by extension
characterize a ``consumption tax'' as its savior. The current
tax system is, however, in fact, a hybrid of income and
consumption tax characteristics.
Forgetting about labels for a moment, I would like to
define a fundamental tax reform as one satisfying the following
characteristics: First, a combination of a business level tax,
which would either be on cash flow or business income,
depending on the system, and a household wage tax. Second, for
an income tax version of tax reform, let depreciation
allowances approximate economic depreciation, and for
consumption taxation, let businesses deduct capital
expenditures. Third, the business level tax would not
distinguish between debt and equity financing. Fourth, in order
to minimize marginal tax rate differences across businesses and
investments, firms could carry forward net operating losses
with interest. Finally, the system would have lower marginal
rates, preferably with a single marginal rate across businesses
and households, but with personal or family exemptions.
To fix ideas, an example of an income tax version of this
kind of reform, is the comprehensive business income tax that
the Treasury suggested in 1992, in which there would be no
interest deduction but no taxation of interest and dividends at
the individual level.
On the consumption tax side, one logical prototype would be
the flat tax that Mr. Armey described. Such a tax would include
both a business cash flow tax and a household wage tax. Is one
of these more radical than the other? They are both quite
radical, and both worthy of consideration.
The only difference in the stylized descriptions I gave you
for the two systems is that the income tax depreciates capital
expenditures, while the consumption tax expenses them.
That is an important point, because one argument that is
often raised against consumption taxation and in favor of
income taxation is that consumption taxes do not tax capital
income, and are hence unfair. But not so fast.
Remember that the only difference between those two
fundamental reforms, income tax and consumption tax, as I
described them, is depreciation versus expensing. That really
amounts to the consumption tax forgiving the tax on the time
value of money on depreciation allowances. That's a very small
component of what is commonly called capital income, most of
which represents returns to risk or entrepreneurial skill.
What are the implications of this observation? Again, I
think it serves to underscore that we think more about
``radical'' than ``income tax'' versus ``consumption tax.''
Thinking about the underlying characteristics, of the reforms,
it is possible to get there from here. One way, of course,
would be an overhaul; simpler still would be to begin with
corporate tax integration and possibly saving incentives.
There are some pitfalls to avoid: I urge you to avoid the
Trojan horse of small simplification proposals, and to avoid
very expensive departures from fundamental tax reform such as
education tax credits.
In closing, Mr. Chairman, on a day when the national
attention is drawn to the problems of the tax system, thank you
for allowing me the opportunity to appear.
[The prepared statement follows:]
Statement R. Glenn Hubbbard, Russell L. Carson, Professor of Economics
and Finance, Columbia University Research Associate, National Bureau of
Economic Research, Director of Tax Policy Studies, American Enterprise
Institute
Mr. Chairman, Ranking Member Rangel, and members of this
distinguished Committee, I appreciate the opportunity to appear
before you today. It is fitting, Mr. Chairman, that you have
chosen ``Tax Day'' as an occasion for investigating the impact
of fundamental tax reform on individuals and families.
Policymakers and economists rightly focus on three criteria for
judging changes in the tax system: economic efficiency,
fairness, and simplicity. On all three grounds, fundamental tax
reform is likely to improve the economic well-being of American
individuals and families.
The Need for Fundamental Tax Reform
Many recent proposals for fundamental tax reform have
advocated replacing the current tax system with a broad-based
consumption tax.\1\ Economists' support for such proposals
centers on gains in economic well-being made possible by tax
reform. Three sources of efficiency gains, it is argued, would
accompany a switch to consumption taxation. First, the removal
of the current tax on returns to new saving and investment
would increase capital accumulation and, ultimately, family
incomes. Second, the consumption tax would remove distortions
in the allocation of capital across sectors and types of
capital. Third, a broad-based consumption tax would avoid
potentially costly distortions of firms' financial structures.
Recent estimates suggest that efficiency gains from consumption
tax reform could be substantial. Professor Dale Jorgenson of
Harvard University estimates the present value of growth
opportunities created by the move from the 1985 tax law to the
Tax Reform Act of 1986 to be about $1 trillion in 1987 dollars
(Jorgenson, 1996). Jorgenson estimates that, had the United
States moved from the 1985 income tax law to a broad-based
consumption tax, gains in growth opportunities would have
doubled to about $2 trillion. The additional gains are due to
leveling the playing field and expensing business investment.
Professor Alan Auerbach of the University of California,
Berkeley estimates that the move from the current tax system to
a broad-based consumption tax would raise output per capita by
about eight percent (Auerbach, 1996).
---------------------------------------------------------------------------
\1\ See, for example, Robert E. Hall and Alvin Rabushka (1983,
1995), Nicholas Brady (1992), and Alliance USA (1995).
---------------------------------------------------------------------------
With respect to fairness, many economists believe that
consumption represents a better measure of ``ability to pay''
than does current income, because households' consumption
decisions depend on wealth and expected future income as well a
current income. Finally, a properly designed broad-based
consumption tax promotes simplicity. Several consumption tax
systems avoid much of the costly complexity associated with the
present income tax.
Another group of proposals has suggested reforming the
income tax, in particular toward taxing broad measures of
income--once.\2\ While the debate between ``income tax reform''
and ``consumption taxation reform'' often characterizes the
differences between the two plans for reform as significant, I
argue below that, with respect to efficiency gains, the
distinction between reform toward a broad-based income tax and
reform toward a broad-based consumption tax is relatively
minor. This is not to say that there are not important
efficiency consequences of moving from the current tax system
to a broad-based consumption tax. Instead, I mean simply that
most such consequences can be traced to reform of the income
tax. In addition, the distributional consequences of broad-
based income tax reform and consumption tax reform are broadly
similar. Much, though not all, of the simplification made
possible by consumption tax reform can be achieved through
income tax reform.
---------------------------------------------------------------------------
\2\ See, for example, American Law Institute (1992) and U.S.
Department of the Treasury (1992).
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Fundamental Tax Reform
The current tax system is widely regarded by economists,
policymakers, and taxpayers generally as a patchwork quilt of
incentives and disincentives. In addition, while it is tempting
to call the current tax system an ``income tax,'' that system
is in fact a hybrid of income and consumption tax
characteristics. Hence, to fix ideas, I use the term
``fundamental tax reform'' to represent tax proposals with the
following characteristics:
(1) A combination of a business-level tax (with either cash
flow or business income the base) and a household wage tax.
(2) For an income tax version of reform, I assume that
depreciation allowances approximate economic depreciation; for
the consumption tax version of reform, businesses will deduct
capital expenditures.
(3) The business-level tax does not distinguish between
debt and equity financing.
(4) In order to minimize the differences in marginal tax
rates across business entities and investments, firms will be
allowed to carry net operating losses forward with interest.
(5) Lower marginal tax rates, with single marginal tax rate
across business entities and households; the household tax can
have a personal or family exemption.
While not all tax reform proposals share these
characteristics, I focus on the characteristics to make a
simple comparison between fundamental income and consumption
tax reforms. I would also hesitate to add that fundamental
income tax reform put this way is very much in the spirit of
radical tax reform.
Bases of Income and Consumption Taxes
To illustrate the difference between broad-based income and
consumption taxes (of the form I just described), compare two
hypothetical taxes--a pure uniform rate income tax and a
subtraction-method value-added tax (as a representative
consumption tax). The base of a pure uniform-rate income tax
includes all forms of labor and capital income; the tax applies
a flat rate against this income. Such an income tax could be
implemented by means of a business-level (both corporate and
noncorporate business) tax on receipts less wages, materials
costs, and capital depreciation, plus a household-level tax on
wages. For simplicity, suppose that the same (flat) rate is
imposed in both the business and household tax. Abstracting
from risk considerations (which I discuss below), then, the
revised income tax has three components: (1) a wage tax, (2) a
tax on returns from marginal investment projects, and (3) a
cash flow tax on returns from existing capital and investment
projects yielding economic profits. Within the context of
broad-based income tax reform, the Treasury Department's (1992)
Comprehensive Business Income Tax (CBIT) proposal generally
followed this model. That proposal would deny deductibility at
the business level of payments to debtholders and
equityholders, but it would not tax such distributions at the
investor level. Hence, in principle, the tax base is receipts
less payments for employee compensation and other variable
inputs and capital depreciation charges.
Under a subtraction-method value-added tax (VAT), each
business has a tax base equal to the difference between
receipts from sales of goods and services and purchases of good
and services from other businesses. This measure of value added
is then taxed at a fixed tax rate. Because the aggregate
business tax base equals aggregate sales by businesses to non-
businesses, the tax base is equivalent to aggregate
consumption. As long as the tax rates are the same, such a tax
is equivalent to a European-style credit-invoice value-added
tax.
Following the Hall-Rabushka Flat Tax (Hall and Rabushka,
1983,1995), one could equivalently permit a deduction for wages
at the business level with wage taxation at the same rate for
individuals. Hence the subtraction-method VAT can be thought of
as a combination of a wage tax and a tax on business cash flow.
Viewed in this way, (this form of) a consumption tax is quite
similar to the broad-based income tax.\3\ The difference
between the two taxes is that the income tax base depreciates
capital expenditures, while the consumption tax base deducts
capital expenditures.
---------------------------------------------------------------------------
\3\ This similarity is true in the context of business taxation.
The Flat Tax addresses the distortion between housing capital and
nonhousing capital more completely than CBIT.
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Differences in the Taxation of Capital Income
The conventional description of a consumption tax or a cash
flow tax assumes that all income from capital is exempt from
taxation. To explain this view, one can decompose the base of
the Flat Tax into two parts: The first is a business cash flow
tax, the base of which is receipts from sales of goods and
services less purchases for labor and materials and expenditure
on capital goods. The second is a wage tax.\4\
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\4\ The subtraction-method VAT combines the two pieces, with a base
equal to receipts less the sum of wages and purchases from other firms.
---------------------------------------------------------------------------
Under the cash flow tax, the present value of depreciation
allowances for one dollar of current investment is one dollar,
while under the income tax, the present value is less than one
dollar. For a risk-free investment project, the tax savings
from depreciation allowances represent risk-free cash flows,
which the firm would discount at the risk-free rate of
interest. For a marginal investment--one in which the expected
rate of return just equals the discount rate--the upfront
subsidy to investment provided by expensing equals the expected
future tax payments. It is in this sense that the return to
capital is not taxed under a cash flow tax or a consumption
tax.
Life-cycle simulation models used to evaluate tax reforms
follow this intuition and generally assume one risk-free return
on accumulated savings.\5\ In such models, the shift from an
income tax to a consumption tax is equivalent to forgiving the
taxation of capital income from new saving and imposing a one-
time tax on existing saving used to finance consumption.
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\5\ See, for example, Alan Auerbach and Laurence Kotlikoff (1987);
R. Glenn Hubbard and Kenneth Judd (1987); and R. Glenn Hubbard,
Jonathon Skinner, and Stephen P. Zeldes (1995)
---------------------------------------------------------------------------
What about investments which yield economic profits? That
is, in addition to risk-free projects, suppose that certain
entrepreneurs have access to investments with returns
associated with rents to ideas, managerial skill, or market
power. In this case, rates of cash flow in excess of the firm's
discount rate for depreciation allowances are taxed. Cash flows
representing economic profits are taxed equivalently under the
broad-based income tax and the cash flow tax (or consumption
tax). As long as the scale of projects with economic profits is
limited, the tax saving from expensing should be invested in
another risk-free asset. Hence, for projects yielding economic
returns, only the return representing the risk-free rate is
untaxed under the cash flow tax or consumption tax.
What about risky investments? First, risky investments
generate high or low returns after the investment is made. The
component of capital income that represents luck after a risky
investment has been made can be treated like the economic
profit in the foregoing example of the income tax and the cash
flow tax.
Second, risky investments have a higher required rate of
return before the investment is made than risk-free
investments, reflecting a risk premium to compensate savers for
bearing risk. Whether either tax system levies a tax on the
risk premium depends on how one defines a ``tax.'' If a tax is
defined as an increase in expected government revenue, then
both the income tax and the cash flow tax include the risk
premium. If, in contrast, a tax is an increase in the
discounted present value of government revenue, then neither
tax system includes the risk premium. In either case, the
central point is that the stylized income tax and the
consumption tax treat the return to risk-taking similarly.
To summarize, what is often called the return to capital
can be thought of as the sum of the risk-free return, economic
profits, and returns to risk taking (payment for bearing risk
and luck). In contrast to the base of the consumption tax, the
income tax includes the opportunity cost of capital, which
equals the rate of return on a marginal riskless project.
Efficiency and Distributional Consequences of Consumption Taxation
Acknowledging that, relative to a broad-based income tax, a
consumption tax exempts only the risk-free component of capital
income may warrant a reconsideration of the efficiency and
distributional consequences of a shift toward consumption
taxation. In the interest of brevity, I discuss below only five
areas that need to be reconsidered: (1) saving and investment,
(2) intersectoral and interasset distortions, (3) distortions
of business financing decisions, (4) asset price effects, and
(5) long-run distributional consequences.
Saving and Investment
Much of the interest by economists and policymakers in
consumption taxation reflects a belief that such tax reform
will increase domestic saving and investment. While the
responsiveness of saving to changes in the net return can be
large in life-cycle simulation models, available empirical
evidence based on household data suggests that the sensitivity
of household saving to changes in the net return is modest, at
least for most households.\6\ In addition, if only the risk-
free interest rate is exempt under a consumption tax (relative
to an income tax), the stimulus to domestic household saving
may not be large. For business investment, however, the
combination of the shift to expensing and recent large
estimates of the responsiveness of investment to changes in the
user cost of capital suggests that consumption tax reform can
still be a potent stimulus for domestic investment.\7\
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\6\ See, for example, the review in Eric Engen and William Gale
(1996).
\7\ See Kevin Hassett and R. Glenn Hubbard (1997).
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Intersectoral and Interasset Distortions
Moving to a broad-based consumption tax eliminates current
distortions in the tax treatment of alternative sectors (for
example, corporate versus noncorporate) and of alternative
assets (for example, owner-occupied housing versus business
capital). Efficiency gains from removing these distortions are
likely to be large.\8\ It is important to note, however, that
these gains--essentially arising from eliminating differential
taxation of alternative forms of capital income--arise from
income tax reform. That is, while substantial intersectoral and
interasset gains may be achieved from a shift from the current
tax systems to a broad-based consumption tax, most such gains
are achievable in a move from the current tax system to an
integrated income tax system, as in the Treasury Department's
CBIT proposal.
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\8\ See, for example, the estimates reported in Alan Auerbach
(1996).
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Financial Distortions
While life-cycle simulation models of tax reform do not
consider distortions of business financing, some evaluations of
tax reform have concluded that tax-induced distortions of
corporate capital structure and dividend decisions can generate
significant efficiency costs (see, in particular, U.S.
Department of the Treasury, 1992). A move to a broad-based
consumption tax of the ``flat tax'' form would clearly remove
these distortions; neither interest payments nor dividends is a
deductible business expense, and neither is taxed to investors.
The same outcome would obtain under income tax reform of the
CBIT form, however.
Asset Price Effects of Tax Reform
Conventional analyses of tax reform using life-cycle
simulation models focus distributional analysis on the short
run--in particular asset price effects in the transition from
the current tax system to a broad-based consumption tax. In
such models in which there is a representative household within
a cohort, asset price effects represent a redistribution across
generations. Relative to fundamental income tax reform, the
shift to a broad-based consumption tax entails two potentially
significant asset price effects. For equities, the shift from
depreciation to expensing reduces the value of old capital and
equity. In life-cycle models with a representative household
within a cohort, the decline in the value of old capital is
largely borne by older generations, who own a
disproportionately large share of the capital. For debt, to the
extent that the price level rises in response to a shift to a
consumption tax, the value of existing nominal bonds falls.
Other significant asset price effects of tax reform stem from
the shift from the current tax system to a broad-based income
tax with uniform capital income taxation. For example, the
adverse consequences of tax reform for the prices of existing
homes reflects this shift in the income tax. In addition, many
effects of tax reform on equity values (through the removal of
dividend and capital gains taxes) arise from corporate tax
integration an income tax reform and not from the shift to
consumption taxation per se. These effects on equity values
would, for example, have accompanied the Treasury Department's
1992 proposals via dividend exclusion or CBIT.\9\
---------------------------------------------------------------------------
\9\ The Treasury Department's ``dividend exclusion'' proposal
follows the CBIT proposal for equityholders would neither be deductible
at the business level nor taxable at the investor level.
---------------------------------------------------------------------------
Long-Run Distributional Consequences of Tax Reform
Critics of consumption tax reform sometimes claim that, as
a tax base, ``consumption'' is less equitable than ``income''
because the benefits of not taxing capital income accrue to
households with high levels of economic well-being.\10\ Recall,
however, that, relative to a uniform income tax, a consumption
tax exempts only the opportunity cost return to capital from
taxation. Using U.S. household data, William Gentry and I
(1997) found that heterogeneity of household portfolios within
a cohort is significant, highlighting the significance of
examining consequences of eliminating differential taxation of
capital income in tax reform. We also found that holdings of
assets most easily identified with economic profits (for
example, active business interests of the households) and risky
returns (for example, equities) are highly concentrated among
high-income and high-net-worth households. This finding
suggests a more progressive distribution of the tax change than
that generated under the assumption that all capital income
represents opportunity cost. Furthermore, our distributional
analysis indicates that this qualification is economically
important. Designing ``distribution tables'' similar to those
used in Washington practice, we find that more than one-third
of the reduction in the shore of taxes paid by very high-income
households in switching from an income tax to a consumption tax
is offset by assuming that only the risk-free return to saving
is exempt from taxation in the reform.
---------------------------------------------------------------------------
\10\ This would be true, for example, if the ratio of household
wealth to permanent income, all other things being equal, increase with
permanent income, as suggested by R. Glenn Hubbard, Jonathon Skinner,
and Stephen P. Zeldes (1995).
---------------------------------------------------------------------------
Conclusions and Implications for the Tax Reform Debate
A shift from the current tax system to a broad-based
consumption tax is best thought of as a two-step process.
First, most elements of consumption tax reform are consistent
with moving to a pure income tax with uniform capital taxation.
Second, for a switch from this pure income tax to a consumption
tax, the key element of reform is replacing depreciation
allowances for physical investment with expensing of capital
assets. These points suggest the need for reevaluating
conventional conclusions about efficiency and distributional
consequences of tax reform. They also indicate that fundamental
income tax reform and consumption tax reform are not in many
responses significantly different directions in tax reform.
The observation that fundamental income tax reform and
fundamental consumption tax reform have similar consequences
also has several implications for policy analysis of tax
reform. First, policy analysis should study effects of tax
reform on economic well-being within cohorts as well as across
cohorts. Second, because many of the gains made possible by
consumption tax reform can be achieved through income tax
reform--and in particular, through integrating corporate and
individual income taxation--income tax reform should occupy a
prominent place in the tax reform debate. Third, incremental
reforms toward integration and toward making capital taxation
more uniform may offer a significant starting point for more
fundamental tax reform. Finally, Mr. Chairman, while the
Committee is rightly concerned with the need for radical reform
of the current tax system, both radical income tax reform and
radical consumption tax reform are likely to improve the
economic well-being of American individuals and families.
Thank you again, Mr. Chairman, for the opportunity to be
with you today.
References
Alliance USA. ``Description and Explanation of the Unlimited
Savings Allowance Income Tax System.'' Tax Notes, March 10, 1995, 66,
pp. 1483-1575.
American Law Institute, Federal Income Tax Project. Reporter's
Study Draft, Integration of the Individual and Corporate Income Taxes.
Philadelphia, 1992.
Auerbach, Alan J. ``Tax Reform, Capital Allocation, Efficiency, and
Growth,'' in Henry J. Aaron and William G. Gale, eds., Economic Effects
of Fundamental Tax Reform. Washington, D.C.: Brookings Institution,
1996.
Auerbach, Alan J., and Kotlikoff, Laurence J. Dynamic Fiscal
Policy. Cambridge: Cambridge University Press, 1987.
Brady, Nicholas F. ``Remarks Presented at the Graduate School of
Business, Columbia University.'' December 10, 1992.
Engen, Eric M., and Gale, William G. ``The Effect of Fundamental
Tax Reform on Saving,'' in Henry J. Aaron and William G. Gale, eds.,
Economic Effects of Fundamental Tax Reform. Washington, DC: Brookings
Institution, 1996.
Gentry, William M., and Hubbard, R. Glenn. ``Distributional
Implications of Introducing a Broad-Based Consumption Tax,'' in James
M. Poterba, ed., Tax Policy and the Economy, Volume 11. Cambridge: MIT
Press, 1997.
Hall, Robert E., and Rabushka, Alvin. Low Tax, Simple Tax, Flat
Tax. New York: McGraw-Hill, 1983.
Hall, Robert E., and Rabushka, Alvin. The Flat Tax (2nd ed.).
Stanford: Hoover Institution Press, 1995.
Hassett, Kevin A., and Hubbard, R. Glenn. ``Tax Policy and
Investment,'' in Alan J. Auerbach, ed., Fiscal Policy: Lessons from
Economic Research. Cambridge: MIT Press, 1997.
Hubbard, R. Glenn, and Judd, Kenneth L. `` Social Security and
Individual Welfare: Precautionary Saving, Borrowing Constraints, and
the Payroll Tax,'' American Economic Review, September 1987, 77, pp.
630-646.
Hubbard, R. Glenn, Skinner, Jonathan, and Zeldes, Stephen P.
``Precautionary Saving and Social Insurance,'' Journal of Political
Economy, April 1995, 103, pp. 360-399.
Jorgenson, Dale W., ``The Economic Impact of Fundamental Tax
Reform,'' in Michael J. Boskin, ed. Frontiers of Tax Reform. Stanford:
Hoover Institution Press, 1996.
U.S. Department of the Treasury. Integration of the Individual and
Corporate Tax Systems: Taxing Business Income Once. Washington, DC:
U.S. Government Printing Office, 1992.
Chairman Archer. Thank you, Mr. Hubbard.
Dr. Asmus.
STATEMENT OF BARRY ASMUS, Ph.D., SENIOR ECONOMIST, NATIONAL
CENTER FOR POLICY ANALYSIS
Mr. Asmus. Thank you, Mr. Chairman. My name is Barry Asmus.
I'm a senior economist at the National Center for Policy
Analysis. And thank you, Chairman Archer, for coming out and
saying hi to us a few months ago.
Good morning to you, and to the distinguished Members of
the Committee on Ways and Means. I cannot think of a more
important task than the need for tax reform on this April 15
day of ``send me the money.''
I'm hopeful that this Committee and this Congress can help
make tax reform a reality. The global information economy is
indeed much different than the industrial one. Labor and
capital are highly mobile.
All you need to start a business today is to have a fax
machine, a modem, and a brain, and you can have a business
anywhere in the world. Labor is highly mobile, but indeed,
capital also is highly mobile. Capital flows are 100 times
greater than world trade flows.
So the world can no longer be understood as a collection of
national economies. Indeed, we're in a situation where
boundaries are porous, and we have to think of the global
economy as an electric highway where capital gets up and goes
to where it's wanted and stays where it's well treated.
This globalized information economy is driving distribution
costs down and transaction costs to zero. Everything is
becoming more efficient, everything except the way we do taxes.
We can no longer afford $200 to $300 billion of compliance
costs. We can no longer afford to treat capital with double and
triple taxation. We can no longer afford a capital gains tax
that locks capital to less productive uses.
Taxing income was always wrong, because it's a tax on
production, supply, output and employment. But now it makes
even less sense in a global, information economy.
The income tax was designed for the industrial age, people
working in factories, on farms and for large companies. Taxes
were withheld. Compliance was relatively easy. That day is
over.
The electronic infrastructure is creating a worldwide
economy where products have value added all over the world. The
dress or shirt you buy at a store in St. Louis may have
originated with cloth woven in Korea, finished in Taiwan, and
cut and sewn in India. Then there is a brief stop in Milan to
pick up its ``made in Italy'' label, before its final journey
to a store in St. Louis.
In short, economic transactions will happen anywhere, and
individual income will come from everywhere.
In my recent book, ``When Riding a Dead Horse, For Heaven's
Sake Dismount,'' I argue that we're moving toward the contract
society. A growing number of American workers will become
entrepreneurs as we enter the 21st century. Many of them will
be working on a contractual basis as a means to earn their
income. There will be more than one employer, and many sources
of income.
Those of us that work for a large company would be assigned
to certain tasks, and will proceed to contract them out to the
high quality, low price bidder. The contractual economy will
make individual income more difficult to track, and the IRS
will have to become even more intrusive in the individual
taxpayer's life.
A consumption tax is the answer for the global economy, it
is efficient and doable in a contractual economy, and it makes
much more sense if we want a growth economy. I strongly agree
with Professor Dale Jorgenson, chairman of the department of
economics of Harvard University, that a revenue neutral
substitution of a consumption tax for the existing income tax
would have an immediate and powerful impact on the level of
economic activity.
There would be a drastic jump in savings, a substantial
rise in labor supply. There would be a huge shift toward
investments, and exports would increase. The fundamental tax
reform we are talking about today would enhance prospects for
U.S. growth and would benefit families.
As America becomes more entrepreneurial and the world
economy more global, taxpayers do not need the high compliance
costs that go with defining and tracing income from a growing
number of sources. Taxpayers do not need an intrusive IRS that
invades their privacy. They do not need a tax that jettisons
incentives to work, produce, create and be employed. They do
not need a tax that reduces wages and is widely perceived as
unfair.
But American families do need a tax that is simple to
comply with, that removes the disincentives to work, that
encourages savings and investment, that will equip them with
more capital, that will empower them by giving them choices as
to how much tax they pay, and will expand their job
opportunities.
Members of the Ways and Means Committee, I ask you: how
many families do you know that would appreciate a tax where
compliance is simple, a tax that is proportional and fair, a
tax that eliminates the underground economy, a tax that
provides the right incentives to save, work and produce, a tax
that abolishes the IRS, a tax that increases their disposable
incomes, a tax that in essence transfers income from a
government that does not earn the money to those people who do.
Imagine with me an American future where the only memorable
thing about April 15 was that it was just another beautiful
spring day. Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Barry Asmus, Ph.D., Senior Economist, National Center for
Policy Analysis
Tax Reform: The Need for a Consumption Tax
Perhaps the most urgent reason for tax reform is that we
risk a breakdown in the implied contract Americans have with
their government, as our system of generally voluntary tax
compliance erodes under abuses by, and mistrust of, the
Internal Revenue Service. However, my remarks today do not
address that point directly, but rather deal with the changing
nature of the workplace which will in the not too distant
future dramatically increase the difficulty of identifying
income, tracking income and collecting a tax on income.
The current income tax system relies heavily on employers
to collect taxes from employees. Employers receive tax
preferences for benefits furnished their employees. But that
employer-employee structure is changing in the Information Age:
(1) The workplace is decentralizing as more and more people
are becoming independent contractors and consultants, receiving
income from a range of diverse sources.
(2) The family and how it functions is evolving, as wives
enter the workforce and both partners assume nontraditional
roles.
These trends will intensify and, as they do, the current
tax system will become even more cumbersome, intrusive and
inefficient than it is today. A consumption tax makes sense
today and it will make even more sense as the decentralization
of work becomes more defined. Technological advances portend a
time in the not too distant future when governments will be
forced to turn to new ways of gathering revenue in a global
economy.
Technology and the Ability to Tax
In the Information Age, the new source of wealth is not
mainly material. It is information. Knowledge extraction,
integration and application are replacing the shipment of raw
materials from remote locations to manufacturing centers as the
dominant world business. Knowledge has become the main source
of economic value. Matter matters less and less. Knowledge and
ideas matter more and more.
Labor in the global economy is highly mobile. What do you
need to be in business around the world? Four things: a
telephone, a modem, a fax machine, and a brain. It is one thing
to rely on an income tax when people work in factories and
taxes are deducted monthly. But the income tax was an
Industrial Age solution meant for Industrial Age employers and
family structure.
It will be much more difficult to rely on an income tax
when entrepreneurs are multiplying by the millions. Compliance
costs are already too high. They will get worse as the society
evolves. Not only will it be necessary to enlarge the Internal
Revenue Service as people find more and more ways to create
wealth, but the IRS will become more intrusive and its
procedures more subject to abuse than at present as it
struggles to trace income. In a one-family-one-paycheck
economy, compliance verification is minimal. But that scenario
is disappearing.
On the other hand, with a national sales tax there would be
no need for the government to know the amount of a person's
income. For purposes of taxation, it would be irrelevant.
And what of tax deductions and credits granted employers
under the present system for their employees' fringe benefits?
Congress spends a lot of time proposing legislation such as the
$500 per child tax credit in an effort to make the current
system fair. The decentralizing workplace will exacerbate the
problems arising from the tax system's current bias toward
working for an employer. By contrast, either a flat tax or a
national sales tax would remove these problems, although the
sales tax would be preferable.
Capital, too, is less likely to be fixed. On the electronic
highway, it can instantly go where it is wanted, and stay where
it is well treated. As information and knowledge are forged
into capital, the world is connected by blips on the computer
screen that race across countries and continents in
microseconds. The dollar amounts we are talking about are huge;
sometimes a hundred times larger than current world trade flows
on an annual basis. How does government track transactions that
get more complicated and cross many national lines?
Adjusting to a Global Economy
The world can no longer be understood as a collection of
national economies. Electronic infrastructure is creating a
world-wide economy. Products have value added all over the
world. The dress you buy in St. Louis may have originated with
cloth woven in Korea, finished in Taiwan and cut and sewn in
India. Then, there was the brief stop in Milan to pick up its
Made in Italy label before the final journey to a store in St.
Louis.
The principles of freedom, private property and the free
market coupled with an intellectual system driven by knowledge
and technology will render obsolete the old paradigm of
extraction and central control by governments and business. The
growing global economy enhances the importance of economic
trade while reducing the influence of politics and control. How
easy it is to walk through a customs checkpoint declaring
``nothing'' when a billion dollar software package resides in
your head.
In the new paradigm, the means of production in capitalism
are not chiefly land, labor, and machines which traditionally
have been regulated, controlled, and taxed by government, but
rather emancipated human intelligence. Under capitalism, the
mind-generated production system, the driving force of growth
is innovation and discovery. Governments must let go of their
paternalistic control over people. So must corporations. The
antiquated income tax must give way to the consumption tax just
as corporate hierarchies yield to flat, horizontal management
controls.
A consumption tax can maximize market efficiencies, broaden
the tax base, encourage growth, savings and investment and thus
promote the economic growth needed to meet the needs of our
social and economic system. It is the only type of tax that can
meet the needs of workers, whether self-employed or working for
an employer, and families in an Information Age.
But American workers and families cannot go forward with an
Industrial Age behemoth like the Internal Revenue Service
grasping at them to hold them back. We need a tax system as
innovative and creative as the American worker. A national
sales tax can meet that need.
Chairman Archer. Thank you, Dr. Asmus.
Our next witness is Dr. Sullivan.
STATEMENT OF MARTIN A. SULLIVAN, Ph.D., ECONOMIST, TAX
ANALYSTS, ARLINGTON, VIRGINIA
Mr. Sullivan. Good morning, Mr. Chairman, and Members of
the Committee. My name is Martin Sullivan. I'm a tax economist.
In the past, I've worked at the Treasury Department, at the
Joint Committee on Taxation, and as a consultant in the private
sector.
Now I work as an economist for Tax Analysts, a nonprofit
organization in Arlington, Virginia.
It's truly an honor for me to be here today before the Ways
and Means Committee, and I'll try my best to make useful
comments.
Let me say at the outset that I firmly believe that the
U.S. tax system needs reform. Americans should not have an
anxiety attack every time they do their taxes. And the Tax Code
should not be a repository of dozens and dozens and dozens of
tax breaks, for everything from historical structures to sewage
treatment facilities.
Mr. Armey's proposed flat tax is a very intriguing piece of
legislation. It certainly does simplify the tax system. All my
friends downtown who practice corporate tax law and
international tax law and pension tax law would be out of
business if the flat tax were enacted.
But on the other hand, the proponents of the flat tax
overplay their hand when they say the tax system would not just
be simpler, but simple, under a flat tax. Under the flat tax
you would still have hundreds of millions of tax forms. You'd
still have complex Tax Court cases. You'd still have an
intrusive IRS, and you'd still have tax lobbyists.
Mr. Armey's flat tax eliminates every--let me say it
again--every single tax loophole in the Code. No more
deductions, except for business expenses, and no more tax
credits. For this, I think, the Majority Leader needs to be
commended.
I mean, who would have ever thought 10 years ago that the
Majority Leader of the House of Representatives would be taking
the lead on repealing the mortgage interest deduction. I think
it's extraordinary, and he deserves a lot of credit.
Finally, the flat tax, with its $22,000 standard deduction
for married couples, and its $5,000 of additional deductions
for each child, does, indeed, provide a lot of tax relief for
middle-income families.
So let's review what we've got here. We've got tax
simplification. We've got loophole closing, and we've got big
tax relief for middle class families. So why don't we go ahead
right away and enact this middle class flat tax cut?
Well, there's one little problem. The plan doesn't hold
together. From both an economic and a political point of view,
it's not credible. Like my grandmother once told me, if it's
too good to be true, then it probably is.
The flat tax simply isn't as good as its proponents make it
out to be, and let me explain why.
The first big problem with the flat tax is the 17-percent
rate. This rate is way too low for revenue neutrality. The
Treasury says the rate has to be closer to 21 percent. I know
some people don't trust the political motives of the Treasury
Department, but I think this number is a very solid number, and
I think Mr. Armey said it himself a few minutes ago when he
said at 20 percent his proposal falls $30 billion short. So
that means 21 percent is a revenue neutral flat tax.
But I think 21 percent is too low realistically, and let me
explain why. The Armey bill doesn't have any transition relief.
If you don't have transition relief, many businesses will be
unfairly saddled with retroactive tax increases.
I think in the end there will be transition relief for any
bill that gets through this Committee. Unfortunately,
transition relief is extremely expensive, and that would add at
least 2 percentage points to the flat tax.
Finally, the third problem with Mr. Armey's flat tax is its
repeal of the earned income tax credit. Does anybody for a
moment really think that this Committee is going to pass a
major tax reform bill with massive cuts in benefits for the
poor?
If I were advising my clients, I'd say that's absolutely
unrealistic. I think you have to add another percentage point
to the flat tax rate when you take into account that the EITC
or something exactly like it is going to be enacted into law.
Now, when you put this all together, you get a revenue
neutral flat tax rate of 24 percent, and I haven't even talked
about mortgage interest deduction, or charitable deduction, or
deduction for payroll taxes.
Now, I know a lot of the proponents of the flat tax are
going to say well economic growth is going to take care of all
these problems. I do think the flat tax will help economic
growth, but it's all orders of magnitude we're talking about
here.
I think if you do a survey, the best you're going to get is
2 or 3 or 4 or 5 percent economic growth after 10 years from
this flat tax. What does that mean in terms of the revenue
neutral tax rate? It means 1 percentage point higher.
So that means you take that 24 percent, you could bring it
down to 23 percent maybe. And when you put all that together,
and then you start doing the calculations, you're going to find
that not everybody gets a tax cut under the flat tax. Namely,
businesses are going to pay more--a lot more-- under the flat
tax. And single individuals are going to pay a lot more under
the flat tax.
For example, under a 23-percent flat tax, the not so
uncommon case of a single worker earning $30,000 would pay 25
percent more in taxes. This would be a little hard to swallow,
considering the fact that many wealthy people would receive
enormous tax cuts under the flat tax.
Under the flat tax it would not be uncommon for wealthy
individuals to have their taxes cut in half. Under the flat tax
in many cases, millionaires would pay no tax at all.
If Congress wishes to provide tax relief for middle income
families, it does not have to radically restructure the tax
system. It could simply raise the standard deduction, or as now
being actively negotiated, a $500 child credit could be added
to the Code.
Finally, I would be remiss if at this hearing I did not
mention that the flat tax would repeal many family friendly
features of the current Tax Code. The flat tax would repeal the
child care credit. It would repeal the adoption credit. It
would repeal medical savings accounts. It would repeal the
deduction for extraordinary medical expenses. It would repeal
the deduction for losses from thefts, fires, floods and other
disasters.
Most importantly, the flat tax would eliminate the tax
benefits for employer-provided health care. This would likely
result in reduction of health insurance coverage for working
families.
This concludes my testimony, and I'm very grateful to the
Committee for this opportunity to share my views.
Chairman Archer. Thank you, Mr. Sullivan. Our next witness
is Mr. Mitchell. Mr. Mitchell, if you would identify yourself
and proceed.
STATEMENT OF DANIEL J. MITCHELL, McKENNA SENIOR FELLOW IN
POLITICAL ECONOMY, HERITAGE FOUNDATION
Mr. Mitchell. Mr. Chairman, and Members of the Committee,
my name is Daniel Mitchell. I serve as McKenna Senior Fellow at
the Heritage Foundation, and the views I express in this
testimony are my own and should not be construed as
representing any official position of the foundation.
Thank you for holding this hearing and giving me the
opportunity to discuss why fundamental tax reform will benefit
individuals and families. In my comments I will be discussing
the flat tax, but it should be noted that other proposed
alternatives that tax economic activity only one time at one
low rate, such as a national sales tax, would have similar
economic benefits.
America's tax system is a disgrace. Productive economic
behavior is severely penalized. Savings and investment are
subjected to as many as four layers of taxation. Billions of
hours are required each year to comply with an increasingly
incomprehensible maze of tax forms, regulations and documents.
The economic damage imposed by our antigrowth Tax Code is
staggering, with economic output reduced by hundreds of
billions of dollars every year. The real cost, however, should
be measured in terms of lost jobs, foregone income, lower
living standards, and reduced economic security.
The problems of the current code are almost too numerous to
quantify, but they can be lumped into three main categories.
Number one is excessive marginal tax rates. The Federal income
tax has a top rate of 39.6 percent, meaning that successful
entrepreneurs receive barely 60 cents of benefit for every
dollar they contribute to the Nation's well-being.
This burden clearly reduces incentives to engage in
productive behavior leading to lower levels of work, saving,
investment, risk taking and entrepreneurship. And, of course,
added on to the Federal income tax are numerous other Federal,
State and local taxes.
The second problem is the bias against savings and
investment. And this is perhaps the most pernicious feature of
the current Tax Code, in the way that capital income is
subjected to discriminatory treatment.
Between the capital gains tax, the corporate income tax,
the personal income tax and the death tax, the government
penalizes any returns with as many as four layers of tax.
Needless to say, this means some income faces effective tax
rates of 80 percent, 90 percent or more.
Not only is this policy unfair. It has profoundly adverse
economic consequences on the economy, since every school of
thought, even Marxism, agrees that the only way to generate
higher wages and rising living standards is through savings and
investment.
And finally we have complexity. We have 5.4 billion hours
spent every year on tax returns. This is more than all the man
hours used in the entire automotive industry in America. The
Tax Foundation estimates that just the income tax system alone
imposes $157 billion of compliance costs on the economy. This
is not the money sent to Washington, DC. It's not the foregone
economic growth. It is simply the lawyers, the accountants, the
lobbyists, the tax preparers and the manhours needed to comply
with the current system.
Well, the Tax Code today is so fundamentally flawed the
only realistic solution is to completely scrap it and start all
over. Fortunately, there is widespread recognition that it does
need radical reform. Indeed, the two major alternatives, the
flat tax and the sales tax would solve all three of the
aforementioned problems.
Both proposals satisfy the following criteria of a simple,
fair, progrowth Tax Code, namely that all income should be
taxed at one low rate, and only one time and the tax should be
collected in the least intrusive way possible.
Let me explain that further. Taxing income at one rate. The
flat tax does tax economic activity at one low rate. Not only
does this ensure equal treatment under the law; it also
minimizes tax penalties against productive economic behavior.
Taxing all income one time: the flat tax eliminates the
myriad forms of double taxation in the Tax Code. By taxing
income only one time, tax reform would substantially increase
savings and investment, which is a prerequisite for economic
growth.
And then simplification: by discarding all the special
provisions in the Tax Code, a flat tax makes the calculation of
tax liability considerably simpler than it is today. Moreover,
the level playingfield created by the flat tax means that
taxpayers no longer have any incentive to time their income and
deductions in ways that minimize tax liability.
As a result, business and personal decisions will be guided
by consumer preference and economic efficiency, rather than tax
consideration. But while the key principle of the flat tax is
equality, it turns out that a simple system based on taxing all
income one time at one low rate will lead to substantially
faster economic growth.
This is confirmed by numerous academic studies, and was
also revealed at a conference of economic forecasters sponsored
by the Joint Committee on Taxation. And while the estimates
obviously vary of the additional economic growth, it is worth
noting that even an increase of just one-half of 1 percent in
the growth rate would by the tenth year mean $5,000 of
additional output for an average family of four.
Faster economic growth is not the only reason why tax
reform will help families. The substantial reduction in
compliance costs will mean additional savings for the average
family. Moreover, if lawmakers decide to combine tax reform
with tax relief, as almost certainly would have to occur to
overcome political inspired objections, taxpayers could benefit
from immediate tax relief.
A 17-percent flat tax, for instance, would reduce tax
liabilities by an average of $1,100.
Thank you very much. I'll be happy to answer any questions.
[The prepared statement follows:]
Statement of Daniel J. Mitchell, McKenna Senior Fellow in Political
Economy, The Heritage Foundation
Mr. Chairman and members of the Committee, my name is
Daniel Mitchell, and I serve as Mckenna Senior Fellow with the
Heritage Foundation. The views I express in this testimony are
my own, and should not be construed as representing any
official position of The Heritage Foundation. Thank you for
holding this hearing and giving me the opportunity to discuss
why fundamental tax reform will benefit individuals and
families. In my comments, I will be discussing the flat tax,
but it should be noted that other proposed alternatives that
tax economic activity only one time at one low rate, such as a
national sales tax, would have similar economic benefits.
America's tax system is a disgrace. Productive economic
behavior is severely penalized. Savings and investment are
subjected to as many as four layers of taxation. Billions of
hours are required each year to comply with an increasingly
incomprehensible maze of tax forms, regulations, and documents.
The economic damage imposed by our anti-growth tax code is
staggering, with economic output being reduced by hundreds of
billions of dollars every year. The real cost, however, should
be measured in terms of lost jobs, foregone income, lower
living standards, and reduced economic security.
The problems of the tax code are almost too numerous to
quantify, but they can be lumped into three main categories.
These are:
Excessive marginal tax rates
The federal income tax has a top rate of 39.6 percent,
meaning that successful entrepreneurs receive barely 60 cents
of benefit for every dollar they contribute to the nation's
economy. This burden clearly reduces incentives to engage in
productive behavior, leading to lower levels of work, saving,
investment, risk-taking, and entrepreneurship. Added on top of
the federal income tax, of course, are numerous other federal,
state, and local taxes.
Bias against savings and investment
Perhaps the most pernicious feature of the tax code is the
way in which capital income is subjected to discriminatory
treatment. Between the capital gains tax, the corporate income
tax, the personal income tax, and the estate or death tax, the
government paralizes any returns with as many as four layers of
tax. Needless to say, this means some income faces effective
tax rates of 80 percent, 90 percent, or more. Not only is this
policy unfair, it has profoundly adverse consequences on the
economy since all economic theories--even Marxism--agree that
the only way to generate higher wages and rising living
standards is through savings and investment.
Complexity
An IRS-commissioned study several years ago estimated that
taxpayers spend 5.4 billion hours on their tax returns. That is
more than all the man-hours used in the entire automative
industry in America. According to the Tax Foundation, our
income tax system alone imposes $157 billion of compliance
costs on the economy. This is not the money sent to Washington.
Nor is it the amount of foregone economic growth. It is the
cost of the lawyers, accountants, lobbyists, tax preparers, and
man-hours needed to comply with the current tax code.
The tax system today is so fundamentally flawed that the
only realistic solution is to completely scrap it and start all
over. Fortunately, there is widespread recognition that the
current tax system needs radical reform. Indeed, the two major
alternatives, the flat tax and the sales tax, would solve the
three aforementioned problems. Both proposals satisfy the
following criteria of a fair, simple, pro-growth tax code:
``All income should be taxed at one low rate and only one
time, and the tax should be collected in the least intrusive
way possible.''
Taxing all income at one rate. The flat tax taxes
economic activity at one low rate. Not only does this ensure
equal treatment under the law, it also minimizes tax penalties
against productive economic behavior.
Taxing all income one time. The flat tax
eliminates the myriad forms of double taxation in the tax code.
By taxing income only one time, tax reform would substantially
increase savings and investment, which is a prerequisite of
increased economic growth.
Simplification. By discarding all the special
provisions in the tax code, a flat tax makes the calculation of
tax liability considerably simpler than it is today. Moreover,
the level playing field created by the flat tax means that
taxpayers no longer have any incentive to time their income and
deductions in ways that minimize tax liability. As a result,
business and personal decisions will be guided by consumer
preference and economic efficiency rather than tax
considerations.
While the key principle of the flat tax is equality, it
turns out that a simple system based on taxing all income just
one time at one low rate will lead to substantially faster
economic growth. Numerous academic studies conclude that tax
reform would boost economic growth, and a conference of
economic forecasters sponsored by the Joint Committee on
Taxation also found strong agreement that shifting to a tax
system that follows the aforementioned principles will increase
the economy's output. Estimates of the additional growth,
needless to say, were varied. It is worth noting, however, than
even an increase of just one-half of one percent in the growth
rate would, by the tenth year, mean $5,000 of additional output
for an average family of four.
Faster economic growth is not the only reason why tax
reform will help families and individuals. Any analysis of the
impact on real people should include the substantial savings in
compliance costs. The Tax Foundation estimates that sweeping
tax reform could reduce compliance costs by more than 90
percent. The bulk of those savings will occur on the business
side, but that will translate into higher wages, lower prices,
and greater returns to workers, consumers, and shareholders.
Moreover, if lawmakers decide to combine tax reform with tax
relief, as almost certainly would have to occur to overcome
politically-inspired objections, taxpayers could benefit from
immediate tax relief. The 17 percent flat tax, for instance,
would reduce income tax liabilities for individuals by an
average of more than $1,100. Even at a 20 percent rate, the
flat tax would provide relief for individuals averaging more
than $500.
Finally, although it would be impossible to put a price tag
on this benefit, fundamental tax reform could have a
significant effect on the level of distrust and hostility which
the public feels toward our tax system. The current system is
riddled with discrimination. Taxpayers are either penalized or
subsidized on the basis of how they earn their income, how they
spend their income, or the level of their income. By adopting a
flat tax, which makes all taxpayers play by the same rules,
lawmakers could help restore confidence is a system that has
lost moral legitimacy.
Thank you and I will be happy to answer any questions.
Chairman Archer. Thank you, Mr. Mitchell.
Our next and last witness is Mr. Dannenfelser. Please
identify yourself for the record, sir, and you may proceed.
STATEMENT OF MARTIN J. DANNENFELSER, JR., ASSISTANT TO THE
PRESIDENT FOR GOVERNMENT RELATIONS, FAMILY RESEARCH COUNCIL
Mr. Dannenfelser. Thank you, Mr. Chairman. My name is
Martin Dannenfelser. I'm assistant to the president for
government relations at the Family Research Council. Mr.
Chairman, and Members of the Committee, I deeply appreciate
this opportunity to discuss the issue of tax reform with
particular emphasis on the need to provide relief to working
American families.
A brief glance at the Federal tax situation for families in
the early fifties will illustrate the urgency felt by me and my
associates at the Family Research Council. At that time, only
about half of working families were subject to the personal
income tax. That is, the $600 personal exemption, plus the
standard deduction were enough to leave the bottom half of
family incomes at the zero tax level.
The payroll tax was paid by virtually everyone, as it is
now, but at much lower levels--under 4 percent, counting the
employee and employer share combined, for the first part of the
fifties.
Today, the median income family is paying around 30 percent
of their income in taxes, about half of that in income taxes,
and about half in payroll taxes.
Should there be any surprise in the light of these figures
that despite the enormous economic progress of recent decades
there is so much talk of a middle class squeeze? Even leaving
aside the relative stagnation in pay growth that began in the
early seventies, this trend in Federal tax burdens on working
families would be enough to make families feel squeezed.
Mr. Chairman, no one is saying that the tax incidence of
the early fifties is something we can return to now. In
particular, the families of that era benefited from the nature
of Social Security's start up as a pay as you go system of
retirement insurance. The first generation of workers had a
lighter burden of retirees to support, and therefore lighter
payroll taxes than would be possible for any subsequent
generation to enjoy.
But consider this simple fact: Year after year in most
countries at most times, workers earn about two thirds of
national income on a pretax basis. The remainder is earned by
holders of capital. This latter kind of income comes not in
wages, but in such forms as corporate profits, rents, interest
income and capital gains, yet workers who account for roughly
67 percent of pretax income are currently paying more than 75
percent of Federal taxes, a share that has been steadily rising
in recent decades.
Holders of capital earn one-third of national income, yet
are paying only one-fourth of Federal taxes. Mr. Chairman, my
guess is that most Americans are unaware of this trend toward
higher taxes on workers, and lighter taxes on capital, even
though they feel the impact of the trend in their take home
pay.
There may even be a surprising number of economists who are
unaware of it. But to the degree that economists are aware of
it, I believe they tend to think this trend is not such a bad
thing. They assume that capital as defined in the lead economic
studies, machines and buildings, is what drives economic
growth, and that the trend of the tax burden away from physical
capital and on to working families will help the overall
economy in the long run more than if the trend were in the
opposite direction.
The problem, Mr. Chairman, is that such economists are
working under an obsolete definition of capital. When capital
theory was formulated in the 19th century, most workers, the
bulk of whom were farm laborers, and a minority of whom were in
factories, had little education. Many if not most were, in
fact, illiterate.
In the 19th century, quantum leaps in economic efficiency
often did not coincide with the invention and use of new types
of machines. The 20th century, which has featured the rise of
management and information technologies is very different.
Today the quantum leaps in economic growth are more often
associated with the education level of a country's work force.
A country can lose virtually all of its buildings and machines,
as Germany and Japan did as a result of Allied bombing in World
War II, and still regain high rates of economic growth within a
few short years.
Why? Germany and Japan lost a much smaller percentage of
their trained workers in the war than they did of their
buildings and machines. And in a modern economy, human capital
is much more important than physical capital.
One of the greatest economists of the 20th century, the
late Theodore Schultz, Nobel prize winner, of the University of
Chicago, recognized the centrality of human capital in modern
economies in part by studying the postwar German and Japanese
experiences.
What is the nature of human capital? Mr. Chairman, we are
back to the tax treatment of the family. Human capital is
created by the family. No other institution is so essential to
the raising of children, and hopefully their development into
the well-fed, healthy, educated workers of the future.
Given what modern economics has learned about the roots of
economic growth, there is no way that the income of working
families should be taxed more heavily than the owners of
machines and buildings. Should tax reform proposals considered
by this Congress put even more of the burden on working
families than is the case today?
Given these realities, I would propose several guidelines
for the Congress to keep in mind as it goes forward with
changing the Tax Code. One, investment in human capital should
be treated no better, but also no worse than investment in
physical capital. Two, just as proper maintenance of machines
and buildings is a necessary business experience, and thus is
fully recognized as such by the Tax Code, proper maintenance of
human capital should also be part of the Tax Code.
Once basic maintenance has been exempted from taxable
income, the most economically efficiency tax system is likely
to involve the widest possible definition of income, and at the
same time as a result, the lowest possible rate of taxation,
consistent with current and projected revenues.
I appreciate the opportunity to share these views, and look
forward to answering your questions.
[The prepared statement follows:]
Statement of Martin J. Dannenfelser, Jr., Assistant to the President
for Government Relations, Family Research Council
Mr. Chairman, I deeply appreciate this opportunity to
discuss the issue of tax reform with particular emphasis on the
need to provide relief to working American families.
A brief glance at the Federal tax situation for families in
the early l950s will illustrate the urgency felt by me and by
my associates at the Family Research Council. At that time,
only about half of working families were subject to the
personal income tax; that is, the $600 personal exemption plus
the standard deduction were enough to leave the bottom half of
family incomes at the zero tax level. The payroll tax was paid
by virtually everyone, as it is now, but at much lower levels--
under 4 percent, counting the employee and employer share
combined, for the first part of the l950s.
Today, the median family is paying around 30 percent of
their income in taxes--about half of that in income taxes and
half in payroll taxes. Should there be any surprise, in the
light of these figures, that despite the enormous economic
progress of recent decades, there is so much talk of a middle-
class squeeze? Even leaving aside the relative stagnation in
pay growth that began in the early l970s, this trend in Federal
tax burdens on working families would be enough to make
families feel squeezed.
Mr. Chairman, no one is saying that the tax incidence of
the early l950s is something we can return to now. In
particular, the families of that era benefited from the nature
of Social Security's startup as a ``pay-as-you-go'' system of
retirement insurance. The first generation of workers had a
lighter burden of retirees to support (and therefore lighter
payroll taxes) than would be possible for any subsequent
generation to enjoy.
But consider this simple fact: year after year, in most
countries at most times, workers earn about two-thirds of
national income on a pre-tax basis. The remainder is earned by
holders of capital. This latter kind of income comes not in
wages, but in such forms as corporate profits, rents, interest
income, and capital gains.
Yet workers, who account for roughly 67 percent of pre-tax
income, are currently paying more than 75 percent of Federal
taxes, a share that has been steadily rising in recent decades.
Holders of capital earn one-third of national income, yet are
paying only one-fourth of Federal taxes.
Mr. Chairman, my guess is that most Americans are unaware
of this trend toward higher taxes on workers and lighter taxes
on capital, even though they feel the impact of the trend in
their take-home pay. There may even be a surprising number of
economists who are unaware of it. But to the degree economists
are aware of it, I believe they tend to think this trend is not
such a bad thing. They assume that capital as defined in elite
economics--that is, machines and buildings--is what drives
economic growth, and that the sub rosa trend of the tax burden
away from physical capital and onto working families will help
the overall economy in the long run more than if the trend were
in the opposite direction.
The problem, Mr. Chairman, is that such economists are
working under an obsolete definition of capital. When capital
theory was formulated in the l9th century, most workers, the
bulk of whom were farm laborers and a minority of whom were in
factories, had little education. Many if not most were in fact
illiterate. In the l9th century, quantum leaps in economic
efficiency often did coincide with the invention and use of new
types of machines.
The 20th century, which has featured the rise of management
and information technologies, is very different. Today the
quantum leaps in economic growth are more often associated with
the education level of a country's work force. A country can
lose virtually all its buildings and machines--as Germany and
Japan did as a result of Allied bombing in World War II--and
still regain high rates of economic growth within a few short
years. Why? Germany and Japan lost a much smaller percentage of
their trained workers in the war than they did of their
buildings and machines. And in a modern economy, human capital
is much more important than physical capital. One of the
greatest economists of the 20th century, the late Nobel Prize
winner Theodore Schultz, of the University of Chicago,
recognized the centrality of human capital in modern economies,
in part by studying the post-war German and Japanese
experiences.
What is the nature of human capital? Mr. Chairman, we are
back to the tax treatment of the family. Human capital is
created by the family. No other institution is so essential to
the raising of children and, hopefully, their development into
the well-fed, healthy, educated workers of the future.
Given what modern economics has learned about the roots of
economic growth, there is no way that the income of working
families should be taxed more heavily than the owners of
machines and buildings. Still less should tax reform proposals
considered by this Congress put even more of the burden on
working families than is the case today.
Given these realities, I would propose several guidelines
for the Congress to keep in mind as it goes forward with
changing the tax code:
l. Investment in human capital should be treated no better,
but also no worse, than investment in physical capital.
2. Just as proper maintenance of machines and buildings is
a necessary business expense, and thus is fully recognized as
such by the tax code, proper maintenance of human capital
should also be part of the tax code. This implies a much more
generous tax exemption or credit for family members than we
have today.
3. Once basic maintenance has been exempted from taxable
income, the most economically efficient tax system is likely to
involve the widest possible definition of income and, at the
same time and as a result, the lowest possible rate of taxation
consistent with current and projected revenue needs.
Mr. Chairman, a flat rate tax system that is family
friendly is a tax system that is achievable as a practical
legislative goal. It also makes the most sense for the future
not just of American families, but for the productivity of our
information economy. I sincerely hope the Ways and Means
Committee and Congress will move in this direction in the
months ahead.
Chairman Archer. Thank you. I'm particularly grateful that
each of you stayed within the suggested 5-minute period, which
is not easy to do. And we'll have an opportunity to elaborate
on your views during the inquiry period.
Let me ask each of you, as a basic question, how many of
you feel that our current tax system is desirable? Raise your
hands. The clerk should record there are no hands raised.
So it's simply a question of how do we reform it? And I
wonder if what we seemed to learn from history is that we never
seem to learn from history, because we have been trying to
reform the income tax since its initiation in 1913.
It seems to me that one of the core problems is that there
probably are not two of you out there, or two economists in
this country who can define income in the same way. It is a
subjective term. Do any of you disagree with that?
[No response.]
Chairman Archer. So as long as we have income as the base
of taxation, will we not forever be going through the exercise
of defining income? Or do you think we can get around that.
Mr. Hubbard.
Mr. Hubbard. No. You have identified a critical point. The
major source of complexity is that from measuring income, and
from measuring certain kinds of expenses--depreciation, the
issue of basis, and international tax provisions.
You are correct in thinking that a consumption tax would
considerably simplify matters.
Chairman Archer. Dr. Sullivan.
Mr. Sullivan. I would add, I entirely agree with Glenn, but
there are still issues under a consumption tax that are still
very thorny, like determining what are proper business
expenses, home office deduction. Those issues would still be
out there under a consumption tax.
But I agree with Glenn.
Chairman Archer. Well, they would not be there under a
sales tax.
Mr. Sullivan. Not under a sales tax.
Chairman Archer. It depends on how you would implement--
what vehicle you would use to implement a consumption tax.
Mr. Sullivan. That's correct. But under the flat tax, that
would be.
Chairman Archer. And just to further develop this basic
concept, Dr. Sullivan, you said that the flat tax would be very
simple for business because it's just a matter of businesses
taking their business expenses.
That, as I listen to you, presumes that we could know
between us what business expenses are. We have seen a Cato
Institute report where they say they're defining corporate
welfare. And one of the items that they claim is corporate
welfare is the business expense of advertising.
So do we not further get into the problem of defining what
business expenses are ultimately even under a flat tax?
Mr. Sullivan. We still have----
Chairman Archer. I mean, what is a legitimate business
expense. Obviously it's like beauty. It's in the eye of the
beholder.
Mr. Sullivan. Yes.
Chairman Archer. Clearly because we hear these debates
going on over and over again today in this country. It
fascinates me that we now have a recommendation, a proposal
from the administration to simplify the Tax Code, and to pay
for that, they want to complicate the foreign source income
provisions.
And in their proposals in their budget, where they want to
do a number of things that are highly desirable politically,
they add significant additional complications to the Code.
And so I simply say that there are a lot of basic things
here, other than just distribution of income, economic
activity, and so forth, that we should look at that are
difficult, I know, for economists to be able to quantify and to
put into their formulations.
How much is freedom and privacy worth to every individual
in this country? If I file a flat tax it clearly is simpler
than the current income tax, and I think it is desirable in
comparison to the current income tax. But does it not still
leave the IRS in my life?
Can they not come back on me and ask me to provide the
records to support the number on my post card tax return for 7
years, and to prove the accuracy of that? Are they not still in
my life, as an individual? And all of you are nodding your
heads, I think.
So I say that preliminarily to asking each of you this
question: How much would each of you individually pay each year
not to have to deal with the IRS?
Mr. Dannenfelser, what would it be worth to you as an
individual, not speaking for your organization, but you as an
individual?
Mr. Asmus. In an average year for me, I'd be willing to pay
$3,000. But on the bad years of the IRS chasing me down, those
years I'd be willing to pay $10,000 to $20,000.
Chairman Archer. All right. Mr. Dannenfelser, how much
would you pay not to have to deal with the IRS every year
personally?
Mr. Dannenfelser. My taxes have probably not been as
complex as some others, and I have a CPA who does them for me,
so I can factor in his costs. And with some of the other things
we get from employers, I think there are probably other people
who have much more complex situations.
Probably I would be willing to pay somewhere between $500
and $1,000--that's for my own direct costs. But there are many
other indirect costs that I'm not seeing probably.
Chairman Archer. Mr. Mitchell, what about you?
Mr. Mitchell. Assuming that we're talking about replacing
the current system with a low rate consumption tax, I'm sure
I'd be willing to pay several thousand dollars just to reflect
the tax savings that I would hopefully receive.
Chairman Archer. Yes. Well, but if it were possible for us
through structural tax reform to get the IRS completely and
totally out of your individual life, how much would that be
worth to you personally?
Mr. Mitchell. That would probably be worth $1,000, $2,000.
Chairman Archer. OK.
Dr. Sullivan.
Mr. Sullivan. I'd pay $500 a year to get the IRS out of my
life.
Chairman Archer. For your tax preparer.
Mr. Sullivan. Yes.
Chairman Archer. How many of you does his own tax return?
And you still pay your tax preparer, Dr. Sullivan?
Mr. Sullivan. I don't have a tax preparer. I do it all
myself.
Chairman Archer. All right. So you don't pay anything to a
tax preparer. OK. And it's worth $500 to you not to have to do
that every year?
Mr. Sullivan. Roughly. Maybe more.
Chairman Archer. Maybe more. OK.
Mr. Steuerle.
Mr. Steuerle. I'd say about the same. About $500, if I can
avoid all interactions with tax authorities. Although I'm not
sure that's possible.
Chairman Archer. Mr. Hubbard.
Mr. Hubbard. I would likely pay I think several thousand
dollars because of the wasted time. But if I might, Mr.
Chairman, I think there are two issues raised by your concern.
One is the ``hassle factor,'' and the other is the ``anxiety
factor.''
I am not anxious about the IRS. Compliance is complicated,
and filling my tax form out is a pain. But I view that as a
hassle. I think many people whose tax returns are simpler than
mine are far more anxious. It is the anxiety about the IRS that
seems to be the public's great fear, not the number of hours
that relatively high income taxpayers might spend filling out
their forms.
Chairman Archer. And it's really very hard to quantify
that, isn't it. That is, what is the price of liberty, privacy
in your individual life? And to each of us, it's a different
thing.
I had a middle-income lady from Connecticut who sat in that
chair where you are, Mr. Hubbard, last year. And I asked this
question of all the witnesses. And the answers were all similar
to the ones you gave until it got to her, and she said I would
give my first born child.
Needless to say, she had had an untoward experience with
the IRS. It wasn't just the monetary costs.
But I do think it's important, as we look at these things,
that we take into account some of the broader aspects of what
the tax system does. Then when you get over into the issue of
economic growth, it seems to me that it doesn't get adequately
handicapped when you talk about distribution tables.
But most of you have alluded to the fact that if we had a
better tax system we could have some degree of economic growth
in excess of what we have under the current system. Does any
one of you disagree with that, that we could actually impact on
our economic growth if we had a different system from the one
that we have now?
Mr. Mitchell. I think the evidence is very clear on that.
The fastest growing economy in the world in the last 50 years
has been Hong Kong, and they have a 15-percent flat tax rate
now for the majority of filers. And the fastly growing economy
coming out of the former Soviet empire is Estonia. They have a
single rate tax system as well.
And you look at our own history, when we reduced tax rates
under Kennedy and under Reagan, the economy grew faster. I have
a hard time believing that anybody could reject the proposition
that a better Tax Code would lead to more economic growth.
Mr. Sullivan. I think the evidence is very unclear on
whether there's economic growth. I think there's a lot of
uncertainty. I think the best guesses are that there are some,
and I think it's worth going for. But I think there's been a
lot of overblown claims about this is going to solve all of our
problems.
We'll get a little bit of growth from a consumption tax,
and I think we should move in that direction. But I think the
claims are way overblown, and there is no certainty about it.
Mr. Asmus. Dale Jorgenson of Harvard University, Mr.
Chairman, isn't known for his overstatements. In fact, I think
his testimony before this Committee a year ago were full of
understatements.
But he argued that there would be a 10- to 13-percent
growth in the gross domestic product or GDP. So he would argue
there's significant growth, massive investment and saving and
great increase in the labor supply and so on.
So I think most economists would say that we would have
significant growth under a national retail sales tax.
Mr. Hubbard. Mr. Chairman, if I might offer an observation.
Chairman Archer. Mr. Hubbard.
Mr. Hubbard. All of the above might be close to correct.
There is sometimes a confusion between a change in the rate of
growth and the change in the level of output. In the long run,
most economists believe output per worker will be higher as a
consequence of tax reform. That is, there will be a higher
level of output and a higher level of consumption.
Over the short term, then, there will be a higher rate of
growth. Very few economists would say that tax reform would
permanently increase a growth rate. That's the sense in which I
think there may be some confusion.
Still, again, most of the evidence from the profession
suggests that there would be significantly higher levels of
output and consumption in response to the kind of tax reforms
you are considering.
Mr. Steuerle. One thing economists don't measure very well,
Mr. Chairman, too, are the gains from simplification. And in my
own book, I think, some of the gains from simplification are
far in excess of some of the gains we're claiming we might get
because of some more elaborate adjustments and incentives of
the system.
I think simplification is a major goal.
Chairman Archer. I'm grateful that you said that, because
the compliance costs today that are a result of complexity in
this country are to me just wasted energy. And the great minds
that are working in trying to cope with this Tax Code if they
were producing wealth would, I think, create significant
economic benefit for this country.
So I'm really glad you threw that in there. I'm also
disturbed, I must say--and there's not been much discussion
about it today--about the underground economy, and our
inability to collect the income tax.
And I believe that one of you alluded to the electronic age
and the way things are changing and shifting now. I've been
told by some experts that the amount of uncollected taxes today
will jump dramatically in the next century with the advent of
the smart card and the ability to transfer money electronically
without trace, which will basically defy the ability of the IRS
to be able to enforce the income tax in bigger and bigger
proportions.
Does any one of you have any concern about that?
Mr. Dannenfelser. We think that that is something that
would be desirable. Looking at the consumption tax, of course,
there would be--some things which would have to be looked at
because whenever you get into higher excise tax and so on, you
create the situation of black market economies, which you may
have to deal with a consumption tax as well.
But to the extent that this is becoming a more serious
problem, that is a very reasonable point to look at.
Our main concern, whether with an income tax or a
consumption tax is to look at families. And with the issue of a
consumption tax we feel that you would need to have some means,
starting with the first dollar or compensating families for
those expenses.
With the income tax, of course, you have the personal
exemption and that sort of thing. There would have to be some
mechanism built in, some kind of rebate that we would hope
would take into account the amount--per family member--would
take into account the family income and the number of family
members to somehow provide a rebate against what people are
paying in consumption taxes, just as we would suggest in an
income tax that you take into account income taxes and payroll
taxes and provide some deduction in that area.
Chairman Archer. Yes. Mr. Mitchell.
Mr. Mitchell. I think we want to be cautious about how much
money we assume that tax reform will get out of the underground
economy. Whether you have a flat tax or a sales tax, a drug
dealer is not going to report his income, nor is he going to
levy a tax on his sales.
Likewise, if somebody wants to evade taxes on the Internet,
whether they earn income that way, or they sell things that
way, if they want to simply remain anonymous, you're going to
have great difficulty under either tax reform collecting money
on people who are either illegal or simply have the ability to
remain anonymous.
But that's an argument for at least having a low rate so
that their incentives to remain illegal or anonymous are lower.
Chairman Archer. Well, I think it is a sine qua non that
there will be leakage in any tax system--in any tax system. The
question is the magnitude of the leakage, and the degree to
which the American people perceive that that leakage is massive
unfair or not.
At least the drug dealer, when they buy a Mercedes is going
to pay under the consumption tax. And the government, for tax
collecting purposes, doesn't need to know their records.
Let me go to other Members for inquiry. Thank you very
much.
Mr. Lewis.
Mr. Lewis. Thank you, Mr. Chairman. Let me thank members of
the panel for being here. As long as there is a government,
there will be taxes. As long as there are taxes there will be a
government agency to collect them. Citizens pay taxes. The IRS
or some other government agency cannot collect taxes without
interacting with citizens.
It is impossible. To say otherwise is to mislead the
American people. We must not attack the IRS for doing its job.
Yes, there are problems with the Tax Code. Yes, some IRS
employees could do a better job. But we must not attack the
IRS.
To attack the IRS is to attack ourselves. Fiery rhetoric
leads to mistrust of the Federal Government, attacks on Federal
employees, and worse.
My question to you, members of this panel, is this: under
any of these proposals, who will collect the taxes and how will
they do so?
Mr. Mitchell. I guess I'll start. I agree with you. As long
as the government is going to take a $1.5 trillion out of the
economy, they are going to need somebody with a gun as the
ultimate enforcement vehicle saying give us the money.
And whether it's one IRS in Washington or 50 different
States collecting it under a sales tax, we're going to have a
tax system that is based on the government being able to force
people to give them the money.
And I don't really blame the IRS. I blame the tax laws for
being so complicated that it causes people to mistrust and
dislike government.
Mr. Steuerle. Mr. Lewis, I may be the only person in the
United States that ever wrote a book which I dedicated to the
IRS. I wrote a book about the IRS, and after interviewing a
number of employees there, I was very impressed by their
dedication.
Having said that, when I examined the IRS, I also concluded
that they had many more functions put upon them than they could
possibly fulfill, and that that was perhaps the principal
reason for their current problems.
In a couple of columns that I have written, sort of open
letters to the Restructuring Commission, I have made this same
point, that if they really want to solve the IRS' problems,
they've got to get at some of these fundamental issues of how
much is demanded of the tax system. That is, you can't totally
separate the issue of tax policy from tax administration.
Policy has to be made somewhat simpler if we want an IRS
that is able to administer the system, and provide the advice
we really think the taxpayers deserve, but we're not willing to
pay for as a people, because we're not willing to pay the
agents the money to provide us the advice, and so on.
Mr. Lewis. Thank you.
Mr. Dannenfelser. Mr. Lewis, one of the other things I know
was alluded to here earlier is one of the great frustrations is
that taxpayers can't get an answer from the IRS that they can
rely on and point to as being something where they know they're
in compliance.
And it's very difficult for a taxpayer to know when they're
in compliance with the law. And there was a survey that said
that 78 percent of the questions were answered incorrectly by
the IRS agents.
Now, that doesn't mean that the IRS agents should be
totally to blame, because the system is unrealistic. But there
needs to be a way to make it simpler so that people can
understand it, but that also they can go to someone and get a
clear answer and that they acted in good faith with that clear
answer by somebody who is accountable, so that they are not
held liable and penalized for following the advice that the
government agent gave them.
And that would do a great deal to restore the confidence of
the people in the system.
Mr. Asmus. Mr. Lewis, John Neisbet wrote a famous book 15
years ago called ``Megatrends.'' And what gave him the idea for
that book was that if someone would have subscribed to all the
German newspapers during World War II--about 600 newspapers--
you literally could have predicted what the Nazis were going to
do in World War II.
So he said what about the idea then of subscribing to a lot
of newspapers, bringing together all the ideas, the column
inches, and see if any ``megatrends'' begin to exist. And so
that was the genesis of writing that book.
Before coming to this Committee, I thought it would be fun
to go on CompuServe and America On Line and pull up all the
stories I possibly could from all the major newspapers in the
United States--the Chicago Tribune, the New York Times, and
right across the country.
And I've got a stack of articles about 3 feet deep. I think
what--if the average American taxpayer knew what was happening
with their fellow taxpayers concerning the IRS, there would be
even more anger than there is now.
What we all go through now is we read an occasional article
in the Wall Street Journal or the New York Times and maybe in
our local newspaper, and so over the course of a year we will
read three or four things about the IRS, but when you kind of
bring all these things together, as Neisbet tried to do as he
put ``Megatrends'' together, it does shift the debate.
Again, it's not that these are mean, ornery people. It's
just that there's no competition. There's no accountability.
There's no control, and they have enormous power over people's
lives. And I think, Mr. Lewis, it would make you angry as well
as it does myself.
Mr. Lewis. OK. I notice my time has expired, Mr. Chairman.
Thank you very much.
Chairman Archer. Thank you, Mr. Lewis. The Chair totally
empathizes and agrees with the comments you made, Mr. Steuerle.
And I will say to my friend, Mr. Lewis, I don't believe there's
been an utterance out of the Chair today bashing the IRS.
There are abuses in the IRS.
Mr. Lewis. Mr. Chairman, I didn't mean to imply that you
had bashed. But I think one of my colleagues said earlier, and
others have said from this position and on the floor and in
other places around the country that we should abolish the IRS.
People have been coming down pretty hard on hard working,
dedicated Federal employees that work for the IRS.
Chairman Archer. Well, I do want to abolish the IRS,
because I want to get the privacy and the freedom of every
individual back into their lives. And there are abuses in the
IRS. But the major problem, I believe, is the complexity of the
Code.
I've been told that something as simple as head of a
household, which is a basic part of our code, that determines
how you are taxed, that if you call the IRS that an agent has
to ask you 42 questions and get the answers to those before
they can with certainty tell you that you qualify as head of a
household.
Now, that to me makes this code virtually obscene on such
simple things as that. And so I really don't want to just bash
the IRS. I want to talk about a code that we have given to them
that is virtually impossible to administer and that has too
many gray areas with too much subjectivity where there cannot
be agreement, where too many taxpayers ending up having to
negotiate their tax liability with the IRS, and reach a
settlement.
We should not have a tax system that puts taxpayers in that
kind of position, or puts the IRS in that kind of a position.
Mr. McCrery.
Mr. McCrery. Thank you, Mr. Chairman. Dr. Sullivan, I want
to start with you, if I may. You didn't raise your hand when
the Chairman asked if the present tax system was as good as we
can do. Basically that's what he asked.
Mr. Sullivan. Oh, I think we could.
Mr. McCrery. You think we can do better?
Mr. Sullivan. We can do better, yes.
Mr. McCrery. OK. In your testimony you didn't really say
how we could do better. You just really ragged on the flat tax.
But give us some positive suggestions. What should we do to
make the current Tax Code better?
Mr. Sullivan. I think I pointed out a lot of positive
aspects of the flat tax.
Mr. McCrery. You did. But your final analysis was we can't
do it.
Mr. Sullivan. Well, no. I'm saying that if we do it, I
think we have to be realistic about the rate. That we could do
it with a 23-percent tax rate. As I say, I think we should try
to keep rates as low as possible. I think we should absolutely
try to eliminate all types of deductions and credits in the
Code, so that we can have a fairer and simpler tax system.
Mr. McCrery. So is the 23-percent flat tax preferable to
what we have now, in your view?
Mr. Sullivan. I'm not trying to be cute, but I'll answer it
in two ways: from an economic point of view, I think it is
absolutely superior to what we currently have. From a personal
point of view, or a philosophical point of view, there's a
question about progressivity of the tax system. Everybody is
entitled to their own opinion about progressivity.
I would like to report that the flat tax would be much
more--much less progressive than current law. If everybody felt
comfortable with a tax system which was much less progressive
than current law, and if I felt that way, then I think it would
be a better system, yes.
Mr. McCrery. So would your concerns be calmed if we had a
simple tax system that had three simple rates, with no
deductions?
Mr. Sullivan. Right.
Mr. McCrery. That would be better than a single rate
system?
Mr. Sullivan. If one desired to have more progressivity, or
to retain the current level of progressivity that we now have,
then yes, I think that would be better than the current system.
It would be simpler. It would have a broader tax base, with
a lot less loopholes. And that type of system would have--you
would try to approximate the progressivity that we have now.
Mr. McCrery. And how, if the base rate is, say, 15 percent,
how high would you go?
Mr. Sullivan. Well, again, that's a matter of personal
preference on what one desires.
Mr. McCrery. Have you looked at the numbers, though, given
your personal bias that we ought to have a more progressive,
simpler tax system? Have you looked at the numbers to show us
where we would be in terms of rates to get a revenue neutral
proposal?
Mr. Sullivan. First of all, I don't have a personal bias, I
don't think I've expressed a personal bias in favor of a
progressive or whatever system, and I haven't looked at the
numbers. I haven't done those calculations.
I think it's perfectly legitimate to argue that the current
tax system should be less regressive. It's a very valid point
of view. All I am pointing out today is that consumption taxes
would be less progressive than current law. That's all.
Mr. McCrery. Thank you. I'm just a lawyer. I'm not an
economist, and I'm not a tax expert, really. And I am convinced
that the current Tax Code is a drag on economic activity in
this country, and certainly is not what we ought to have in the
next century. And frankly I lean toward the Chairman's idea of
some sort of consumption tax, but I'm not there yet.
So let me ask the panel a few questions about the
consumption tax. And as I say, I'm not really an economist, so
bear with me.
I read that a huge percentage of our GDP occurs as a result
of consumer activity. Consumption. So if we impose a
consumption tax, wouldn't that dampen consumer activity, at
least initially, and wouldn't that perhaps bring down our GDP,
at least initially?
Where am I wrong in that analysis? Explain that to me.
Mr. Hubbard. Your question, Mr. McCrery, raises both a
short-run and a long-run issue. Part of the goal of the
consumption tax is to raise savings rates, which would
ultimately lead to a higher capital stock, which would
ultimately lead to higher wages and higher consumption.
In your GDP accounting, another component of GDP is
investment, which would respond very positively to a
consumption tax. Most economists would argue that in the long
run--whatever that means, of course--output per worker and
consumption per worker would be higher as a result of the
consumption tax.
Mr. McCrery. Yes. That's what concerns me, is what is the
long run? How many years does it take for us to get to the long
run, and what do we do in the meantime?
Mr. Mitchell. Well, if I could jump in. Even though I'm a
flat tax fan, I think the sales tax wouldn't really have short
term consequences in the sense that if you eliminate the income
tax--and truly can do that, which is my concern with the sales
tax--don't forget everyone gets a big boost in take home pay by
the elimination of their withholding and for income taxes.
And so even though retail prices might rise by whatever the
tax rate is, you'd have that much higher take-home pay. The
only short term consequence that I think might be significant
is everybody might not rush out and buy all their big consumer
purchases December 31, and then for the first 3, 6 months of a
sales tax, or whatever that period would be, you might have
some sort of big, artificial jump up and drop off. But I think
that would be a relatively short-term phenomenon.
Mr. Steuerle. There is, Mr. McCrery, a major issue among
people who get into the technicalities of how you design
consumption taxes, and that has to do with what one would do
with existing pension savings, which are on the order of about
$7 trillion in the economy.
In fact, one of the fears is that if you immediately go to
a consumption tax where you no longer favor pension savings,
that in fact it would lead to a consumption binge by some
current owners of pensions. And so that's one of the issues.
It's actually in the opposite direction.
Mr. McCrery [presiding]. I have a lot more questions, but I
will allow my colleagues to follow their own line.
Mr. Collins.
Mr. Collins. Thank you, Mr. Chairman. Mr. Steuerle, you do
bring up a very interesting and important point there about the
transition problem with funds that are already in savings.
We've talked a lot about the consumption tax versus the
flat tax, but in reality both of them levied would be assessed
at a flat rate.
The flat rate on income would have your standard and your
personal deductions, but then would also tax income on savings.
Whereas the consumption tax, and a flat rate, would only tax
those that are expended funds from an income, and the
difference would be the income tax flat rate would be levied at
the end of the year, and the consumption would be immediately.
So that both are a flat tax as they affect the taxpayer.
And in talking about flat tax and consumption tax, we fail to
mention anything about payroll tax. Because the payroll tax has
been one of the most concerned areas due to the fact of how
much it's increased in recent years, and what it will increase
or potentially increase for what's out there for potential long
term liability based on those of us who happen to be born in or
around or right after World War II and what that's going to do
to those entitlement programs that address the payroll tax.
That is a real concern. So that has not been mentioned, but
I did want to bring that point up.
Mr. Dannenfelser, you mentioned physical capital versus
human capital. I'm a firm believer that physical capital also
creates human capital by encouraging investments in machines
and buildings that results in jobs of manufacturing or
construction.
But my question is this, because it's been mentioned, too,
by several of you on the child tax credit--should we be looking
at a child tax credit? Or should we be looking at possible
increase, both phased in over the next 5 years, in the
dependent and standard deductions, one versus the other?
I think both would have substantial reduction in the tax
liability of families. What are your comments in those areas?
Child tax credit versus an increase in standard or dependent
deductions?
Mr. Dannenfelser. They would have similar effects. We
believe that in the short run, at least looking at the $500-
per-child tax credit, that the costs associated with raising
children are such a burden for families right now. And that
with the increased tax burdens and so on that you've mentioned,
such as payroll taxes and others, that it is becoming much more
difficult.
That is a part of people's wages that are just
disappearing, and it's not accounted for in some of the other
calculations. But certainly either one would be a benefit to
families. But I think our preference in the short run would be
for the $500-per-child tax credit.
Mr. Steuerle. Mr. Collins, may I add to that?
Mr. Collins. Yes.
Mr. Steuerle. In theory, if all families were the same
size, I could in theory design a tax system rate structure with
a credit that was exactly identical to a rate structure that
had an exemption. I won't go into the details of why, but I
could literally make them replicate each other exactly.
But what complicates matters significantly is that we also
have a lot of welfare transfer systems, earned income credits
out there. The existence of these systems, all of which in some
sense you might think of as credit based, there's kind of a
basis of support that phases out, as one's income goes up. This
leads me to believe that one could get a better integrated
system by thinking about a child credit as a mechanism.
So that when one moved out of welfare, or never went on
welfare in the first place, one had something like a child
credit that went with one's family. If you do that, I think you
can not only reduce some of these large work disincentives in
welfare, you can also reduce where the really largest marriage
penalties are, for low income people who marry. I mean,
tremendous marriage penalties. They lose 30 percent of their
income in some cases just because they marry.
If you start going toward a child credit that is available
that kind of goes with the child, independently of marital
status, you can get at some of these problems. And it's for
those reasons, primarily, that I tend to favor a child credit
as opposed to a dependent exemption.
But I say in theory, the pure tax system without welfare
transfers or anything else, you could design systems that would
be roughly approximately the same.
Mr. Collins. Another difference, too, though would be the
credit again is issued at the end of the year, where if you had
an increase in the standard deduction or dependent deduction,
that could be on a weekly or biweekly or monthly payroll.
Mr. Steuerle. I think you could effect both of them with
withholding, I think.
Mr. Collins. I have one other question. We're down to short
rows. May I ask it, Mr. Chairman?
Mr. McCrery. Sure, Mr. Collins.
Mr. Collins. The next question, if we should change--and
I'd like to use a good Southern word, supposing--supposing we
should change from the current system after making some interim
changes, like the capital gains and dealing with the death tax
and the alternative minimum tax and such, what would be your
suggested date of implementation of that change? 1998, 1999,
2000, 2001?
Mr. Mitchell. I assume, just on the basis of avoiding a
presidential veto, we're not talking about actually doing this
legislation until 2001. But you all on the other side have
probably better control of that than I do.
Mr. Collins. Anyone else have a date they would like to
throw out? A year? I agree with the 2000's, implementation in
2001. To take the presidential politics out of it. Any other
comments?
Thank you, Mr. Chairman. Thank you all. It's been very
interesting listening to you.
Mr. McCrery. Thank you. Mr. Hayworth.
Mr. Hayworth. Thank you, Mr. Chairman. For the purposes of
full disclosure I should make mention of preexisting
association with two of our panelists today. First, Dr. Barry
Asmus, who I enjoy. He had the great good sense to live in
Arizona, although I would like to see him move to the Sixth
District instead of the Fourth District. But his daughter and
my daughter went to high school together.
And I also appreciated Dr. Asmus and his unique free market
perspective, offering a humorous perspective, often when he
would come to visit the Rotary Club of Phoenix, of which I was
a member. And to Mr. Mitchell, my sometime broadcast partner,
on National Empowerment Television.
I thank you all for coming down today.
Dr. Asmus, I want to return to a line of questioning that
my colleague from Louisiana brought up, about a consumption
tax, most often reflected in a national retail sales tax.
I apologize, because I was meeting with other Arizonans out
here, so perhaps this question has been asked before. And, Mr.
Mitchell talked about it in passing a couple of moments ago.
And that is the impact, again to use the term, the
colloquialism of the gentleman from Georgia--suppose. Suppose
we go to a national consumption tax, reflected in a national
retail sales tax. You're looking at a one-time increase in
prices of x amount.
Now, we have seen comments from retailers saying, no, no,
no. Let's not do this. It puts too much of a burden on
retailers and point of sale, and it's very difficult for the
retailers to do this, they maintain, or it adds another burden
on them.
I'm curious about the temptation factor, I'll call it.
Let's say that prices have to increase, obviously to pay the
tax, retail sales tax. Is there temptation for retailers then
to add in an extra percentage for the amount of work they have
to do?
In other words, if we had to see a one time increase in
prices of 17 percent, does the temptation exist for retailers
to say, you know, that's worth about 3 percent to us with the
extra work we have to kick in. Let's just jack up prices to 20
percent.
And would that not unintentionally--could that not within
the realm of possibility unintentionally trigger an
inflationary spiral? Or would that be--even with the increase,
that would still be desirable over the system we have today?
Mr. Asmus. Business and corporations do not pay taxes.
Individuals do. They're reflected in the higher price of the
products that people buy. The problem with our system today,
that it's all hidden taxes, and everybody is not only confused,
but truly does not know how much tax is represented in the
price that they pay.
So as we go to a national retail sales tax, it's clean,
it's fair, it's above board. We can see it very clearly. Now,
Dale Jorgenson says that producer prices probably would lower
by about 20 percent.
So if we are talking about a national retail sales tax of,
say, 20 percent, I think this should net out at about the same
consumer prices as we went in. But what's nice about this
system that we're talking about today is now the consumer sees
very clearly the tax portion of that.
Furthermore, on your question, I do not think, if we're
going to make retailers not only collect the State sales tax,
but the Federal sales tax, I think there has got to be a
remuneration for them providing that service.
I don't think that it would be fair to have them have to
bring in a lot more people or whatever it would take to do that
for nothing.
Mr. Mitchell. If I could just add to that, Congressmen
Schaefer and Tauzin, I believe we need to have a one-half
percent rebate to retailers to reflect the cost of collection.
Mr. Hayworth. Dr. Asmus, you mentioned Dr. Jorgenson, and
his estimation of the decrease in the production costs of some
20 percent. Again, I guess it echoes what my colleague from
Louisiana talked about, and that is the timeframe involved to
do this. Those who proposed a flat tax, those who champion a
consumption tax talk about this transition phase, how do we get
there from here?
Dr. Asmus, from your perspective, what should we keep in
mind in that transition that would help to ease some of the
problems that might be presented?
Mr. Asmus. Well, I think the thing that would help ease
some of the problem is if we're going to continue to stress
progressivity on the taxing end of it, we've got some really,
really serious problems here. But if we begin to say let's
deliver our progressivity on the government expenditure end of
it, we can begin to mitigate some of those problems.
So as this discussion heats up and we continue to move into
it, if progressivity is going to be the bending point, and it
certainly bothers a lot of people, this is going to be a very
difficult transition. But if we can say, look, is there a law
on high, on Mount Sinai, that says that taxes, that we have to
be as progressive as the current system that we have now?
And we begin to then do it on the expenditure side, I think
we can get from point A to point B.
The point that I was trying to make in my testimony is
this: that in a global economy and in a contractual economy,
the question is not if we have to do this. The question is only
when and how we are going to do this, because tracing income,
as Chairman Archer has already pointed out, is one difficult
problem. And it's going to get more complicated with each
passing month, as we go into the global information economy.
And so I think it is not going to be long when everybody is
going to be sitting around this Committee saying, we know we
have to do it. Now the question is how do we get there. And
there are some transitional problems without question.
Mr. Hayworth. Mr. Chairman, I have no further questions. I
would just simply like to thank the panel for their attendance,
and I look forward to continuing this discussion and moving
past words to actions in the years ahead. Thank you very much.
Mr. McCrery. Thank you, Mr. Hayworth.
Gentlemen, if you would indulge me for just a couple of
more minutes. First of all, Dr. Asmus, you said that we could
infuse our system with progressivity through the spending side
of government. Would you elaborate on that, please?
Mr. Asmus. If we're concerned that we have a situation
where people are too rich and other people are too poor, then
we obviously have to do some things that would make it more
pleasant for those that are on the poor side.
For example, Dick Armey says we're going to make the first
$33,800 of income exempt from a flat tax.
Mr. McCrery. That's progressivity in the Tax Code. I'm
talking about some examples of providing progressivity through
spending--not tax expenditures, but spending.
Mr. Asmus. Well, I think we would have to look at corporate
welfare and say we must and should back away from that. And we
leave welfare, poor welfare in place.
Mr. McCrery. That's what I was afraid you were going to
say. It frightens me to think that we're going to create
progressivity through the spending side. We've tried that for a
long, long time, and it hasn't worked very well.
It infuses our society with all kinds of perverse
incentives, none of which, I hope, we want to continue. So I
would like for you to think about that long and hard, and when
you come back here next time maybe have some more concrete
examples of what you mean that maybe would allay my fears.
Mr. Mitchell.
Mr. Mitchell. Let me just comment that I think that the
concerns about progressivity are greatly overblown, because
they rest on--I'm talking the tax side--because they rest on
the assumption that the economy is a fixed pie, and it's simply
the job of you, the policy maker, to figure out who gets what
slice.
We saw in the twenties when we cut tax rates, the sixties
when we cut tax rates, and the eighties when we cut tax rates,
the rich reported more taxable income. Now, whether that was
income they were hiding or whether that was new income they
earned, the point is, at the end of these period of tax rate
reductions, they wound up shouldering a greater share of the
tax burden.
And I think if we lose that fundamental understanding, that
the whole reason we're doing tax reform is because we want the
pie to get bigger, then it's going to be impossible to do tax
reform, and that's an issue that has to be taken on directly.
Mr. McCrery. Well, isn't there an inherent progressivity in
a consumption tax?
Mr. Mitchell. Well, that also depends on whether you're
talking about just proportional progressivity, where Donald
Trump makes a million times more than me under a flat tax will
pay a million times more in taxes. Or are you talking about a
system where you want him to pay at even higher and higher
rates, and then you get into all the questions about will he
simply start hiding or not earning as much income, and thereby
avoid the payment of tax?
Mr. McCrery. But in Chairman Archer's national sales tax,
isn't there inherent progressivity in that system?
Mr. Mitchell. Are you talking about the universal rebate?
As far as I understand he doesn't have a bill.
Mr. McCrery. No. I'm talking about those who consume more,
pay more.
Mr. Mitchell. Yes, but it's always measured on the basis of
what is your total amount of resources you have available
divided by how much tax you're paying. I think the
progressivity in a flat tax and sales tax would be identical,
and I think it would be the right definition of progressivity,
which is everybody being treated equally under the law.
Mr. McCrery. You touched on this earlier, gentlemen. What
about the issue of, the transition from an income tax to a
consumption tax system--say, the national sales tax for the
elderly? For those who have saved under the current system,
paid taxes on their income, saved after tax dollars, and now
they're at the point where they have no income to speak of, but
they are consuming.
Doesn't that present a problem of fairness to the elderly?
You're nodding yes. No one wants to speak to it.
Mr. Hubbard. There is no easy answer to your question, Mr.
McCrery. Transfer payments to the elderly could certainly be
indexed. In that sense, the elderly would be indemnified.
Regarding their wealth, the jury is actually out as to what
the effect on asset prices is of fundamental tax reforms,
because those reforms also involve forgiving the income tax.
Imagine that I am a little old lady on Park Avenue, and I
own stocks. While it is true that depreciation deductions are
being disallowed in the companies in which I am holding stock,
there is no more tax on dividends and capital gains.
So it's not altogether clear that the elderly would be
significantly worse off.
Mr. McCrery. That's not what I'm hearing from the elderly.
Mr. Asmus. And if you could also convince them that there's
already probably a disproportionate share of transfer of income
toward the elderly, vis-a-vis Social Security, Medicare, and so
forth, that then certainly middle aged people and younger
people could argue that our society is already transferring
more income to the elderly than, quote unquote, their fair
share.
So you take that with his point and maybe this isn't as
difficult as it might seem.
Mr. McCrery. That's a good point. That's not easily made,
but that's a good point.
Mr. Steuerle. Mr. McCrery, a long time ago, I discovered
that the only way to have legal change that doesn't create
winners and losers is to maintain the status quo. And I'm not
trying to be entirely facetious.
There's a danger, and even people like myself play this
game about identifying losers of, say, a proposal I might not
like. But in fact all proposals, typically if there's a legal
change, involves some transfer of functions, or some taking
away of something government does, and it does create some set
of losers and winners.
And so despite the fact that we're not sure who all those
are going to be, you certainly are going to face that issue no
matter what reform you would undertake.
Mr. McCrery. I agree, and certainly I want to make it clear
that I am--I've already said this--I think the current system
is terrible, and it ought to be junked, literally, thrown into
the trash can. And we ought to start all over. And there are
going to be winners and losers. No question about that.
But in order to move this process forward, we're going to
have to bluntly face these questions that are being asked by my
constituents, by various interest groups. You can't just wave a
wand and make it happen. You have to meet all these political
objectives to get there.
So I thought as long as I had such a distinguished panel, I
would at least broach a few of these and get some ideas.
Another question, and then I'll let you go. Another concern
is people who have put much of their savings, their life time
savings, frankly, into purchasing their own home. And now
you're going to change the way that you tax not only purchasing
that home, but the gain that's from the home.
It presents us with some terribly difficult questions, I
think, of fairness, generational fairness, and all those
things.
But I really want to commend you for excellent testimony. I
think you have helped establish the case for a new Tax Code.
And I hope you will be willing to help us figure out a way to
construct a new Tax Code that is, indeed, fair. Can be defended
as fair, and also more advantageous for our economy.
Thank you all.
[Whereupon, at 12:57 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of Steven Cord, President, Center for the Study of Economics
The Federal Government should tax land values, exactly as
it has already done in 1798, 1811 and 1861, instead of taxing
income, sales, estates, gifts or value-added. Why?
Income, sales, estates, gifts and value-added are
all desirable, so they should not be penalized by taxes. If
they are taxed, the government is creating poverty and much
irksome tax-preparation for American individuals and families.
If land values are taxed instead, land-sites will
have to be efficiently used, thereby creating jobs and economic
growth. If those sites are under-used, then the improvements on
them will not generate enough income to pay the higher land tax
as well as a reasonable profit for the improvements, so they
are likely to be fully used. Here is a tax which actually
creates not only revenue for the federal government but also
jobs and economic growth.
Most Americans will pay less with this land value
tax, aud so it could generate political support. It is more
based on ability-to-pay than any current or suggested taxes.
EVERY study that has been made of the 18 jurisdictions that
have implemented a tax shift to land values has demonstrated
that a spurt in new construction has followed the shift. No
wonder that eight (8) recent American winners of the Nobel
Prize in economics have endorsed laud value taxation.
A land value tax should not be confused with taxes on
workers aud businesses. It differs completely from those
bummers. It can provide revenue while promoting the economy.
The more of it, the better.
But a federal land value tax must be properly implemented.
This non-profit organization has studied LVT implementation for
over 40 years and we have been intimately involved in the 18
jurisdictions mentioned above so that we have hands-on
experience. If the Committee is interested in learning more
about this untapped revenue source, it should contact us for
further information.
It is not worthwhile to replace a bad tax with a maybe not-
so-bad tax. Be kind to American individuals and families.
Steven Cord testifies here on behalf of the Center for the
Study of Economics, 2000 Century Plaza (#238), Columbia MD
21044, (Ph.) 410-740-1177, (Fax) 410-740-3279, (E-mail)
hgeorge(@ smart.net, (Web) http://www.smart.net/hgeorge.
Statement of Hon. Dan Schaefer (R-CO)
Thank you, Mr. Chairman, for inviting all of us here to
testify before the Committee. I commend you for holding this
series of hearings. Comprehensive tax reform is an issue that
enjoys broad and clear support from citizens across the
country, and will undoubtedly dominate this nation's agenda in
the coming years. Your leadership in the tax reform debate is
critical if we are to move forward on this issue.
As you know, Congressman Billy Tauzin (R-LA) and I
introduced legislation in the 104th Congress to close the
Internal Revenue Service (IRS), eliminate the federal income
tax and replace it with a National Retail Sales Tax. Today,
Representative Billy Tauzin and I, joined by Representatives
Joel Hefley, Charlie Norwood, Sonny Bono, John Linder, Bob
Stump, Sue Myrick, Ralph Hall, and Roger Wicker, have
introduced H.R. 2001, the National Retail Sales Tax Act of
1997.
The federal income tax system is impossibly complex, overly
intrusive and economically destructive. Americans will spend
over five billion hours and at least $200 billion complying
with the income tax this year alone. That is the equivalent of
three million Americans working full time just to fill out
paperwork for the IRS.
According to Stephen Moore of the CATO Institute, ``The
average fee for preparation of a tax return is now almost $200.
IRS data confirm that, in 1992, more than 50 million individual
returns were done by tax preparers at an average fee of $200.
Today, 80 percent of those using professional preparers have
incomes below $50,000 of adjusted gross income. All told,
Americans spend about $30 billion a year for the services of
tax accountants and lawyers.'' Mr. Chairman, with all due
respect to tax accountants and lawyers, those services add
nothing to our national wealth.
Tracking all this paperwork requires an IRS five times the
size of the Federal Bureau of Investigation to watch our every
financial move. The powerful IRS may search our property and
records without a court order. When challenged by the IRS,
Americans are considered guilty until they can prove themselves
innocent.
However, the most disturbing aspect of the income tax is
its bias against hard work, savings and investment. Every
dollar saved or invested by Americans is taxed at least twice--
lowering savings, driving up interest rates and weakening
economic growth. As a result, the average family today earns
15-20 percent less than they would without the biases of the
income tax code.
Contrast that to a National Retail Sales Tax, which would
be easy to understand, visible and conducive to economic
growth. A National Retail Sales Tax would be similar to the
sales tax currently imposed by 45 states. Because H.R. 2001
would eliminate the IRS, the states would collect the 15
percent national sales tax just as they collect the state tax
today. Both states and retailers would receive generous
payments to cover their administrative costs.
So how would the Schaefer-Tauzin National Retail Sales Tax Act of 1997
affect individuals and families?
To begin, the Schaefer-Tauzin legislation repeals federal
personal and corporate income taxes, capital gains taxes,
estate and gift taxes and all non-trust fund dedicated excise
taxes. For families and individuals, this means no more hidden
income tax withholding or complicated tax forms to file every
year. The National Retail Sales Tax Act of 1997 would end the
multiple taxation of economically productive savings and
investment by imposing a single 15 percent consumption tax on
the final retail sale of all goods or services.
Regardless of whether income is derived from wages,
dividends, capital gains or any other source, it would not be
taxed until it is consumed at the retail level. For example,
the purchase of stock would not be taxed, but the brokerage fee
would be, since it represents a service. Likewise, the proceeds
from the sale of a stock would not be taxed as long as that
money stays invested in the economy. On the other hand, if
those proceeds were consumed for personal enjoyment, they would
be taxed.
Laurence Kotlikoff, a professor of economics at Boston
University, conducted a study on the economic impact of
replacing federal income taxes with a national retail sales
tax. His computer-simulated model evaluated the impact on U.S.
savings by replacing all federal personal and corporate income
taxes with a national retail sales tax.
Professor Kotlikoff's study concluded that a national sales
tax ``would do away with the differential tax treatment of
corporate and non-corporate businesses, which distorts business
decisions; of capital gains and dividends, which affects
decisions about retaining earnings; and of investment in
equipment, structures, and inventories. A sales tax would also
end encouragement of current relative to future consumption,
the tax exemption for health insurance premiums.''
Additionally, the study concluded that, in the long-run, a
shift to a National Retail Sales Tax would raise the stock of
U.S. capital between 29 and 49 percent and raise living
standards in the U.S. between 7 and 14 percent. Further,
Koflikoff found that a National Retail Sales Tax would end the
work disincentive associated with the current tax structure.
The Schaefer-Tauzin proposal would encourage savings and
investment and discourage frivolous consumption. Savings are
critical to a growing economy because they provide the pool of
money that can then be used to invest in capital and equipment.
Stimulated by new investment capital, the economy would respond
with strong and steady growth. And since greater economic
expansion and job creation would create a larger tax base, the
National Retail Sales Tax could raise more revenue than the
income tax does today.
Mr. Chairman, I believe the greatest strength of the
National Retail Sales Tax is that it exposes the hidden tax
burden on every American. Under the federal income tax,
personal and corporate income taxes are hidden in each and
every consumer transaction. First, personal income tax is
withheld from the consumer's paycheck, requiring every purchase
to be made in after-tax dollars. The second hit comes at the
cash register, when the consumer pays the hidden business taxes
and compliance costs of every business that had a hand in
producing that good or service.
To help ensure that a national sales tax is not regressive,
the Schaefer-Tauzin proposal provides a tax credit to guarantee
that all workers receive a refund equal to the sales tax rate
times the poverty level (adjusted for the number of dependents)
in every paycheck. As a result, every wage earner will earn up
to the poverty level tax free.
Further, in an effort to help protect senior citizens
against any increase in prices that may be caused by a shift to
the National Retail Sales Tax, the Schaefer-Tauzin legislation
requires the Social Security Administration to include the
national sales tax in their benefit formula when determining
cost-of-living adjustments for Social Security recipients.
Finally, in the Schaefer-Tauzin legislation, the burden of
proof lies with the government in any dispute with a taxpayer.
And since H.R. 2001 closes the IRS, taxpayers will no longer
have to worry about being intimidated by overzealous IRS
agents.
As consensus builds in America that the income tax should
be reformed, it is clear that the National Retail Sales Tax
would provide the greatest benefit to American taxpayers.
Again, I want to thank the Chairman for holding these hearings
and for his leadership in this most critical of debates.
Statement of Hon. W.J. ``Billy'' Tauzin (R-LA)
Mr. Chairman, it is my honor to address the Committee on
the benefits of a national retail sales tax, and its impact on
individuals and families. Today, Congressman Dan Schaefer (R-
CO) and I introduced the National Retail Sales Tax Act of 1997.
In the 104th Congress we received overwhelming support from
citizens across the country and are dedicated to pursuing this
endeavor in the 105th. I look forward to working with you and
the members of the Committee to overhaul our current system and
lift the burden of the income tax from the shoulders of all
Americans.
Mr. Chairman, all taxes reduce our ability to consume and
are really ``consumption taxes.'' Everyone I know intends to
consume all the money they make, now or in the future. Some of
us want to defer the consumption until we retire or until our
kids are ready to go to college. Others want to consume a part
of their earnings by donating it to a church or other
organization. Others just use their earnings to consume today.
However, anything we decide to do with the money we earn is
consumption.
Now, anytime government taxes away part of my money, it is
reducing my ability to consume. Therefore, a 15% tax withheld
from my income at 15% reduces the money I have with which to
consume goods and services. For example, to purchase a $10 item
of clothing with an income tax of 15%, I would actually have to
make $11.80, pay 15% of this amount or $1.80 of income tax, and
then use the remaining $10.00 to purchase the clothing.
With a 15% national retail sales tax, I would have to earn
$11.50 in order to pay the $1.50 in national retail sales tax
and net the $10.00 needed to buy the article of clothing. In
the case of an income tax or of a national retail sales tax,
the taxes reduce my ability to consume because I have fewer
dollars to use for consumption.
My question to the committee is this, if all taxes are
really consumption taxes, shouldn't we replace the present
failed income tax system with a national retail sales tax that
accomplishes the following:
1. Frees individuals from filing any type of federal tax
returns;
2. Requires only simple returns from retail businesses;
3. Abolishes the IRS and tears the income tax out by the
roots;
4. Increases our competitiveness in the world economy;
5. Ensures that the members of the underground economy pay
their share;
6. Eliminates the taxes on production, investment and
savings;
7. Requires illegal immigrants and importers to pay taxes
in the U.S;
8. Empowers all Americans by giving them the choice as to
how much tax they pay.
How would the Schaefer-Tauzin Retail Sales Tax Act of 1997 affect
individuals and families?
First, the Schaefer-Tauzin bill frees individuals from
filing any type of federal tax returns. In 1994, there were
107,291,000 individual income tax returns filed. 107,291,000
Americans were forced to spend in excess of 2 billion hours
trying to calculate the amount of income taxes owed to the
federal government. This is absurd.
The national retail sales tax requires no federal
individual tax returns of any kind. Individual Americans will
pay their taxes when they make purchases of retail goods and
services. No receipts, no tax returns, no audits, no hassle.
Our legislation eliminates the taxes on work, investment
and savings. Legislators understand that taxing something will
produce less of it. By eliminating the income tax which
penalizes work, investment and savings, we will get more work,
investment and savings. Dr. Lawrence Kotlikoff and Dr. John
Qualls both conducted detailed studies about the impact of
replacing the present income tax with the national retail sales
tax. They both found that the national retail sales tax causes
the private savings rate (both personal and business savings)
to rise substantially and produces faster economic growth and
higher productivity. In both studies, the higher level of
capital stock created under the national retail sales tax
results in more job creation. More earnings by employees in the
private sector fuels more consumer spending. Consumer spending
thus rises from its current level, but actually declines as a
percentage of GNP.
There will also be what some economists call the ``sponge
effect.'' The U.S. is the world's largest market and has the
best infrastructure of any country on earth. When the income
tax is replaced with the national retail sales tax, it will
become the world's largest tax haven and a ``sponge'' for
capital from around the world. According to Martin Armstrong of
the Princeton Economic Institute, replacing the income tax with
a national retail sales tax will create an inflow of foreign
capitol into this country like we have never seen. Mr.
Armstrong points out that the nearest comparable period in
modern history was in 1940. Seeking to avoid the ravages of
World War II, capital flooded into the United States and
government bond rates were at one percent.
A conservative estimate is that the adoption of the
national retail sales tax will lower interest rates between 200
and 300 basis points. Overnight we will see the debt service on
our national debt reduced, perhaps enough to bring the budget
in balance. Our businesses will be more able to purchase
equipment and rapidly increase productivity. Our citizens will
be able to refinance their homes and save hundreds of dollars
per month in interest payments. In short, the United States
will experience the greatest economic boom in our history which
will be felt by all Americans.
Finally, the Schaefer-Tauzin National Retail Sales Tax Act
of 1997 will empower all Americans by giving them the choice as
to how much tax they pay. Our present income tax system takes
our money through withholding before we even receive it. Most
of us now consider that our wages are really the ``take-home
pay'' that we get net of all the deductions. Under the present
system, it doesn't matter if one of us is more frugal than the
other because we all pay the same amount of tax. In fact, if we
are more frugal than our neighbor we are actually going to pay
more and more tax because our earnings on our savings will be
taxed each year.
With the national retail sales tax we receive all of the
money we earn. Our checks are increased by the amount
previously deducted for federal income tax. With this money in
hand, we have the power to determine the amount of federal tax
we pay based on how much we choose to spend. The American
people, not some bureaucrat lawmaker in Congress, will have the
power.
Also because of the way that the present income tax system
hides the amount of taxes we pay in the price of goods and
through withholding, I don't think any of us can really tell
how much tax we are paying to the federal government. By
eliminating the individual and corporate income tax, the estate
and gift tax and all non-trust fund excise taxes and replacing
them with a simple national retail sales tax, all of us will
see the amount of federal tax we pay each time we make a
purchase.
For each of us who really wants to make the government more
accountable this is a compelling difference between the present
income tax, the other income tax proposals and the national
retail sales tax. When our citizens see how much they are
paying in federal taxes they will demand that we become more
efficient and deliver better services to them.
In closing, I believe that we should re-examine the basic
ideas on which this government was founded. Our Founding
Fathers insisted on the use of indirect taxes on individuals
and specifically forbade direct taxes like the income tax. They
did this because they were students of history and they know
that every despotic country had one thing in common--direct
taxation which helped enslave the people. We have an
opportunity to eliminate the income tax, the IRS, tax returns,
audits, and the penalties of our work, savings and investments
and replace them with an indirect national retail sales tax.
For all individuals and families, we must free America from the
income tax.
Mr. Chairman, thank you again for holding these hearings
and for your leadership on this critical issue.
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