**GRADUATE RESEARCH INSTITUTE ON POLICY STUDIES**

######### Policy paper

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####### TAX REFORM IN USA

###### AN ALTERNATIVE APPRAOCH

**\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--**

**chetan b sanghi 18 june 2003**

ADB -- Japan Scholarship Program

Course : Masters in Public Policy

Student ID : MEP 02054

Country : India

Service : Indian Administrative Service

91-40-23316777, 91-40-23372431

sanghi_chetan@yahoo.com

######### Tax Reform In USA

######### An Alternative Approach

#### CONTENTS page

1.  **Abstract**
    .......................................................................**3**

2.  **EXECUTIVE SUMMARY 4**

3.  **scope and method of study**
    ........................................**6**

4.  **background 7**

5.  **BAsics of taxation**
    ........................................................**8**

6.  **desirable features 8**

7.  **important taxes in usa**
    .................................................**9**

8.  **problems in current tax code in usa 10**

9.  **alternative proposals**
    ...............................................**16**

10. **problems in implementation 20**

11. **present proposal in brief**
    ..........................................**23**

12. **basic principles 24**

13. **important aspects**
    .......................................................**24**

14. **implementation 31**

15. **comparison**
    ...................................................................**41**

16. **pitfalls analysis 48**

17. **difficult to evaluate**
    ................................................\...**54**

18. **conclusion 55**

**references and annexures**

##### Tax Reform In USA 

##### An Alternative Approach

## Abstract

In the last around twenty-five years, there has been considerable
discussion in the USA on the reasons and ways to change the way taxes
are levied and collected but the fact remains that the proposals
weren\'t transformed into policy action. This proposal presents another
alternative to the collection of taxes in the USA. The key aspect of
this proposal is the process by which the revenues will be raised in the
changed scenario. Almost every payment originates in the bank as the
figures above suggest. Even if the cash payment is ignored, the total
payments being routed through banks in the year 2000 added up to US\$
780 Trillion. It is proposed that, 1% of this total transaction is
passed on by banks towards tax revenues to the Government treasury. The
revenue thus available to the Governments would be substantially higher
then the present gross tax revenues. To be a bit specific, it would be
US\$ 7.82 Trillion as compared to the total receipts of all kinds of
taxes in 2001 of US\$3.02Trillion. The proposal deals with all possible
pitfalls and analyzes the same thoroughly. Wherever required some
changes in the basic framework are also incorporated. Scope and method
of study with scenarios of uncertainty are also dealt with.
Comprehensive references are provided.

## [Executive Summary]{.smallcaps}

The study is a proposal to revamp the entire taxation system of the USA.
In the last around twenty-five years, there has been considerable
discussion in the USA on the reasons and ways to change the way taxes
are levied and collected. Some very bold proposals have been under
discussion with very limited success, all along. But the proposals
weren\'t transformed into policy action due to many reasons.

Taxes can be broadly categorized into Direct and Indirect. Generally
speaking, any tax system should have some desirable features like: it
should not interfere in the efficient allocation of resources; should
have low administrative cost; be transparent; be fair and flexible.

Important Taxes in the USA are individual income tax, the payroll tax,
corporation income tax, estate, sales tax and the gift tax etc. The
current tax code is unfair, costly, and unreasonably confusing. It
hampers personal financial opportunity. and allows for loopholes. Sales,
import, payroll and other taxes impose a double, triple and even a
quintuple burden on taxpayers.

Alternative proposals have been the: USA tax, National sales tax, The
Armey plan, Value Added Tax etc. But there have been problems in their
implementation as well.

This brings us to the question of whether there is any alternative to
the present regime at all, which is practicable and can be implemented.
The answer is yes. This paper deals with it.

Broadly speaking it involves levying of a 1% charge on every withdrawal
of funds from any bank account by any user for any purpose at a flat
rate. The proposal is revenue neutral. This charge can then be shared
between the Federal, State and the Local authorities. The rollover to
the new system would be easy and practicable.

For the purposes of levying this 1% charge, the proposal examines the
Payments system in the US. It also gives an outline of a simple
arrangement at the bank level for the payments to flow smoothly into the
desired activity and the tax to be deducted at more than one simple rate
of taxation. The proposal thereby allows for changes in the tax rates
for different activities in the financial markets. Some of the
transactions are totally exempted from any tax deduction, as these
transactions are central to managing the liquidity or exchange rate in
the system.

The changes proposed confirm to the requirements of simplicity,
efficiency and fairness. There would be less incentive to evade/avoid
than to pay the taxes. In fact the payments would be automatic. The
proposal confirms to the general economic principles, which guide a
sound taxation policy.

## 

## 

## Scope and method of study

The study is a proposal to revamp the entire taxation system of the USA.
For this the current taxation structure was studied. The basics and
features of this system were examined. An attempt was made to highlight
the problems with the current system and then past proposals for
reforming this system were examined. The proposal also examines the
payment system of the USA and finds a way to merge the taxation system
and the payment system to synergise the two while radically reforming
the taxation system. In so doing the new proposal for taxation attempts
to highlight as to how the proposed system is a better option than the
present arrangement. The possible pitfalls are also discussed before
conclusion. Appropriate references and annexures have been provided
where necessary. A comment has been made on possible aspects where the
proposal deals with parameters or issues, which are difficult to predict
at this stage.

**[Background]{.smallcaps}**

In the last around twenty-five years, there has been considerable
discussion in the USA on the reasons and ways to change the way taxes
are levied and collected. Some very bold proposals have been under
discussion with very limited success, all along. All these proposals
generally agree that the present tax regime (esp. the Income Tax) is
very complex and inefficient. The proposals also argue that their
alternatives are simpler, fairer and more progressive. The proposals can
be broadly classified under the category of Consumption tax or some form
of Value Added Tax. The public response to these proposals has been very
enthusiastic because the American taxpayer has been generally not very
enthused by the complex tax codes and due to the perception that the
exemptions (read loopholes) favor a few sections of the society. The
list of reasons though is long and subjective, and the fact remains that
the proposals weren\'t transformed into policy action. Many reasons have
been put forth for this resounding inaction. Lack of political
salability of the proposals due to their apparent pro-rich bias and
involvement of unchartered territories in terms of implementation
program - appear to be among the important reasons for the inaction.

**[Basics of Taxation^1^]{.smallcaps}**

Taxation is very old. As old as perhaps organized Government itself. But
unlike feudal taxes, modern taxes are monetized. Today, taxes can be
broadly categorized into Direct and Indirect. The Direct taxes are on
the individuals and the corporations; and the indirect taxes are on
various goods and services. Further, the Federal, State and the Local
governments in the USA levy taxes.

Generally speaking, any tax system should have some ***desirable
features***.

The tax system should not interfere in the efficient allocation of
resources. For example, if any tax is levied on any particular activity,
there would be a tendency to avoid that activity or resources would
shift from that area of activity. This can bring in very inefficient
allocation of resources. In case where the individual can do nothing to
reduce his tax liability, there are less chances of any distortion.
Lump-sum taxes are one such kind of taxes. Similarly, a corrective
taxation (for example, a tax on polluting activities) can improve
economic efficiency.

Any kind of tax administration has costs of administering it. This is
dependent on the complexity of the system and the different rates it
applies to various categories of taxpayers. Lower the administrative
cost of collecting any tax, the better it is.

Another feature is the transparency of the tax policy and the changes
that are brought in. People should know as to how much they pay as
taxes. A tax system also ought to be fair i.e. it should have Horizontal
and Vertical equity. A system with Horizontal equity is the one where
individuals who are equal in all respects are treated equally. Vertical
equity essentially means that individuals who are in a better position
to pay more taxes should in fact do so. The tax code should also be
flexible to adapt to changing requirements. It should be changeable with
relative ease depending on the ever-changing economic circumstances.

**[Important Taxes in the USA^2^]{.smallcaps}**

At the Federal level the direct taxes in the USA include primarily the
individual income tax, the payroll tax (fixed percentage of wages with
some upper limit and used to finance social security) and the
corporation income tax i.e. a tax on the net income of a corporation.
The tax on bequests from one generation to another i.e. the estate and
the gift tax are the other important direct federal taxes.

Apart from the above, at the state and the local level another important
direct tax exists i.e. the tax on the property. Customs and excise
duties are the main indirect taxes at the federal level. At the state
and the local level there is the sales tax, which is an important
indirect tax.

In 1997, at the Federal level, social security taxes and individual
income taxes accounted for over 80% of revenues and corporation income
tax another 12%. At the state and local level, individual income and
payroll taxes together makeup just over one-fifth of revenues; and
property taxes, sales taxes and transfers from the federal government
each account for another fifth.

## [Problems in the Income Tax Code and with other taxes]{.smallcaps}

The current tax code is unfair, costly, and unreasonably confusing. The
Income tax code is no doubt a complex one and the I.R.S. estimates that
over 40% of Americans no longer comply with the current tax code! Over
half of American taxpayers seek professional help simply to prepare
their returns. And according to Money Magazine, chances are 99% that an
average taxpayer will pay someone to file an incorrect return!
Compliance with the tax code is not only very difficult and complicated,
but unreasonably expensive as well. It is estimated that it costs
taxpayers \$225 billion for tax filing, tax record keeping, and tax
reduction advice. That\'s the equivalent of about \$850 for every man,
woman and child in America! We have taxation without comprehension!

The current income tax code unfairly hampers personal financial
opportunity. When citizens are taxed on their earnings and on what they
produce, hard work is discouraged. It is held that the current income
tax code inhibits economic growth, capital formation, and, most
importantly, job creation. The current income tax code is also
criticized for punishing personal savings and investments.

The code allows for loopholes encouraging politicians and lobbyists to
pick winners and losers. There are more lobbyists registered in
Washington for taxes than for any other issue^3^.

The IRS lists a dozen popular schemes, which are used by tricksters to
cheat the tax authorities or innocent taxpayer. Significantly it says
that such schemes appear close to the filing season, as \'traditional
upswing\' every year. This shows that the tax code is complex for
ordinary folks to understand and they fall prey to such tricks. Aside
from the double taxation of dividends, the U.S. tax code imposes
multiple taxes on Americans in a number of other ways \-- and those
taxes fall most heavily on lower-income families, experts report.

Sales, import, payroll and other taxes impose a double, triple and even
a quintuple burden on taxpayers. People are subjected to multiple
taxations stemming from sales taxes and federal and state excise taxes
that add to the prices of products. Property taxes are also a form of
double taxation, since they are levied on assets bought with income that
has already been taxed \-- especially the estate tax. Some critics also
add payroll taxes for social security as a form of multiple taxation.

It is held that when all taxes are taken into account, the tax burden
\-- as a percentage of pretax income \-- is roughly the same for all
income groups. A family in the bottom 20th percentile pays 18 percent of
its income in taxes, or an average of \$1,449. Those in the second 20th
percentile pay out 14 percent of income, or an average of \$2,847. The
percentages then begin to rise \-- ending at 19 percent of income in
families earning in the top 20th percentile. This reflects the
regressive, and hidden, nature of multiple taxations throughout the tax
structure^4^.

Commenting on U.S. federal tax cuts in 2001, a report from the
Organization for Economic Cooperation and Development (OECD) explains
that the U.S. tax system is unusually complex and has disincentive
effects out of proportion to the revenue raised. A key source of
complexity is the Alternative Minimum Tax, which appears to be unique
among industrialized countries. It is supposed to ensure that all rich
people pay some taxes; but its burden now falls most heavily on middle
income taxpayers.

Another source of complexity are special provisions of the tax law. At
least 50 so-called tax expenditures have been added to the Tax Code
since 1986, lowering federal revenue by about 1.5 percent of gross
domestic product. The great achievement of the Tax Reform Act of 1986
was to get the top income tax rate down to 28 percent. But with the top
rate now around 39 percent, rich people spend considerably more time
sheltering their income. The OECD says this misdirection of economic
activity reduces federal revenue and stifles growth. Thus \"the fall in
tax yields from rate cuts would be significantly offset by changed
behavior and perhaps most markedly at high income levels^5^.\"

Another issue on which the present tax system has failed according to
critics is its inability to effectively bring the underground economy to
book. Internal Revenue Service Commissioner Charles Rossotti had
estimated that the federal government loses \$195 billion per year in
revenue due to the failure of people to report income and pay taxes on
it. Other data show the substantial growth of the so-called underground
economy \-- economic activity that is illegal, or unreported to avoid
taxes, that isn\'t included in gross domestic product. An indirect way
to measure its size is to compare income reported to the IRS with other
measures of income, such as Commerce Department calculations of adjusted
gross income (AGI) from sources such as total wages paid by corporations
and total interest paid by banks.

In 1995 it was estimated that Americans failed to report \$630 billion
in AGI on their tax returns. That year they paid 14 percent of their AGI
in federal income taxes. Assuming they would have paid the same rate on
their unreported income, this suggests that the federal government lost
at least \$88 billion in individual income taxes alone in 1995. If that
income were taxed at 22 percent (the average marginal tax rate for all
taxpayers), the revenue loss rises to \$139 billion. Unreported income
rose from 10.1 percent of AGI in 1988 to 13.1 percent in 1995. This may
well be a response to the higher tax rates that were enacted in 1990 and
1993. As tax rates rise, hiding income becomes more profitable.
Conversely, lower tax rates such as those enacted in 1986 reduce evasion
because the cost of reporting one\'s true income is lower^6^.

Then there are the odd taxes. This may sound trivial but is an issue as
the collection and imposition have problems of their own. Some examples
are given here.

Seventeen states, including Alabama and North Carolina, tax people
involved in illegal drug transactions, from use to possession to
distribution and sales. The rate varies according to the substance. In
Alabama, marijuana is taxed at \$3.50 a gram (other tax values are
determined from the marijuana tax values \-- if a gram of cocaine, for
example, costs 10 times what a gram of marijuana costs, then cocaine
would be taxed at 10 times the tax for marijuana, or \$35 a gram.)

In North Carolina, within 48 hours of obtaining a fixed quantity of
illegal drugs or alcohol, buyers must purchase stamps from the state and
affix them to the controlled substance. If the person gets busted
without stamps, they still must pay the tax. Since the law was enacted
in 1990, just 63 people have purchased drug stamps \-- many are believed
to be collectors. Meanwhile, the state has assessed some 60,000 fines
for failure to display the stamps, collecting nearly \$68 million in
revenue till the end of Dec 2002.

Cities and states also levy taxes on the income earned by athletes,
entertainers, and their various entourages. Any money earned while
playing in that particular city or state gets taxed. Alabama has a
10-cent tax on decks of cards that contain \"no more than 54 cards\".
Chicago\'s 0.5 percent charge on all carryout food, technically called
the \"anti-litter\" tax. Chicago has a 9 percent \"fountain soda drink\"
tax - levied on any soft drink not from a can or bottle^7^.

The problems with the current methods of taxation as given in a nutshell
above are only an indicative list as widely perceived. Many scholars and
practitioners have a wide variety of other reasons for being critical of
the current methodology of tax collection or tax legislation. These
problems are the main reasons for many political activists and tax
analysts to attempt solving them. Hence many have propounded various
methods and types of taxation to replace the existing tax structure and
practice. Some of these are described in brief below:

## [Alternative proposals]{.smallcaps}

***The USA tax*** (Unlimited Savings Allowance \-- proposed by Sen. Sam
Nunn and Sen. Pete Domenici) would:

Allow taxpayers to deduct savings with no limits \-- in effect
permitting \"Super IRAs\" from which they could make early withdrawals
without penalties. It would allow deductions for mortgage interest and
charitable giving; but eliminate them for medical expenses, casualty
losses, and state and local property taxes. But a new value-added tax of
11 percent would be imposed for businesses, incorporated or not. And a
40 percent top tax rate kicks in at \$14,400 for single taxpayers and at
\$24,000 for joint filers.

***National sales tax*** (supported by Bill Archer, introduced by Rep.
Dan Schaefer and Rep. Billy Tauzin) proposes that:

In lieu of the income tax, all retail purchases would be subject to a
federal tax somewhere between 10 to 20 percent, thus taxing consumption
rather than production or savings. It would phase out the IRS , while
states would administer the tax in exchange for a small percentage of
the take to cover costs. A tax credit in paychecks would ensure that
those below the poverty level pay no taxes. A \"used-property tax
credit\" would refund the entire amount of the tax when a home is sold,
applicable to the next home purchase^8^.

The \"***flat tax***\" was first proposed by two Stanford economists,
Robert Hall and Alvin Rabushka, in their 1983 book \"Low Tax, Simple
Tax, Flat Tax.\" The Hall-Rabushka plan, on which the Armey-Shelby bill
is based, would replace the current personal income and corporate income
tax structure with a two-level tax designed to tax all income exactly
once, and at the same rate (in H-R\'s version, 19 percent). A number of
so-called \"flat tax\" plans have been proposed by various prominent
Republicans to replace the current federal personal income tax and the
corporate income tax.

***The Armey plan*** 's- key elements are: Individuals would report only
wages and pensions on their individual tax forms. Small business owners
would pay themselves a salary so they could file an individual tax form
(along with a business tax form) to take advantage of the proposed
exemptions from the wage tax. Income from interest, dividends and
capital gains would not be reported on any form. All individual itemized
deductions and credits would be eliminated. Most adult taxpayers would
be allowed a personal exemption. The flat tax would also apply (without
exemptions) to employer-paid fringe benefits. Businesses would file tax
forms similar to the current forms, except that (a) all capital
investments and inventory purchases would be deductible immediately (b)
business income from dividends and capital gains would not be reported;
(c) interest income would not be included in income and interest
expenses would not be deductible. The federal estate tax would be
repealed. Rep. Armey proposes a 20% tax rate in 1997 and 1998, dropping
to 17% starting in 1999.

***Malcolm S. Forbes, Jr. plan*** proposed a flat tax plan similar to
Armey\'s except that: Forbes\'s exemptions from the wage tax portion of
the plan would be considerably larger than under the Armey plan:
\$13,000 per taxpayer plus \$5,000 per child. The tax rate under the
Forbes plan would be 17% immediately.

***The Kemp Commission*** endorsed an Armey-style flat tax, but with
amendments: Itemized deductions, for mortgage interest, charitable
donations and, apparently, state and local taxes would be retained.
Employer-paid social security taxes would not be subject to the flat tax
as a \"fringe benefit.\" The Commission called for \"transition rules\"
to \"protect\" profits generated from existing investments. The
Commission did not specify a tax rate or wage-tax exemptions, but called
for a rate \"as low as possible\" and for \"generous\" exemptions.

***Sen. Phil Gramm (R-Tex.)*** proposed: Individuals would still report
capital gains on their tax forms, but indexing the basis of capital
assets for inflation. Businesses would continue to depreciate capital
investments, rather than write them off immediately, but depreciation
deductions would be increased from the already generous write-offs
allowed under current law. While not spelled out in detail, individuals
would apparently continue to report dividends on their tax forms, but
companies would apparently get a deduction for dividends paid. Itemized
deductions for mortgage interest and charitable donations would be
retained. The standard deduction would be \$11,000 per taxpayer, plus
\$5,000 per child\--about the same as under the Armey plan^9^.

### **Value Added Tax** A value-added tax is a tax assessed at the company level on the difference between what a company sells and what it buys. Almost all countries with value-added taxes allow the full purchase price of capital equipment to be deducted immediately rather than depreciated. This procedure allows the tax base to be less than the \"value added\" by the labor and capital within the firm and converts an income-based value-added tax into a consumption-based tax. The VAT is usually assessed at a flat rate, although many countries have attempted to implement various exemptions and differential rates, at a very large cost in terms of complexity and administration.

When we see the plethora of alternative proposals we assume that people
are conscious and receptive to the idea that something needs to be done.
This demand for change is catalysing the proposals. The various flat tax
proposals have some obvious benefits and merits like: a reduction in
cost of compliance; dramatically simplify federal taxation; eliminate
many of the most complex aspects of federal taxation- including
depreciation accounting and capital gains taxation; exempt personal
saving from taxation, deductions and exemptions; most of the benefits of
which accrue to the wealthy, would be eliminated; tax burden would shift
from poor and middle-class wage earners to those with higher incomes;
simplifying the tax code would eliminate the main business of special
interest lobbyists; the working poor would pay no tax until well above
the poverty line \-- thus a family of four would pay no tax until its
income reached \$33,300 (under the Armey-Shelby plan); because of the
personal allowance and dependent allowances, the flat tax would be
progressive; economy would grow faster, which would raise wages and
create more jobs etc.

**[Problems in Implementation]{.smallcaps}**

If it were so, then why are these alternative taxation proposals not
seeing the light of the day? There are some criticisms and problems
pertaining to their acceptability and implementation. These criticisms
and problems, however, do not make these proposals any less appealing to
the ordinary taxpayer. Some of these are given as below:

The present system has some form of visible progressive discrimination
between the rich and the poor i.e. the rich pay at a higher rate of tax.
The new proposals do not have the visible progressivity. At the same
time these are not very beneficial to the poor taxpayer, as he has to
part with a considerable part of his income (17 to 20 percent
generally). So while the ordinary taxpayer is enthused by the simplicity
that the new proposals promise to usher in, he is not very encouraged by
the potential of savings to himself.

It is also perceived that the new proposals are pro-rich. This is
because their tax slab reduces more than the reduction in the tax slab
for the poor. For example the elimination of capital gains tax.

For the state, most of the proposals are not \"Revenue Neutral\" at
generally acceptable rates of tax. They entail considerable deficits
depending on the kind of tax.

Leading flat-tax plans from Forbes, Armey and the Kemp Commission would
exempt capital income\--interest, dividends, capital gains, etc.\--from
personal income tax entirely, and repeal the federal estate tax. But
lowering the taxable income of the rich is hardly what most people mean
when they say they want a simpler tax code. On the contrary, the real
answer to tax avoidance by the rich is to close the loopholes that make
it possible. That entails cracking down on excessive \"depreciation\"
write-offs, ending preferential treatment of capital gains, curbing
multinational tax abuses and so forth. Reforms like these may or may not
make the tax code simpler\--often rules that are too simple are the
easiest for lawyers and accountants to get around\--but they would
address most people\'s real concern about complexity: that the rich
aren\'t paying their fair share^10^.

The sales tax proposals also have critics. Bruce Bartlett, senior fellow
at the National Center for Policy Analysis, warns of substantial
problems with the sales tax approach. A sales tax of more than 10
percent on services would encourage massive evasion. Under a national
sales tax, states might abolish their own sales taxes while increasing
income taxes \-- thus eliminating the sales tax collection machinery
upon which the plan depends. A sales tax could be changed into a value
added tax that could be raised too easily because it\'s hidden.

Among the various limitations of VAT, the following are more common: VAT
is levied on ad valorem basis and does not admit of physical output as
the basis for tax liability determination. In a federation VAT would be
difficult to operate due to tax rivalry and lack of co-ordination among
federal and provincial governments. In spite of the self-policing nature
of VAT, the experience of some countries is quite contrary where both
the taxpayers and the tax officials create a lot of opportunities for
evasion and fraud. The methods commonly applied to defraud the
government under VAT include: use of fake invoices to claim tax credit;
tax credit claims on purchases for personal use; over-reporting of sales
of zero-rated goods; secret deals between buyers and sellers as regards
issuance of receipts;

formation of fake companies which sell receipts to traders to enable
them to claim tax credit on inputs.

The point is that although the alternative proposals have been talked
about for quite a long time now, nothing substantial has progressed on
this front, in part due to the problems enumerated above. This brings us
to the question of whether there is any alternative to the present
regime at all, which is practicable and can be implemented. The answer
is yes. This paper deals with it hereunder.

######## Present Proposal in brief

This proposal presents another alternative to the collection of taxes in
the USA. As is well known there are many different kinds of taxes at the
Federal, State and Local levels in the USA, as indicated in brief
elsewhere above. The taxes include the Direct, Indirect and local taxes.
All these taxes invariably have complex codes and procedures. These are
also taxed at different stages of transaction and otherwise. They have a
whole lot of exemptions etc., which make the very complex to understand
for a common taxpayer. These are also very costly for the Governments to
collect. This proposal outlines an alternative method of taxation, which
will eliminate all the various kinds of taxation (Federal, State and
Local). The collection of the proposed tax would be simple and effective
at a single stage of transaction. Broadly speaking it involves levying
of a 1% charge on every withdrawal of funds from any bank account by any
user for any purpose at a flat rate. The proposal is revenue neutral.
This charge can then be shared between the Federal, State and the Local
authorities. The rollover to the new system would be easy and
practicable.

## [Basic Principles]{.smallcaps}

This proposal attempts to take a fresh approach to the policy overhaul.
The basic principles followed by this proposal are the ones, which any
good taxation policy should espouse and are enumerated as follows:

The changes proposed confirm to the requirements of simplicity,
efficiency and fairness. There would be less incentive to evade/avoid
than to pay the taxes. In fact the payments would be automatic. The
proposal would confirm to the general economic principles, which guide a
sound taxation policy.

**[Important Aspects]{.smallcaps}:**

There are three aspects of this proposal: The total requirement of
taxes, the total payments quantum in the entire US economy and the
process of taxation. The three are explained below:

***1. Requirement of revenues:*** For the year 2001 the total collection
of all kinds of taxes put together for the Federal Government was
US\$2.128 trillion. This excludes the figure of Customs duty as the
nature and purpose of Customs duty is very much different than what this
proposal deals with. The total tax collection of all kinds put together
for all the states and local bodies, as an aggregate for the year 2001
is US\$ 892 billion. [Thus the total tax collection for the entire
country as a whole (except customs duty) for the year 2001 comes to
US\$3.02 trillion. For this proposal to be revenue neutral, this figure
becomes relevant]{.underline}. The annexures 'A' and 'B' as given below,
indicate the above-mentioned figures with sources of data:

Fed Gov - Tax collections- type of tax- 2001 & 2002 - [Annexure
'**A**']{.underline}.

National total of State & Local tax Revenue, by type of tax - [Annexure
'**B**']{.underline}.

State Taxes per capita & State Taxes by type - [Annexures '**C**' &
'**D**']{.underline}.

Internal revenue collections, (Type of tax 1973-2002) - [Annexure
'**E**']{.underline}.

Fed. Individual Income Tax (Tax Liability & Marginal Tax rates) -
[Annexure '**F**']{.underline}.

Estimated State & Local Taxes - by family of 4 in cities - [Annexure
'**G**']{.underline}.

The other annexures given above deal with the very important analytical
reference points for examining any tax reform proposal i.e. the tax paid
by an average family, marginal income tax rates and tax liability for
individual income tax at the federal level, per capita taxes at the
state level and the importance of taxes in terms of collections at the
state level.

Even with the weak economy in 2002, tax receipts remain high as a share
of the economy. Total federal tax receipts in 2002 are estimated to be
19.4 percent of GDP. Since World War II, total tax receipts as a share
of GDP were higher in only six years (1969, 1981, 1998, 1999, 2000, and
2001). Individual income tax receipts are estimated to be 9.2 percent of
GDP. Since World War II, individual income tax receipts as a share of
GDP were the same or higher in only seven years (1969, 1981, 1982, 1998,
1999, 2000 and 2001). Even with the tax cut and the current economic
downturn, projected total tax receipts over the 2002-2011 period are
higher as a share of GDP than over any previous ten-year period.
Projected individual tax receipts are also higher as a share of GDP over
the 2002-2011 period than over any previous ten-year period^11^.

***2.Payments system in USA:*** In the USA, there are three kinds of
payments. The Cash payments, the Check payments and the very large scale
transfers of money (See [Annexure **'H'**]{.underline}). The cash
payments add up to US \$ 2.2 Trillion in year 2000. In the same year,
the check payments added up to US \$ 85 Trillion in value. And the very
large value payments (mainly through the ***FedWire*** and ***CHIPS***
systems -- ([see annexures. **'I'** and '**J**'
respectively]{.underline}) added up to US \$ 695 Trillion in 2000. The
total payments for the year 2000 then add up to US\$ 782.2 Trillion.

***3.Process of taxation*** The key aspect of this proposal is the
process by which the revenues will be raised in the changed scenario.
Almost every payment originates in the bank as the figures above
suggest. Even if the cash payment is ignored, the total payments being
routed through banks in the year 2000 added up to US\$ 780 Trillion. It
is proposed that, 1% of this total transaction is passed on by banks
towards tax revenues to the Government treasury. The revenue thus
available to the Governments would be substantially higher then the
present gross tax revenues. To be a bit specific, it would be US\$ 7.82
Trillion as compared to the total receipts in 2001 of US\$3.02Trillion.

The proposal, though very simple on the face of it, deals with a very
sensitive feature of the economy. This sensitive feature is the
***\'Large value Payments\'*** system. By definition, the large value
payments involve: **1**. Bank to bank Transfers for settlement payment
between clearing associations; **2**. Interbank overnight loans; **3**.
Intercorporate transfers and **4**. Settlement of securities
transactions.

The banks resort to some of these transactions in the interest of the
economy (e.g., to maintain adequate liquidity, to intervene in the
interest rate fluctuations and the maintenance of value of dollar in
tune with the federal banks guidance). So logically such transactions
should not be taxed. Hence, some of these \'large value\' payments are
likely to have some major exemptions. These exemptions may bring down
the probable figure of likely revenues from US \$ 7.82 trillion to a
lower figure. How and why this happens will be dealt with hereunder in a
sequential manner. It will be clear by the end of the analysis that the
proposal is more than \'revenue neutral\' i.e. it generates equal (or
more) than the present revenues from all kinds of taxes (which is US\$
3.02 trillion for the year 2001)

***The \'large value\' payments*** are largely the amounts transferred
by the FedWire and the CHIPS networks. As has been indicated above, the
Federal bank operates FedWire for large transfers of funds. It
transferred US\$ 423 Trillion in 2001. CHIPS is in the private sector
and had transferred US\$ 311 in the year 2001. But to what extent these
amounts can be taxed or exempted?

The answer is that these large value payments are in themselves a
fraction of what needs to taxed. To get to this answer we need to take a
look at the process of Netting. ***\'Netting***\' or the ***Net
Settlement Systems*** is a system in which banks continually send
payment instructions over a period of time, with final transfer
occurring at the end of the processing cycle. During the period, a
record is kept of net debits and credits. This is explained with an
example of large value transaction i.e. in the Equity/capital markets,
as given below:

The USA has a very large and vibrant equity/capital market. This market
has a very advanced system of clearance and settlement of transactions
in equities/bonds/ UITs /Derivatives/Commodities etc. The Figures of one
such clearing center (Depository Trust and Clearing Corporation - DTCC)
indicates that the total value of transactions of settlement undertaken
by it in 2001 was US\$ 88 Trillion for equity and US\$ 250 Trillion for
Govt Security, Corporate bonds, Municipal Bonds and Unit Investment
trusts etc. The DTCC netted these large transactions and only moved
about 4% of this large amount of transaction through the FedWire and
CHIPS systems. Put differently, the transactions of US\$ 250+88
trillions would be reflected in FedWire or CHIPS handled very large
payments by only around US\$ 14 Trillions only (i.e. 4% of 338 trillion
US\$).

Similarly, the CME (Chicago Metal Exchange) reported that it settled
411million contracts in 2001, at a value of US\$ 328 trillion. The New
York Mercantile Exchange Clearing Corporation, Board of Trade Clearing
Corporation and Options Clearing Corporation report similar large
figures of contract settlements. In addition there are Depositories,
Large-value cross-border payment transactions etc.

Although it sounds complex, buying and selling financial instruments in
the wholesale market is really no different than buying or selling an
\"ordinary good\" in the retail market.

If all these are such huge transactions of buying and selling, then why
do the numbers only reflect US\$ 695 Trillion in 2000 for large value
payments? As seen in the example of DTCC above, the effect of Netting is
that, it reduces the amount of transaction in the end. That is why we
can safely conclude that the large value Intercorporate transfers,
Equity transactions (and the transactions of Bonds, UIts, Govt
Securities, Options/Futures, Commodity exchange transactions etc) are
shown as only a portion of the large value payment figures - as they are
\'Netted\' figures. Therefore it is eminently possible that the
non-Netted figures for the large value payments would be considerably
larger, say in the range of above US\$ 1,000 Trillion or so.

The point is all these transfers should be levied \'tax\' at their
non-Netted aggregates, at a predetermined rate. At the same time this
should be done in a manner, so as to, not to jeopardize the financial
market operations. If it is required to protect the financial markets
structure, the rate of taxation for transactions in financial market
instruments can be lower than the general rate of taxation (ie, 1%), say
@ 0.2% to 0.5% depending on the type of instrument and the purpose for
it is meant. The proposal would still be revenue neutral or rather
revenue surplus.

Now we come to the last part of the proposal and try to settle two
crucial issues. One, how will it be implemented? Two, how will it be
better than the current taxation system in place?

**[Implementation:]{.smallcaps}**

There are few important elements to the process of implementation, which
are enumerated below:

***First***, in case of large value transactions the banks should deduct
tax from the non-Netted aggregates at the prescribed rate of taxation.
The actual transfer of funds can continue to be in the netted form to
keep the system as efficient and low cost as it is today. All the
participating entities in a large value settlement or transaction would
be forwarding their non-netted transfer requests to the settlement
corporation or bank. The settlement corporation (like DTCC or CHIPS)
then goes on to \'Net\' the requests for these participants and then
makes the transfer. The deduction of tax should be made on the
non-netted figures of transfer for each entity and the transaction per
se can then go on in the netted form so as to retain the efficiency of
the system. A minor change in the algorithm of these large value
settlement entities or transfer entities is all that is needed for this
to take shape.

***Second***, total exemption should be given to the interbank transfers
for maintenance of liquidity or interest rate or value of the currency
etc as mandated by the central bank.

***Third*** is the simple deduction of 1% from all amounts that are
\'w*ithdrawn*\' from any bank by any means. Means here may include
Electronic (Wire transfer, Credit Card, Debit Card etc), Check and by
Cash. This will be very simple, as the banks only have to change their
computer program to deduct the amount and remit it to the treasury. The
deduction would be automatic and without any emphasis on where the money
is going or how it is going to be used. it also will be irrespective of
who is withdrawing or using the money i.e. whether its an individual or
a firm or any other entity. By this method alone the total collection
would come to around US\$ 0.872 trillion (i.e. for the year 2000 taking
the cash transactions of the order of US\$2.2trillion and check
transactions to the order of US\$ 85 trillion = a total of 87.2 trillion
US\$)

Similarly, when large value intercorporate transfers or payments for
securities, derivatives trading or commodities trading occur over the
banking networks, a 1% charge should be deducted automatically by the
bank from which the money is being drawn and remitted to the treasury as
tax. These transactions should be charged only once during the entire
transaction i.e. from the payment making entity to the payment receiving
entity. A simple yet effective model has been developed for this purpose
and is explained elsewhere below.

By this method, taking the non-netted transaction figures given by the
DTCC and the CME for only equities and commodities respectively (for the
year 2001) as US\$ 88trillion and US\$ 328 trillion, a total of US\$ 416
trillion worth of transaction results. If just 1% of this is deducted
and remitted by the banks through which this transaction money
originates, the total remittance comes to US\$ 4.16. If cash and check
transactions\' resultant 1% is added to this, the amount goes up further
by US\$ 0.872 trillion. This is much more than the total requirement of
taxation revenues, which stand at US\$ 3.02 trillion in the year 2001.
And this is yet to take into account the remittance from other major
source as given in the next point.

***Fourth*** is the preferential rate of deduction for certain class of
transactions. Here only those transactions that are very high volume
financial market transactions (like Govt securities or Municipal Bonds)
will be covered. The Govt Security, Corporate bonds, Municipal Bonds and
Unit Investment trusts (and similar class of financial instruments)
carry a very low rate of interest and transaction in this is usually
done to manage liquidity or raise scarce resources. These instruments
can be treated differently by deducting a charge of 0.2% as tax on their
non-netted figures. A separate payment chain can be set up for this. A
simple yet effective model that caters to this preferential rate of
taxation of funds has been worked out and is given elsewhere below.

Figures for these transactions as taken from the DTCC alone for the year
2001 show US\$ 250 Trillion for Govt Security, Corporate bonds,
Municipal Bonds and Unit Investment trusts etc. A 0.2% deduction means
revenue of US\$ 0.5 trillion. And the figures of other similar entities
like the New York Mercantile Exchange Clearing Corporation, Board of
Trade Clearing Corporation and Options Clearing Corporation. In addition
there are Depositories, Large-value cross-border payment transactions
etc are not even considered as yet.

This surge in volumes of tax revenues by the proposed method can take
the entire tax collections in the US to a higher percentage of GDP. This
is certainly not the intention of this proposal if this hurts the
all-important financial market and the economy as a whole consequently.
There are some suggestions or corrective propositions here. One, there
may be some duplication in the Check transactions and the Equity
transaction numbers. So the number may be slightly lower. Second,
considering the exact numbers, rate of deduction for transactions in
securities and commodities trade can be a bit lower than the proposed
1%. Or otherwise, the rate of deduction for transactions in financial
instruments can be lower than even 0.2%. Third, the transactions for
which total exemption is to be given can be more than what are suggested
here. The suggestion here is in any case indicative and not exhaustive.
The federal bank in consultation with the Treasury or other departments
can define which kind of large value transactions need not have any
deductions. Generally speaking such transactions would only be those,
which aid the monetary policy and the liquidity parameters required for
the economy as a whole. For example, transactions made by the banks for
the statutory liquidity maintenance by the banks could be one such.
Similar could be transactions made by the federal bank in the bond
market for maintaining liquidity or transactions by the federal banks to
maintain the exchange rate etc.

All the steps enumerated above can bring the surge in potential revenues
from the new system to some respectable parity with the current
aggregate tax revenues. But this should not distract the policy makers
much, as the gross taxation as a percentage of GDP in the US is much
lower when compared to the OECD countries or many other developed
European countries. In 2001, total federal, state and local taxes in the
United States were 29.0% of its gross domestic product, ranking 27th
among the 30 OECD countries. Only Korea (27.5%), Japan (27.1%) and
Mexico (18.3%) had lower taxes. In 2001, total taxes in the 26 OECD
nations with higher taxes than those of the US ranged from 29.2% of GDP
in Ireland to 53.4% in Sweden. In 2002, total U.S. taxes fell to only
26.3% of GDP.(Source OECD) The two annexures ('**K**' and '**L**') will
amply clarify the issue.

***Fifth*** is the issue of complimentary enabling actions the
Government has to take for the implementation of this proposal. These
may be of three major types.

*[One]{.underline}*, is the proactive measures like the federal and
other financial intermediaries including banks making appropriate
changes in their software for the designated percentage of tax amount to
be deducted automatically and remitted to the treasury. This by itself
will not be a problem. Another proactive measure would be disqualify or
ban all forms of virtual currency as to allow people to use currency
which can taxed in reality. The system would essentially shift from
taxing good or services to taxing the movement of money. The government
can also encourage the usage of credit cards or debit cards so that more
and more cash transaction is canalized through the banks. The Govt will
also have to set up a mechanism to decide the kinds of transactions in
the financial markets, which would be exempted from any deduction.

*[Two]{.underline}*, is the issue of the readying of the Federal
Structure to adapt to this system. Typically, as all other forms of
State and Local taxes would be abolished, the states may not prefer to
adapt to this system as it may limit their freedom to raise more taxes.
They may perceive this new system to be penalizing their enterprising
new initiatives to attract capital and investment in their jurisdiction.
It seems complex to handle on the face of it, but when the issue of
complete simplicity of collection is driven home to the states in a
revenue neutral manner they may agree to take a look at it. The pressure
from the users i.e. the tax payers to adapt to the new system also will
make the decision makers in the states polity to take a real hard look
at the new proposal. The states can continue to receive the taxes from
the gross collections in a proportionate manner depending upon what
accrued to them over the last 3-5 year period. All the states will have
to together evolve a formula for this and further devolve funds to the
local bodies in a similar manner. The states and the local bodies would
be free to invite investments by giving them various incentives, which
are non-tax related (for e.g., land subsidy, labor law relaxations or
other kinds of regulatory relaxations). This will encourage public
private partnership and also boost development bringing in employment.
For too long the tax regime has been used to favor or attract specific
sectors. It may be time to consider other methods of revenue generation
and community development as described in great detail in the book
\'Reinventing Government\' by David Osborne and Ted Gaebler.

*[Third]{.underline}* is the issue of rollover to the new system. As
explained earlier, it does not take much by way of software changes to
deduct the designated rates of taxes from transactions and remit these
to a central pool from where these can be shared by the federal, local
and the state authorities. However the major rollover problem could be
the use to which the huge tax levying and collection machinery in place
at all levels. It would be by and large redundant. But if judiciously
used they can trained and redeployed elsewhere. A significant number
would be required in any case to handle the legacy issues of the old
system at all levels. Typically this could include the refunds for tax
benefit related investments done as per the previous tax regime. They
would also be required to enforce the new system as human ingenuity may
surely find ways and means to trick or con the new system as well. But
their task would be enormously simpler as they would be chasing money
instead of consumption or income or people. Instead of multifarious
agencies for different taxes, though, a unified agency to cater to the
regulatory or enforcement activities of this single taxation methodology
will be required.

Coming to the last part of the implementation jigsaw and before moving
to the next section of comparing the proposed system with the present
system, the issue of designing a model for deducting different rates of
interests for different kinds of transactions is dealt with here. (This
was also indicated above).

Basically, there would be four categories of transactions. One would be
the simple cash or check transactions, which would attract a uniform
deduction of 1% per withdrawal. The banks would achieve this by simply
modifying their software to this extent.

Second would be the transactions, which would attract no deductions.
These transactions would be the ones, which would be identified by the
Federal Banks in consultation with the Treasury etc. These transactions
would typically be to manage the liquidity in the banks, the interest
rates and the exchange rate etc. The entities which would indulge in
transactions to further these requirements would be Banks themselves as
per the advice of the federal bank, generally speaking. Such
transactions would not attract any tax deduction. The banks can always
change their software for this purpose. The Federal Banks can keep a
watch on this to ensure that no non-entitled transaction gets this
benefit. Some of the staff from the existing taxation agencies can be
retrained and redeployed for this. It is understood that as all the
Federal banks would also be very keen to ensure proper revenue
realization for the Governments, they would be careful in this activity.

Third kind of transactions would in the Govt Security, Corporate bonds,
Municipal Bonds and Unit Investment trusts and the like. These would
attract deduction at the rate of 0.2%(the rate can be lower as well).
Fourth kind of transactions would be in the stocks and Commodities
markets. These would attract deduction at the rate of 1% as per the
present proposal (this rate can be lower too). Both these are dealt
together as these typically have brokers and exchanges (clearing houses)
as intermediaries between the buyer and the seller. As the volumes are
large enough, it is imperative that the transaction is not charged
multiple times and is charged only once in the entire transaction chain
between the buyer and the seller. Needless to say that all deductions
would be on the non-netted amounts of transactions.

To cater to these kinds of transactions, the brokerages will have to
open two sets of paired accounts. One set would deal with instruments
that are to be charged @ 0.2% (let us call this as \'Set A\') and the
other set would deal with instruments that are to be charged @ 1% (let
us call this as \'Set B\'). None of these accounts should accept cash.
Each set of accounts would be a paired account i.e. it would have two
accounts internally. One internal account would be able to ONLY receive
funds from the prospective buyers (individuals or firms) and forward it
ONLY to the exchange or the clearinghouse for the specified instrument.
The second internal account within a set would be able to ONLY receive
funds from the exchange or the clearing house and forward it to the
actual seller (individual or firm). When funds are transferred from
these two sets of accounts into each other through the exchanges or
clearing houses or to the sellers account, no tax deduction would be
made by the bank. Tax would be deducted @ 0.2% if any funds are moved by
a firm or individual into that account of \'Set A\' - which can receive
funds from prospective buyers. Similarly, tax \@1% would be deducted if
a firm or individual moves any funds into that account of \'Set B\' -
which can receive funds from prospective buyers. Lastly, no funds should
be allowed to be moved from any 'Set A' account to any Set B account or
vice versa of either the same brokerage or different brokerages.
Similarly, the exchanges or the clearinghouses should also forward the
funds after settling the sale of any instrument to the same of account
(i.e. Set A or Set B as the case may be) from where that transaction
originated. Needless to say that, even if the exchange does netted
settlement, it should report the non-netted transaction particulars to
the bank for deduction of the tax.

The simple enablers required for this model to work would be the opening
of two sets of accounts by the brokerages and notifying these to the
banks. The banks can then suitably update their software to be able to
deduct tax @ 0.2 or \@1% depending upon the destination. Infact the
banks would only need to keep track of the destination only in cases
where money is going into \'Set A\' account i.e. where deduction is to
be \@0.2%. This is because they would in any case be deducting \@1%
generally even otherwise. Of course they would take into account the
non-netted transactions reported by the exchanges and clearing houses
for the deductions in case of all money flows into both \'Set A\' and
\'Set B\' accounts. The retrained functionaries of the various tax
authorities can be suitably deployed to keep track of smooth functioning
of these accounts and deductions.

**[Comparison:]{.smallcaps}**

Having completed the outline of implementation of the proposed scheme of
taxation, we can now clearly focus on the aspect of comparing this
scheme with the present system. It will also assess the possible
scenarios for tax burden for families under the new system.

**1**. In the new system there would be no other tax (at the Federal,
State and the Local level) other than the levy of 1% for everyone at the
point of withdrawal of money from bank. (Of course, the preferential
rate of 0.2% or 0% for specified large value transactions would be taken
care of). This would make system of taxation simple. There would be no
detailed tax codes and no returns. if there is one comparison which
needs no further elaboration, it is this one. The new system would be
eminently simpler.

**2**. The new system would be more economically efficient. It would
have little or no distortionary effects. The entire taxation methodology
would be transparent and information would be freely available. There
would be no periodic announcements about taxation policy or rates to
bring in distortions. The consumption within or outside of any
organization would be incurring the same tax rate. So there would be
less consumption related distortions of behaviour. There would be no tax
on the return on capital and no capital gains tax. Hence no general
equilibrium effects would be there. There would be no distinction
between forms of transaction in general production and consumption
areas. Hence there would be no distortion on this count as well. There
would be nothing an individual can do to reduce his tax liability and
hence there would be no scope of distortion. Of course he can choose not
to use his money in the bank. But this would only increase saving and
disposable income, both of which are beneficial to the economy.

**3**. There would be minimum or no record keeping for most of the
activities. Any marginal increase in record keeping would be at the
level of banks and financial intermediaries. As the system would be
vastly less complex, the cost of running it would be lesser as well. As
there would be no income categories or deduction categories generally
speaking, there would be no costs for calculating the different
liabilities and the consequent litigation costs. Presently, the IRS
spends around 40-50cents per \$100 collected. This excludes the expenses
at the state and the local levels. The cost of collection in the new
system is going to be considerably less. It maybe as low as under 10% of
the present aggregate costs of collection or even lower, as the entire
collection and record keeping would be a function of software and
minimum staff for regulation or enforcement would be required.

**4**. This tax system would be more flexible on count of political ease
to change the tax rate, as it would not discriminate between sectors and
activities. As long as the overall revenue requirements are met, the
rate of 1% can be increased or decreased without much problem from
sectors or lobbies and also from the implementation point of view. In
fact if the tax rate is indexed to inflation or to any other key
parameter then it would automatically increase or decrease without much
intervention on a regular basis. Of course this system has the advantage
of being hugely revenue surplus at the conceptual level, therefore
retaining its inherent flexibility of having lower rates for financial
market instruments.

**5**. This system would have lot of transparency when compared to the
present system of taxation. People would know how and when they would be
taxed and by how much very easily. This will also make them realize that
for the vast majority of the taxpayers in the middle and lower income
group, the new system has a big benefit and therefore there would be a
demand-pull for implementing this system. This would in turn make the
proposed system very politically acceptable for implementation. The same
demand-pull will ensure that the federal system of states and local
bodies would also welcome it.

**6**. In the present system, for a family of four which has two wage
earners and two school going children and owns their own home, it is
seen that their taxes would range from 7.5% to 12% of their income
depending on which city they live in and how much is their income (i.e.
between US\$ 25,000 to 150,000). This data is

available in the Annexure 'G'. These taxes are only the visible ones.
These taxes do not include any federal taxes. These taxes only include
state and local sales, income, auto and real estate taxes.

When this is contrasted with what the liability of such a family would
be in the proposed system, then it can be seen that it would be only 1%
of their income instead of 7.5 to 12%. What is more significant is that
it would be inclusive of ALL taxes including the federal ones. The
comparison should logically end here in favor of the new system.

But it would be just as interesting to see as to how much the federal
taxes would be. A pointer is available in the [Annexure
'**F**']{.underline}. It gives the effective rate between 4 to 20% for a
single person having adjusted gross income between US\$ 10,000 to
75,000. So the new system easily scores over the present one.

One point can be raised is that under the new system, everyone has to
pay tax \@1%. So how about the people who have income less than, say
US\$ 5,000. This is the question of social engineering through tax
breaks and rates, which has actually brought the tax system to its
present crisis levels. But to tackle the issue, it can be said that the
issue is open for a political answer, where such people i.e. the poorest
of the poor are exempted and their accounts in banks are allowed to be
operated without any deductions. However it is also equally possible
that such person may not be paying anything at all as he may not be
operating any bank account to begin with. So the question of any
taxation would not arise in such a case.

**7**. When the data of 1999 Corporation Income Tax Returns: Returns of
Active Corporations read with Table 6\--Balance Sheet, Income Statement,
Tax, and Selected Other Items, by Major Industry as published by the IRS
is seen at ([Annexure '**M**']{.underline}), it is clear that the major
industries collectively received US\$ 18.893 trillion as total receipts
and paid total taxes amounting to US\$ 372 billion. This means they paid
on an average around 2% as taxes of their gross receipts. And this is
just the corporate income tax data and does not include other kinds of
taxes, which the corporates may be paying at various levels. The present
proposal would have made them pay only around half of that amount and
which would have included all kinds of taxes. So the individuals and the
large businesses both would be paying less under the new system.

The question then arises is that if the individuals and corporates are
both going to pay less under the new system, then how would the new
system by revenue neutral or surplus as is seen elsewhere? The answer to
this central question is that, there are high net worth firms and
individuals who trade in stocks, commodities, derivatives, Govt
securities and the like instruments. That they must be there need not be
proved. It does not matter as the trade and the volume and value of such
trade, which is reported and referred elsewhere, holds the key. As long
as such instruments are traded and as long as tax is deducted at a
non-netted form on such trade the tax collections would be comfortable.
It must be entirely possible that despite such huge volumes in trade in
such instruments, not much capital gains or income tax is resulting at
the moment due to either the business not being profitable per se or due
to the taxation methodology which gives such dealers to avoid paying
taxes. It however does not stand to reason that people would continue to
invest in a business in considerable volumes and value despite such
business not being very paying. Here again it does not matter, as to
what is the motivation of people and firms to be in such business under
the new system. The new system will ensure that they all pay a certain
very minimum percentage of taxation and which is enough.

**8**. Although there is debate among economists about the
responsiveness of savings to changes in the tax rates, it would be safer
to assume that under the new system, people would be able to save more.
This might even result in more consumption. Both these eventualities are
good for the economy.

**9**. Another benefit would be the increase in the labor supply, which
would be available due to very low tax rates. People who would have
otherwise opted out of the labor market due to high marginal taxes would
try to remain in the market. As there would be very minimum preference
for allocation of capital due to a uniform tax structure, the allocation
of capital would be more efficient. A clear possibility would be that
due to reduced taxes all across the board, the costs of production and
the hence the costs of goods and services may fall. This can clearly
improve the competitiveness of the economy as a whole. This would mean
that the factors of production would be able to produce more with less.
Imports may become uneconomical in many cases and exports would get a
boost.

**10**. On the issue of fairness of a system in terms of vertical and
horizontal equity, the present system has been criticized enough.
Without going into those details, it can be safely said that the
proposed system is designed to treat everyone who is similarly placed in
a similar manner. All would be taxed at the same rate. But people who
are placed better would be logically trading in financial instruments
and hence their share of taxes would be higher. The poor would not be
using much of banking transactions and hence would not be paying much.

**[Pitfalls Analysis]{.smallcaps}**:

Before ending, a look at the possible pitfalls in the proposal are also
touched upon briefly as under:

**1**. *What if the people start resorting to cash transactions instead
of through banks?*

This is difficult to materialize, as there would be an emphasis from the
Govt to encourage the usage of banking channels. For example the
government can disallow retaining of cash above a certain level with the
individuals and firms. The newly retrained IRS and other taxation agency
staff can chase cash. Then, it can be seen that the transactions are so
voluminous that it will be by default through the banks. There is also
the risk of dealing in cash due to the sheer insecurity associated with
handling currency in large volumes. In short, dealing with currency,
through banks and electronic means, as a medium of exchange or value has
come to stay.

**2**. *What if people resort to barter or virtual currency (internet
currency)?*

Not everyone is a seller and a buyer from the same entity. So barter
would be difficult if not impossible. For example, what can an employee
buy from his firm in lieu of his wages. Or, what can a person sell to
the supermarket in lieu of goods he buys from the supermarket. The cases
of financial markets where this is possible are already covered in the
proposal. The Govt also would be expected to outlaw some kinds of
transactions like that of Internet currency. The staff, which would be
retrained, can be keeping a watch on these other kinds of currency or
large value dealing in cash.

**3**. *What would happen to the parallel economy?*

It is to be emphasized that parallel economy does not mean that it is
only dealing in cash. It is seen more often that bulk of parallel
economy proceeds ultimately go to the stock market or to the real estate
market. Stock market is covered already, as each transaction has to be
routed through the bank at some stage. In the real estate sector, it
would be more enticing for the holder of black money to pay a simple 1%
tax on the entire amount and be above board than to take risks. In any
case, with so much work reduction for the tax authorities under the new
system, they will have more time and resources to devote to chasing the
unaccounted wealth. By definition parallel economy extent is difficult
to gauge. But various estimates indicate the unreported transactions to
be to the tune of 10-15% of the GDP of the USA. At a 1% rate of tax
there would be a lot of incentive to the parallel economy to come above
board. And in any case the bulk proceeds of the parallel economy would
get covered by the new system when investments are made in financial
instruments or real estate. In fact, on the issue of parallel economy,
the new proposal has considerable merit over the old one.

**4**. *Why should people be happy paying 1% on the real estate?*

Because there would be no estate tax, which is recurring every year. The
1% tax is only when people buy a property. When they sell it, they don't
pay any tax. Not even the capital gains tax. In fact people would find
it very simple and easy to pay a 1% tax at purchase and forget about any
tax on the property forever.

**5**. *What if the stock market, commodity market, derivatives and
other financial instruments transactions go down as a result of the 1%
tax? Similarly, what if the transactions in the securities and bond
markets etc go down as a result of the 0.2% tax?*

First the stock, commodity, derivatives markets etc. These may find the
1% tax on transactions very heavy at the first look. But if it seen
closely, it is not 1% per transaction for every party i.e. the buyer and
the seller. The 1% tax is only for the buyer when money moves from his
account to the sellers through the broker and the exchange or clearance
center. Now, when anyone buys a stock or commodity option etc he buys
with the intention of making more than 1% profit at least. More often
than not, the target is 4-10% of profit. Yes there is a potential for
loss as well. But looked at it differently, there is no capital gains
tax or corporate income tax or personal income tax. No sales tax even.
So the profitability of the companies would improve and so would the
returns on investments. Even otherwise, even in an unchanged scenario of
the profitability of the companies, the selling of a stock or derivative
or commodity in the old system results in a capital gains tax and a
personal income tax to the seller. The proportion of this tax to the
profit would be greater when the capital gains tax is @ 25%. At 1% rate
of aggregate tax all told, the take home returns would improve if anyone
sells a stock even with a minimum of 4% profit. It is seen from data
that transactions happen even if there is a fall of say 10% and above or
a rise of say 10% and above in any of these instruments. Just because
there is going to be a loss, buyers and sellers don't stop trading or
speculating. They simply, factor the possible downside and carry on. The
reason why they do so is that, if there is a downside to their
transaction in theory, there is also a potential for gain. This 1% tax
will be simply factored in as a transaction cost. The transaction costs
were rather high when equity trading was not computer based. But the new
system does not propose to bring in inefficiency. Rather, it would
simply eliminate all taxes including capital gains, which means that
there is a much higher potential upside for the companies and the
investor as well in case of the particular financial instrument doing
well.

Why should they be paying when they make a loss is another question. If
this analogy is stretched, then no business should be paying any
transaction cost \@1% as there is always a possibility of the business
going into losses. The same can be stretched to the personal
consumption. But is should be borne in mind that for any tax to be so
low as 1%, it should be treated as a transaction cost and not tax per
se. A transaction cost for being able to execute the transaction in a
safe and secure environment. A transaction in a milieu where insurance
covers work, where system supports are available. Where health,
education and social security cover is retained even if the business
goes into losses. In fact it should be logically construed as a cost of
doing business and a cost of being part of a very progressive civil
society. This perhaps was the basic intention of the first tax ever
levied. Whether one makes a profit or a loss, the transaction cost of 1%
should be factored right in the beginning. Equity, commodity or
derivative transaction etc should be viewed as being no different. It
also deserves to be treated as business like any other instead of being
looked as more of speculation.

Coming to the issue of securities and bond markets etc, the rate of
proposed tax is already suggested at a very different 0.2%. This is
because the rates of interest are very low and the returns are very
limited and known. There is no potential for making huge profits. Hence
the rate is very low. As explained in the case of equities etc., the
rate of tax here should be construed more as a charge on transaction,
rather than anything else. If supposing the rate of interest still goes
down to say 0% even then there would be a cost of transaction for
keeping the money safely with the banks. It should be no surprise to
anyone that transaction costs would be higher than the returns in such a
case. It should be remembered that the interest income in all such cases
would be totally tax exempt, as well.

Lastly, the proposal leaves scope for downward revision of the proposed
deductions in case of equities, commodities, securities, bonds etc,
depending on the actual turnovers.

**6**. *Is it not discriminatory if some transactions are totally
tax-free?*

A nation, a democratic nation at that, has a right to decide as per law
what is in the interest of the nation and treat it appropriately. In an
interdependent world, it is extremely important to have some say in the
price level of its currency. It should also be able to guide and control
its money and liquidity markets properly. In doing so, it cannot
penalize its own tools i.e. the financial intermediaries who carry out
such functions in accordance with clear policy and guidelines. Hence
such transactions are not only liable to be exempted, there would also
be scope to increase or decrease such exempted variety of transactions.
It would be nothing but financial statecraft.

**7**. *How will the multinationals of other countries treated?*

There should be no discrimination between the financial transactions of
the foreign firms or those owned by residents but operating abroad. All
similar transactions in the US should be similarly taxed. And due to
this if flight of capital abroad is anticipated, even then just before
the flight, the capital would be automatically subjected to a cut of 1%.
This may not happen though as US markets are too lucrative and the new
tax also would be much more favorable.

**[Difficult to evaluate:]{.smallcaps}**

Before concluding it would prudent to deal with a few difficult to
evaluate scenarios.

One such scenario would be the response of the states to do away with
their own kinds of taxation as that gives them a lot of political clout.
There would be pressures on the states, however, to adapt to the new
system as it would much more convenient. However the formula to share
the taxes can be difficult one to arrive at.

Second would be the exact rates of taxation for different instruments.
There maybe considerable disagreement on the exact rate of taxation for
various instruments. But this will not be insurmountable as all tax
rates go through this process of debate and lobbying. This proposal has
the advantage here in that, in the present shape, it is rather revenue
surplus and there is scope for its adjustments depending on the detailed
figures of transactions in each such instrument.

Lastly, there would be resistance from the lobbyists and the
practitioners of the present system, as they would be finding it hard to
adjust to the new environs. If the debate this proposal generates is
conclusive enough then this question is automatically taken care of -
either way.

**[Conclusion:]{.smallcaps}**

To conclude, it appears on balance that this proposal is worth being
debated by informed stakeholders seriously.