United States General Accounting Office

GAO Report to the Chairmen and Ranking

Minority Members, Committee on

Finance, U.S. Senate and Committee on

Ways and Means, House of

Representatives

January 1998 TAX

ADMINISTRATION

Potential Impact of

Alternative Taxes on

Taxpayers and

Administrators

GAO/GGD-98-37

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-265785 

January 14, 1998

The Honorable William V. Roth, Jr.

Chairman, Committee on Finance

United States Senate

The Honorable Daniel Patrick Moynihan

Ranking Minority Member, Committee on Finance

United States Senate

The Honorable Bill Archer

Chairman, Committee on Ways and Means

House of Representatives

The Honorable Charles B. Rangel

Ranking Minority Member, Committee on Ways and Means

House of Representatives

In the past few years, many proposals have been put forward to

comprehensively reform the federal income tax system. Proponents of tax

reform believe that replacing the current income tax system would

improve the performance of the economy and make the tax system fairer.

Proponents of several proposals also believe that reform would make

administration of the tax law easier and less costly for the government and

make compliance with the law easier for taxpayers.

To help Congress evaluate how tax reform would affect tax administration

and the burdens taxpayers face in complying with the tax law, we studied,

at our own initiative, the basic design features of several kinds of tax

systems.1

 The generic systems we studied are a national retail sales tax

(RST), two types of value-added taxes (VAT), a flat tax, a personal

consumption tax, and several versions of broad-based income taxes.

Various forms of these alternative tax systems have been included in

specific legislative proposals in the current and past sessions of Congress

or have been prominent in tax reform discussions generally.

In this report, we describe (1) the major differences in design among the

alternatives we studied and (2) how the alternatives, by incorporating

different design features, may affect the taxpayers’ burden of complying

with the tax laws and the government’s responsibilities for administering

those laws. The basic design features we considered in contemplating

1

For information on how comprehensive tax reform could affect the economy, see Congressional

Budget Office, The Economic Effects of Comprehensive Tax Reform, July 1997.

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alternative systems are the tax base (what is taxed); the types of taxpayers

(whether individuals, businesses, or both are legally subject to tax); tax

preferences (tax system provisions, including exemptions, deductions,

credits, and multiple rates, directed at various economic and social goals);

and the tax rate(s). We considered taxpayers’ compliance burden to

include the time, effort, and cost of filing the required returns and

maintaining necessary records. We defined tax administration as including

the government processing taxpayer returns, assessing compliance with

tax laws, collecting taxes owed, and providing taxpayer assistance.

This report is intended to be a reference document for readers with

different interests and needs. The letter summarizes (1) how the basic

design features are included in the current income tax system and could

be incorporated into alternative tax systems and (2) what the resulting

impacts on compliance burden and administration could be. For readers

who want more details on particular alternative tax systems, the relevant

appendixes contain more in-depth treatment.

Background Tax systems can have multiple goals. For example, in addition to the

common goal of raising revenue for the government, goals can also

include redistributing income, stabilizing the economy, and achieving

various other social and economic objectives through the use of

preferences. Generally speaking, the greater the number of goals, the more

complex is the tax system.

Criteria and Trade-Offs

Relating to the Design of a

Tax System

Tax systems are commonly judged and compared according to four

criteria: equity, economic efficiency, simplicity, and administrability. A tax

system is generally considered better than alternatives that raise the same

amount of revenue if it is more equitable, more economically efficient,

simpler for taxpayers to comply with, and easier and less costly to

administer.2

 In this report, we focus on simplicity and administrability and

do not analyze equity and efficiency. In deliberating on any changes to the

current tax system, Congress would need to consider each of the four

criteria.

2

Equity refers to value judgments about how to tax taxpayers with either similar or differing abilities to

pay tax; thus, different people have different views of what constitutes a fair tax system. A tax is

economically efficient if, in the absence of market failures or other distortions, it does not alter or

distort incentives, such as incentives to save, work, and consume. See, also, Joint Committee on

Taxation, Description and Analysis of Proposals to Replace the Federal Income Tax (JCS-18-95),

June 5, 1995, pp. 58-59.

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Designing a tax system that is superior on each of the four criteria is

difficult because the criteria frequently conflict with one another and

trade-offs must be made. For example, a tax system that provides credits

to low-income individuals may be judged by some to be more equitable

than a system without this feature. However, if including credits makes it

necessary for more individuals to calculate their income and file tax

returns, the tax system could become more complex for both taxpayers

and tax administrators.

The Current System The federal tax system raised about $1.4 trillion in fiscal year 1995 through

individual and corporate income taxes, payroll taxes, various excise taxes

on certain goods and services, and estate and gift taxes. Income taxes

accounted for 62 percent of total federal tax revenue.

The current income tax system includes an individual tax and a business

tax. Wages, interest and dividend income, capital gains, and some types of

business income, including that of sole proprietorships and partnerships,

are taxed under the individual income tax. Individual income is taxed at

graduated rates. Income earned by certain corporations is subject to a

separate business income tax, also at different rates.

The current system provides exemptions and different tax rates on savings

and investment through a variety of special provisions, such as the

preferential treatment of pensions, individual retirement accounts, life

insurance, annuities, state and municipal bonds, and capital gains. The

result is a hybrid income-consumption system of taxation that exempts

some types of saving and investment from tax but taxes others.3

The current system includes numerous other tax preferences. Examples

include the earned income credit; specific deductions for home mortgage

interest, charitable contributions, and state and local taxes; and exclusions

of employer contributions for health insurance.

Requirements for filing returns and performing other tax-related functions

vary. All individuals with gross income above certain thresholds based on

personal allowances and a standard deduction must file returns.

Businesses have certain responsibilities beyond filing returns, including

withholding and remitting employee income and payroll taxes, such as

Social Security, Medicare, and unemployment taxes. Further, many

3

A consumption tax is designed to tax only income that is used for consumption, effectively exempting

from tax income that is saved or invested.

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businesses must send information returns to the Internal Revenue Service

(IRS) and to individuals detailing income paid as wages, interest, and

dividends.

For more detailed descriptions of the federal income tax system, as well as

its complexity and burdens for both taxpayers and tax administration, see

appendix II.

Kinds of Alternative Tax

Systems We Studied

In the last several years, proposals for making fundamental changes to the

tax system have been discussed by policymakers and tax experts in

government, academia, and the private sector. An overview of tax reform

design issues appears in appendix III. The alternative tax systems we

studied are briefly described below and are further detailed in appendixes

IV through VIII.

• A national RST would generally be collected by businesses making retail

sales to final customers, with sales to other businesses generally not

taxed.

• VATs, now widely used internationally, are business-level taxes levied

directly on the sales of goods and services. All types of businesses, not just

retail businesses, are subject to the tax, and sales to both consumers and

other businesses are taxable. With the credit method VAT, used by most

industrialized countries, businesses claim a credit for tax paid on their

purchases from other businesses, and with the subtraction method VAT,

businesses deduct the amount of their purchases of goods and services

from other businesses. Thus, under a VAT, businesses pay tax on the value

they add to the goods and services they purchase.

• The flat tax discussed in this report would have both business and

individual components. The business tax would be similar to the

subtraction VAT, except that wages, salaries, and pensions would be

deducted by businesses. Individuals would pay tax on wages, salaries, and

pensions received above levels of allowances for themselves and their

dependents. The same, single (flat) tax rate would apply to both

individuals and businesses.

• A personal consumption tax would look much like the current individual

income tax in that individuals would continue to pay tax on many kinds of

income, such as wages, salaries, and interest and dividend payments

received. It would differ in that borrowed funds would be included in the

tax base, and funds that are saved or invested would be deducted. In most

proposals, the personal consumption tax has been supplemented by a

business tax designed to ensure that business purchases of goods and

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B-265785 

services for consumption, such as nonpension fringe benefits, would be

taxed.

• Income tax reform options that would replace the current income tax with

a more broadly based income tax have been discussed by the Department

of the Treasury and others over the years. Instead of being replaced by a

consumption tax system, the current tax system could be changed to a

broad-based income tax system by, for example, eliminating preferences

on certain types of income. Some proposals for reforming the income tax

would also change the collection point, or level, of tax. Options we studied

include levying taxes on businesses only, on businesses combined with a

relatively simple individual tax, and primarily on individuals.

Results in Brief The alternative tax systems we studied differ in their potential impacts on

taxpayer compliance burden and tax administration. The different

potential impacts of the tax systems can largely be explained by four basic

design features: (1) the basis for taxation (income or consumption);

(2) the type of taxpayer (individuals, businesses, or both); (3) preferential

tax treatment (e.g., exemptions, special deductions, and credits) for

certain individuals, businesses, or goods and services; and (4) the rate

structure for individuals (single or multiple rates). Table 1 compares the

design features of the tax systems we studied and shows:

• Many of the alternatives, namely, a national RST, VAT, flat tax, and personal

consumption tax, would tax the same base—consumption.

• Two consumption tax alternatives—the national RST and the VAT—would

levy tax only on businesses, while the other two—the flat tax and the

personal consumption tax—could tax both individuals and businesses.

Similarly, an income tax could be designed to tax individuals only,

businesses only, or both individuals and businesses.4

• Regardless of the base or the type of taxpayer, preferences could be

included in any tax option, although the types of preferences provided

would differ among systems.

• Finally, under income or consumption tax systems that include a tax on

individuals, individuals could be taxed at different tax rates, possibly

including a zero rate.

4

Regardless of whether a tax is levied on individuals or businesses, individuals will ultimately bear the

economic burden of any tax. For example, while an RST is levied on, or collected by, businesses,

individuals are commonly thought to bear the economic burden of the tax through higher prices.

Because this report focuses on compliance burden rather than on economic burden, we use the term

taxpayer to refer to the individual or other entity on whom the tax is levied rather than to whoever

bears the economic burden of the tax.

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Table 1: Major Design Features of Alternative Tax Systems and the Current System

Tax base Type of taxpayer Tax preferences

Number of tax rates for individualsa

Tax system

alternative Income Consumption Individuals Businesses Yes Possibly One

More than

one

Possibly

more than

one

Current

system

x x x x x x

Reformed

income tax

alternatives

x x

- - - - - - - - 

x

- - - - - - - -

x

- - - - - - - - 

- - - - - - - -

x

x x

National RST x x x N/A N/A N/A

Value-added

tax

x x x N/A N/A N/A

Flat tax x x x x x

Personal

consumption

tax

x x b x x

N/A = not applicable

aOther than a tax rate of zero.

bAppendix VIII discusses options for taxing business purchases of consumer goods and services,

such as nonpension fringe benefits. One option would be to supplement the personal

consumption tax with a business-level cash flow tax.

Source: GAO analysis of the designs of alternative and current tax systems.

The differences in the four basic design features of the tax systems we

studied explain in large part the differing potential impacts of the tax

systems on taxpayer compliance burden and tax administration. For

example, consumption-based taxes, such as the national RST, VAT, flat tax,

and personal consumption tax, would eliminate many of the issues of

defining and recognizing income that complicate income tax systems and,

in this respect, reduce taxpayer compliance burden and tax administration

activities. This is because under an income tax, taxpayers would be

required to establish depreciation costs for different types of assets,

account for income earned but not necessarily received, and keep records

on the value of assets over time. Conversely, under a consumption tax,

taxpayers could generally rely on records of sales, of purchases, or of

funds actually received to calculate their tax liability. Simplifying the

determination of tax liability for taxpayers could simplify assessing

compliance and providing taxpayer assistance for tax administrators.

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While different from income tax systems, the consumption-based systems

could also differ from each other in their potential impact on taxpayer

compliance burden and tax administration. For example, the personal

consumption tax, requiring individuals to report their borrowing and

saving, could be more burdensome for both taxpayers and administrators

than other consumption-based systems. Another example involves a VAT

and a national RST. Because all sales, not just retail sales, are included in a

VAT, more recordkeeping and taxpayers could be required under a VAT than

under a national RST. However, some experts believe that the additional

records could make compliance assessment simpler for tax

administrators.

Tax systems that would tax only businesses, rather than individuals and

businesses, could reduce taxpayer compliance burden and the costs of tax

administration by greatly reducing the number of taxpayers required to file

returns. With a VAT, a national RST, or a business-level income tax, only

businesses would be responsible for determining tax liability, filing

returns, and remitting taxes. Individuals’ compliance burdens could be

eliminated. Tax administrators could focus on many fewer taxpaying

entities, thus reducing the numbers of returns processed, actions taken to

collect taxes owed, and taxpayer questions needing answers. In addition,

businesses would no longer be required to withhold individual tax and file

many types of information returns.

Tax systems that combine a business tax with a relatively simple

individual tax, such as the flat tax or some versions of a reformed income

tax, could add limited burden relative to a business-only tax. A simple

individual tax, if administered largely through withholding and document

matching, would have little need for the filing of individual tax returns.

Tax systems requiring individuals to report more information about their

personal finances, such as a personal consumption tax or a more

complicated individual income tax, could add more burden than a

business tax combined with a simple individual tax because more

individuals could have to file tax returns and the returns would be more

complicated. More tax returns and more complicated returns would make

returns processing, assessing taxpayer compliance, and answering

taxpayer questions more difficult for tax administrators.

The alternative tax systems in table 1 could all incorporate tax

preferences. But, incorporating tax preferences—exemptions, special

deductions, credits, or multiple rates on goods and services aimed at

various economic and social goals—would generally add complexity. Tax

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preferences generally increase taxpayer compliance burden by

complicating the determination of tax liability, adding recordkeeping

requirements, and creating incentives to engage in tax planning. Similarly,

tax administration would be made more complicated because tax

administrators would need more information and time to verify the

accuracy of tax returns and collect taxes owed. Tax administrators would

also face more questions from taxpayers.

Tax systems with multiple tax rates for individuals, which could include

income taxes and a personal consumption tax, do not need to add burden

to taxpayers’ calculation of tax liability compared to single-rate systems.

Multiple rates for individuals add little to the burden of computing tax

liability because the use of tax tables minimizes this burden. Rate

schedules for multiple rate systems could include a zero rate or provide

one implicitly through a standard deduction or personal exemptions. A

zero rate or its equivalent would limit the number of taxpayers having to

file returns and reduce the processing volume for tax administrators.

However, tax systems with multiple rates could encourage tax planning,

which would increase burden for taxpayers and make tax administration

more complex.

In addition to impacts due to the four basic design features, the transition

to an alternative tax system could affect taxpayer compliance burden and

tax administration. The extent of the impact would depend on the type of

transition allowed. For example, if a consumption tax system were

adopted, a transition might allow for the gradual phaseout of depreciation.

In the event of such a transition, taxpayers and tax administrators could

be required to keep and check records for both the old and the new

systems, complicating the determination and verification of tax liability

during the transition period.

Major Design

Differences Among

Alternative Tax

Systems

Table 1 lists four basic design features of the tax systems we studied:

(1) the basis for taxation (income or consumption); (2) whether

individuals, businesses, or both would be subject to tax; (3) whether tax

preferences could exist for certain individuals, businesses, or goods and

services; and (4) the rate structure for individuals (single or multiple

rates).

An Income or

Consumption Tax Base

One major difference in the design of alternative tax systems is whether

the tax base is income or consumption. An income tax system generally

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does not allow deductions for savings and requires that earnings on

savings be measured and taxed as they are earned. Also, it generally

requires that businesses depreciate their purchases of assets, that is,

deduct the cost of assets over time rather than at the time they are

purchased.

Consumption-based tax systems differ from income-based tax systems in

that they generally exempt from tax income from savings and investment.

The national RST, VAT, flat tax, and personal consumption tax would

achieve this exemption in different ways. Under a national RST, businesses

would generally not pay tax on goods and services they buy. Under the VAT

and the flat tax, businesses could immediately deduct purchases of goods

and services, including purchases of plant and equipment, that they made

from other businesses. Under a personal consumption tax, funds that are

saved or invested would be deducted by individuals.

Type of Taxpayer Another major design difference among alternative tax systems is who

would be subject to tax. Consumption and income taxes could be levied

on individuals, businesses, or both. By levying tax directly on individuals, a

tax system can make distinctions among individuals or households to

account for varying individual circumstances by, for example, allowing

deductions and multiple rates. Alternatively, a tax system could focus only

on businesses and thus require fewer taxpayers.

The alternative consumption tax systems we considered differ from one

another according to who would be taxed.

• The national RST and the VAT generally would only tax businesses. All types

of businesses, including corporations, as well as partnerships and sole

proprietorships, could be subject to tax. A national RST would differ from a

VAT in that only businesses making retail sales would be subject to a

national RST, while retail and wholesale businesses could be VAT taxpayers.

• The flat tax would collect much of the tax base from businesses but also

would include a relatively simple individual tax.

• The personal consumption tax would continue to tax individuals. In

conjunction with this tax, businesses could be subject to a supplemental

tax.

Similar to the national RST, VAT, or flat tax, an income tax could be

designed to collect taxes from businesses rather than from individuals.

Such an income tax could, for example, disallow business deductions for

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wages and free individuals from filing returns. It would collect tax on all or

part of individuals’ incomes where the incomes were generated and before

they were paid. Other income tax options would, like the current income

tax system and the personal consumption tax system, tax most types of

income at the individual level.5

Preferential Treatment Each of the various alternatives could include tax preferences, although

the types of preferences provided would differ among alternatives. These

preferences could include special deductions, exemptions, and/or credits,

as well as various tax rates on different types of income or goods and

services.

The types of taxpayers in a tax system would influence the type of

preferences that could be allowed. Alternatives that tax individuals

directly could include preferences designed to target specific groups of

individuals. It would be more difficult for a tax system, such as a national

RST or a VAT, that applied only to businesses to provide preferences for

groups of individuals because businesses can apply different tax rates to

goods and services but cannot distinguish among individuals. Preferences

under business-level taxes could also include exemptions of specific types

of businesses or activities.

Tax Rates The fourth design difference is the rate structure for individual-level

income or consumption tax systems. The alternatives that we considered

that include an individual-level tax—the flat tax, the personal consumption

tax, and several income tax options—could tax different individuals at

different rates. All these options could include what is, in effect, a zero tax

rate by providing a standard deduction or personal allowances. For

example, under the flat tax, individuals with wage income under the

personal allowance amount would not owe any individual tax; wage

income above the deduction or allowance amounts would be taxed at a

single rate. Individual-level taxes in general could apply a single tax rate or

multiple rates.

5

The various income tax options are described in appendix IV.

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Implications of the

Alternative Tax

Systems for Taxpayer

Compliance Burden

and Tax

Administration

Because of differences in the four basic design features, the tax systems

we studied would have different impacts on taxpayers’ and tax

administrators’ responsibilities, and thus on taxpayers’ compliance burden

and the costs of tax administration. This section describes basic types of

taxpayer and administration responsibilities and the potential effects of

the alternative tax systems on each of them.

Taxpayers’ and Tax

Administrators’ Basic

Responsibilities

The taxpayer compliance burden created by any tax system will depend on

how many taxpayers have tax-related responsibilities, such as filing tax

returns, and on what difficulties these taxpayers face carrying them out.

Similarly, tax administration is affected both by the number of taxpayers

and by the difficulty of carrying out administrative responsibilities related

to each taxpayer. Table 2 shows the basic taxpayer and tax administration

responsibilities we identified.6

Table 2: Basic Responsibilities of

Taxpayers and Tax Administrators

Taxpayers’ responsibilities

Tax administrators’ related

responsibilities

File tax returns Process filed returns and maintain

accurate taxpayer accounts

Determine correct tax amounts, maintain

supporting documentation, and produce

support for information on returns upon

request of tax administrator

Devise programs, such as examination

and document matching programs, to

assess taxpayers’ compliance with laws

Remit taxes owed Collect taxes owed but not remitted

Get assistance, if necessary, from tax

administrators or paid preparers to

voluntarily comply

Assist taxpayers by answering specific

questions, providing tax forms and

publications, or helping with tax return

preparation

Source: GAO analysis of taxpayer and tax administrator responsibilities under tax systems in

general.

In many respects, tax systems that are relatively easy for taxpayers to

comply with will also be relatively easy to administer, and alternatives that

are relatively burdensome for taxpayers will also be more difficult to

administer. For instance, the more taxpayers that have to file returns, the

more returns the administrators must process and accounts they must

maintain. Likewise, a system’s complexity resulting from exemptions,

6

In this report, we do not focus on tax administrators’ activities, such as monitoring private pension

plans, that do not fall under one of the four basic responsibilities we describe. Similarly, we do not

address whether new government spending programs that could require separate administration

would replace certain activities now encouraged through the tax system.

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deductions, and other preferences could affect taxpayers and

administrators similarly by increasing their respective burdens.

However, in some instances, burden could be shifted from government

administrators to taxpayers or from taxpayers to government

administrators. For example, U.S. businesses currently perform some

duties to help ensure compliance, such as withholding and providing

information returns, that tax administrators could do through other

means.

Potential Effects of

Alternative Tax Systems on

Taxpayers’ and

Administrators’ Basic

Responsibilities

The overall costs to taxpayers and tax administrators of carrying out their

basic responsibilities under the tax systems we studied are difficult to

quantify. Even for the current income tax system, while IRS’ administration

costs are known, only very rough estimates exist for taxpayer compliance

burden. This is because of the difficulty in separating accounting and

recordkeeping costs for tax purposes from those that are incurred for

other purposes and because taxpayers may not measure such costs.

Estimates of taxpayer compliance burden for the current income tax vary

widely, but all are many times larger than IRS’ fiscal year 1998 budget of

$7.8 billion.

In a qualitative sense, changing from the current income tax system to an

alternative system would potentially affect each of the basic

responsibilities that taxpayers and tax administrators have. The following

discussion of possible impacts on each area of responsibility precedes a

table summarizing them and relating them to different tax systems.

Return Filing and Processing The tax systems we studied could differ significantly from each other in

the number of returns filed by taxpayers and processed by administrators.

Business-level tax systems generally have fewer filers than individual-level

tax systems or systems that combine a business and individual tax.

Business-level tax systems also generally require less information

reporting.

The current income tax system is relatively complex in the sense that

some income is taxed at the individual level, some at the business level,

and some at both levels. In 1995, taxpayers filed and IRS processed about

116 million individual tax returns, of which about 18 million reported

income from a sole proprietorship. Another 6 million returns were filed by

partnerships and corporations. Employers, investment institutions, and

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others sent IRS about 1.1 billion information returns, including withholding

documents for wages and information on investment earnings.

The alternative tax systems that would only tax businesses, such as the

national RST or the VAT, would eliminate individual tax filing requirements.

In addition, businesses would not be required to file information returns

related to individuals. The total number of returns filed under these

options would depend on how many businesses were subject to tax and on

how frequently returns were required. For instance, while only businesses

would be required to file tax returns under a national RST or a VAT, they

could be required to file quarterly or monthly. Under a VAT, small

businesses could be exempted, and under a national RST, wholesalers

would not have to file tax returns.

The alternatives that include a business tax and a relatively simple

individual tax would likely require return filing by businesses and by some

individuals. However, the number of individual returns filed and processed

under these alternatives could be significantly less than under the current

income tax system. Under a flat tax or one reformed income tax option, a

“return-free” filing system could be feasible because wages and salaries

would be the only type of income subject to tax for many individuals.

These employees would not have to file returns if employers withheld tax

on wages during the year and made any necessary adjustments in

withholding at the end of the year so that the amount of tax withheld

equaled tax liability. If these alternatives also featured large standard

deductions or personal allowances, the need for individual returns would

be further reduced.

Under the personal consumption tax or certain reformed income tax

options we studied, large numbers of individual tax returns and

information returns could still be required. The individual tax under these

systems would be relatively complex in the sense that many types of funds

or income would be taxable for individuals. Withholding correct amounts

of tax would be more difficult for employers and other businesses because

final tax liability would depend on the total amount of income or funds

individuals receive from many sources. Unless withholding was extended

to other types of taxable funds, individuals would likely be required to

account for all types of taxable funds on their tax returns, and employers

and businesses could be required to provide information returns to both

individuals and tax administrators. Under a personal consumption tax,

additional information returns related to borrowing and saving could be

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required, resulting in increased burden for the businesses required to file

the returns and for tax administrators.

Determining Correct Tax

Amounts and Assessing

Compliance

Because of differences in the four design features we discussed earlier, the

tax systems we studied would differ in the burden experienced by

taxpayers in determining their tax liability and in the costs to tax

administrators of assessing compliance.

In terms of the first design feature, the basis for taxation,

consumption-based taxes, such as the national RST, VAT, flat tax, and

personal consumption tax, could make determining tax liabilities by

taxpayers and, correspondingly, tax administrators’ assessment of

taxpayers’ compliance simpler in some respects than income-based taxes.

This is because many difficulties of defining and recognizing income

would be eliminated. To measure income from saving and investment as it

is earned, taxpayers have to estimate costs for depreciation, account for

income earned but not necessarily received as cash, and keep records on

the value of assets over time. Also, taxpayers could have to decide if

expenses are deductible or must be capitalized. Similarly, tax

administrators must be able to verify the income measurements required

under an income tax. In contrast, consumption tax liability can generally

be accurately calculated by taxpayers and verified by tax administrators

by using records of sales, purchases, and funds actually received.

Whether an income or consumption tax system includes an individual tax

and how complex that tax is would also affect the ease or difficulty of

determining taxes and assessing compliance. Under the flat tax and one

income tax option we considered, many individuals would face relatively

few recordkeeping responsibilities and determining tax liability would be

relatively simple, especially if taxes on wages were withheld by

businesses. Tax administrators could largely administer these individual

taxes by checking that proper amounts were withheld or by matching

individual tax returns with information returns. Based on experience with

the current income tax system, compliance would likely be high and few

audits of individuals might be necessary. In contrast, under alternatives

with more complex individual-level taxes, recordkeeping and tax

determination burdens would likely be higher. For example, under some

individual income tax options, individuals would have to keep records or

receive information reports for many types of income. Under a personal

consumption tax, individuals could be responsible for keeping records on

borrowing and saving and including these amounts in their tax

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calculations. More extensive document matching and auditing would

probably be needed to ensure a high level of compliance.

Even though a national RST and a VAT tax the same

base—consumption—and the same type of taxpayer—businesses—they

could still affect assessing tax compliance differently. For a national RST

and a subtraction VAT, administrators would have to rely on businesses’

own records to verify that the proper tax had been paid. However, with a

credit VAT, there would be a certain amount of checking available through

records of other businesses; this is thought by some tax specialists to

improve compliance. Also, based on state and international experience,

many experts believe that including sales of all types in the tax base and

allowing businesses to deduct or receive a tax credit for purchases from

other businesses, as under a VAT or flat tax, would have some compliance

advantages over a national RST. While including sales of all types in the tax

base would require more recordkeeping and more taxpayers, it could

better ensure that business purchases would not be overtaxed, taxes of

sales to households would be reported, and a paper trail would be created

so that compliance could be better assessed.

Preferences—that is, exemptions, deductions, credits, and multiple rates

on goods and services—could be part of any of the alternative tax systems

we considered and could often complicate, but sometimes simplify, how

tax liability is determined and verified. Preferences could force taxpayers

to determine and tax administrators to verify whether an income or

consumption item is taxable, nontaxable, deductible, or taxable at a

different rate. The burdens associated with extensive use of preferences

could include (1) more recordkeeping than otherwise, as was the case for

the estimated 33 million individuals who reduced their tax liability by

itemizing tax deductions for tax year 1993; (2) more time for determining

and reporting tax liability; and (3) more tax planning by taxpayers. These

burdens would require more audit time from tax administrators. On the

other hand, in some instances, preferences given through exemptions

could simplify taxpayers’ burden. For example, if, as is commonly done

with a VAT, large numbers of small businesses were exempted, they would

not have to file returns or remit tax, thus easing their compliance burden.

However, tax administrators would have to verify compliance by

determining that only eligible taxpayers took the exemption.

The fact that some tax systems—the current income tax, versions of a

reformed income tax, and the personal consumption tax—have or could

have multiple rates on individuals imposes little additional burden on

Page 15 GAO/GGD-98-37 Alternative Taxes
B-265785 

taxpayers or tax administrators except to the extent that multiple rates

encourage tax planning. Graduated rates alone have little effect on the

actual tax calculation burden of taxpayers who can determine their tax

liability through a tax table. Tax administrators still must verify that

proper rates have been applied. However, multiple tax rates could

encourage taxpayers to devote resources to tax planning in order to avoid

high marginal rates.

Tax Remittance and Collection The issues related to this third area of taxpayer and tax administration

responsibilities we discuss—tax remittances and collections—may not

differ greatly among the tax systems we considered except that widely

different numbers of taxpayers would be responsible for remitting the

taxes. If individuals, including the 18 million individuals owning sole

proprietorships, no longer had to file tax returns as individuals but only in

their capacity as business owners, nonbusiness collection issues related to

them would disappear. Similarly, if a simpler tax reduced the problems tax

administrators found during examinations, or if changes in withholding or

other information reporting reduced the number of mismatches requiring

follow-up, tax administrators would be less likely to assess additional

taxes they would then have to collect.

In its responsibility for collecting unpaid taxes from taxpayers who filed

but did not pay the required tax or who did not file required returns, in

fiscal year 1995, IRS’ collection function disposed of millions of taxpayer

delinquencies. Business delinquencies most commonly involved

employment taxes.

An issue of concern to administrators in the current tax system involves

businesses, particularly small ones, getting into financial difficulty and

using collected taxes as working capital rather than remitting them to the

administrators. This problem could continue under many of the

alternatives we considered, including a national RST or a VAT, and it could

be more pervasive if the amounts of taxes to be collected and remitted by

businesses were higher than under the current income tax system or state

sales tax systems. The amounts could be higher because specific

businesses would be processing federal taxes on their sales in addition to

their payrolls and could face a greater temptation to retain some of the

money for their own use. More frequent remitting and filing could reduce

noncompliance but increase the burden on businesses.

Taxpayer Questions and

Assistance

Although the universe of taxpayers who must file returns could change

under the various alternatives, those who would still need to file would

Page 16 GAO/GGD-98-37 Alternative Taxes
B-265785 

likely have questions that still needed to be answered. Even if a

“return-free” tax system were adopted, questions about individuals’

involvement with the system would still arise. However, the probable

reduction in the number of taxpayers, particularly individuals, under some

of the alternatives and the removal of certain complex provisions, such as

defining and recognizing income and providing deductions, would likely

reduce the overall level of assistance needed.

On the other hand, the more complications introduced under any

alternative tax system, such those introduced with many preferences, the

greater would be the need for tax administrator assistance in those areas.

Greater assistance would also be needed for certain alternatives’

distinctive complicating features, such as the personal consumption tax’

reliance on borrowing and savings information. The more radical the

departure from the current income tax system, the more likely that

assistance or education would be needed in the short term.

Table 3 provides primarily qualitative information about alternative tax

systems in the four areas of taxpayer and tax administrator responsibilities

we have just discussed. More detailed tables for each tax system are

shown in appendixes IV through VIII.

Page 17 GAO/GGD-98-37 Alternative Taxes
B-265785 

Table 3: Potential Implications of

Alternative Tax Systems for Taxpayers

and Tax Administrators

Tax system alternative Return filing and processing

Current system In 1995, 116 million individual tax returns, including

18 million sole proprietorships; 6 million corporate

and partnership tax returns filed; 1.1 billion

information returns filed by businesses and other

payers

Reformed income tax

alternatives

For individual tax, number of filers contingent on

amounts of standard deduction and withholding;

number of tax and information returns reduced (or

possibly eliminated) by options taxing more income

at business level

National RST Businesses, including at least 10 million retailers

and service providers, responsible for filing

periodically during the year if they sell to final

consumers; information returns generally eliminated

VAT About 24 million businesses (corporations,

partnerships, and sole proprietorships) responsible

for filing, unless small businesses exempted;

information returns eliminated

Flat tax Both individuals and businesses responsible for

filing, though nearly half of individuals possibly

excused owing to large personal allowances; no

information returns for savings or investment

Personal

consumption tax

Large number of individual filers likely; business

filings or allocations to individuals needed; new

information returns possible

Page 18 GAO/GGD-98-37 Alternative Taxes
B-265785 

Taxpayer and tax administrator responsibilities

Determining correct tax amounts and

assessing compliance Tax remittance and collection Taxpayer questions and assistance

Need to define and recognize income; wide

range of exemptions, deductions, and credits;

complex calculations; documents matched,

enhancing compliance; about 1.7 and 2.0

percent of individual and corporate returns,

respectively, examined in fiscal year 1995

Collections needed from millions of

nonfilers and filers without full remittance;

small businesses’ employment taxes a

particular problem

Almost 111 million calls answered by IRS

in fiscal year 1995

Complexity owing to measuring capital

income; continuing need to match documents

and/or examine returns; possibly complex

changes needed to tax all income but tax

planning possibly reduced

For individual tax, most tax remitted by

businesses through withholding, but

delinquent accounts possibly increased by

taxing more types of income; individual

remittances and delinquent accounts

possibly reduced under other options

Most current questions still relevant, unless

individual-level tax simplified or eliminated

No need to define and recognize income;

difficulties arising from exemptions for goods

and services or sales to businesses and from

incompatible state and federal tax systems;

compliance chiefly verified by checking

records on sales, not income

Nonbusiness collection issues eliminated;

delinquent amounts a continuing concern

given large collections by businesses and

possible temptation for small businesses,

especially, to use collections as working

capital

Fewer questions than under the current

system because of individuals not filing

and fewer likely areas of inquiry

No need to define and recognize income;

fraud potential related to exports; credit VAT:

tax system complicated by exemptions of

goods or services and multiple rates,

administration simplified by invoice

mechanism; subtraction VAT: unlike credit

VAT situation, multiple rates and exemptions

not suitable and auditing dependent on

business’ own records

Nonbusiness collection issues eliminated;

tax payment spread over all businesses,

not just those selling to final consumers; if

small businesses not exempt, collection

problems increased

Fewer questions than under the current

system because of individuals not filing

and fewer likely areas of inquiry

Compliance aided by no need to define and

recognize income, by fewer deductions, and

by continued withholding; unlike credit VAT

situation, auditing dependent on business’

own records

Fewer delinquency problems for

individuals likely if withholding continues,

but small business difficulties similar to

difficulties with employment taxes

Taxpayer assistance on many complex

issues unneeded owing to tax’s simplicity,

although individual returns still possibly

required

Many issues of defining and recognizing

income eliminated; information returns, audits

needed to verify borrowing (e.g., on credit

cards), proceeds from sales of assets, and

savings

Withholding possibly not closely matching

tax liability, with more returns owing taxes

after matching, possibly leading to more

delinquent accounts than otherwise

Questions on filing requirements, filing

status, account information continued but

not on calculations of capital income; new

questions on borrowing, proceeds from

sales of assets, savings

Source: GAO analysis of tax system alternatives.

Transition to a New

Tax System

A wide range of options exist for moving from the current income tax

system to an alternative tax system, and the way that any transition is

formulated could have significant effects for economic efficiency, equity,

taxpayer compliance burden, and tax administration. Many transition

Page 19 GAO/GGD-98-37 Alternative Taxes
B-265785 

issues involve how income and deductions related to saving done before

the transition to the new system should be treated. Consumption taxes,

while designed to encourage new saving, could tax existing saving when it

is used for consumption; in general, existing saving would not be subject

to tax again under the current income tax system. Special rules designed

to exempt existing saving from tax could burden individuals with

additional recordkeeping, filing, and tax determination requirements and

create additional tax compliance issues for tax administrators. Another

transition issue involves whether tax credits and other tax benefits already

earned under the current tax should be made available under a new

system. For example, what would happen to depreciation expenses for

existing investments that businesses would have been able to deduct if the

current tax were retained? Depending on how these and other compliance

issues are addressed, taxpayer compliance burden and tax administration

responsibilities could be greater in the transition period than when a new

system is fully phased in. We discuss transition broadly in appendix III and

on an alternative-by-alternative basis in appendixes IV through VIII.

Other Issues Other issues, many of which are hard to handle even now, could also have

significant implications for both taxpayers and tax administrators under

most, if not all, of the alternative tax systems we discuss. Some of these

issues are (1) the extent to which employee benefits, such as

employer-provided health insurance, should be included in the tax base;

(2) how to deal with the special complexity and difficulty of taxing

financial services; (3) how housing would be taxed; (4) whether

governments and nonprofit organizations should be taxpayers and filers;

and (5) how international activities would be taxed.

Another important issue would be the relationship between federal tax

filing and reporting requirements and those of states and localities,

especially in those jurisdictions that currently piggyback on the federal

income tax system. Changing the federal system could effectively force

states to change or even abandon their own income tax systems because

they depend on the federal tax infrastructure. For example, states depend

on IRS’ information reporting program and use income reported on federal

tax returns as a starting point on state returns.

These issues are discussed broadly in appendix III or in separate sections

in the appendixes for the various tax system alternatives.

Page 20 GAO/GGD-98-37 Alternative Taxes
B-265785 

Scope and

Methodology

To accomplish our objectives related to the different alternatives, we

(1) studied relevant literature, (2) reviewed our previous reports covering

taxpayer compliance burden and tax administration issues throughout the

1980s and 1990s, (3) held discussions with tax specialists inside and

outside IRS, and (4) examined data related to current tax systems. The

bibliography at the end of this report lists our major references on

alternative tax systems. We did our work in Washington, D.C., between

August 1995 and November 1997 in accordance with generally accepted

government auditing standards. Our objectives, scope, and methodology

are further discussed in appendix I.

The alternatives included in this study were chosen because they

represented different approaches that have emerged in public discussions

about tax reform. They do not include all possible ways of changing the

current income tax system. The report focuses on the implications for

compliance burden and administration of replacing the current income tax

system, although some advocates for changing the tax system have

proposed replacing other taxes as well. The report does not analyze

implications for the economy, such as effects on saving, work incentives,

and economic growth, or for the distribution of the tax burden among

different types of individuals.

Agency Comments

and Our Evaluation

We provided a draft of this report to the Secretary of the Treasury and the

Acting Commissioner of Internal Revenue for comment. IRS deferred to

Treasury, and responsible Treasury officials, including the Director of the

Office of Tax Analysis, provided comments in a July 31, 1997, meeting. The

Treasury officials had no major problems with the draft but suggested

various points that we should emphasize, make parallel, or clarify. We

have incorporated their comments as appropriate.

We will send copies of this report to the Secretary of the Treasury, the

Commissioner of Internal Revenue, other interested committees, and other

interested parties on request.

Page 21 GAO/GGD-98-37 Alternative Taxes
B-265785 

This work was done under the direction of Mark J. Gillen, Assistant

Director for Tax Policy and Administration Issues; other major

contributors are listed in appendix IX. If you have any questions, please

call either one of us on (202) 512-9110.

Lynda D. Willis

Director, Tax Policy and

 Administration Issues

James R. White

Associate Director, Tax Policy

 and Administration Issues

Page 22 GAO/GGD-98-37 Alternative Taxes
Page 23 GAO/GGD-98-37 Alternative Taxes
Contents

Letter 1

Appendix I 

Objectives, Scope,

and Methodology

30

Appendix II 

Current Income Tax

33

Background 33

Impact on Taxpayers’ Compliance Burden 35

Impact on Tax Administrators 45

Appendix III 

Overview of

Alternative Tax

Systems and Design

Issues

55

Differences Between Income and Consumption Taxes 57

Income and Consumption Taxes Can Be Levied on Individuals or

Businesses

60

How Consumption Taxes or a Reformed Income Tax Could

Affect Tax Expenditures and Therefore the Tax Base

68

Consumption Tax Design Issues Affecting Tax Administration 72

Definition and Measurement of Compliance Costs 75

Appendix IV 

Income Tax Reform

Options

78

Description 78

Potential Impact on Taxpayers’ Compliance Burden 90

Potential Impact on Tax Administrators 98

Other Issues 103

Appendix V 

National Retail Sales

Tax

106

Description 106

Potential Impact on Taxpayers’ Compliance Burden 110

Potential Impact on Tax Administration 115

Other Issues 124

Appendix VI 

Credit and

Subtraction

Value-Added Taxes

127

Description 127

Other Issues 131

Credit VAT 133

Subtraction VAT 145

Page 24 GAO/GGD-98-37 Alternative Taxes
Contents

Appendix VII 

Flat Tax

157

Description 157

Taxation of Individual Taxpayers and Potential Impact on

Individual Taxpayers’ Compliance Burden

159

Taxation of Business Taxpayers and Potential Impact on

Business Taxpayers’ Compliance Burden

163

Flat Tax Compliance Costs 165

Potential Impact on Tax Administrators 166

Other Issues 172

Appendix VIII 

Personal

Consumption Tax

174

Description 174

Potential Impact on Taxpayers’ Compliance Burden 177

Potential Impact on Tax Administrators 184

Other Issues 188

Appendix IX 

Major Contributors to

This Report

191

General Government Division, Washington, D.C. 191

Bibliography of

Sources on

Alternative Tax

Systems

192

Tables Table 1: Major Design Features of Alternative Tax Systems and

the Current System

6

Table 2: Basic Responsibilities of Taxpayers and Tax

Administrators

11

Table 3: Potential Implications of Alternative Tax Systems for

Taxpayers and Tax Administrators

18

Table II.1: Estimated Number of Tax Year 1993 Individual Tax

Returns Classified by the Highest Marginal Rate at Which Tax

Was Computed

34

Table II.2: Summary of Some Key Aspects of the Compliance

Burden of the Current Income Tax on Taxpayers

36

Table II.3: Information and Withholding Documents Filed in 1995 37

Page 25 GAO/GGD-98-37 Alternative Taxes
Contents

Table II.4: Estimate of Individuals Reporting Different Items on

Their Tax Returns for Tax Year 1993

38

Table II.5: Individual Tax Returns Showing a Paid Preparer’s

Signature, Tax Year 1993

40

Table II.6: Summary of Some Key Impacts of the Current Income

Tax on Tax Administrators

45

Table II.7: Summary of IRS’ Fiscal Year 1996 Budget 46

Table II.8: IRS’ Fiscal Year 1995 Examination Coverage 48

Table II.9: Percentage of Earnings Categories Reported by

Different Taxpayer Groups

49

Table II.10: Largest Open Examination Issues for Largest

Corporations as of December 12, 1995

49

Table II.11: 1988 Gross Tax Gap Estimate for Tax Year 1992 50

Table II.12: 1996 Ranges of Estimates of the Tax Year 1992 Gross

Individual Tax Gap

51

Table III.1: Tax Treatment of Saving Under Income and

Consumption Taxes

59

Table III.2: Alternative Income and Consumption Taxes by Level

of Tax

62

Table III.3: Components of Alternative Consumption Taxes 63

Table III.4: Components of Alternative Income Taxes 67

Table III.5: Fiscal Year 1997 Saving and Investment Income Tax

Expenditures

70

Table III.6: Other Current Tax Expenditures, Fiscal Year 1997

Estimates

71

Table IV.1: Income Items and Number of Returns Reporting

Them, Tax Year 1993

80

Table IV.2: Current Tax Code Adjustments, Deductions, and

Credits for Individuals, Tax Year 1993, and Possible Treatment

Under a Reformed Income Tax

84

Table IV.3: Overview of Alternative Income Tax Reform Options 88

Table IV.4: Summary of Some Key Potential Impacts of Income

Tax Reform Options on Taxpayers

91

Table IV.5: Summary of Some Key Potential Impacts of Income

Tax Reform Options on Tax Administrators

98

Table V.1: Treatment of Businesses Under a National RST

Compared With the Current Income Tax

107

Table V.2: Summary of Some Key Potential Impacts of a National

RST on Business Taxpayers

111

Table V.3: Income Tax Returns by Business and Industry

Category as of 1993

112

Page 26 GAO/GGD-98-37 Alternative Taxes
Contents

Table V.4: Summary of Some Key Potential Impacts of a National

RST on Tax Administrators

117

Table VI.1: Key Elements of VATs 128

Table VI.2: Summary of Some Key Potential Impacts of a Credit

VAT on Business Taxpayers

135

Table VI.3: Summary of Some Key Potential Impacts of a Credit

VAT on Tax Administrators

138

Table VI.4: Summary of Some Key Potential Impacts of a

Subtraction VAT on Business Taxpayers

148

Table VI.5: Summary of Some Key Potential Impacts of a

Subtraction VAT on Tax Administrators

150

Table VII.1: Key Elements of the Flat Tax 158

Table VII.2: Summary of Some Key Potential Impacts of a Flat

Tax on Individual Taxpayers

159

Table VII.3: Summary of Some Key Potential Impacts of a Flat

Tax on Business Taxpayers

163

Table VII.4: Summary of Some Key Potential Impacts of a Flat

Tax on Tax Administrators

167

Table VIII.1: Comparison of the Current Income Tax With a

Personal Consumption Tax

175

Table VIII.2: Comparison of the Current Income Tax With a

Personal Consumption Tax and Business Cash Flow Tax System

177

Table VIII.3: Summary of Some Key Potential Impacts of a

Personal Consumption and Business Cash Flow Tax on

Taxpayers

178

Table VIII.4: Summary of Some Key Potential Impacts of a

Personal Consumption and Business Cash Flow Tax on Tax

Administrators

184

Figure Figure II.1: Sources of IRS Gross Revenue, Fiscal Year 1995 33

Page 27 GAO/GGD-98-37 Alternative Taxes
Contents

Abbreviations

AMT Alternative minimum tax

CBIT Comprehensive Business Income Tax

CBO Congressional Budget Office

FICA Federal Insurance Contributions Act

IRA Individual retirement arrangement

IRS Internal Revenue Service

OECD Organization for Economic Cooperation and Development

RST Retail sales tax

TDA Taxpayer delinquent account

TDI Taxpayer delinquency investigation

VAT Value-added tax

Page 28 GAO/GGD-98-37 Alternative Taxes
Page 29 GAO/GGD-98-37 Alternative Taxes
Appendix I 

Objectives, Scope, and Methodology

Our work had two objectives. The first was to describe major differences

in attributes among alternative tax systems. Our second objective was to

describe how the alternatives, by incorporating these differences, may

affect taxpayers’ burden of complying with the tax laws and the

government’s responsibilities for tax administration. Taxpayers’

compliance burden includes their filing the required returns, maintaining

the necessary records to support the information reflected on those

returns, and accurately calculating their tax liabilities in the face of

whatever complexity the tax code presents. Tax administration

responsibilities include processing taxpayer returns and maintaining

accurate taxpayer accounts, verifying the accuracy of return information,

collecting the proper amount of taxes owed and considered delinquent,

and providing taxpayers with needed information or assistance. We

selected the major alternatives we studied based on the ideas that have

emerged in public discussions about tax reform.

To accomplish our first objective—describing the major differences in

attributes among alternative tax systems—we studied the literature related

to the current income and sales tax systems and to various alternative tax

systems that have been developed over the years. This literature included

our own reports on income and consumption taxes and reports of other

government organizations, journal articles, academic and research papers,

and other materials related to the various alternatives. A bibliography of

sources we used discussing alternative tax systems appears at the end of

this report. We also attended tax conferences to enhance our

understanding of these tax system alternatives and how they related to

specific proposals that have emerged. In the report, we limited ourselves

to discussing the basic features of each alternative system, knowing that

any implementing details would have to evolve through the political

process.

In accomplishing the first part of our second objective—describing how

alternative systems might affect taxpayer compliance responsibilities—we

considered what categories of taxpayers might still have to file returns

under the various systems. We also researched the literature for

information that would enable us to analyze items, such as the amount of

taxpayer recordkeeping and calculations that would be required in

preparing tax returns, the type of information that would be included in

the returns, and filing frequency. Finally, we pinpointed references in our

previous reports to taxpayer compliance burden issues and assessed how

these issues would be affected under new systems.

Page 30 GAO/GGD-98-37 Alternative Taxes
Appendix I 

Objectives, Scope, and Methodology

We did similar work in accomplishing the last part of our second

objective—describing the alternative systems’ potential impacts on tax

administration. In reviewing the relevant literature, we specifically

examined our previous reports covering various aspects of the tax systems

and IRS. We also discussed specific administrative functions with tax

specialists inside and outside IRS, reviewed data on IRS’ recent

administrative experiences from published sources and from within IRS,

and studied summaries of state sales tax experiences. In analyzing the

alternatives, we addressed (1) the administrative functions of returns

processing, document matching and examination, collections, and

taxpayer services; and (2) issues pertaining to transition, state tax

administration, and international tax administration.

In addition, to help accomplish the second objective, we interviewed

officials of, and reviewed documents from, three state tax administrations

and two state tax associations. The three states were New York, Florida,

and New Mexico. We selected these three states based on suggestions

from the Federation of Tax Administrators of states that were

knowledgeable about issues we were examining. Because of the existence

of actual sales tax systems in the various states and credit-invoice

value-added taxes (VAT) in different countries, the collective experience

with these taxes was more specific than the experience with other

alternatives we were studying.

Our intention in doing this study was to stress compliance and

administration issues associated with the alternative systems using

knowledge that we had accumulated throughout the 1980s and the 1990s.

Our intention was not to examine other implications of the alternatives,

such as their effect on the economy or on the distribution of the tax

burden. Nor did we rank them against each other, assess the relative

severity of the various implications, or weigh the administrative arguments

and counterarguments regarding particular ideas.

In identifying issues in as broad an arena as the potential impact of

alternative tax systems on taxpayers and the potential implications for tax

administration, we touched on some topics only briefly or not at all. For

example, we did not do an in-depth analysis of the relationship of

alternative systems to IRS’ sweeping Tax Systems Modernization plans.

This IRS effort, inextricably linked with streamlining whatever

IRS-administered tax system might exist, regardless of whether it modified

or replaced the current income tax, involves years of work and billions of

dollars. However, basic tax administration functions, such as returns

Page 31 GAO/GGD-98-37 Alternative Taxes
Appendix I 

Objectives, Scope, and Methodology

processing, document matching and examination, collections, and

taxpayer services, would still be in place under a new system. We did not

try to estimate the resources or costs involved in administering any of the

systems, regardless of how the modernization effort proceeded.

Similarly, our study did not focus on the relationship of individual

alternatives to the particular problems of taxpayer compliance and tax

system administration for specific types of entities. For example, this

report does not concentrate on the special considerations that would

apply under different alternatives regarding the financial services industry

and nonprofit organizations. It does, however, describe how financial and

nonprofit services might present administrative difficulties under a

consumption tax.

In focusing on the effects on the agency primarily responsible for tax

administration, we did not analyze the impacts on other agencies. For

instance, we did not examine how the U.S. Customs Service’s taxation of

imports and tracking of exports would be affected. Nor did we evaluate

the role of the Federal Reserve System in receiving payments under a new

tax system.

We requested comments on a draft of this report from the Secretary of the

Treasury and the Acting Commissioner of Internal Revenue. IRS deferred to

Treasury, and we met with Treasury officials on July 31, 1997, to discuss

the report. Treasury’s comments are characterized near the end of the

letter of this report and incorporated into the letter and appendixes as

appropriate.

We did our work in Washington, D.C., between August 1995 and

November 1997 in accordance with generally accepted government

auditing standards.

Page 32 GAO/GGD-98-37 Alternative Taxes
Appendix II 

Current Income Tax

Background In fiscal year 1995, IRS’ revenues totaled about $1.4 trillion from a variety of

sources.1

 As shown in figure II.1, about half came from the individual

income tax, more than three-quarters of which had been withheld by

employers. About a third more arrived through employment taxes, with

the largest component by far being Social Security and Medicare taxes

under the Federal Insurance Contributions Act (FICA). Another 13 percent

of IRS’ total revenues resulted from the corporate income tax.2

Figure II.1: Sources of IRS Gross

Revenue, Fiscal Year 1995

39% • Individual income tax (withheld)

10% • Individual income tax (not

withheld)

13%•

Corporate income tax

•29%

FICA tax

•

4%

Self-employment tax

•

5%

Other

Source: IRS, 1995 Data Book.

Individual Income Tax As shown in table II.1, depending on its amount, individuals’ income is

taxed at five different rates, ranging from 15 to 39.6 percent, with most

1

This amount is before considering refunds of $106 billion and associated interest.

2

Based on IRS estimates projected from samples, about 2 percent of the 2.1 million income year 1993

returns of active corporations (not including S corporations, real estate investment trusts, and

regulated investment companies) accounted for about 96 percent of the income tax after credits due

from those corporations for that year.

Page 33 GAO/GGD-98-37 Alternative Taxes
Appendix II 

Current Income Tax

taxpaying individuals falling into the 15-percent tax bracket. Individuals in

certain circumstances are not liable for any income tax at all and may even

be eligible for the earned income credit, which can pay them money. The

credit is available to low-income working people with children and,

beginning in tax year 1994, to certain people without children.

Table II.1: Estimated Number of Tax

Year 1993 Individual Tax Returns

Classified by the Highest Marginal

Rate at Which Tax Was Computed

Tax rate category Number of returns (in millions)

15 percent 65.6

28 percent 21.2

28 percent (capital gains) 0.3

31 percent 2.2

36 percent 0.8

39.6 percent 0.5

Form 8615a 0.3

All categoriesb 90.7

Note: This table excludes individual tax returns with no tax liability.

aThis form contained certain investment income reported by children under age 14.

bThe number in this row does not equal the sum of the other rows because of rounding.

Source: IRS, Individual Income Tax Returns 1993.

Individuals figure their income tax by going through a series of steps. First,

they compute their taxable income by determining their filing status (e.g.,

single versus married); the exemptions to which they are entitled; their

total income; adjustments to income; and deductions from income, either

a standard deduction based on filing status or deductions itemized to their

specific circumstances. They then use their taxable income to compute

their tax liability, which may be adjusted by, among other items, tax

credits and other taxes such as the alternative minimum tax (AMT).

Corporate Income Tax Corporations determine their income tax in the same basic way as

individuals do: they subtract various deductions from their income to

reach taxable income, and they compute their final tax, considering AMT if

needed. The corporate AMT is intended to ensure that taxpayers with

substantial economic income or with positive financial statement income

in a given year remit tax for that year. Deductions subtracted from income

in computing regular taxable income include the cost of goods sold,

wages, interest, contributions to employee benefit programs, and

Page 34 GAO/GGD-98-37 Alternative Taxes
Appendix II 

Current Income Tax

depreciation of assets, such as equipment whose full value cannot be

deducted immediately. Depreciation spreads the cost of such assets over

time to reflect their benefits in the periods the businesses use them.

Depending on their taxable income, corporations remit regular tax (as

opposed to AMT) using four rates, ranging from 15 to 35 percent.

Relationship to State and

Foreign Income Taxes

For reasons of simplicity and compliance, state income tax systems

greatly depend on the federal system. According to the Federation of Tax

Administrators, 37 states (including the District of Columbia) with an

individual income tax use either the individual’s federal tax liability,

taxable income, or adjusted gross income as a starting point for the

individual’s state income tax computation. Forty-two of the 47

jurisdictions with a corporate income tax start their calculations with the

corporations’ federal taxable income. In addition, as the Multistate Tax

Commission has pointed out, states rely on federal information reporting

and withholding rules for their own administrative purposes and depend

extensively on federal audits of taxpayers.3

Both U.S. individuals and corporations are subject to U.S. income tax on

their worldwide taxable income. If they remit foreign income taxes on

foreign-source income, they may, in a complicated calculation, generally

take foreign tax credits against U.S. income tax imposed on that income.

The United States has a network of about 50 bilateral tax treaties that

cover how nations interact on the income tax.

Impact on Taxpayers’

Compliance Burden

As taxpayers strive to comply with federal, state, and local tax

requirements, they spend time, incur costs, and experience frustration. We

refer to this time, cost, and frustration as taxpayer compliance burden.

Table II.2 summarizes key aspects of the burden, which can vary from

little to great from taxpayer to taxpayer, that taxpayers experience under

the current income tax.

3

According to its executive director, the Multistate Tax Commission is an interstate compact agency

created to preserve federalism and promote fairness in state and local taxation of businesses.

Page 35 GAO/GGD-98-37 Alternative Taxes
Appendix II 

Current Income Tax

Table II.2: Summary of Some Key

Aspects of the Compliance Burden of

the Current Income Tax on Taxpayers

Burden Characteristics of the burden

Burden on individual taxpayers

Return filing 116 million returns filed in 1995

Records kept Records supporting tax returns supposed to be

kept—e.g., receipts, proof of payment, and

documentation supporting deductions and credits;

burden alleviated by information reports given to

individuals

Calculations made Complicated calculations for some taxpayers included for

provisions such as dependency tests and capital gains

Complexity faced Many pages of instructions involved and millions of

supplemental forms and schedules filed—e.g., 33 million

schedules of itemized deductions for tax year 1994;

difficulties existing in defining and recognizing income;

however, in actual practice, minimal complexity faced by

millions of individuals

Burden on business taxpayers

Return filing 24 million returns filed in 1995

Records kept Records supporting income and expenses supposed to

be kept

Calculations made Complicated calculations included for provisions such as

depreciation, the alternative minimum tax, and the foreign

tax credit

Complexity faced Detailed rules involved; complexity reflected in areas

such as depreciation, the alternative minimum tax, and

the foreign tax credit; difficulties existing in defining and

recognizing income

Requirement to furnish

information returns

1.1 billion information and withholding documents filed

Source: GAO analysis of available information about the current income tax.

Documents Filed One indicator of this burden is that every year taxpayers and others file

millions of documents with IRS, with some filing one and others filing

many. For example, in 1995, individuals filed 116 million personal income

tax returns, with most of them including salaries, wages, or pensions.4

These individuals included 18 million schedules for sole proprietorships.

Because corporations and partnerships filed another 6 million income tax

or income returns, the total number of business returns filed was

4

The potential universe of individual filers is larger than the 116 million filers in 1995. For instance, for

tax year 1992, IRS identified almost 60 million potential individual nonfilers, mostly by matching data

on information returns, such as wage statements from employers, with data on filed income tax

returns. However, IRS took no enforcement action on most of them, primarily because it later

determined that the individuals had no legal filing requirement. For instance, the individual might not

have had enough gross income to have to file.

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Current Income Tax

24 million. In addition, employers submitted 29 million employment tax

returns. Finally, as table II.3 shows, employers, financial institutions, and

others filed 1.1 billion information and withholding documents, which ease

the burden recipients would bear if they had to generate the information

on their own. Documents, such as wage and various other income

statements, are important for compliance purposes but not very

burdensome for recipients to retain, although employers must generate

them. Although almost all information returns were filed with IRS in

nonpaper format through magnetic tape filing, electronic filing, or diskette

filing, most business income and employment tax returns and most

individual tax returns were not filed electronically.

Table II.3: Information and Withholding

Documents Filed in 1995

Type of filing

Number of

filings (in

millions)

W-2: Wage and Tax Statements 205

1099DIV: Dividends and Distributions 101

1099INT: Interest Income 259

1099MISC: Miscellaneous Income 74

1099R: Distributions From Pensions, Annuities, Retirement or ProfitSharing Plans, IRAs, Insurance Contracts, Etc.49

1099B: Proceeds From Broker and Barter Exchange Transactions 92

1099G: Certain Government Payments 59

5498: Individual Retirement Arrangement Information 63

1098: Mortgage Interest Statement 64

K-1 (Form 1065): Partner’s Share of Income, Credits, Deductions, Etc. 21

1099SSA/RRB: Social Security Benefit Statement and Payments by the

Railroad Retirement Board

46

Others 30

Total 1,062

Note: Total does not add due to rounding.

Source: IRS, Calendar Year Projections of Information and Withholding Documents for the United

States and Service Centers: 1996-2003, 1996 Update.

Although in recent years over 100 million individuals filed income tax

returns annually, as table II.4 shows, most of them did not report many

common income, adjustment, deduction, and credit items every year. For

instance, for tax year 1993, most of the 114.6 million individuals who filed

did not claim such items as capital gains or losses, rental income, itemized

deductions, the earned income credit, or the foreign tax credit, minimizing

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their compliance burden. And, although almost 33 million individuals

itemized their deductions and included themselves in the millions of

taxpayers filing supplemental forms and schedules, relatively few of those

itemized, for instance, miscellaneous deductions that generally involve

much taxpayer time and recordkeeping whether claimed or not. Over a

lifetime, of course, circumstances could allow taxpayers to include many

items on their returns that do not show up every year.

Table II.4: Estimate of Individuals

Reporting Different Items on Their Tax

Returns for Tax Year 1993

Item Number reporting (in millions)

Salary and wage income 98.0

Taxable interest income 65.2

Dividend income 24.7

Business or professional net income or loss 15.6

Net capital gain or loss 18.4

Pensions and annuities in adjusted gross

income

17.4

Rent and royalty net income or loss 11.0

Partnership and S corporation net income

less loss

5.5

Primary taxpayer IRA adjustment 4.0

Standard deduction 80.8

Any itemized deduction 32.8

Medical and dental expenses 5.5

Taxes paid 32.3

Interest paid 27.5

Charitable contributions 29.8

Total miscellaneous deductions 8.3

Earned income credit 15.1

Foreign tax credit 1.3

Source: IRS, Individual Income Tax Returns 1993.

Another indicator of the tax system’s impact on taxpayers is how often

they must file returns and remit taxes—the greater the frequency, the

more the burden. Generally, individuals must file annually, even though

their wages and salaries may be withheld throughout the year. Individuals,

including sole proprietors, however, did file 36 million estimated tax

returns in 1995, and they paid estimated taxes as many as four times

during the year. Businesses generally file income tax returns annually and

often remit estimated tax four times a year. They also withhold income,

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Current Income Tax

Social Security, and Medicare taxes from their employees periodically, file

quarterly employment tax returns, and transfer the funds withheld to a

financial institution monthly, semiweekly, or even more often depending

on the amount of tax.

Records Kept Another burden of complying is that individuals and businesses must keep

records supporting their tax returns. For instance, individuals should keep

receipts, canceled checks or other proof of payment, and documentation

to support any deductions or credits claimed. Similarly, for small

businesses, IRS requires that records be kept to support the income,

expenses, and credits reported. IRS believes, though, that generally these

are the same records needed for businesses to monitor themselves and

prepare financial statements. Nevertheless, the corporate tax return does

have a schedule on which the taxpayer reconciles the income or loss

shown on its books with that shown on its tax return. The schedule

includes such items as depreciation and contribution carryovers.

Individuals and businesses can use various methods of accounting,

although many businesses are precluded from using the cash method for

tax purposes. Instead, they use the accrual method, designed to match

income and expenses in the correct year. The accrual method is required

when income-producing inventory is involved.

Keeping the right documentation has been a problem for some taxpayers.

We found this, for example, when we reviewed 185 Tax Court petitions

dealing with “ordinary and necessary” business expenses related to a

taxpayer’s trade or business. For sole proprietors, small and medium-sized

corporations, and individuals claiming employee business expenses, the

most frequent source of disagreement with IRS in those petitions was the

adequacy of documentation for a given expense deduction. These disputes

were especially frequent where the documentation requirements were the

most rigorous—for entertainment, travel, meals, and automobile

expenses.5

In another example, we found that the test that taxpayers used to claim

other people as dependents on their tax returns was too complex and

burdensome for them to voluntarily comply with. The test required

taxpayers to maintain detailed records and make complex calculations.

According to our estimates, 43 percent of taxpayers that IRS found had not

5

See Tax Administration: Recurring Issues in Tax Disputes Over Business Expense Deductions

(GAO/GGD-95-232, Sept. 26, 1995).

Page 39 GAO/GGD-98-37 Alternative Taxes
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Current Income Tax

met the dependent support test did not have adequate records to show

whether they provided the necessary support.6

Level of Simplicity or

Complexity

The forms that taxpayers need to file vary with the circumstances, as does

the use of paid preparers. In 1994, we reported that IRS publishes about 400

tax forms and accompanying instructions each year. More detailed

guidance is provided in about 100 publications.7

 Still, as reflected in table

II.4, most individuals file relatively basic forms, such as the estimated 71

percent of about 115 million individual filers for tax year 1993 (almost

81 million) that took the standard deduction as opposed to itemizing

deductions and needing a separate schedule.

As shown in table II.5, for tax year 1993, 48 million of 115 million

individuals (42 percent) filed the Form 1040EZ or the Form 1040A instead

of the standard Form 1040. As table II.5 further shows, although these

individuals filed income tax returns designed to be easier than the

standard return, they still sometimes paid preparers to complete them. In

all, about half of all individual tax returns had a paid preparer’s signature

on them. Some of the taxpayers who filed the simpler forms and claimed

the earned income credit may have paid a preparer simply as a way to file

their returns electronically and get their credit early.

Table II.5: Individual Tax Returns

Showing a Paid Preparer’s Signature,

Tax Year 1993

Form

Number filed (in

millions)a

Number with paid

preparer’s

signature (in

millions)

Percentage with

paid preparer’s

signature

1040EZ 20.4 1.5 7%

1040A 27.9 5.8 21

1040 66.4 49.2 74

Total 114.6 56.6 49%

Note: Numbers do not add to total because of rounding.

aThese numbers are estimates based on samples.

Source: IRS, SOI Bulletin (Winter 1995-1996).

6

See Tax Administration: Erroneous Dependent and Filing Status Claims (GAO/GGD-93-60, Mar. 19,

1993). We were 95-percent confident that the true percentage of these taxpayers with inadequate

records was between 33 percent and 52 percent.

7

See Tax Administration: IRS Efforts to Improve Forms and Publications (GAO/GGD-95-34, Dec. 7,

1994).

Page 40 GAO/GGD-98-37 Alternative Taxes
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Current Income Tax

The complexity of the tax code, itself, is a major reason why federal tax

compliance is burdensome. It stems from areas such as depreciation

requirements, which all 17 businesses we interviewed for testimony told

us caused them to keep some detailed records solely for tax purposes;

uniform capitalization rules and the AMT requiring time-consuming

calculations; and inventory, foreign income, and capital gains calculations.8

In 1994 testimony, IRS noted that the code had grown from 504 pages in

1939 to over 2,700 pages, and this did not include implementing

regulations. A guiding principle we have stated regarding tax rules and

compliance is “the simpler . . . the better.”9

Much of the complexity of the tax code stems from the difficulties faced in

defining income and determining when to recognize it on the tax return.

For instance, the complexity surrounding calculations and records needed

for determining capital income is great, creating accompanying

compliance and administrative costs. To determine capital income,

taxpayers must separate capital gains from ordinary income, determine

depreciation, and decide if expenses are deductible or must be capitalized.

Complexity is also created by the tension between the ideal economic

definition of income—changes from one year to the next in asset

value—and the need to recognize income only when it is actually

realized—in a market transaction, such as a sale of stock. For instance, the

tax law has provisions to keep taxpayers from borrowing money to buy

assets, deducting the interest, and not paying current tax on the assets’

appreciation. This contributes to different kinds of interest expense being

treated differently for tax purposes.10

Interaction of Taxpayers

and Tax Administrators

A final aspect of the current system’s (and any system’s) burden on

taxpayers is the amount and nature of interaction the public has with tax

administrators. As we allude to later, taxpayers annually experience

millions of IRS notices; more than a million examinations; when delinquent,

hundreds of thousands of tax liens placed against their assets; and millions

of unanswered telephone calls. Neither we nor IRS know the level of any

alleged IRS “abuse” of taxpayers through the public’s interactions with IRS

employees. When we studied the issue in 1996, IRS, while improving certain

controls, had not yet established a capability to capture management

8

See Tax System Burden: Tax Compliance Burden Faced by Business Taxpayers (GAO/T-GGD-95-42,

Dec. 9, 1994).

9

See Taxpayer Compliance: Reducing the Income Tax Gap (GAO/T-GGD-95-176, June 6, 1995).

10Henry J. Aaron and Harvey Galper, Assessing Tax Reform (Washington, D.C.: The Brookings

Institution, 1985), pp. 22-24.

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Appendix II 

Current Income Tax

information that is needed to ensure that abuse is identified and

addressed.11

Estimates of Compliance

Costs for Existing Taxes

As described in appendix III, compliance cost studies in general have been

limited by different factors. These factors include the difficulty in

differentiating between recordkeeping for tax purposes from

recordkeeping that would have been done anyway and the difficulty in

generalizing to all taxpayers from surveys with low response rates.

Because of the importance of the issue of compliance costs and their

possible magnitude, various efforts have been made to measure

compliance costs. These included several academic studies of compliance

costs for U.S. income taxes, a study of paperwork burden of U.S. taxes

done for IRS, and recent estimates based on the IRS-sponsored burden

study.

Studies of Compliance Costs of

U.S. Taxes

Several compliance cost studies have been done by Joel Slemrod of the

University of Michigan and co-authors.12 Two studies were done on

compliance costs for the individual income tax, and one study was done

on compliance costs for large corporations, all using mailed

questionnaires. The studies of the individual income tax surveyed

Minnesota residents; the more recent of the two studies found that on

average taxpayers spent about 27 hours on federal and state income tax

matters and spent about $66 on tax assistance and other expenses. The

study also obtained information on the wages of the respondents to place

a value on the time spent on taxes.

The consulting firm Arthur D. Little studied paperwork burden for IRS in

1984.13 The Little study used questionnaires to gather information on how

much time individuals and businesses spent in 1983 to meet tax filing

requirements. Individual costs were also measured through a diary study,

11See Tax Administration: IRS Is Improving Its Controls for Ensuring That Taxpayers Are Treated

Properly (GAO/GGD-96-176, Aug. 30, 1996).

12See Joel Slemrod and Nikki Sorum, “The Compliance Cost of the U.S. Individual Income Tax

System,” National Tax Journal, Vol. XXXVII, No. 4 (Dec. 1984), pp. 461-74; Marsha Blumenthal and Joel

Slemrod, “The Compliance Cost of the U.S. Individual Income Tax System: A Second Look After Tax

Reform,” National Tax Journal, Vol. XLV, No. 2 (June 1992), pp. 185-202; and Joel Slemrod and Marsha

Blumenthal, “The Income Tax Compliance Cost of Big Business,” Public Finance Quarterly, Vol. 24,

No. 4 (Oct. 1996), pp. 411-38. Also see Joel Slemrod, “Which Is the Simplest Tax System of Them All?”

in Henry J. Aaron and William G. Gale, eds., Economic Effects of Fundamental Tax Reform

(Washington D.C.: Brookings Institution Press, 1996) for a summary of the strengths and limitations of

this work.

13The methodology of the Little study is reviewed in Slemrod (1996).

Page 42 GAO/GGD-98-37 Alternative Taxes
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Current Income Tax

in which taxpayers were asked to contemporaneously record costs as they

occurred rather than recall costs. For businesses, burden categories

included recordkeeping, getting advice and learning about filing

requirements, obtaining materials, finding and using tax preparation

services, preparing the tax return, and filing the tax return. For individuals,

burden categories included recordkeeping; learning about the tax law;

preparing the tax return; and copying, assembling, and sending the return

to IRS. Little obtained a 65-percent response rate from the individual

questionnaire and a 37-percent response rate to the business

questionnaire.

The purpose of the Little study was to gather data and develop a

methodology that IRS could use to estimate the average number of hours

taxpayers spend to complete particular tax forms. To do this, Little used a

statistical analysis to find variables, such as the number of lines on a tax

form and associated worksheets and the number of attachments required,

that could predict the level of burden found in the questionnaires.14 While

several models were evaluated, the models ultimately chosen were those

that could be easily updated by IRS rather than those that best predicted

the survey results. The study noted that “in a few instances significant

accuracy was sacrificed by selecting a simplified model” over a more

complicated and accurate model. As a result, IRS estimates of

recordkeeping burden for a business tax form are only dependent on the

number of lines on the form and associated worksheets, and the estimated

time for preparing a form is dependent on the number of lines on the form

and worksheets, the number of references in the instructions to the

Internal Revenue Code and accompanying regulations, and the number of

attachments that are requested. One researcher has called these models

“transparently implausible” and also pointed out that the model estimates

of burden for corporations and partnerships in 1983 were five times higher

than the results found in the survey for the same year.15

Recent Estimates of

Compliance Costs of Current

Tax System

Two authors have used the paperwork burden hours estimates from the

IRS models to estimate income tax compliance costs in terms of both hours

and dollars. To convert hours of burden into an estimate of the dollar

value of these hours, the authors generally multiplied the hours estimate

by an amount representing the time value of each hour. The estimates

therefore rely on the underlying IRS methodology and are sensitive to the

hourly dollar amount used. In theory, the dollar value chosen should

14Little adjusted the individual questionnaire results to reflect the generally lower cost estimates found

in the diary study.

15Slemrod (1996), pp. 383-84.

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Current Income Tax

represent the opportunity cost of spending an hour on tax matters; for

individuals, for example, this could be an additional hour of wages, the

value of an hour spent in a leisure activity, or the hourly amount that an

individual would be willing to pay to not have to calculate taxes.

Arthur Hall of the Tax Foundation, citing IRS and Office of Management

and Budget historical data, recently estimated that taxpayers would spend

about 5.3 billion hours complying with federal tax laws in 1996. Hall then

applied an hourly rate of $42.40 to this hours estimate to obtain an

estimate of $224.7 billion of compliance costs for the entire federal tax

system.16 Based on his calculations, he asserted that at least 70 percent of

this cost was due to the income tax. Applying this 70 percent to the total

burden would make income tax compliance costs $157 billion for 1996.

Hall estimated that business compliance costs would be $105 billion,

leaving individual compliance costs at about $52 billion.

In his book and in testimony before the Ways and Means Committee,

James Payne also made estimates of compliance burden resulting from the

tax system. In his 1993 book, Payne estimated that federal compliance

costs in 1985 amounted to $159.42 billion.17 This estimate was made by

multiplying the Little model estimates of 5.4 billion taxpayer burden hours

for 1985 by an hourly value of $28.31 (an average of IRS and Arthur

Andersen labor costs) and adding an estimate for tax preparer costs. In

1995 testimony, Payne estimated that taxpayer burden in terms of hours

for 1995 was 10.2 billion hours.18 The increase in the estimate reflected, in

part, increases in the number of taxpayers and an increase in total burden

of 3.7 percent in each year from 1985 through 1995, based on findings in

Blumenthal and Slemrod (1992) that individual burden had increased by

26 percent from 1982 to 1989.

Recently, Slemrod offered what he described as “back-of-the-envelope”

estimates of the compliance costs of the income tax, based on his views on

the strengths and weaknesses of the existing evidence.19 Adjusting the

results from the 1989 Blumenthal and Slemrod survey of individual

taxpayers and using $15 for the per hour cost, Slemrod estimated that the

16See Arthur P. Hall, “Compliance Costs of Alternative Tax Systems,” Tax Notes, Vol. 71, No. 8 (May 20,

1996), pp. 1081-89.

17James L. Payne, Costly Returns: The Burdens of the U.S. Tax System, (San Francisco: Institute for

Contemporary Studies, 1993).

18Statement of James L. Payne prepared for the House Ways and Means Committee Hearings on

Replacing the Federal Income Tax, June 6, 7, and 8, 1995.

19See Slemrod (1996).

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Current Income Tax

cost of the individual income tax was probably around $50 billion. He also

estimated that businesses (partnerships and corporations) spend about

800 million hours complying with taxes, a figure in line with the results of

the Little survey rather than derived from the IRS model estimates. Valuing

business hours at $25 per hour, Slemrod estimated the cost of compliance

for these businesses at about $20 billion.

Impact on Tax

Administrators

Table II.6 summarizes some of the key impacts of the current income tax

system on tax administrators.

Table II.6: Summary of Some Key

Impacts of the Current Income Tax on

Tax Administrators

Item Characteristics of the current income tax

Number of returns processed Hundreds of millions of returns and other materials

received

Refund processing 92 million refunds issued in fiscal year 1995

Examination approach Tax returns matched with information returns; fiscal year

1995 examination coverage at 1.36 percent, with

corporate audits taking longer than individuals’ audits

Compliance problems Compliance problems related to income definition,

unreported income, and more specific issues identified in

areas such as transfer pricing, depreciation, deductibility

of business expenses, small businesses, independent

contractors, and the underground economya

Collections from tax

delinquents

Millions of taxpayer delinquent investigations and

accounts disposed of, with most of the latter being for

individuals and most business dispositions covering

employment taxes

Individuals’ questions

received

Millions of taxpayer inquiries fielded, covering a wide

variety of questions

aTransfer prices are prices companies charge related parties for goods and services. Inaccurate

transfer pricing can result in improper allocation of income among interrelated companies.

Source: GAO analysis of available information about the current income tax.

Table II.7 shows IRS’ fiscal year 1996 actual budget along functional lines to

help put the discussion that follows into perspective.

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Table II.7: Summary of IRS’ Fiscal Year

1996 Budget Full-time equivalent positions Budget dollars

IRS function Number

Percentage of

total

Amount (in

millions)

Percentage of

total

Returns

processing

20,460 19% $781 11%

Document

matching

2,086 2 73 1

Examination 27,327 26 1,555 22

Collection 17,916 17 855 12

Taxpayer

services

8,031 8 492 7

Other 30,822 29 3,461 48

Total 106,642 100% $7,217 100%

Note 1: Percentages do not add to totals due to rounding.

Note 2: The budget for IRS’ appeals function is included in the counsel part of the “other”

category, as opposed to the examination category where IRS put it for fiscal year 1997. Counsel’s

fiscal year 1996 budget was 4,999 full-time equivalents and $362 million. “Other” also included

positions and funds supporting functions such as examination and collection.

Source: IRS fiscal year 1998 budget estimates, Feb. 6, 1997.

Processing of Returns When IRS annually receives the hundreds of millions of returns,

remittances, and other materials from taxpayers and others, the first thing

it must do is process them. Returns processing includes (1) receiving,

sorting, and establishing controls over the materials; (2) editing,

perfecting, and coding them for transcription onto computer tape;

(3) transcribing, verifying, and correcting tax document information;

(4) maintaining accounting records for assessments, collections,

receivables, refunds, and other transactions affecting taxpayer accounts;

and (5) preparing correspondence to taxpayers. IRS’ fiscal year 1996 budget

for returns processing was almost $800 million for more than 20,000

full-time equivalent positions.

IRS’ returns processing workload is primarily affected by the number of

returns filed and the work needed to prepare those returns for posting to

taxpayer accounts. For instance, according to IRS data, it takes

significantly fewer keystrokes to enter data into the computer from a

paper Form 1040EZ and Form 1040A than from an average Form 1040.

Although generally more and more tax returns are being filed

electronically and processed by computer, thus minimizing the human

effort needed to prepare them for posting, the vast majority of returns are

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Current Income Tax

still filed on paper and processed manually by IRS. Consequently, a

significant part of IRS’ returns processing effort involves error correction

because returns filed on paper and processed manually are more prone to

errors by both preparers of the returns and the IRS staff processing them.

Statistics on the number of notices sent and refunds given to taxpayers

illustrate the level of IRS activity involved in processing returns. For

instance, as we noted in a 1994 report, IRS sent more than 60 million

notices to taxpayers in 1993 concerning the status of their tax accounts.20

(Recently, IRS announced a dramatic reduction in the number of notices to

be sent.) Similarly, in fiscal year 1995, IRS issued 92 million refunds to

taxpayers.

Matching and Examination

Programs

A taxpayer’s most likely enforcement contact with IRS is receiving word

about a computer match of income reported on his or her return with

information returns provided to IRS by third parties. These third parties

include employers and payers of interest and dividends. Discrepancies

between the amounts reported on the tax return and the information

return indicate potential underreporter cases. When a tax return is not

filed for income that is reported on an information return, IRS is to

establish a nonfiler case. IRS’ fiscal year 1996 budget for document

matching was $73 million and about 2,100 full-time equivalent positions.

As another part of its enforcement efforts, IRS’ examination function,

funded in fiscal year 1996 at almost $1.6 billion and about 27,000 full-time

equivalents, administers a nationwide audit program to see if taxpayers

correctly determined their tax liabilities. One of the ways IRS selects

returns to audit is by using a system that scores each return’s audit

potential. After learning the results of an audit, taxpayers may agree with

the findings, appeal them through IRS’ appeals function, or take IRS to

court. As shown in table II.8, in fiscal year 1995, IRS had many different

kinds of examinations, with an overall examination coverage rate of

1.36 percent. Although many more examinations were done of individuals

than of corporations, corporate examinations took much longer.

20See Tax Administration: IRS Notices Can Be Improved (GAO/GGD-95-6, Dec. 7, 1994).

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Table II.8: IRS’ Fiscal Year 1995

Examination Coverage Numbers in thousands

Category of tax return

Returns filed in

calendar year

1994

Total

examinations

Percentage of

examination

coverage

Individual 114,683 1,919 1.67%

Corporation 2,530 52 2.05

Fiduciary, estate, and gift 3,384 18 0.52

Employment 29,298 54 0.18

Excise, partnership, S

corporation, and other

4,399 57 1.30

Total 154,294 2,100 1.36%

Note: Percentages do not always compute exactly due to rounding of other numbers.

Source: IRS, 1995 Data Book.

Although IRS does not generally track noncompliance by subject matter

through its examination program, it does know quite a bit about taxpayer

noncompliance. Its knowledge comes from its random, though dated,

detailed audits of tax returns through its Taxpayer Compliance

Measurement Program and from other sources. As we testified using 1988

IRS estimates of tax year 1992 compliance, individuals voluntarily paid

83 percent of the income taxes they owed, and corporations remitted

81 percent.21 In addition, as shown in table II.9, according to IRS estimates,

compliance was not uniform across groups of taxpayers. IRS data show

that compliance was highest for individuals where there was tax

withholding, a little lower where there was information reporting to IRS,

and much lower where there was neither. The complexity of tax rules was

another factor influencing the level of compliance, with a more

complicated tax code allowing more opportunities for disagreement over

the “fine points” of the law.

21See GAO/T-GGD-95-176. In 1996, IRS also reported that the tax year 1992 noncompliance estimate as

a percentage of the “true” tax liability for individuals was about 83 percent.

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Table II.9: Percentage of Earnings

Categories Reported by Different

Taxpayer Groups

Taxpayer group

Percentage of

earnings category

reported

Is information

reporting generally

required?

Is withholding

generally required?

Wage earners 97 percent of their

wages

Yes Yes

Interest recipients 90 percent of their

interest income

Yes No

Dividend recipients 87 percent of their

dividend income

Yes No

Self-employed (sole

proprietors)

36 percent of their

income

No No

Informal suppliers

(self-employed

individuals operating

on a cash basis)

11 percent of their

income

No No

Note: These percentages take into account individuals who did not file tax returns.

Source: GAO/T-GGD-95-176.

Variations in compliance patterns also existed in the corporate sector.

Small corporations, whose compliance level for 2.3 million firms was

61 percent for tax year 1987 (down from 81 percent for a smaller number

of tax year 1980 firms), tended to mirror the compliance patterns of sole

proprietors. Underreported income was the biggest compliance problem

and enough documentation was often a difficulty. Large corporations, in

contrast, tended to have issues associated with the ambiguity and

complexity of the tax code. Table II.10 shows, as of late 1995, the largest

open examination issues in the examination program covering various tax

years for the nation’s largest corporations.

Table II.10: Largest Open Examination

Issues for Largest Corporations as of

December 12, 1995

Dollars in billions

Issue

Proposed IRS adjustments to income

and credits

Transfer pricing $7.2

Availability of the installment method of

income recognition

5.9

Deductibility of trade or business expenses 3.4

Deductibility of capital expenditures 3.4

Depreciation 1.9

Note: According to an IRS official, these dollar figures are not precise because they include only

the top 10 issues in the corporations being audited and reflect conservative estimates of case

managers.

Source: IRS.

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Current Income Tax

In 1988, IRS estimated a “tax gap” of as much as $127 billion between tax

year 1992 income taxes owed on income from legal sources and income

taxes voluntarily remitted. This gap did not include taxes that go

uncollected from illegal activities, such as drug dealing and prostitution.

Thus, the gap reflected part of the underground economy—the legal

transactions that occurred without being reported to the tax agency—but

not the other part—the illegal transactions. As shown in table II.11, IRS

attributed about three-fourths of the tax gap to individuals and about

one-fourth to corporations.

Table II.11: 1988 Gross Tax Gap

Estimate for Tax Year 1992 Dollars in millions

Source of tax gap Tax gap amount

Tax gap distribution

(percent)

Individual tax gap $93,994 73.9%

Corporate tax gap 33,135 26.1

Small corporations 6,999 5.5

Large corporations 23,716 18.7

Other 420 0.3

Corporate remittance gap 2,000 1.6

Total tax gap $127,129 100.0%

Source: Income Tax Compliance Research, IRS Publication 1415 (7-88) and Income Tax

Compliance Research: Net Tax Gap and Remittance Gap Estimates, IRS Publication 1415 (4-90).

In 1996, IRS presented new estimates of the individual income tax gap, this

time using compliance data for tax years 1985 and 1988, as opposed to

1982. The gap consisted of a nonfiling gap, or tax liability owed by those

not filing required returns voluntarily and in a timely manner; an

underreporting gap, or liability not voluntarily reported by filers; and an

underpayment gap, or liability reported but not paid voluntarily and in a

timely manner.

As shown in table II.12, the largest dollar components of the

underreporting part of the individual tax gap (covering underreported

income and overstated deductions and credits) were ranges related to

nonfarm proprietor income and informal supplier income. The items with

the highest reporting noncompliance, as shown by the ranges of net

misreporting percentages, were informal supplier income, tax credits

(reflecting overreporting of the earned income credit), nonfarm proprietor

income, farm income, and income from the sale of business property.

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Table II.12: 1996 Ranges of Estimates

of the Tax Year 1992 Gross Individual

Tax Gap

Dollar amount

Net misreporting

percentagea

Dollars in billions

Gross tax gap component Low High Low High

Nonfiling gap $13.5 $13.8 N/A N/A

Underpayment gap 8.4 8.4 N/A N/A

Underreporting gap 71.3 73.1 N/A N/A

Capital gains 2.4 2.5 6.9% 7.2%

Income from sales of business property 0.7 0.7 27.1 28.0

Nonfarm proprietor income 16.4 16.9 31.3 32.3

Informal supplier income 12.3 12.3 81.4 81.4

Farm income 3.3 3.4 31.3 32.2

Rents and royalties 3.6 3.7 16.6 17.2

Tax credits 6.0 6.2 38.9 40.2

Other items 26.6 27.3 N/A N/A

Legend: N/A = Not applicable or not available.

aNet misreporting percentage is the ratio of the net amount of income misreported on the tax

return in the taxpayer’s favor to the sum of the absolute values of what should have been

reported.

Source: Federal Tax Compliance Research: Individual Income Tax Gap Estimates for 1985, 1988,

and 1992, IRS Publication 1415 (4-96).

According to a 1993 IRS report on the employment tax gap, noncompliance

with employment taxes was relatively low except in the self-employment

area. For self-employment taxes estimated for tax year 1987, the tax

liability not paid voluntarily was more than half the “true” tax liability. This

estimated ratio of unpaid liability to true liability was projected to remain

relatively stable for tax years 1984 through 1997.

Although for FICA taxes the equivalent 1987 estimated ratio of unremitted

liability to true liability was only about 4 percent, almost all of the

underreported wage and salary part of the FICA tax gap was attributable to

misclassification of employees. In June 1996, we testified that from fiscal

year 1988 through fiscal year 1995, IRS’ almost 13,000 Employment Tax

Examination Program audits resulted in reclassifying 527,000 workers

from independent contractors to employees.22 Common-law rules for

classifying workers as employees or independent contractors were

unclear and subject to conflicting interpretations. IRS’ strategy is to reduce

22See Tax Administration: Issues in Classifying Workers as Employees or Independent Contractors

(GAO/T-GGD-96-130, June 20, 1996).

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Current Income Tax

independent contractor noncompliance by requiring businesses to treat

misclassified independent contractors as employees subject to

withholding taxes. Efforts to improve the misclassification situation were

continuing during our review.

Just because IRS proposes adjustments does not mean taxpayers will

agree. In 1993, we reported on the most prevalent issues appealed by

taxpayers. As of September 30, 1992, out of about 12,000 disputed

relatively large issues that IRS stated were predominately corporate, almost

a quarter involved trade or business deductions, gross income, or

depreciation.23 Similarly, of all the cases contained in Tax Analysts’ Index

to U.S. Tax Court Petitions and Complaints Filed in the Court of Federal

Claims and the 94 U.S. District Courts During 1993, about a third of the

pages of listings involved just two Internal Revenue Code sections—those

dealing with gross income and trade or business expense deductions.

When we analyzed appealed trade or business deductions in a separate

report, we found that large corporate taxpayers disagreed with IRS most

frequently over the issue of capital expenditures, more specifically over

whether large expenses were immediately deductible.24 IRS was unable to

provide us with a breakdown by subject matter of all 219,000 cases closed

by its Chief Counsel in fiscal year 1994.

Collection Activities With a fiscal year 1996 budget of almost 18,000 full-time equivalent

positions and about $850 million, IRS’ collection function is responsible for

collecting taxes from taxpayers who did not file required returns or those

who filed returns but did not remit the required tax. Its first step is to

notify taxpayers in writing and ask them either to remit outstanding taxes

or to file unfiled returns. If taxpayers do not respond at the notification

stage, IRS generally refers the cases to its automated call sites, where IRS

employees may telephone taxpayers to ask for remittance. At that time,

balance-due accounts are referred to as taxpayer delinquent accounts

(TDA), and nonfiler cases are called taxpayer delinquency investigations

(TDI). If telephone calls are not successful, IRS revenue officers must try to

collect higher priority cases through personal visits to taxpayers and other

collection enforcement actions. The cases may be resolved in many ways,

ranging from taxpayers’ voluntarily making full remittances to IRS’ taking

actions involving liens, levies, or seizures. As an example of the volume of

activity that is involved, in fiscal year 1995, IRS issued about 800,000

23See Tax Administration: Recurring Tax Issues Tracked by IRS’ Office of Appeals (GAO/GGD-93-101,

May 4, 1993).

24See GAO/GGD-95-232.

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Current Income Tax

notices of tax liens, sent out 2.7 million notices of levies, and made 11,000

seizures.

IRS is involved with millions of TDA and TDI cases, although not all of them

eventually need the attention of IRS collection officials. In fiscal year 1995,

IRS disposed of 4.2 million TDAs and 1.7 million TDIs. About two-thirds of

the accounts were for individuals, and about three-quarters of the business

accounts related to employment tax returns. The business returns most

commonly resulting in investigations were also employment tax returns.

According to an IRS official, businesses holding employment taxes are

tempted to keep them to overcome cash shortfalls.

Our high-risk series 1995 report on IRS’ accounts receivable illustrates how

the problems in different IRS functions affect each other and therefore how

a change in problem levels can affect a tax administrator’s other

operations.25 We pointed out that if returns processing did not properly

account for a taxpayer’s remittance, collection personnel may have to try

resolving an invalid account receivable.26 Similarly, if an IRS compliance

effort overstated a taxpayer’s liability, it would make additional work for

collection personnel with no guarantee of revenue generation.

Concerning IRS’ accounts receivable, we reported that individual taxpayers

with primarily nonwage income owed about three-quarters of IRS’

September 30, 1993, tax debt owed by individual taxpayers of $79.2 billion.

Half of the total debt was owed by taxpayers whose primary source of

income was from self-employment (27 percent) or from interest and

dividends (23 percent).27

Taxpayer Services With a fiscal year 1996 taxpayer services budget of about 8,000 full-time

equivalents and $500 million, IRS did various things to try to help taxpayers

comply with tax laws. In fiscal year 1995, for example, it answered the

telephone in almost 111 million instances to provide various forms of

assistance. For instance, although IRS received many more calls than it was

able to answer, IRS personnel staffing its toll-free system did respond to

almost 38 million procedural, account, and tax law calls. Of these contacts,

IRS disposed of over 29 million account calls concerning tax bills and

25See High-Risk Series: Internal Revenue Service Receivables (GAO/HR-95-6, Feb. 1995).

26According to a recent report, Tax Administration: Alternative Filing Systems (GAO/GGD-97-6,

Oct. 16, 1996), when IRS investigated 1.8 million potential 1991 underreporter cases in certain

categories, about half resulted in no change to the taxpayers’ tax liabilities.

27See Tax Administration: Tax Compliance of Nonwage Earners (GAO/GGD-96-165, Aug. 28, 1996).

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notices, and it handled almost 8 million calls on tax law matters, which

included technical tax information related to specific laws and regulations.

IRS estimated that 8 different categories each covered almost 10 percent of

the tax law calls, with each call being counted only once. These categories

were (1) filing information; (2) dependents, exemptions, and filing status;

(3) individual income; (4) individual business income and deductions;

(5) capital gains and losses; (6) pensions and deferred compensation;

(7) individual deductions and adjustments; and (8) tax computation,

credits, and payments. Thus, not only did the tax law calls fall into a

number of similarly sized categories, but also each category comprised

only a very small percentage of the 38 million toll-free calls answered.

Tele-tax is another form of IRS telephone assistance, one through which

taxpayers can receive recorded tax information on the status of their

refunds and on many tax law issues. In fiscal year 1995, IRS counted about

61 million “hits,” or tape menus accessed by callers, about double the year

before. According to an IRS official, 80 to 90 percent of these hits involved

questions about refunds. Refunds were especially problematic in 1995

when IRS enhanced its efforts to ensure the appropriateness of refund

claims, resulting in millions of refunds being delayed and much adverse

reaction. For the hits that did not involve refunds, IRS supplied us with lists

of topics accessed by taxpayers for the years ended in June 1994 and

June 1995. Other than general subjects, topics receiving more than 75,000

calls and thus ranking in the top 15 of the 1995 list were (1) electronic

filing; (2) dependents; (3) medical and dental expenses; (4) earned income

credit; (5) menu of filing requirements, filing status, and exemptions;

(6) filing status; (7) which form—1040, 1040A, or 1040EZ; (8) business

entertainment expense; (9) moving expenses; (10) child and dependent

care credit; and (11) collection issues.

In fiscal year 1995, IRS also provided over 4.2 million people with taxpayer

education programs. It reached over 80 percent of them through the

Volunteer Income Tax Assistance and Tax Counseling for the Elderly

Programs and the rest of them through a community outreach program,

small business workshops, and tax practitioner institutes.

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Overview of Alternative Tax Systems and

Design Issues

In recent years, several proposals for fundamental tax reform have been

put forward. These proposals would significantly change tax rates, the tax

base, and the level of tax (whether taxes are collected from individuals,

businesses, or both). Some of the proposals would replace the federal

income tax with some type of consumption tax levied only on businesses.

Consumption taxes levied only on businesses include retail sales taxes

(RST) and value-added taxes (VAT). The flat tax would also change the tax

base to consumption but include both a relatively simple individual tax

along with a business tax. A personal consumption tax, a consumption tax

levied primarily on individuals, has also been proposed. Similar changes in

the level at which taxes are collected could be made while retaining an

income tax base.

If Congress were to decide to fundamentally reform the tax system, it

would have to make choices on several basic issues, all of which have

ramifications for tax compliance and administration. First, should the tax

base be income or consumption or, as under the current system, contain

elements of both? Second, should taxes be levied on businesses,

individuals, or both? Third, should the preferential tax treatment now

given certain goods and services and types of income be maintained or

eliminated, thereby affecting not only the economic and social purposes

for which they were established but also the ease of tax compliance and

administration? Fourth, if consumption is chosen as the appropriate base

for taxation, what issues arise in making the transition to a new tax base,

and how should certain types of consumption that are difficult to tax be

treated? Fifth, how should a new system be designed to balance other

goals for the tax system with the goals of minimizing administration costs

and taxpayers’ costs of compliance?

This appendix provides some information to clarify these issues. To

summarize, the fundamental difference between income and consumption

taxes lies in the treatment of saving and investment. A broad-based income

tax would tax all income, regardless of how it is used and regardless of its

source. In particular, a broad-based income tax would tax income

regardless of whether it is used for consumption or for saving and

investment and would tax all income earned from saving and investment.

In contrast, consumption taxes are designed to tax only income used for

consumption, exempting from tax income used for saving and investment.

Under certain conditions, this is equivalent to exempting income earned

from saving and investment. As a result, different consumption taxes can

in effect exempt saving and investment in different ways, so taxes that

appear to be different may actually tax the same base—consumption.

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Either income or consumption taxes could be levied on individuals,

businesses, or both. The choice of level of tax (or collection point) alone

does not determine the base of a tax or who will bear its economic burden.

The choice does affect how equitable and how complicated a tax may be

because it determines whether a tax can treat different individuals

differently. A tax levied on individuals, whether income- or

consumption-based, can tax different individuals at different rates or allow

for adjustments such as standard deductions or exemptions for dependent

children. Such provisions may make a tax system more equitable but may

also make it more complicated. A tax levied solely on businesses

(corporations, partnerships, and sole proprietorships) may be simpler to

administer and less costly for taxpayers to comply with because the

number of tax return filers may be substantially reduced and because only

businesses would be burdened with tax-related recordkeeping and

accounting tasks. Businesses may keep some of the same records for

nontax purposes and are likely to be more efficient at recordkeeping and

accounting than individuals. However, taxes levied solely on businesses

are generally less able to make distinctions between individuals for

reasons of equity.

The current income tax is actually a hybrid tax because it exempts or

lightly taxes some types of saving and investment from tax but fully taxes

other forms. The current tax also grants preferential treatment to some

types of consumption, such as employer-provided health insurance. A

reformed tax system could treat saving and investment more uniformly,

either by taxing all saving and investment (income tax) or by exempting all

saving and investment (consumption tax). A reformed tax system could

also eliminate the current tax code preferences for certain items of

consumption, or it could maintain them.

Any tax reform that replaces the current income tax with a consumption

tax would have to address transition issues. In particular, the decision on

whether to tax existing wealth could raise issues of fairness and

administrability, as well as revenue. Moving to a consumption tax would

also raise issues involving the taxation of some types of goods and

services that could be difficult to tax from an administrative viewpoint. In

particular, decisions would have to be made on whether to tax and how to

tax financial services, housing, fringe benefits, and goods and services

produced by governments and nonprofit organizations. Some of these

items are also difficult to tax under an income tax.

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While some information is readily available on administration costs,

policymakers have little quantitative evidence on compliance costs

available to help them design new tax systems. Compliance costs are costs

that individuals and businesses incur, in terms of both time and money

directly spent, because of the requirements of the tax system. Compliance

and administrative costs are interrelated because some of the tasks that

need to be done to collect taxes can be done by the public sector or by the

private sector. As a result, costs can be shifted from one sector to another.

The distribution of compliance costs among different businesses and

individuals is also important for understanding the full effects of a tax

system. A major difficulty in measuring compliance costs is disentangling

accounting and recordkeeping costs due to taxes from the costs that

would have been incurred in the absence of the tax system. As a result, the

reliability of the results of most compliance cost studies that have been

done to date is limited.

Differences Between

Income and

Consumption Taxes

The fundamental difference between income and consumption taxes lies

in their treatment of saving and investment.1

 Income can be used for either

consumption or saving and investment, so if income used for saving and

investment can be exempted from tax, the result will be a tax only on

consumption. As described below, the exemption of saving and investment

can be done in different ways, so consumption taxes can be structured

differently and yet still have the same overall tax base. In contrast, income

taxes do impose a tax on income used for saving and investment. The

current tax system is considered to be a hybrid between a pure income tax

and a pure consumption tax because it effectively exempts some types of

saving and investment from tax but taxes other forms of saving and

investment.

Tax Treatment of Saving

and Investment

Consumption taxes exempt income used for saving and investment in one

of two ways. First, tax could be levied only on income used to buy

consumption goods and services. This could be done by either taxing the

sale of goods and services to consumers or by allowing individuals to

deduct the amount that they saved from their income. Under either

method, the income that an individual saved or invested would not be

taxed until it was used to buy goods and services for consumption.

1

For a similar discussion, see Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen’s Guide to the

Great Debate Over Tax Reform (Cambridge, Mass.: The MIT Press, 1996), pp. 168-71.

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A second way to in effect exempt saving and investment from tax would

be to exempt income earned by saving and investment. Over time, not

taxing the earnings from savings can be economically equivalent to not

taxing the amount saved originally. As shown below, under certain

conditions, these two methods are equivalent in that what individuals earn

through saving, the rate of return to saving and investing, is the same

under these seemingly different taxes.2

In contrast to consumption taxes, a broad-based income tax would levy

tax on income from all sources and tax income regardless of whether it is

used for consumption or saving. In particular, all income earned from

saving and investment would be taxed, and income used for saving and

investment would not be deductible.

A simple example focusing on the treatment of saving under alternative

taxes is shown in table III.1. The example compares an income tax to two

forms of consumption taxes and also illustrates the equivalence between a

consumption tax that exempts saving and a tax that exempts the income

earned by saving. The three cases all assume that $100 of wage income is

earned in the first year, all after-tax income is saved the first year and used

for consumption in the second year, the interest rate is 10 percent, and the

tax rate is 20 percent.

2

Michael Graetz, “Expenditure Tax Design,” in Joseph A. Pechman, ed., What Should Be Taxed: Income

or Expenditure? (Washington, D.C.: The Brookings Institution, 1980), pp. 172-73, lists the conditions

that must hold for the taxes to be equivalent. For example, the tax rate an individual faces must be

constant over time, taxpayers must consume all the income they earn during their lifetime, and

individuals must be able to borrow and lend unlimited amounts at a constant rate of interest.

Consumption taxes effectively exempt the “normal” or competitive rate of return on investment but

can tax rates of return above this level. For a discussion of whether consumption taxes exempt the

return for risk-taking, see William M. Gentry and R. Glenn Hubbard, “Distributional Implications of

Introducing a Broad-Based Consumption Tax,” in James M. Poterba, ed., Tax Policy and the Economy,

Volume 11 (Cambridge, Mass.: MIT Press, 1997).

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Table III.1: Tax Treatment of Saving

Under Income and Consumption Taxes

Income tax

Consumption tax

income from

saving not taxed

Consumption tax

saving not taxed

First year

Wages $100 $100 $100

Tax 20 20 0

Amount saved or

invested

80 80 100

Second year

Additional income

from saving or

investment

$8 $8 $10

Tax 1.6 0 22

After-tax return on

saving

8% 10% 10%

Present value of

taxes

$21.45 $20 $20

Source: GAO analysis of alternative taxes.

The first column shows how a person would be taxed under an income

tax. In the first year, the individual pays $20 in tax and saves the balance

($80). In the second year, the individual earns $8 in income from saving,

and pays $1.60 in tax on this income, leaving $86.40 available for

consumption. Because the earnings from saving were subject to income

tax, the after-tax rate of return on the individual’s saving is 8 percent

($6.40 of $80) instead of the 10-percent rate ($8 of $80) that would be

earned without the income tax.

The second column shows how the same individual would be taxed under

a consumption tax that does not tax the earnings from saving. In the first

year, the individual would be taxed on all income ($100), so as in the

income tax case, $20 would be paid in tax and $80 would be available for

saving. Once saved, the $80 would earn a 10-percent rate of return ($8), as

in the income tax case, but the earnings from saving would not be taxed.

Thus, in the second year, the individual has $80 in saving and $8 in

earnings on saving available for consumption, for a total of $88. In

comparison to the income tax, which reduced the after-tax return to

saving, the rate of return on saving is not changed by the consumption tax,

so incentives to consume today or save for the future are not affected by

the tax.

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Design Issues

The third column shows how the individual would be taxed if a deduction

from income for saving were allowed and all income was taxable when

used for consumption. In the first year, the individual owes no tax because

all income is saved. The $100 saved earns a 10-percent rate of return, so in

the second year $110 would be available for consumption before tax. The

individual would owe $22 in tax (20 percent of $110), leaving $88 for

consumption after tax, the same amount as under the first consumption

tax. 3

While the two consumption taxes differ in the timing of the tax payment,

as shown under this simple scenario, they would be equivalent in terms of

the present value of the taxes owed. Under the first consumption tax, the

individual owes $20 in tax the first year and none in the second; under the

alternative consumption tax, the individual owes no tax in the first year

and $22 in the second. In this case, having no tax liability in the first year

would enable the person to save an additional $20 and therefore earn an

additional $2, just enough to pay the additional tax in the second year.

Therefore, under the consumption tax in column 2, the individual

effectively prepays the consumption tax in the first year by paying $20; the

individual has paid an amount that if saved, would earn just enough to pay

the tax owed when the income was actually used for consumption.

Income and

Consumption Taxes

Can Be Levied on

Individuals or

Businesses

Both income and consumption taxes can be levied on individuals or

businesses. Whether collected from individuals or businesses, ultimately,

individuals will bear the economic burden of any tax.4

 The choice of

whether to collect a tax at the business level or the individual level

depends on whether it is thought to be desirable to levy different taxes on

different individuals. A business-level tax, whether levied on income or

consumption, can be collected “at source”—that is, where it is

generated—so there can be many fewer tax filers and returns to

administer. Business-level taxes cannot, however, directly tax different

3

Alternatively, the same $22 tax liability could be expressed as 25 percent of consumption. Since RSTs

are computed as a percentage of consumption rather than as a percentage of income (less saving), the

appropriate RST rate would be 25 percent. The result would be the same—under either an RST or a

personal consumption tax, income (less saving) would be reduced by 20 percent by the tax, and the

tax liability would amount to 25 percent of consumption.

4

For example, most economists would agree that the economic burden of a tax on wages would be

generally borne by workers, regardless of whether workers directly remit tax (send a payment) to the

government, businesses withhold tax from paychecks and remit the tax, or businesses are required to

remit tax on wages they paid. Alternatively, because taxes can be shifted through price changes and

changes in income, the statutory incidence of a tax (who is legally responsible to remit tax to the

government) “tells us essentially nothing” about economic incidence (whose real income is changed as

a result of the tax). See Harvey Rosen, Public Finance, 3rd ed. (Burr Ridge, Illinois: Irwin, 1992), pp.

274-77.

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Design Issues

individuals at different tax rates. Individual-level taxes can allow for

distinctions between different individuals; for example, standard

deductions and/or graduated rates can be used to tax individuals with low

income (or consumption) at a lower rate than individuals with greater

income (consumption). Other individual characteristics can also be taken

into account. For example, adjustments can be made for family size, and

additional deductions could be allowed for individuals who have very

large medical expenditures. However, individual-level taxes require more

tax returns, impose higher costs to comply with the tax laws, and would

generally require a larger tax administration system.

Table III.2 shows alternative income and consumption taxes that are

levied on businesses only, individuals only, or both. The current tax, while

including a separate corporate income tax, could be considered primarily

an individual tax because most types of income are taxed under the

individual tax. As mentioned earlier, the current tax is somewhere in

between a pure income and pure consumption tax because under the

current tax some forms of income from saving are taxed, while others,

particularly income from saving for retirement, are not taxed. We describe

each of the alternative taxes in the next two sections.

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Design Issues

Table III.2: Alternative Income and

Consumption Taxes by Level of Tax Level of tax/features Consumption type Income type

Business level

Tax collected at source

No filing by individuals

No way to vary tax rates or

base according to

characteristics of

individuals

National RST

Consumption VAT

 Credit method

 Subtraction method

Income VAT

Mixed business/individual

Many parts of tax base

collected at source

Simplified individual tax

base

Standard deductions or

exemptions can be used

for progressivity, but no

way to apply different rates

to entire tax base

Flat tax Comprehensive Business

Income Tax discussed by

Treasury, augmented with

wage tax at individual level

Individual level

Tax levied on individuals

Business must allocate

income or consumption to

individuals; may also

withhold and remit tax

Tax rates can vary

according to individual

characteristics

Personal consumption tax Integrated individual

income tax

Source: GAO analysis of alternative tax systems; also, see Joel Slemrod, “Deconstructing the

Income Tax,” The American Economic Review, Vol. 87, No. 2 (May 1997), pp. 151-55.

Alternative Types of

Consumption Taxes

The second column of table III.2 shows two business-level consumption

taxes (a national RST and a VAT), a mixed business/individual-level

consumption tax (a flat tax), and an individual-level consumption tax (a

personal consumption tax). Table III.3 shows an overview of the major

components of the alternative consumption taxes and details the major

differences between them. While the taxes differ because they tax

consumption at different levels, they ultimately all tax the same base.

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Table III.3: Components of Alternative

Consumption Taxes

Component

National

RST VAT Flat tax

Personal

consumption

tax

Business level

 Included

Sales of consumption

goods and services

• • •

Sales of goods and

services to other

businesses, including

investment goods

• •

 Deducted

Purchases of goods and

services from businesses,

including investment goods

• •

Wages •

Individual level

 Included

Wages • •

Cash flows received:

interest and dividend

income, funds from asset

sales, withdrawals from

accounts, borrowed funds

•

Distributions from sole

proprietorships,

partnerships

•

 Deducted

New saving: purchases of

stock, bonds; deposits in

accounts, repayment of

debt

•

Contributions to sole

proprietorships,

partnerships

•

Source: GAO analysis and compilation of available information on alternative consumption taxes.

National Retail Sales Tax The consumption tax that Americans are most familiar with is the retail

sales tax, which in many states, is levied when goods or services are

purchased at the retail level. The RST is a consumption tax because only

goods purchased by consumers are taxed, and sales to businesses,

including sales of investment goods, are generally exempt from tax. In

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contrast to an income tax, then, income that is saved is not taxed until it is

used for consumption.

Under a national RST, different tax rates could be applied to different

goods, and the sale of some goods could carry a zero tax rate (exemption).

However, directly taxing different individuals at different rates for the

same good would be very difficult.

Value-Added Tax The second column in table III.3 shows the components of a VAT, which

like the RST, is a business-level consumption tax levied directly on the

purchase of goods and services. The two taxes differ in the manner in

which the tax is collected and paid. In contrast to a retail sales tax, sales of

goods and services to consumers and to businesses are taxable under a

VAT. However, businesses can either deduct the amount of their purchases

of goods and services from other businesses (under a subtraction VAT) or

can claim a credit for tax paid on purchases from other businesses (under

a credit VAT). Under either method, sales between businesses do not

generate net tax liability under a VAT because the amount included in the

tax base by businesses selling goods is equal to the amount deducted by

the business purchasing goods. The only sales that generate net revenue

for the government are sales between businesses and consumers, which is

the same case as the RST.

Flat Tax The flat tax was developed in the early 1980s by economists Robert Hall

and Alvin Rabushka.5

 The Hall-Rabushka flat tax proposal includes both

an individual tax and a business tax. As described by Hall and Rabushka,

the flat tax is a modification of a VAT; the modifications make the tax more

progressive (less regressive) than a VAT. In particular, the business tax

base is designed to be the same as that of a VAT, except that businesses are

allowed to deduct wages and retirement income paid out as well as

purchases from other businesses. Wage and retirement income is then

taxed when received by individuals at the same rate as the business tax

rate. By including this individual-level tax as well as the business tax,

standard deductions can be made available to individuals. Individuals with

less wage and retirement income than the standard deduction amounts

would not owe any tax.

Personal Consumption Tax A personal consumption tax would look much like a personal income tax.

The major difference between the two is that under the consumption tax,

taxpayers would include all income received, amounts borrowed, and cash

flows received from the sale of assets, and then deduct the amount they

5

See Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford, Calif.: Hoover Press, 1995).

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saved. The remaining amount would be a measure of the taxpayer’s

consumption over the year. When funds are withdrawn from bank

accounts, or stocks or bonds are sold, both the original amount saved and

interest earned are taxable because they are available for consumption. If

withdrawn funds are reinvested in another qualified account or in stock or

bonds, the taxable amount of the withdrawal would be offset by the

deduction for the same amount that is reinvested.

While the personal consumption tax would look like a personal income

tax, the tax base would be the same as an RST. Instead of collecting tax on

each sale of consumer products at the business level, a personal

consumption tax would tax individuals annually on the sum of all their

purchases of consumption goods. Because it is an individual-level tax,

different tax rates could be applied to different individuals so that the tax

could be made more progressive, and other taxpayer characteristics, such

as family size, could be taken into account if desired.6

Alternative Types of Income

Taxes

Table III.2 also shows three alternative integrated income taxes: a

business-level tax (income VAT), a mixed business/individual-level tax

(Comprehensive Business Income Tax (CBIT)), and an individual-level

income tax (integrated individual income tax).

All income taxes, including the current tax, differ from consumption taxes

in their treatment of investment. To produce the goods and services they

sell to customers, businesses purchase a variety of goods and services

themselves. While some of the goods and services that businesses buy are

used up immediately in production, other goods and services, such as

plant and equipment, for example, can be used for production over time.

The purchase of goods and services of this type is referred to as

investment, and such goods and services are also referred to as business

assets.

Under consumption taxes, investment is either exempt from tax or

deducted immediately (expensed). In fact, all business purchases of goods

and services, regardless of how long they are used in production, are

6

To tax certain types of consumption that can occur within a business, such as fringe benefits or the

personal use of goods such as cars, many personal consumption tax proposals also include a

business-level “cash flow” tax. Investment would be expensed under such a tax to ensure that the

overall tax base would be consumption. See appendix VIII for more details.

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exempted or expensed because business purchases generally do not

represent consumption.7

Investment is treated differently under an income tax. Under an income

tax, income is calculated by deducting costs from revenue; therefore, the

costs that businesses incur from purchasing goods and services, including

the costs from owning assets, should be deductible. For goods and

services that are used up or become worthless in the same year as they

were purchased, the economic cost to the business will be the entire

amount they paid for the goods and services, and therefore the entire

amount should be deductible immediately (in the same tax year as the

goods or services were purchased). However, business assets do not lose

all their value immediately; rather, they wear out or become obsolete over

time (the assets depreciate). The economic cost incurred by owning an

asset during a particular year is the reduction in the value of the asset

during that year, so under an income tax businesses should be allowed a

deduction for depreciation that reflects this reduction in value. Depending

on the rate at which an asset loses economic value, a proportion of the

amount originally paid for the asset can be deducted for depreciation each

year until the total amount deducted over time is equal to the amount

originally paid.8

The current income tax differs from the other three income tax options in

that the current corporate income tax is not integrated with the personal

income tax. For example, under the current tax, corporations cannot

deduct dividends paid to shareholders, and shareholders pay tax on the

dividends they receive. Noncorporate income, however, is taxed only

once, at the individual level. The three options would tax all forms of

business income, corporate and noncorporate, once.

Table III.4 shows the components of the current tax and three alternative

income taxes that would integrate the business and individual taxes. The

alternative income taxes differ in that they would tax income at different

levels. The income VAT would tax all income at the business level. Wage

income would be taxed at the business level by denying businesses a

deduction for wages. The CBIT option would tax business income,

7

Investment in plant and equipment, like the purchase of financial assets such as corporate stock or

bonds, is a form of saving. By investing in assets like plant and equipment and using them over time to

earn income from the production and sale of goods and services, owners of businesses postpone

consumption today to make possible additional consumption in the future.

8

This tax treatment would be appropriate if there is no inflation. In appendix IV, we discuss how

inflation creates problems in measuring depreciation.

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including profits and the interest income earned by lenders, at the

business level. Wage income would be taxed at the individual level.

Table III.4: Components of Alternative

Income Taxes

Component

Current

tax

Income

VAT CBIT

Integrated

individual

income tax

Business level

 Included

Sales of goods and

services

• • •

Interest, dividend income •

 Deducted

Purchases of goods and

services, except

investment goods

• • •

Depreciation on

investment assets

• • •

Wages • •

Interest paid •

Dividends paid

Individual level

 Included

Wages • • •

Interest income • •

Dividend income • •

Capital gains • • •

Income from sole

proprietorships,

partnerships

• •

Share of undistributed

corporate income

•

Source: GAO analysis and compilation of available information on alternative income taxes.

Integrated Individual Income

Tax

An integrated individual-level income tax would be much like the current

tax. Individuals would be responsible for filing returns containing

information on all taxable forms of income. The taxation of business

income would change so that all business income, corporate and

noncorporate, would be taxed at the individual level. The tax rate would

apply to all forms of income that an individual receives, and individuals

could be taxed according to graduated rates if desired. Other taxpayer

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characteristics, such as the number of dependent family members, could

be taken into account.

CBIT The CBIT option would move much of the taxation of business income to

the business level, leaving a simplified individual tax return (primarily

wages). Business deductions for interest and dividends would not be

allowed, so this form of income would be taxed at the business level. The

business tax would effectively withhold tax on business income at the tax

rate that was applied to the business. Since individuals would file returns,

standard deductions and dependency exemptions could be part of the

system. A flat rate could be levied at the individual level, or multiple rates

chosen, but the multiple rates would only apply to the simplified base.

Income Value-Added Tax An income VAT would move the taxation of wage income to the business

level as well. No individual returns would be necessary, so the burden of

complying with the tax law would be eliminated for individuals. An

income VAT would not allow businesses to deduct dividends, interest, or

wages, so the income VAT remitted by businesses would include tax on

these types of income. Calculations would not have to be made for

different individuals, which would simplify tax administration and

compliance burdens but not allow for treating different individuals

differently.

How Consumption

Taxes or a Reformed

Income Tax Could

Affect Tax

Expenditures and

Therefore the Tax

Base

If Congress decides to reform the current tax, it could incorporate existing

tax preferences into a new tax system or eliminate the current preferences

and replace them with direct expenditure programs. These preferences are

referred to as “tax expenditures” because they can be thought of as

alternatives to direct outlay programs. They may take the form of

exclusions, credits, deductions, preferential tax rates, or deferral of tax

liability.9

Tax Expenditures for

Saving and Investment

The current tax system taxes some types of income from saving and

investment but exempts others. The alternative tax systems would treat all

types of income from saving and investment uniformly either by

exempting all types of income from saving or by taxing all types of income

9

For a more extensive classification of current tax expenditures according to whether current tax

treatment would be automatically provided for under consumption taxes, see Martin A. Sullivan, Flat

Taxes and Consumption Taxes: A Guide to the Debate (New York: American Institute of Certified

Public Accountants, Dec. 1995), pp. 91-96.

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from saving. Consumption tax proposals would expand existing incentives

and narrow the tax base by effectively exempting all saving and

investment from tax, and an income tax reform could end the incentives

by including income from all forms of saving and investment in the tax

base.

Table III.5 shows a list of major projected fiscal year 1997 tax

expenditures for saving and investment in the current tax code. For

instance, under current law, some forms of saving, such as those

producing pension and certain interest income, are already effectively

exempt from tax. A move to a broad-based consumption tax would

effectively exempt all saving, treating it like pension or tax-exempt interest

income is treated today. While some types of investment are granted

relatively favorable tax treatment currently, under a consumption tax all

investment would be expensed (deducted immediately). A tax reform

designed to tax all income would also move toward uniformity by

removing the relative preference now given to some forms of saving and

investment to tax income of all types equally.

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Table III.5: Fiscal Year 1997 Saving and

Investment Income Tax Expenditures Tax expenditure category Amount (in billions)

Exclusion of employer plan pension earnings and

contributions

$70.5

Exclusion of investment income on life insurance and

annuity contracts

21.6

Deferral of gain on sale of owner-occupied housing 18.6

Exclusion of $125,000 of capital gains from sale of

principal residences for persons age 55 and over

4.9

Exclusion of capital gains at death 15.5

Maximum 28-percent rate on long-term capital gains 10.5

IRAs 9.3

Keogh plans 3.7

Exclusion of interest on public purpose state and local

government debt

14.1

Exclusion of interest on state and local government

bonds for private nonprofit hospitalsa

1.7

Exclusion of interest on state and local government

bonds for rental and owner-occupied housing

3.0

Reduced rate on first $10 million of corporate taxable

income

4.1

Expensing of certain depreciable propertyb 1.0

Expensing of research and experimental expendituresc 2.4

Accelerated depreciation for equipment 28.7

Accelerated depreciation for structures 4.6

aTax expenditures of $1 billion or less would also be potentially eliminated for tax-exempt bonds

for each of the following purposes: industrial development; community development; and

sewage, water, hazardous waste, and other facilities.

bInvestments in the following categories are also expensed: (1) certain fuel, mineral, and timber

development costs; (2) agricultural costs; and (3) others. The estimated revenue loss for each of

these tax expenditures is less than $500 million annually.

cThe tax credit for qualified research expenditures, as well as credits for certain other

investments, could potentially be eliminated under consumption taxes.

Source: Joint Committee on Taxation data on tax expenditures; Sullivan, p. 93; and GAO analysis

of consumption tax proposals.

Other Current Tax

Expenditures

Table III.6 shows a number of other tax expenditures under current law

and fiscal year 1997 revenue loss estimates associated with them. Both

income and consumption tax reform could eliminate these preferences,

thereby broadening the tax base. Any tax reform would have to decide

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whether to continue the relative tax preference for certain fringe benefits,

government benefits, and a number of other items.

Table III.6: Other Current Tax

Expenditures, Fiscal Year 1997

Estimates

Tax expenditure category/provision Amount (in billions)

Fringe benefits (other than pensions)

Exclusion of employer contributions for health

insurance, medical care

$51.5

Exclusion of benefits provided under cafeteria plans 5.0

Exclusion of miscellaneous fringe benefits 5.5

Exclusion of premiums on group term life insurance 1.7

Exclusion of employer-paid transportation benefits 3.1

Government benefits

Exclusion of Social Security and Railroad Retirement

benefits

25.3

Exclusion of Medicare hospital insurance benefits 12.2

Exclusion of Medicare supplementary insurance

benefits

5.5

Exclusion of workers’ compensation 3.8

Other

Deduction of nonbusiness state and local government

income and personal property taxes

27.3

Mortgage interest deduction for owner-occupied

residences

41.3

Deduction for property taxes on owner-occupied

residences

15.6

Charitable deductions for social services 16.1

Charitable deductions for education 3.0

Charitable deductions for health 2.2

Deduction for medical expenses and long-term care 4.3

Earned income credit (not including direct outlays) 3.5

Low-income housing tax credit 2.8

Credit for child care and dependent care expenses 2.8

Additional standard deduction for the blind, elderly 1.9

Tax credit for Puerto Rico and possession income 3.2

Source: Joint Committee on Taxation data on tax expenditures; Sullivan, pp. 95-96; and GAO

analysis of alternative consumption taxes.

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Consumption Tax

Design Issues

Affecting Tax

Administration

In addition to the issue of whether currently tax-favored items should

maintain some tax preference in a new system, some other issues in the

design of a potential consumption tax would have an effect on tax

administration. A transition from the current tax to a consumption tax

base could raise significant administration issues. In addition, if a

consumption tax base is chosen, important decisions would have to be

made regarding whether particular hard-to-tax goods and services are

included in the tax base.

Implementing a

Consumption Tax May Tax

Existing Wealth

Under an income tax, no deduction for saving is allowed, and the income

from saving is taxed as it is earned by the saver. However, the amount that

was saved is not subject to further tax. For example, a bondholder will pay

tax on interest income but does not owe tax on the principal when it is

repaid.

If the income tax was replaced by a consumption tax, the saving that has

been done in the past using taxed funds might be subject to tax again. For

example, suppose that an individual buys a bond while the income tax is in

effect. Then suppose that the income tax is replaced by a national RST, and

the bondholder receives interest income and the principal is returned as

the bond matures. If the bondholder uses all of these funds for

consumption, all—interest income and principal—would be subject to tax.

In this way, replacing the income tax with a consumption tax could levy a

one-time additional tax on saving done before the tax change.

If it is thought to be unfair to subject prior saving to tax again, transition

rules would have to be written so that prior saving could be recovered

tax-free, as it would have been under the income tax. One difficulty is that

to replicate the treatment that saving and income from saving would have

received under the income tax, income from saving would have to be

separated from the return of the original amount saved. Otherwise,

taxpayers might get a windfall gain if they were able to get their previous

capital income back tax-free along with their prior saving. The particular

administrative challenges that would have to be addressed for a transition

to the alternative consumption taxes are briefly discussed in appendixes V

through VIII.

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A Consumption Tax May

Be Difficult to Administer

for Certain Goods and

Services

Any consumption tax proposal would have to address several areas where

levying tax might be difficult in terms of compliance and administration.

These items can be taxed if special rules are developed and taxpayers and

administrators devote resources to compliance. Including these items

would broaden the base of a consumption tax, enabling the same amount

of revenue to be raised at a lower rate than otherwise. Exempting these

items would also be possible, but exempting some goods and services

while taxing others would create administrative difficulties.10

Fringe Benefits Some fringe benefits can be thought of as consumption that takes place

within a business. As such, no separate transaction between an individual

and a business takes place that would be subject to tax under the normal

rules for an RST or a VAT, and there is no cash flow to an individual that

would normally be included under a personal consumption tax. The same

difficulties are present for the current income tax and would be present

for any modification of the income tax that sought to broaden the income

tax base.

To illustrate, consider employer-provided health insurance, perhaps the

most significant fringe benefit aside from employer-provided pensions.

The purchase of an employer-provided health insurance plan is a

business-to-business transaction, and the payment of medical bills by

insurance companies is also a business-to-business transaction. Ordinarily,

business-to-business transactions are ignored under an RST and deductible

(or creditable) under a VAT, so under normal rules, the consumption of

medical services would not be taxed.

If the purchase of health insurance was to be taxed under tax reform

proposals, exceptions to the general rules would have to be written. Under

a national RST, the purchase of health insurance or medical services could

be taxable regardless of whether they were purchased by an individual or

a business. For a VAT, the purchase of health insurance or payments for

medical services by businesses for their employees could be

nondeductible (or noncreditable). In either case, the taxable transactions

or purchases that would not be deductible would have to be specified.

Similarly, under the personal consumption tax, a business-to-business

transaction would never be reflected in an individual’s cash flow, so under

general rules, the consumption would not be taxed. To include this

consumption in the tax base, the value of the fringe benefit would have to

10For a discussion of the specific items in this section in the context of a VAT, see Congressional

Budget Office (CBO), Effects of Adopting a Value-Added Tax (Feb. 1992).

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be imputed or allocated to the employee so that it could be included in

taxable receipts. The same steps would have to be taken to include the

value of this form of compensation for income tax purposes.

Financial Services Financial services can be difficult to tax under a consumption tax because

the recipients of the services are not always charged explicit service fees.

Financial institutions typically do not charge explicit service fees for

maintaining checking and saving accounts and for arranging loans.

Instead, they charge higher interest rates on loans and offer lower rates on

deposits than otherwise. To include financial services in the tax base,

consumption taxes that do not include all types of cash flows in the tax

base (such as an RST, VAT, or flat tax) would include some rules to impute

the value of the sale of the financial service.11

Housing Taxing the consumption of services from owner-occupied housing poses a

potential problem for consumption taxes.12 Housing, like other durable

consumption goods, provides consumption services over time. For rental

housing, this is not a problem; rent could be taxed like any other

consumption item because there is a transaction between an individual

and a business (owner of the rental unit), so the normal rules can apply.

For owner-occupied housing, the individual consuming housing services

and the supplier of the house are the same person, so there is no

transaction to tax.

Consumption taxes could overcome this problem by subjecting the full

purchase price of owner-occupied housing to tax at time of purchase, even

though the house will not be consumed all at once. This essentially

prepays the consumption tax. However, this raises potential problems of

liquidity (the one-time payment of tax may be very large), and taxing

existing housing, as well as new housing, may be difficult. To tax new

housing, a business (the developer, for example) could charge tax on the

purchase price of the house.

Government and Nonprofit

Services

As under income taxes, consumption taxes must include rules for sales

and purchases of goods and services by government entities and nonprofit

organizations. In theory, consumption taxes could tax all goods and

11See David F. Bradford, “Treatment of Financial Services Under Income and Consumption Taxes,” in

Henry J. Aaron and William G. Gale, Economic Effects of Fundamental Tax Reform (Washington, D.C.:

Brookings Institution Press, 1996) and references he cites for arguments on whether financial services

should be included in a consumption tax base. Bradford also points out that financial services pose

similar difficulties for income taxes as well as for consumption taxes.

12Housing services may be more difficult to tax under an income tax than a consumption tax. See

appendix IV for information on the treatment of housing under an income tax.

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services used for consumption in the same way, regardless of whether

they are produced by governments and nonprofit organizations or by

private for-profit businesses. However, because governments and

nonprofit organizations do not charge a price for many of the goods and

services they provide, these goods and services would be undertaxed

relative to those sold by the private sector under the normal application of

an RST or VAT. Under an RST, goods and services produced by governments

and nonprofit organizations could be implicitly taxed to some extent by

treating these entities as consumers rather than businesses. This would

tax the purchases they make from businesses. Under a credit method VAT,

governments and nonprofit organizations could be exempted from tax;

this means that they would be unable to obtain credits for taxes they paid

on purchases they made from businesses.

Under the flat tax, governmental entities, nonprofit organizations, and

businesses could be treated more uniformly than under the RST and VATs

because wages paid to employees of all these organizations can be taxable

and government entities and nonprofit organizations would be taxed on

fringe benefits provided for workers. A personal consumption tax could

tax state and local government services by not allowing a deduction for

state and local taxes.13

Definition and

Measurement of

Compliance Costs

Taxes impose three types of costs on society as a whole as resources are

transferred from the private sector to the public sector. First, taxpayers

must use resources to comply with the requirements of the tax system

(compliance costs). Second, resources must be provided to the public

sector to administer the tax, including collecting the revenue and ensuring

that taxpayers comply with the requirements (administration costs). Third,

taxes can also distort economic behavior, leading to a misallocation of

resources (excess burden). Ideally, in determining the amount of revenue

to be raised and the type of tax used to raise the revenue, the level and

distribution of each of these costs would be weighed against the benefits

derived from the use of the revenue by the public sector.14

13For more details on these issues, see Joint Committee on Taxation, Impact on State and Local

Governments and Tax-Exempt Organizations of Replacing the Federal Income Tax (JCS-4-96),

April 30, 1996. Also, for a discussion of whether state and local business taxes should be deductible

under consumption tax alternatives and other issues, see Douglas Holtz-Eakin, “Fundamental Tax

Reform and State and Local Governments,” National Tax Journal Vol. XLIX, No. 3 ( Sept. 1996), pp.

475-86.

14Compliance cost assessments are done in the United Kingdom for major tax provisions. For

examples of these assessments and summaries of several recent studies on compliance costs, see

Cedric Sandford, ed., Tax Compliance Costs: Measurement and Policy (Perrymead, England: Fiscal

Publications in association with the Institute for Fiscal Studies, 1995).

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Compliance costs are costs that individuals and businesses incur, in terms

of both time and money directly spent, because of the requirements of the

tax system. Ideally, compliance costs should be measured by calculating

the value of the time and the resources used doing tax-related tasks in

their best alternative use (opportunity cost) net of any value derived from

the information produced by complying with the requirements.15

Compliance costs and administrative costs are interrelated because some

of the tasks that need to be done to collect taxes can be done by the public

sector or by the private sector. As a result, costs can be shifted from one

sector to another. For example, in the United States, businesses take on

some responsibilities that encourage compliance by withholding tax on

wages and providing information returns on payments of interest and

dividend income. As a result, a high level of compliance on those forms of

income may be achieved at lower administrative cost because matching

information returns with tax returns can substitute for large numbers of

audits. Also under the current system, taxpayers receive information and

help with their tax filing responsibilities through both the private sector

paid preparer industry and IRS taxpayer service activities.

The distribution of compliance costs among different businesses and

individuals is also important for understanding the full effects of a tax

system. For example, withholding tax on wages and providing information

returns are costly tasks for businesses, but receiving these documents

lowers compliance costs for individuals.16 Some studies have indicated

that small businesses may bear higher compliance costs as a percentage of

sales than larger businesses, and some businesses may receive cash flow

benefits from being able to retain tax they collect for a period until

remittance to the government is required. A full analysis of the

distributional effects of different tax policies would take these effects of

compliance costs into account.

Measurement of

Compliance Costs

A major difficulty in measuring compliance costs is disentangling

accounting and recordkeeping costs due to taxes from the costs that

would have been incurred in the absence of the tax system. For example,

where the rules regarding the calculation of income for tax purposes

15Some experts believe that some businesses may derive managerial benefits from accounting

information produced for tax purposes. See Cedric Sandford, Administrative and Compliance Costs of

Taxation (Perrymead, England: Fiscal Publications, 1989), p. 13.

16The economic burden of these costs may not reduce business profits if they result in higher prices,

lower wages, or lower interest payments.

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coincide with rules for determining income for financial statement or

regulatory purposes, the additional costs of taxation can be minimal.

Because public corporations must report financial statement income

under the rules of the Securities and Exchange Commission, some

recordkeeping useful in calculating tax liability may be done for nontax

purposes. For other businesses, calculating financial statement income

may be required by banks or other potential lenders. Some individuals may

need to calculate their income in order to apply for mortgages or financial

aid for college. However, significant compliance costs may arise when the

tax code requires businesses or individuals to keep records and calculate

income differently than they do for other purposes.

A related issue is whether other government agencies would require

taxpayers to produce the same or similar information if it is not required

for tax purposes. For example, the federal government might need a

measure of individuals’ income to determine eligibility for means-tested

transfer programs, and state and local governments that now rely on

federal income tax records might need to have similar information for

their own tax and transfer programs even if the federal income tax were

eliminated. To the extent that income tax requirements would be

recreated by other government agencies if the income tax were repealed,

compliance costs would have to be considered to be government

compliance costs rather than stemming solely from the tax system.

The reliability of the results of most compliance cost studies that have

been done to date is limited by several factors, which are commonly

acknowledged by the authors of the studies. First, written or telephone

questionnaires have generally been used to ask individuals or businesses

how much money or time they spend on tax matters. In evaluating these

studies, it is difficult to know whether respondents can differentiate

between recordkeeping that would have been done anyway and

recordkeeping that is only done for tax purposes. Reported compliance

costs may be exaggerated if respondents include costs for nontax

purposes. In addition, it is not known whether respondents did everything

required to fully comply with the tax law. For example, if a particular tax

rule was so complex that taxpayers did not even attempt to comply,

respondents might truthfully answer that they spent no time or money to

comply with the rule. The compliance costs as measured by the survey

would be zero, so the results of the survey would not give an indication of

just how complex the rule really is. Finally, response rates for these

studies have generally been low, so the results from the surveys may not

reliably estimate costs for taxpayers in general.

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Income Tax Reform Options

Description In this appendix, we describe several options for reforming the income tax

and also the administrative issues that would be important if these options

were considered. The four options we describe are based on past and

current proposals and academic discussions and analyses. The options

were chosen to best describe the trade-offs and choices that would have to

be made in reforming the income tax and to best facilitate comparisons of

income tax reform options and consumption tax proposals.

The goal of each of the four income tax reform options we discuss is to

have a more comprehensive and accurately measured income tax base

than under the current income tax. To do this, all of the reform options

could make three major changes to the current system. First, the income

tax base could be broadened so that most forms of income would be taxed

annually. This could be done by including more types of income in the tax

base and by eliminating some adjustments, credits, and deductions.

Second, the calculation of income could include explicit inflation

adjustments so that the tax base would better measure the real income of

individuals and businesses. Under the current tax, inflation can lead to an

overstatement or an understatement of real income. Third, the corporate

and personal income taxes could be integrated so that business income

would be taxed once annually, regardless of the legal form of the business.

Under the current tax, corporate income is taxed differently than the

income of noncorporate businesses, such as sole proprietorships and

partnerships.

The income tax options we discuss would integrate the corporate and

personal taxes but would do so in different ways. Just as consumption

taxes can be levied on businesses, individuals, or both, the income tax

options would levy the income tax at different levels. Two options would

tax individuals directly on most or all of their income. These options, like

the current system, would allow for many individual characteristics to be

taken into account when determining tax liability. Administration of these

options would also be similar to that under the current system, with

individuals filing returns and information returns used to check

compliance. Two other options would tax most or all income at the

business level, essentially withholding tax before income is received by

individuals. These options could reduce the need for individual returns

and information reporting; administration efforts would be focused

primarily on business returns. These options would not be as able to take

individuals’ characteristics into account and would be facilitated by a

flatter tax rate structure.

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Income Tax Reform Options

This appendix first describes the changes that any of the four income tax

reform options could make to more comprehensively and accurately

measure income and elaborates on the options themselves. Then, it

discusses the potential impact of these options on taxpayers’ compliance

burden and on tax administration.

Broadening the Income

Tax Base

The income tax base could be broadened by taxing certain types of

income that are now exempt from tax and by eliminating some

adjustments, deductions, and credits. Broad-based taxes can offer several

advantages in meeting the goals of the tax system—promoting economic

efficiency and equity and reducing taxpayer compliance burden and

administration costs. By making fewer distinctions among activities, a

broad-based tax can be simpler and easier to administer, and because

under a broad base a given amount of revenue can be raised with a

relatively low tax rate, economic efficiency may be enhanced. However, a

more narrowly defined tax base, while generally requiring higher tax rates

to raise the same amount of revenue, could be preferable to a broad tax

base if exemptions, credits, or deductions promote economic efficiency

and equity or simplify compliance and administration to a sufficient

extent.

Broadening the tax base could in some respects increase the complexity of

the tax system, but it could simplify it in other respects. For example,

including some forms of income in the tax base could in some

circumstances complicate compliance and administration, particularly if

these forms of income are difficult for taxpayers to calculate and

administrators to verify. However, if one form of income was exempted

and other forms were taxed, rules and definitions would have to be

developed to differentiate one form of income from the others. These rules

would have to be followed by taxpayers and compliance with the rules

checked by tax administrators.

Taxing Additional Types of

Income

Table IV.1 shows major types of income that are currently reported on

Form 1040 and the number of returns that reported some amount of each

type of income in tax year 1993. It also shows how the tax treatment of

some items that are currently reported could change under a more broadly

based tax, and it shows some additional income items that are not taxed or

reported under current law. The major changes from the current system

are discussed following the table.

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Income Tax Reform Options

Table IV.1: Income Items and Number

of Returns Reporting Them, Tax Year

1993

Item

Current tax

treatment

Millions

of

returns

reporting

item

Possible

reformed

income tax

treatment

Currently reported items

Salaries and wages Taxed 98.0 Taxed

Taxable interest Taxed 65.2 Taxed,

adjusted for

inflation

Tax-exempt interest Taxed under

some

circumstances

4.7 Taxed,

adjusted for

inflation

Dividends Taxed 24.7 Taxed

Net capital gain or loss Taxed when

realized, nominal

gain included

18.4 Taxed on

accrual basis,

indexed for

inflation

Distributions from pensions and

annuities

All distributions

taxed

17.4 Not taxed

Unemployment compensation Taxed 9.7 Taxed

Social Security benefits Taxed under

some

circumstances

5.7 Amounts

above

contributions

taxed

Business or profession net income

or loss (sole proprietorships)

Taxed 15.6 Taxed

Rental and royalty net income or

loss

Taxed 11.0 Taxed

Partnership and S corporation net

income less loss

Taxed 5.5 Taxed

Estate and trust net income less loss Taxed 0.5 Taxed

Farm net income less loss Taxed 2.3 Taxed

Additional income items

Contributions to pension plans;

earnings from life insurance,

annuity, and pension plan reserves

Not taxed N/A Taxed

Employer-paid fringe benefits

(other than pensions)

Not taxed N/A Taxed

Government benefits (Medicare,

workers’ compensation)

Not taxed N/A Taxed

Imputed service value of

owner-occupied housing and other

household durables

Not taxed N/A Taxed

(Table notes on next page)

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Income Tax Reform Options

Legend: N/A = not applicable.

Sources: IRS, Statistics of Income Division, Individual Income Tax Returns 1993. Additional

income items from David Bradford, Untangling the Income Tax (Cambridge, Mass.: Harvard

University Press, 1986), pp. 33-34.

Tax-exempt interest income. Current law allows interest income from

bonds issued by state and local governments and tax-exempt organizations

to be exempt from tax if the bonds are used for certain purposes. While in

some circumstances this interest income can be taxable and is therefore

reported on tax forms, it is not subject to information reporting. The

income tax base could be broadened by removing the tax exemption for

this interest income.

Accrued capital gains. Under current law, capital gains are generally

subject to tax only when assets are sold or otherwise disposed of. Owners

of assets that have appreciated in value over the course of a year but have

not been sold generally do not report the increase in asset value as

income. Since such income is not reported until the asset is sold, tax on

this income is deferred.1

Capital gains could in effect be taxed as they are earned (on an accrual

basis) in two ways. First, the owner of the asset could calculate the

difference between the value of the asset at the end of the year and the

value of the asset at the beginning of the year. Tax would be paid on the

amount of the difference, regardless of whether the asset was actually

sold. This could be done most readily for assets that are bought and sold

frequently, such as publicly traded corporate stock, because the market

values of the assets would be relatively easy to obtain and check. Under a

second approach, taxation of gains could occur only when assets are sold,

as under current law. However, an interest charge could be imputed and

added to the gain so that the tax saving from the deferral of income would

be offset.2

 This approach could be applied to assets for which market

values are not readily available because they are bought and sold

infrequently, or for all assets generally.

1

The current tax code contains several provisions to force the recognition of income to prevent

deferral of gain in some circumstances. Shuldiner notes that Internal Revenue Code sections 475 and

1256 require mark-to-market for the inventory of security dealers and certain financial instruments;

sections 453A and 1291 impose interest charges on deferral. Reed Shuldiner, “Indexing the Tax Code,”

Tax Law Review, Vol. 48 (1993), pp. 556-57, notes 70, 72.

2

For details of such an approach, see Alan J. Auerbach, “Retrospective Capital Gains Taxation,” The

American Economic Review, Vol. 81, No. 1 (Mar. 1991), pp. 167-78. Also, see David J. Shakow,

“Taxation Without Realization: A Proposal For Accrual Taxation,” University of Pennsylvania Law

Review, Vol. 134, No. 5 (June 1986), pp. 1111-1205.

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Income Tax Reform Options

Contributions to pension plans and retirement accounts; earnings from

retirement accounts and life insurance, annuity, and pension plan

reserves. In general under an income tax, income that is saved is taxed,

and income from saving is taxed when it is earned. Under the current tax,

there are significant exceptions to this general rule, and in some cases

saving is treated as it would be under a consumption tax. In particular,

contributions to pension plans and certain individual retirement

arrangements (IRA) are not included in an individual’s income, and

earnings in these plans are not taxed until they are distributed. In addition,

earnings in certain life insurance and annuity plans are not taxed until they

are distributed. The income tax base could be broadened by taxing

contributions to pension plans and IRAs, and by taxing earnings in pension,

IRA, life insurance, and annuity plans when they are earned.

Employer-paid fringe benefits. In addition to pensions, under current law

businesses can provide several types of fringe benefits to employees on a

tax-favored basis.3

 Qualified expenditures on these fringe benefits,

including premiums paid for employer-provided health insurance, are

deductible for the business as are other forms of compensation. However,

unlike many other forms of compensation, the value of the benefits is not

taxable to the employee.

The income tax base could be broadened either by making expenditures

for fringe benefits nondeductible for businesses or by including the value

of the benefits in the taxable income of the employee. If benefits were not

deductible, they would in effect be taxed at the tax rate that the business

faces. If benefits were included in the taxable income of the individual,

they would be taxed at the individual’s tax rate.

Government benefits. Currently, several types of government benefits are

not taxed, including Medicare benefits and workers’ compensation. Also,

Social Security benefits under a certain level are not taxed when they are

received. The income tax base could be broadened by including more of

these benefits in taxable income.

Income from owner-occupied housing. Under the current tax and income

taxes in general, income earned through the ownership of assets is

generally subject to tax, and the costs of earning the income are

deductible. However, under the current tax, the treatment of

owner-occupied housing represents a significant exception to the general

3

More detail on the tax treatment of fringe benefits is presented in Tax Policy: Effects of Changing the

Tax Treatment of Fringe Benefits (GAO/GGD-92-43, Apr. 7, 1992).

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Income Tax Reform Options

rule. If a home is rented, the income earned by the owner of the home is

taxed much like the income earned from owning other assets is taxed. In

this case, the owner of the house would receive rent in exchange for the

housing services provided to the renter. The rent received by the owner

would be taxable, and costs, such as depreciation, maintenance, and

interest expense, would be deductible. In contrast, if the homeowner

occupies the house, the value of the housing services received by the

owner is not included as income, and maintenance and depreciation are

not deductible. However, mortgage interest is deductible.

Most analysts believe that it would be very difficult to tax income from

owner-occupied housing precisely. The major administrative difficulty in

taxing income from owner-occupied housing like income from other

investments is the lack of a transaction, the rent payment, that would

measure the income earned. An amount would have to be estimated, or

imputed, possibly based on the market value of the house. Estimating

market values for housing on an annual basis is a challenge for local

property tax administration. Here, too, the problem is a lack of a

transaction on which to base a measurement because only a fraction of

houses are sold within a given year.4

Eliminating Some Deductions

and Credits

As noted in Treasury’s 1984 study of tax reform, broadening the income

tax base by eliminating certain adjustments, deductions, and credits would

also be possible.5

 To measure income accurately, an income tax should

allow deductions for the costs of earning income, and the current income

tax allows some costs to be deducted. Other adjustments, deductions, and

credits represent subsidies designed to encourage certain types of

spending thought to be socially beneficial. Still, others represent additional

modifications of the income tax base to better measure an individual’s

ability to pay tax. For example, individuals with sufficiently large medical

expenditures may not be as able to pay tax as individuals without such

expenditures. Table IV.2 shows adjustments, deductions, and credits in the

current tax code and how these items might be treated under an income

tax with a broader base. Items that are considered to be tax expenditures

could be eliminated, while items that can be considered costs of earning

income could be deductible. Other items, such as the standard deduction

4

Several European countries that also tax net wealth have, at certain times, levied a tax on imputed

rent by including a certain fraction of the assessed value of a house in the income tax base. See OECD

Studies in Taxation, The Personal Income Tax Base: A Comparative Survey (Paris: 1990).

5

U.S. Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth Vol. 1

(1984), pp. viii-ix.

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Income Tax Reform Options

and the foreign tax credit, could be retained as a part of the overall

structure of the income tax.

Table IV.2: Current Tax Code

Adjustments, Deductions, and Credits

for Individuals, Tax Year 1993, and

Possible Treatment Under a Reformed

Income Tax

Item

Millions of individual

returns reporting item

Possible treatment

under reformed income

tax

Adjustments

IRA deduction 5.8 Eliminated

Deductions for

self-employment

retirement plans (Keogh

and simplified employee

pension plans)

0.9 Eliminated

Deduction for

self-employment tax

12.5 Possibly deductible

Self-employment health

insurance

2.9 Eliminated

Deductions

Standard deduction 80.8 Retained

Additional standard

deduction for age 65 or

blindness

10.5 Eliminated

Itemized deductions: 32.8

Medical and dental

expense

5.5 Eliminated

Taxes paid 32.3 Eliminated

Mortgage interest paid 27.2 Deduction retained,

adjusted for inflation if

income from

owner-occupied housing

is taxed; otherwise,

deduction eliminated

Investment interest 1.5 Deduction retained,

adjusted for inflation

Charitable

contributions

29.8 Eliminated

Unreimbursed

employee business

expenses

9.3 Retained

Credits

Earned income 15.1 Possibly eliminated

Child care 6.1 Possibly deductible

Elderly or disabled 0.2 Eliminated

(continued)

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Income Tax Reform Options

Item

Millions of individual

returns reporting item

Possible treatment

under reformed income

tax

Foreign tax 1.3 Retained

General business 0.3 Eliminated

Alternative minimum tax 0.3 Eliminated

Sources: Data on number of returns with line item: IRS, Statistics of Income Division, Individual

Income Tax Returns 1993. Possible changes from Joint Committee on Taxation, Estimates of

Federal Tax Expenditures for Fiscal Years 1997-2001 (JCS-11-96), Nov. 26, 1996; and Joint

Committee on Taxation, Impact on State and Local Governments and Tax-Exempt Organizations

of Replacing the Federal Income Tax (JCS-4-96), Apr. 30, 1996; and Bradford (1986), pp. 33-34.

Indexing the Tax System

for Inflation

The current tax code does not include explicit adjustments to take

inflation into account in calculating business income. As several studies,

including the Department of the Treasury’s 1984 proposal for tax reform,

have shown, without adjustments for inflation (indexing), taxable income

could be overstated or understated relative to the real income of the

taxpayer. That study and others have concluded that business income

would be better measured if inventories, depreciation, interest income,

interest expense, and capital gains were all indexed for inflation.6

 Some

analysts have stated that concern about added complexity was one reason

why indexing was not adopted in the Tax Reform Act of 1986.7

An example can illustrate the income mismeasurement problem caused by

inflation. Suppose a business bought equipment for $1,000 in 1985.

Suppose also that the equipment was expected to be used for 10 years, and

the business was allowed a deduction for depreciation over the course of

the 10 years. The total amount deducted over time would add up to $1,000,

the historical cost or purchase price of the equipment. Suppose further

that the business could deduct $100 in each of the 10 years for

depreciation. With inflation, the value of the deduction for depreciation

erodes over time because the $1,000 is fixed in terms of 1985 dollars. In

other words, a $100-deduction in 1995 would understate the real economic

6

For a more detailed analysis of indexing, see Shuldiner (1993); Bradford (1986), Ch. 3; Daniel Halperin

and Eugene Steuerle, “Indexing the Tax System for Inflation,” in Henry J. Aaron, Harvey Galper, and

Joseph A. Pechman, eds., Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax

(Washington, D.C.: The Brookings Institution, 1988); and Joel Slemrod and Jon Bakija, Taxing

Ourselves: A Citizen’s Guide to the Great Debate Over Tax Reform (Cambridge, Mass.: The MIT Press,

1996), Ch. 8. For information about foreign experience with indexation provisions, see Milka

Casanegra de Jantscher, Isaias Coelho, and Arturo Fernandez, “Tax Administration and Inflation,” in

Richard M. Bird and Milka Casanegra de Jantscher, eds., Improving Tax Administration in Developing

Countries (Washington, D.C.: International Monetary Fund, 1992).

7

Shuldiner (1993), p. 598, and Slemrod and Bakija (1996), p. 238.

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Income Tax Reform Options

cost of operating the equipment because $100 was not worth as much in

1995 as it was in 1985. Thus, the income of the business would be

overstated because its costs as calculated would not represent the real

costs to the business.

While inflation adjustments could correct this problem, the tax code has

featured accelerated depreciation to indirectly offset inflation. If an

inflation adjustment for the historical cost of the machine were made, the

$1,000 historical cost figure would be increased to reflect inflation each

year, and the deduction for depreciation would therefore be increased so

that it reflected the real economic cost of operating the equipment.

Instead, the tax code has allowed accelerated depreciation (allowing

relatively larger deductions in the first few years after the asset is

purchased) but kept historical basis calculations. While it is possible to

develop accelerated depreciation schedules that offset the effects of a

given rate of inflation, depreciation schedules would have to be changed

to prevent renewed overstatement or understatement of income if the rate

of inflation changes.

A similar problem exists in the calculation of capital gains. As noted

above, capital gains on the sale of assets are taxed when assets are sold.

To calculate gain or loss, the sale price of the asset is compared to the

price that was originally paid for the asset.8

 Part of this gain may be the

result of inflation. Assets that have lost value on an inflation-adjusted basis

could show a gain when the effect of inflation is ignored. This problem is

one justification for applying a preferential tax rate to capital gains income

to, albeit imperfectly, offset the overstatement of income. However, having

a preferential tax rate, in turn, creates incentives for taxpayers to structure

transactions so that income is characterized as a capital gain rather than

as ordinary income, and further rules are designed to prevent or limit this

activity.9

Integrating the Corporate

and Individual Income Tax

Another objective of income tax reform could be the integration of the

corporate and individual income taxes.10 The differences in the current tax

code between the tax treatment of corporations and noncorporate

businesses, such as partnerships and sole proprietorships, have long been

8

For depreciable assets, the calculation of gain or loss would also take into account depreciation

deductions taken over time.

9

See Treasury, pp. 180-81.

10For a comprehensive study of the issue of integration, see U.S. Department of the Treasury,

Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (Jan. 1992).

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Income Tax Reform Options

criticized. Some forms of corporate income can be taxed twice, while

income earned by noncorporate businesses is taxed once. Under the

current tax, corporate income paid out as dividends to individual

shareholders is taxed twice; it is first taxed in effect at the corporate level

because dividend payments are not deductible, and it is generally taxed

again when shareholders receive the dividend payment as income.

Table IV.3 details several options for integrating the corporate tax with the

individual tax so that all business income, whether earned by a

corporation or a noncorporate business, would be taxed once annually.

Under all the income tax reform options, business income would be taxed

at either the business level or the individual level, but the same income

would not be taxed at both levels. In contrast to the consumption tax

options that would allow an immediate deduction for investment

spending, each income tax option would allow a deduction for

depreciation of investment assets over time. The income tax options differ

in the degree to which income would be taxed at the business level or the

individual level.

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Table IV.3: Overview of Alternative

Income Tax Reform Options

Item

Current

tax

Income

VAT CBIT

Integrated

corporate

income tax

Integrated

individual

income tax

Business level

 Included

Sales of goods and

services

• • • •

Interest, dividend

income

• •

 Deducted

Purchases of goods

and services, except

investment goods

• • • •

Depreciation on

investment assets

• • • •

Wages • • •

Interest paid • •

Dividends paid •

Individual level

 Included

Wages • • • •

Interest income • • •

Dividend income • • •

Capital gains • • • •

Income from sole

proprietorships,

partnerships

• • •

Share of undistributed

corporate income

•

Source: GAO analysis of alternative income tax reform options.

Integration Options That Tax

Most Types of Income at the

Individual Level

Two options would be similar to the current tax in that most types of

income would be taxed at the individual level. Like the current income tax,

the structure of these taxes would allow for any combination of rates and

standard deductions and exemptions. Large standard deductions and a

single rate would be possible, or the tax could feature graduated tax rates

and subsidies such as the earned income credit. Family size and individual

circumstances, such as being over 65 or blind, could be taken into account

if desired.

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Integrated Individual Income Tax. Under an integrated individual income

tax, all corporate income would be taxed at the individual level at the

individual’s tax rate. As under the current tax, income earned by

corporations and distributed to shareholders as dividends would be taxed

at the individual level. Undistributed corporate income would be allocated

to shareholders and taxable to them much as income earned by

partnerships and S corporations is taxed currently. If the tax base was

broadened, fringe benefits would be similarly allocated to the employees

receiving the benefits.

Integrated Corporate Income Tax. An integrated corporate income tax

would differ from the integrated individual tax in that undistributed

corporate income would not be allocated to shareholders; rather, it would

be taxed separately at the corporate level. Corporations would be allowed

to deduct dividends paid to shareholders, and shareholders would pay tax

on dividends they receive. Deductions for expenditures on fringe benefits

could be disallowed, effectively taxing this income at the corporate level

rather than as income to employees. Compared to the integrated individual

tax, this option would tax more types of corporate income at the corporate

level at the tax rate that applies to corporations rather than at the

individual’s tax rate.

Integration Options That Tax

Most Types of Income at the

Business Level

The other two options would move the taxation of most types of income to

the business level. Many of the simplifications made in the consumption

tax proposals come about because more of the tax base is taxed at the

business level than at the individual level. For example, the national retail

sales tax (RST) and value-added taxes (VAT) have no individual filing, and

the flat tax reduces the number of items taxed at the individual level

substantially. Taxing all or most of the tax base at the business level could

also be done while maintaining an income tax, eliminating or substantially

reducing the scope for individual filing. Any income or consumption tax

that is levied primarily at the business level gains simplicity for individuals

but sacrifices the ability to tax individuals according to their individual

circumstances.

Income VAT. It would be possible to tax income with only a business-level

tax by using an income VAT. The difference between an income VAT and the

consumption VATs we describe in appendix VI is the treatment of

purchases of capital assets. Under the consumption VATs, these

investments are deducted immediately, or expensed. Under an income VAT,

businesses would depreciate capital goods over time, as they now do

under the income tax. Wages, interest, and dividends would not be

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Income Tax Reform Options

deductible, so these forms of income would effectively be taxed at source.

Under such a system, as under a consumption VAT, individuals would not

have to file returns themselves, and tax administration would be limited to

business returns. Also, like a consumption VAT, individual characteristics

could not be taken into account to make the tax more progressive or

better reflect ability to pay.

Comprehensive Business Income Tax (CBIT). It would be possible to tax

most types of income at the business level and have a simplified individual

tax that included only a few income items. For example, one of the

prototypes for corporate integration analyzed by the Treasury Department,

the CBIT would not allow deductions at the business level for interest and

dividends, essentially collecting tax on these forms of income at the

business level. Under such a system, individuals would pay tax on only

wages and certain capital gains.11 The CBIT would modify the income VAT

by allowing a deduction for wages at the business level and taxing wages

at the individual level. Including personal exemptions, a standard

deduction, and other features in the individual tax could then make the tax

more progressive than an income VAT.

Potential Impact on

Taxpayers’

Compliance Burden

Table IV.4 summarizes some of the ways in which a reformed income tax

could affect taxpayers, and a more detailed discussion follows.

11“Certain capital gains” are increases in the value of stock that are unrelated to undistributed business

income, which is already taxed at the business level under the CBIT. Such increases in the value of

stock might result from anticipation of increases in future earnings or from increases in the value of

assets owned by the business itself. See Treasury (1992) Ch. 8 for more details on how capital gains

might be taxed under different corporate tax integration options.

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Table IV.4: Summary of Some Key

Potential Impacts of Income Tax

Reform Options on Taxpayers

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of income tax

reform options on

taxpayers

Burden on individual

taxpayers

Impact on individual

taxpayers

Return filing 116 million returns filed in

1995

Individual taxes: Broader

base; more individuals

possibly filing, depending

on standard deduction

amount and amounts of tax

withheld 

CBIT: Limited base; fewer

filers possible

Income VAT: No individuals

filing

Records kept Records supporting tax

returns supposed to be

kept—e.g., receipts, proof

of payment, and

documentation supporting

deductions and credits;

burden alleviated by

information reports given to

individuals

Individual taxes: Records

reduced by eliminating

some deductions and

credits; increased by

adding other types of

income to base

CBIT: Reduced; many types

of income no longer taxable

Income VAT: Eliminated

Calculations made Complicated calculations

for some taxpayers

included for provisions such

as dependency tests and

capital gains

Individual taxes:

Calculations added by

indexation, taxing accrued

capital gains; reduced by

eliminating deductions,

credits

CBIT: Made for certain

capital gains only

Income VAT: Eliminated

Complexity faced Many pages of instructions

involved and millions of

supplemental forms and

schedules filed—e.g., 33

million schedules of

itemized deductions for tax

year 1994; difficulties

existing in defining and

recognizing income;

however, in actual practice,

minimal complexity faced

by millions of individuals

Individual taxes: Complexity

increased by indexing,

need to accrue capital

gains taxes; reduced by

treating income, expenses,

and savings more uniformly

CBIT: Capital gains

complexity only

Income VAT: Eliminated

(continued)

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Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of income tax

reform options on

taxpayers

Burden on business

taxpayers

Impact on business

taxpayers

Return filing 24 million returns filed in

1995

All options: Returns filed by

all businesses, either

paying tax separately or

allocating income to

owners. Withholding on

wages eliminated under

income VAT

Records kept Records supporting income

and expenses supposed to

be kept

All options: Records

needed for revenues;

expenses, including

depreciation; fringe

benefits—allocated or

nondeductible

Integrated individual:

Added records for

allocation of income to

shareholders

Calculations made Complicated calculations

included for provisions such

as depreciation, the

alternative minimum tax,

and the foreign tax credit

All options: Calculations

added by indexation,

reduced if AMT eliminated

Complexity faced Detailed rules involved;

complexity reflected in

areas such as depreciation,

the alternative minimum tax,

and the foreign tax credit;

difficulties existing in

defining and recognizing

income

All options: Income

measurement, international

issues remain; AMT

possibly eliminated, debt

versus equity distinctions

not as important

(continued)

Page 92 GAO/GGD-98-37 Alternative Taxes
Appendix IV 

Income Tax Reform Options

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of income tax

reform options on

taxpayers

Requirement to furnish

information returns

1.1 billion information and

withholding documents filed

Integrated individual tax:

Possible need for returns

showing allocation of

corporate income, fringe

benefits

CBIT: No need for returns

on dividends, interest

Income VAT: None related

to individuals

Source: GAO analysis of available information about alternative income tax reform options.

Number of Tax Returns Under the individual tax options, as under the current income tax, both

businesses and individuals might file returns. Under current law,

individuals must file returns if their gross income exceeds certain

thresholds. These thresholds vary according to filing status and are

determined by the amount of the applicable standard deduction and the

value of personal exemptions. If individuals with gross income below

these thresholds have had tax withheld during the year, they can file a

return to claim a refund. If these thresholds were unchanged by tax reform

and the income tax were broadened to include more types of income,

more individual returns might be filed. For example, individuals who have

small amounts of wage income and some tax-exempt interest income

might not have to file a return under current law; these individuals might

have to file a return under the individual income tax options because all

interest income would be taxable. However, if the additional revenue

acquired from broadening the tax base were used to increase standard

deduction or personal exemption amounts, the number of filers might be

reduced.

Business filing under these options could be similar to the current system.

Sole-proprietorship income could be included with individual tax returns.

Partnerships could continue to file information returns, and partners

would report their share of the income earned by the partnership on their

individual returns. Depending on the type of corporate integration reform

adopted, corporations would either pay tax separately or file

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Appendix IV 

Income Tax Reform Options

partnership-like information returns that allocate corporate income to

shareholders.

The number of information returns would be greater than under the

current system if such reporting were extended to newly taxable income.

Currently, interest on tax-exempt bonds is not subject to information

reporting like taxable interest income; information reporting might be

extended to all forms of interest income. The value of fringe benefits

received by employees and income earned in pension fund reserves could

also be reported.

In contrast to the individual tax options, the number of individuals filing

returns could fall under the CBIT. Rather than increasing the number of

types of income subject to tax at the individual level, the CBIT would

reduce the number of types of income reported by individuals to wages

and certain capital gains, and other forms of income would be taxed at the

business level. Therefore, individuals whose income is limited to interest,

dividends, and small amounts of wage income would not have to file

returns. If taxes continued to be withheld on wages, for many individuals

the amount of tax withheld could very closely match their annual tax

liability. As under the flat tax, a return-free filing system would be more

feasible.

Under the CBIT, all businesses, including sole proprietorships, would have

to file tax returns, withhold tax on wages paid to employees, and file

certain information returns. If interest on bonds issued by governments

and nonprofit organizations were made taxable, these entities would have

to file returns and remit tax on interest on any debt they had issued.

Governments and nonprofit organizations would also have to withhold tax

on wages paid to employees. However, businesses, governments, and

nonprofit organizations would not have to file information returns for

interest or dividend income.

An income VAT could reduce the number of tax returns still further.

Businesses, governments, and nonprofit organizations would remit tax and

file returns, but no individual filing would be required. As a consequence,

information returns related to individuals’ receipt of interest or dividends

would not be needed.

Recordkeeping Under either of the individual income tax reform options, broadening the

tax base would both increase the need for recordkeeping in some areas

Page 94 GAO/GGD-98-37 Alternative Taxes
Appendix IV 

Income Tax Reform Options

and possibly decrease it in other areas. Eliminating various tax credits and

deductions in the current tax code would reduce individuals’ need to keep

records on these items. For example, broadening the tax base by

eliminating deductions for state and local taxes, charitable contributions,

health insurance payments, and large medical expenditures would

eliminate the need for taxpayers who now itemize deductions to keep

records on these expenditures.

However, broadening the tax base by taxing additional types of income

could lead to additional recordkeeping. For example, records might have

to be kept by individuals for interest income that is currently tax-exempt,

pension earnings, fringe benefits, and government benefits, particularly if

information reporting is not extended to these types of income. If owners

of assets were required to pay capital gains tax on increases in the value of

an asset, regardless of whether it was sold, they would have to obtain

information to determine or estimate the value of the asset. This

requirement would increase burden relative to the current tax, but the

need to keep records over long periods of time might be reduced because

capital gains from prior years would have already been subject to tax.

In some areas, however, including additional types of income might

eliminate the need to distinguish between different types of income,

reducing the need for recordkeeping. For example, currently taxpayers

must use separate accounts for IRAs and other saving. A reformed income

tax could treat savings more uniformly, eliminating the need for separate

accounts and the associated recordkeeping. Similarly, under current law,

interest expenses must be characterized according to many different rules

to prevent taxpayers from deducting interest expense from debt used to

generate tax-exempt income. A more uniform treatment of income may in

turn allow for a simpler, more uniform treatment of interest expense.

Although a more uniform treatment of all forms of income might require

more complicated rules for some forms of income, it might also reduce

incentives for tax planning and reduce the number of transactions

undertaken for tax reasons. For example, the Tax Reform Act of 1986

instituted some complex rules to reduce the attractiveness of tax shelters.

While complying with these rules may be burdensome and costly, if they

succeed in reducing the amount of resources used in structuring tax

shelters, the result might be that overall, fewer resources will be used

complying with the tax code and attempting to minimize tax liability.

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Appendix IV 

Income Tax Reform Options

If many of the tax preferences in the current tax code were eliminated and

if tax rules measured economic income more accurately, Congress might

conclude that the corporate or individual alternative minimum taxes (AMT)

were no longer needed. Under the AMT, taxpayers must account for a

number of items differently than they do for regular tax or financial

statement purposes. The requirements to keep two or more sets of records

for certain items and make special calculations might be eliminated if

Congress decided that an AMT was no longer needed after income tax

reform.12

The need for individuals and businesses to keep records under a reformed

income tax would also depend on the option chosen. For the individual

taxes, the integrated individual tax would require corporations to allocate

all their income to shareholders. This would likely lead to additional

recordkeeping, especially for widely held corporations whose

shareholders may have owned stock only briefly during a year. Integrating

the corporate tax by allowing a deduction for dividends might not

significantly complicate the tax system. Both integration plans would

reduce the need to distinguish between debt (for which interest payments

are currently deductible) and equity (for which dividend payments are

currently not deductible).

The CBIT option would reduce recordkeeping requirements for individuals.

Since taxes on wages could continue to be withheld, other forms of

compensation would be in effect taxed at the business level, and interest

and dividend income would not be taxable to individuals, individuals’

recordkeeping responsibilities would be limited to certain capital gains. If

the income tax base was also broadened to include fringe benefits,

businesses would need to keep records that identified business

expenditures that could be considered nonwage compensation of

employees because these expenses would not be deductible. The

distinction between debt and equity would not have to be made under the

CBIT because neither interest nor dividends would be deductible.

The income VAT would eliminate all recordkeeping for individuals. If the

tax base was broadened, all compensation would be nondeductible for

businesses, so records would not have to distinguish between forms of

compensation for income tax purposes. However, businesses would have

to distinguish between compensation and other expenses that would be

12Under the reformed income options that include a business-level tax and indexing, taxable income as

measured by tax rules would be different from income reported on financial statements. Congress

would need to decide whether an AMT was needed to ensure that corporations that reported income

to shareholders in a particular year also paid tax in that year.

Page 96 GAO/GGD-98-37 Alternative Taxes
Appendix IV 

Income Tax Reform Options

deductible. Businesses would not be required to withhold income tax on

wages; however, withholding for payroll taxes would still have to be done

unless the payroll tax was eliminated as a part of tax reform.

Calculations Required Both the introduction of indexing the tax base for inflation and taxing

capital gains on an accrual basis would affect the calculations required for

computing income tax liability. Under all the tax reform options we are

discussing, depreciation and inventories could be indexed. For the options

that tax capital gains or interest income at the individual level, these items

could be indexed as well. For individuals, indexation would make the

calculation of capital gains more complicated, and adopting a system of

taxing capital gains as they accrue could increase the frequency with

which capital gains calculations would need to be made. Indexing interest

income might add to individuals’ calculations unless it was actually done

for individuals by businesses or financial institutions. For businesses,

indexation would also increase the number of calculations required for

depreciation and inventories, and under some options for interest expense

deductions and interest income. These calculations are not done for

financial reporting purposes.

Under the CBIT option, individuals would have to make capital gains

calculations, but since interest income would not be taxable for

individuals, no indexing calculations would have to be made for interest

income. For businesses, inflation adjustments would be needed for

depreciation and inventories, but inflation adjustments for interest

expenses would not be needed because neither real nor nominal interest

expense would be deductible.

The income VAT would eliminate taxes on individuals, so no calculations

would have to be made by individuals. Businesses would also have fewer

calculations. The calculations for computing tax liability would be similar

to those for the CBIT except that calculations related to deductions for

wages and withholding tax on wages would not be needed for income tax

purposes.

Effects of Income Tax

Reform on Compliance

Costs

Joel Slemrod recently estimated potential compliance cost savings from a

reformed income tax similar to the integrated corporate income tax

option.13 The reformed income tax he described would simplify the

income tax base by eliminating itemized deductions except for the

13See Slemrod (1996), pp. 377-80, for further details.

Page 97 GAO/GGD-98-37 Alternative Taxes
Appendix IV 

Income Tax Reform Options

mortgage interest deduction; restricting business deductions for fringe

benefits; and ending the child care and elderly credit, the tax-exempt

status for interest on state and local government bonds, and savings

incentive programs like IRAs and Keogh plans. AMTs would be eliminated,

and a dividend credit would be established to integrate the corporate and

individual taxes. A 10-percent tax rate would apply to about 75 percent of

individual taxpayers, and withholding would be extended to interest

payments, making tax return filing unnecessary for many taxpayers.

Slemrod estimated that such reforms could reduce individual compliance

costs by at most 15 percent and business compliance costs by about

5 percent.

Potential Impact on

Tax Administrators

Table IV.5 shows some of the effects that various income tax options

could have on tax administrators, and a more detailed discussion of those

effects follows.

Table IV.5: Summary of Some Key

Potential Impacts of Income Tax

Reform Options on Tax Administrators

Item Current income tax Income tax reform options

Impact on number of

returns processed

Hundreds of millions of

returns and other materials

received

Individual taxes: Possibly

similar to current tax,

increased number of

information returns

CBIT: Fewer individual

returns and information

returns

Income VAT: No individual

returns or information

returns related to individuals

Impact on refund

processing

92 million refunds issued in

fiscal year 1995

Individual taxes: Possibly

increased if no withholding

on other forms of income

CBIT: Possibly fewer

refunds with more accurate

withholding

Income VAT: Individual

refunds eliminated

(continued)

Page 98 GAO/GGD-98-37 Alternative Taxes
Appendix IV 

Income Tax Reform Options

Item Current income tax Income tax reform options

Impact on examination

approach

Tax returns matched with

information returns; fiscal

year 1995 examination

coverage at 1.36 percent,

with corporate audits taking

longer than individuals’

audits

Individual taxes: Similar to

current system; audits and

matching information

returns with individual

returns

CBIT: Scope of individual

examinations, matching

reduced

Income VAT: Examination of

businesses only

Continuation of old

compliance problems

Compliance problems

related to income definition,

unreported income, and

more specific issues

identified in areas such as

transfer pricing,

depreciation, deductibility

of business expenses, small

businesses, independent

contractors, and the

underground economy

All options: Compliance

problems continued with

unreported business

income, deductibility of

business expenses,

depreciation, small

businesses, transfer pricing

Resolution of old

compliance problems

Not applicable All options: Compliance

issues for some deductions,

credits eliminated; debt

versus equity distinction

reduced in importance

Creation of new

compliance problems

Not applicable All options: Indexing

calculations 

Individual taxes: Accrual of

capital gains, reporting of

additional income items

CBIT: Capital gains only

Impact on collections from

tax delinquents

Millions of taxpayer

delinquent investigations

and accounts disposed of,

with most of the latter being

for individuals and most

business dispositions

covering employment taxes

Individual options: Possibly

increased if more

balance-due returns

CBIT: Fewer delinquent

accounts for individuals

Income VAT: Individual

accounts eliminated

(continued)

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Appendix IV 

Income Tax Reform Options

Item Current income tax Income tax reform options

Impact on individuals’

questions received

Millions of taxpayer

inquiries fielded, covering a

wide variety of questions

Individual taxes: Most

questions continued and

new questions added

CBIT: Many questions no

longer applicable

Income VAT: Only

questions related to

business remain

Source: GAO analysis of available information about income tax options.

Processing of Returns The individual tax reform options, combined with a broadened income tax

base, would have several effects on the need to process returns.

Broadening the tax base by adding income items would lead to some

additional line items and perhaps some additional schedules and more

information returns. These changes would, by themselves, increase

returns processing workloads. However, the elimination of some

deductions, adjustments, and tax credits would eliminate some line items,

reducing the workload. In addition, if added revenue from a broadened tax

base were used to increase the standard deduction, the number of

taxpayers required to file could decrease, which would also reduce the

processing workload.

The CBIT option would be more likely to reduce returns processing

workload because the number of individual tax returns could be reduced,

the individual tax return would contain fewer line items, and fewer

information returns might be needed. While taxing additional types of

income, such as accrued capital gains, could generate additional schedules

and information returns as mentioned above, other types of income, such

as interest and dividends, would no longer be reported on individual

returns. Information returns for these types of income would not be

needed, so the need to process them and match them with tax returns

would be eliminated.

An income VAT would have the most significant impact on the returns

processing workload because individual returns and most information

returns would be eliminated. Returns would need to be processed for

businesses (approximately 24 million in 1995) and nonprofit organizations

and government entities.

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Appendix IV 

Income Tax Reform Options

Noncompliance and

Enforcement

Income tax reform, like the other tax reform alternatives, could resolve

some compliance and enforcement issues, create some new issues, and

leave some issues unresolved. In general, issues concerning the

measurement of income from saving and investment would remain

because the reforms would continue to tax this income. As under the

consumption tax alternatives, unreported sales or income would remain

an issue for tax administration, as would separating deductible business

expense from personal consumption in areas like automobile use and

meals and entertainment deductions. Issues involving differential

treatment of some types of capital income would be resolved, although the

added calculations used to uniformly measure capital income would have

to be checked.

Under any of the income tax options, a broadened tax base would

eliminate some administrative tasks but create others. The elimination of

some credits and deductions would simplify administration. Because

mortgage interest is the only deduction currently covered by information

reporting, the elimination of other deductions would not reduce the need

to match information returns with tax returns, but would reduce the need

to audit tax returns. However, taxing some additional types of income

would increase administrative tasks. Some types of income such as

currently tax-exempt interest income and pension income could be subject

to information reporting, so the identification of underreporting of these

types of income could result from matching. To identify unreported or

underreported accrued capital gains, audits would be necessary unless

information returns were filed for owners of assets, not just for the sellers

of assets as is done currently.

As under the current tax, issues involving the calculation of income from

saving and investment would remain because the tax base would include

these types of income. The capitalization or deductibility of business

expenses, contentious in cases where it is difficult to determine whether a

business expenditure creates an asset for the business, would likely

remain an issue for tax administration. However, issues that arise because

of differences in the tax treatment of certain types of income from saving

and investment may be reduced because this income would be treated

more uniformly. For example, checking that the rules and limitations on

IRA, 401(k), and pension accounts had been followed would not be

necessary.

Under all the income tax options, as well as all the alternative

consumption taxes, identifying unreported or underreported amounts

Page 101 GAO/GGD-98-37 Alternative Taxes
Appendix IV 

Income Tax Reform Options

would remain a major concern for tax administration. Issues involving

consumption in a business, as under consumption taxes, also would

continue under any reformed income tax.

The CBIT and income VAT options would simplify examination by

eliminating the need to verify many types of income for individuals. Under

the CBIT, the compliance of individuals could be checked largely through

information return matching on wages. Identification of certain capital

gain income would also be necessary, as would the verification of filing

status and the proper number of dependents. However, the identification

of other forms of income and verification of deductions would not be

needed, and administrators could focus relatively more attention on

business returns. Under an income VAT, clearly all examination and

compliance efforts would involve business returns.

Collections As under the current income tax, under any of the reform options, there

would likely be taxpayers who do not file returns or who file but do not

pay the correct amount of tax. Under the individual income tax options,

the number of such balance-due or delinquent accounts might increase for

two reasons. First, if withholding is generally limited to wages as it is

currently, the amount withheld might not be as close to the actual tax

liability because additional types of income would be subject to tax.

Second, some of the types of income that might be taxed under a reformed

income tax, such as accrued capital gains, are not received as cash. Unless

individuals carefully adjusted their withholding to take this additional

income into account, more individuals might have to pay tax when they

filed. These individuals might not pay the correct amount or might not file

if they do not have cash available to pay the tax. However, if a broadened

income tax was accompanied by lower tax rates, some individuals who

have difficulty paying their tax liability currently might be able to pay the

tax they owe.

Collections activity might fall under the CBIT option simply because fewer

individuals would be liable for tax and, for individuals, fewer types of

income would be subject to tax. As noted in appendix II, in 1995, about

two-thirds of delinquent accounts were individual accounts. Under the CBIT

option, tax withheld on wages might closely match actual tax liability,

especially for taxpayers without capital gains income. An income VAT

would do away with individual payments; businesses would be responsible

for remitting all tax. Therefore, collections activity would be focused on

business tax liability.

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Appendix IV 

Income Tax Reform Options

Taxpayer Services In terms of taxpayer calls to IRS for assistance, most calls now received

concern procedural issues, refunds, notices, and other account

information. Additional calls concern filing status, dependents, and

exemptions. The extent to which this assistance would still be needed

under the various reform options would depend on the number of

individual taxpayers filing returns under each option.

The tax reform options would likely generate additional demand for

taxpayer services and education in the areas of indexation (how to make

adjustments for inflation) and calculations of accrued capital gains. On the

other hand, some currently asked questions concerning pensions and

deferred compensation and individual adjustments and deductions might

no longer be asked if the tax base was broadened to tax income more

uniformly.

Other Issues

Transition Issues While transition issues would likely arise from any type of tax reform,

some issues that could be particularly significant in a transition from the

current tax to a consumption tax might not be as significant under income

tax reform. The tax treatment of existing business assets, a significant

issue in transition to a consumption tax, would not be as significant an

issue for income tax reform. For example, indexing depreciation

deductions for inflation would be a less significant change than adopting

expensing as under most of the consumption taxes. Existing business net

operating loss carryforwards could continue with a new system.

Some other transition issues raised by income tax reform could be

significant and could create administrative problems. If pension income

were made taxable and if the old treatment was maintained for existing

pension assets, taxpayers would have to segregate old from new accounts,

and administrators would have to check these accounts. Individuals

receiving dividends could receive a windfall gain if dividend taxes were

eliminated or if dividend deductibility was granted; again maintaining the

old system for current equity shares would be difficult. Under the CBIT

option, ending the deduction for interest at the corporate level and ending

the taxation of interest at the personal level is an issue that could be

handled through tax rules or might be ignored if it was thought that the

private sector would renegotiate the terms of the debt.

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Appendix IV 

Income Tax Reform Options

Federal/State Issues Currently, 38 states and the District of Columbia levy income taxes that

conform to some degree with the federal income tax. Many states also rely

on federal enforcement efforts and information to administer their income

taxes.14 If the federal income tax were changed, the states could make

adjustments in their income taxes to conform to the reformed federal tax.

Under the income tax options that include an individual-level tax, the

states that now follow the federal tax could continue to tax individual

income and rely on federal administration efforts. The inclusion of

additional income items could expand state and local income tax bases if

those governments chose to conform with the federal tax base. On the

other hand, under the CBIT or income VAT, the ability of states to tax

individual income would be reduced, as would be the case with the VAT,

national RST, or flat tax, because much of the information, such as

information returns, that are currently used to administer the federal

individual income tax would no longer be available.

International Issues Under the current income tax, the income of U.S. citizens and

corporations is subject to tax wherever it is earned—that is, income is

taxed on a worldwide basis. Income earned abroad may also be taxed by

foreign governments, so the United States provides a limited credit for

foreign income taxes paid (the foreign tax credit) to prevent double

taxation. Income earned in the United States by foreign corporations and

foreign residents is also taxed, and withholding taxes are levied on certain

interest and dividends paid to foreign investors. These withholding taxes

are commonly reduced through income tax treaties with foreign

governments.15

Under current law, income earned abroad by U.S. corporations may not be

subject to U.S. tax until it is distributed to the United States (repatriated).

However, taxpayers’ ability to defer tax by retaining income abroad is

limited for some types of income by the so-called subpart F rules. If

income tax reform included taxing accrued capital gains for domestic

assets, it would be consistent to tax all types of income earned abroad

when they are earned rather than when repatriated. The current rules to

limit deferral are considered complex, but extending these rules might

reduce tax planning by treating different types of income uniformly, might

14Joint Committee on Taxation, Impact on State and Local Governments and Tax-Exempt

Organizations of Replacing the Federal Income Tax (JCS-4-96), Apr. 30, 1996, pp. 6-8.

15For a summary of U.S. international tax rules and policies, see Hugh J. Ault and David F. Bradford,

“Taxing International Income: An Analysis of the U.S. System and Its Economic Premises,” in Assaf

Razin and Joel Slemrod, eds., Taxation in the Global Economy, (Chicago: University of Chicago Press,

1990).

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Appendix IV 

Income Tax Reform Options

simplify the foreign tax credit, and might reduce transfer pricing

controversies for U.S. corporations with foreign operations.16

For foreign corporations operating in the United States, transfer pricing

would likely continue to be a difficult area for taxpayers and tax

administration as long as the U.S.-source income of these corporations is

taxed. A related policy issue would arise regarding whether the benefits of

corporate tax integration should be extended to foreign corporations and

investors automatically or through treaty. The integrated individual tax

option (by eliminating the corporate-level tax) and the integrated

corporate tax (by allowing a deduction for dividends) would pass

integration benefits to foreign shareholders automatically. On the other

hand, the CBIT and income VAT options would retain a corporate-level tax

and replace an explicit withholding tax on certain distributions to

foreigners with implicit withholding through the nondeductibility of

interest and dividends.17

16For further details, see U.S. Department of the Treasury, International Tax Reform: An Interim

Report (Jan. 15, 1993).

17In its report on corporate tax integration, the Treasury recommended integration options that did not

automatically pass benefits to foreigners because these provisions might simply transfer tax revenue

from the United States to foreign governments. See Treasury (1992), Ch. 7, for a detailed discussion of

international issues regarding corporate tax integration.

Page 105 GAO/GGD-98-37 Alternative Taxes
Appendix V 

National Retail Sales Tax

Description As the name implies, a retail sales tax (RST) is levied on the retail price of

goods or services sold to final consumers. The tax is familiar to most

Americans, originating in many states in the 1930s and now found in 45

states, the District of Columbia, and thousands of local tax jurisdictions.

The federal government currently administers excise taxes, which are

related to an RST, but differ from it in important respects.1

 Few

industrialized countries have attempted to institute a nationwide RST,

although many have adopted the related value-added tax (VAT).

Some proponents of a national RST have suggested that it should be

administered primarily by the states. One reason for this is that states have

already identified and registered many businesses selling to final

consumers. In addition, they might be able to expand their existing

systems with less effort devoted to fundamental retraining and systems

development because of their experience in administering sales taxes.

Even if states became the primary administrators, the federal government

could be required to coordinate and audit the states’ programs, administer

any taxes not replaced by the national RST, and act as the primary

administrator in the five states without sales tax systems and in other

states that do not agree to be the primary administrator.

As illustrated in table V.1, a national RST would be a consumption tax

because it is collected only on goods and services that are consumed. Only

business elements are addressed because individuals generally have no

filing responsibilities under an RST, although they typically pay the taxes

collected by businesses on sales of goods and services.

1

Unlike an RST, excise taxes are levied on relatively few items; generally, they apply to preretail stages

of production or distribution and do not exempt business purchasers in those cases where they are

applied to retail sales (such as the communications services tax).

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Appendix V 

National Retail Sales Tax

Table V.1: Treatment of Businesses

Under a National RST Compared With

the Current Income Tax

Tax base element Current income tax National RST

Sales of goods and services Included Included (retail sales only)

Sales of business assets Gain included Not included

Sales of financial assets Gain included Not included

Loans and new stock issues Not included Not included

Purchases of goods and

services for business use

Deducted Not included

Purchases of capital goods Depreciated over time Not included

Wages paid Deducted Not included

Fringe benefits Deducted Not included

Interest paid Deducted Not included

Dividends paid Not deducted Not included

Source: GAO analysis of state and proposed national RSTs.

Based on recent proposals, a national RST might replace, rather than

supplement, existing federal income, gift, estate, and excise taxes, which

together yielded about $805 billion in fiscal year 1995. Raising these

revenues under a national RST would require a relatively high tax rate

compared with state RST rates, which generally range from 3 to 7 percent,

except for higher rates on selected items in some states.2

 Taxing most or

all personal consumption, which totaled $4.9 trillion in 1995, would tend to

reduce the required tax rate. However, such a tax might encompass retail

categories generally excluded under state systems, including housing,

medical care, financial intermediation, and other services. A narrower tax

base that excludes certain categories, transition rules to deal with

preenactment savings, or tax rebates would tend to increase the required

rate.

National RST Design

Features

Administration of a national RST would be distinguished from the income

tax by a fundamentally different tax collection mechanism. Under an RST,

businesses collect taxes from retail consumers and periodically send their

collections to the government. Unlike the income tax, individuals generally

have no tax reporting responsibility, although, as with other taxes, they

are the actual taxpayers. An RST’s complexity and its impact on

administrative and compliance burdens depend on the extent of its tax

base exemptions and exclusions. One type of exemption—items

purchased for use in a business—would be required to avoid the

2

Proponents have suggested that a rate of 15 to 17 percent would be required in a national RST,

assuming a broad-based tax.

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unintended economic effects that result from taxing not only goods and

services sold at retail but also the costs of producing those goods and

services.

Without a mechanism to obtain information on individuals, a national RST

could not incorporate exemptions or credits based on personal or family

status.3

 Ways of modifying an RST’s tax base have instead included

statutorily excluding or exempting certain goods and services or business,

nonprofit, or government purchasers. Some states also levy reduced sales

tax rates on certain goods or services, such as motor vehicles or certain

production goods. As noted in Treasury’s 1984 tax reform report, multiple

rates introduce administrative complexities similar to those discussed

below for exemptions.4

 Another approach, using automatic rebates to in

effect exclude a certain level of individual purchases, has been proposed

at the national level.

Most states exempt designated goods and exclude sales of real estate and

a wide range of services, including medical, legal, and financial services,

although three states—New Mexico, South Dakota, and Hawaii—tax both

goods and services broadly. Almost all states exempt certain business

purchases, and most exempt sales to government and nonprofit

organizations. Vendors apply exemptions at the point of sale based on

their understanding of the exemption criteria for designated goods and

services, or evidence, in the form of an exemption certificate, of a

purchaser’s exempt status.

In theory, according to various descriptions of sales taxes, RST systems

need to exempt valid business purchases if they are to avoid the

unintended economic effects of tax pyramiding and not tax capital

income. Pyramiding occurs when a sales tax is applied to business

purchases of items intended for resale or used in the production of retail

products, and then applied again to the final retail sale. It results in a

preretail tax component that is not visible to consumers and that varies, in

an unintended manner, depending on how a product is developed. Total

taxes applied to an item would increase with the number of intercompany

transactions involved in its development, resulting in a competitive

advantage for firms that consolidate production and distribution

3

In theory, some personal exemptions could be administered under an RST using technology such as

computerized identification cards, which might be encoded with an individual’s age or disability status

and applied at the point of sale.

4

See U.S. Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth, Vol.

1 (1984), p. 217.

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operations internally. Likewise, imported goods whose inputs are not

taxed would have a tax advantage over domestically produced goods.

State RSTs result in significant pyramiding because business exemptions

are often limited to items purchased for resale or directly incorporated

into final products. Other business and production costs—such as fuel,

utilities, and various business services—are taxed in many states.

Another aspect of a national RST is that it would tax retail purchases by

foreigners in this country and could also be assessed on U.S. citizens’

foreign purchases that are used or consumed in this country. The latter

feature would parallel “use” taxes under some state RSTs, which apply to

out-of-state purchases used or consumed in the purchaser’s state of

residence.

National RST Versus VAT:

Similarities and

Differences

A national RST and credit VAT with the same tax base and a common rate

would appear identical to final consumers, provided that both were

itemized on sales invoices. Moreover, given identical compliance rates,

they would yield the same amount of revenue. They differ primarily in

their methods of avoiding tax pyramiding. An RST depends on the use of

exemption certificates that businesses provide to their suppliers, whereas

a VAT allows businesses to credit taxes paid on their purchases against the

taxes collected on their sales. A VAT appears to offer an administrative

advantage for exemption of business purchases because it requires

businesses to maintain purchasing records supporting their claimed

credits and thereby provides an audit trail for verifying these claims.

Under a national RST, by contrast, auditors might need information from all

of a business’ suppliers, who retain exemption certificates to document

their own tax-exempt sales.

An RST also concentrates the entire tax collection burden on businesses

selling to final consumers, while a VAT spreads collections across a broader

range of businesses. Some commentators maintain that a national RST

would therefore be more susceptible to noncompliance because many

vendors are small businesses, which have been relatively noncompliant

under the current income tax. Enforcement efforts under a national RST,

however, could be focused on a somewhat smaller population of filers,

excluding businesses that do not sell at retail.

In addition, businesses under a credit VAT might be less likely to

underreport their sales, knowing that another business is likely to keep

records of the sale to support its claimed credits. However, this

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“self-enforcing” mechanism, which does not exist in an RST, also does not

apply to the retail sales stage of a VAT, since final consumers are not

eligible for credits and are generally not required to keep records of their

purchases. Another purported enforcement advantage of a credit VAT is

that it provides greater incentives for businesses to file in order to claim

credits on their purchases.5

 However, this argument does not apply with

equal weight to some businesses—such as some small service

providers—who make minimal purchases from other businesses.

Potential Impact on

Taxpayers’

Compliance Burden

A national RST replacing the income tax would reduce the number of

entities filing returns. Compliance burdens would depend on the system’s

design, particularly the extent of exemptions provided and degree of

consolidation with state systems, and might in some circumstances fall on

individuals as well as on business filers. Some of the ways in which an RST

might affect businesses are summarized in table V.2, followed by

additional information on these and other considerations.

5

See Bruce Bartlett, “Replacing Federal Taxes With a Sales Tax,” Tax Notes, Vol. 68, No. 8 (Aug. 21,

1995), p. 1001; and Charles E. McLure, Jr., “State and Local Implications of a Federal Value-Added

Tax,” Tax Notes, Vol. 38, No. 13 (Mar. 28, 1988), p. 1520.

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Table V.2: Summary of Some Key

Potential Impacts of a National RST on

Business Taxpayers

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of a national RST

on business taxpayers

Return filing 24 million returns filed in

1995

Vendors the only

businesses to be included

Records kept Records supporting income

and expenses supposed to

be kept

Records of sales and

exemptions needed but not

records for items such as

depreciation

Calculations made Complicated calculations

included for provisions such

as depreciation, the

alternative minimum tax,

and the foreign tax credit

Calculations for

depreciation, alternative

minimum tax, and the

foreign tax credit not

needed; state return forms

require calculation of net

taxable sales

Complexity faced Detailed rules involved;

complexity reflected in

areas such as depreciation,

the alternative minimum tax,

and the foreign tax credit;

difficulties existing in

defining and recognizing

income

Rules for characterization

and timing of income, and

items such as depreciation,

the alternative minimum tax,

and the foreign tax credit

eliminated, but determining

exemptions and multiple

sales tax rates and

harmonizing with state

systems possibly added

Requirement to furnish

information returns

1.1 billion information and

withholding documents filed

Information returns

generally eliminated

Source: GAO analysis of available information about state and proposed national RSTs.

Number of Tax Filers A national RST that exempted business purchases would limit routine filing

requirements to vendors—that is, entities selling to final consumers. Thus,

the number of filers would be less than the 24 million businesses that filed

income tax returns in 1995 and a fraction of total filers. Below this upper

limit, the actual number of filers under a national system would depend on

its design. The number would decrease to the extent that vendors in some

industries are excluded from the tax base—for example, most states

exclude many service providers. However, the number would increase

somewhat if the system required a separate return from each outlet of

multilocation retailers.6

 Many states allow consolidated filing but require

location-specific data.

6

Census data indicate that the number of outlets of retail companies exceeded the number of retail

companies by about 20 percent in 1992, although some of these additional outlets may already be filing

separate returns.

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Estimation of potential filers under a national RST is also hampered by

limited data on the number of businesses acting as vendors. IRS classifies

business returns into one of nine industrial sectors based on their primary

business activity, as shown in table V.3. However, the classification

generally does not distinguish vendors from nonvendors, except in the

retail sector, which is limited to vendors by definition, and the service

sector, which primarily consists of vendors except for a “business

services” subsector.7

 Together, these sectors, excluding business services,

represent roughly 10 million potential filers under a national RST. The

number of retail vendors in other sectors is unknown but potentially large.

The construction sector, for example, includes general contractors as well

as self-employed plumbers and electricians who might serve either final

consumers or businesses, or both. Even manufacturers might maintain

retail outlets as a secondary activity not captured under IRS’ current

classification system.

Table V.3: Income Tax Returns by Business and Industry Category as of 1993

Business category

In thousands

Industry group Sole proprietorships Corporations Partnerships Total

Retail goods 2,444 729 134 3,307

Services 7,718 1,158 256 9,132

[Business services

subgroup]

[1,820] [349] [51] [2,219]

Construction 1,927 417 62 2,406

Finance, insurance, and

real estate

1,273 641 793 2,707

Transportation and utilities 711 176 21 908

Agriculture, forestry, and

fishing

2,425a 141 120 2,686

Mining 124 35 32 191

Wholesale trade 416 338 19 773

Manufacturing 472 307 25 805

Not allocable 265 21 7 293

Total 17,776 3,965 1,468 23,208

Note: Totals do not add because of rounding.

aIncludes 1.9 million farmers filing Schedule F with their Form 1040.

Source: IRS Statistics of Income published data.

7

The business services subsector includes advertising, janitorial, photocopying, and other services

provided to business purchasers.

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As with corporate tax revenue, most RST revenue could come from

relatively few businesses. Based on IRS data, in 1992, corporations and

partnerships took in about 86 percent of the business receipts in the retail

and service sectors, and 80 percent of this amount was taken in by about

286,000 entities. In addition, as shown in table V.3, corporations and

partnerships comprised only about 18 percent of the businesses in these

sectors. This concentration is consistent with the states’ experience—New

York and California, for example, derive about 90 percent of their sales tax

revenues from 10 percent of their filers.

Compliance Burdens A national RST replacing the income tax could eliminate many existing

recordkeeping and filing burdens and introduce a different set of

requirements focused on vendors. Taxpayers would no longer need to

cope with complex tax provisions such as those associated with the

characterization and timing of income, depreciation of business assets,

foreign tax credits, or calculation of the alternative minimum tax. And they

presumably could dispense with filing most existing information returns.

Under a national RST, vendors could be required to register as sales tax

collectors, collect taxes and apply any exemption criteria, retain

appropriate records, and file periodic sales tax returns. Except in some

circumstances, individuals would not need to maintain records or file

returns. Of course, taxpayer burdens would increase if a national RST

supplemented rather than replaced existing income taxes.

Vendor Burdens Vendors under a national RST would presumably face burdens similar in

nature to those encountered under state RST systems. A vendor’s initial

burden in state systems is completing a registration form, which is

generally one or two pages long and identifies the business, its nature,

owners, and level of expected sales. Only registered vendors are permitted

to act as the state’s collection agents or, in some states, obtain the

exemption certificates required to make tax-free business purchases. The

states are about evenly split on allowing consolidated registration versus

requiring each outlet of multilocation businesses to register separately.

One of a vendor’s major compliance efforts is that needed to interpret and

apply exemption criteria when collecting taxes at the point of sale. This

task often falls on the cash register operator, who, for example, may need

to distinguish the appropriate tax treatment of marshmallows in a state

that exempts small marshmallows as food but taxes large marshmallows

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as candy.8 The register operator must also obtain exemption certificates

from exempt purchasers. In many states, vendors must check the

reasonableness of claimed business exemptions to avoid liability for the

uncollected taxes when exemption certificates are misused.

Vendors’ recordkeeping requirements also depend on the extent of an RST’s

exemptions. To substantiate exempt and taxable sales, vendors must

retain exemption certificates accepted in addition to sales invoices. Some

states require vendors to use a system matching each exemption

certificate to its related sales invoice.

Costs of complying with a national RST are unclear. Vendors’ cost of

complying with state systems in 1990 averaged about 3.5 percent of

revenues collected, according to a study sponsored by the American Retail

Education Foundation.9

 Converting this percentage to dollars, adding an

amount for compliance costs related to service transactions, and factoring

in an increase in inflation-adjusted retail sales, one author estimated 1996

compliance costs for a particular national RST to be about $8 billion.10

According to another author, because a national RST rate would have to be

substantially higher than current state RST rates, incentives to evade taxes

would increase. Retailers would have to be increasingly vigilant in

distinguishing between taxable and exempt items and between retail sales

and sales to companies.11

The effort required to prepare sales tax returns is influenced by filing

frequency and the type of information required. Filing intervals in most

states depend on a vendor’s sales volume, generally ranging from monthly

for the largest to semiannually or annually for the smallest. Intervals are

shorter for large filers to minimize forgone interest and the size of

potential losses in delinquent accounts. Most states use one- or two-page

return forms, although the number of line items on the forms ranges

8

Scanning cash registers used by some businesses can be programmed to recognize exempt items and

thereby reduce the burden on register operators.

9

Price Waterhouse, Study to Estimate the Cost of Collecting State and Local Sales and Use Tax

(Washington, D.C.: Aug. 30, 1990).

10See Arthur P. Hall, “Compliance Costs of Alternative Tax Systems,” Tax Notes, Vol. 71, No. 8 (May 20,

1996), pp. 1088-89.

11Joel Slemrod, “Which Is the Simplest Tax System of Them All?” in Henry J. Aaron and William G.

Gale, eds., Economic Effects of Fundamental Tax Reform (Washington, D.C.: Brookings Institution

Press, 1996), pp. 368-70.

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widely, depending on whether itemization of exempt sales is required.12

For example, Connecticut devoted 56 lines to itemizing nontaxable

transactions in 1995. However, some states limit their return forms to 10 to

12 lines by summarizing exempt sales under one line item. Aside from

address and subtotal lines, the following basic items are required on state

returns:

• gross sales,

• total deductions,

• net taxable sales,

• tax due,

• penalty due, and

• interest due.

Some states have begun to implement electronic or telefiling systems,

which could ease some filing burdens.

Added Difficulty of Complying

With More Than One RST

A national RST would increase vendors’ compliance burdens beyond those

associated with state RSTs to the degree that state and federal tax bases

and administrative requirements differed. The current difficulties

associated with state exemptions would be compounded if the federal

system introduced additional tax base exemptions or defined exempt

categories differently. Differences in filing intervals, penalties, appeals,

and other administrative procedures could also entail added confusion and

compliance costs.

Potential Burdens on

Individuals

Some compliance burdens could extend to individuals as well as

businesses, depending on how a national RST is structured. For example,

taxpayers may need to keep records in some circumstances if provisions

are included to tax real estate or items purchased in foreign countries but

consumed in the United States or to relieve sales taxes when savings

already subjected to the income tax are spent on goods and services. Also,

if instead of receiving automatic rebates as has been proposed at the

national level, individuals had to apply for them, as has happened at the

state level, they would face a new compliance burden.

Potential Impact on

Tax Administration

The states’ experience indicates the types of administrative processes and

hurdles that might apply to a national RST. Administration in the states

includes identifying and registering vendors and returns processing,

12Many lines are also allotted for local tax allocations in some states that collect taxes for local

governments.

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enforcement, collection, and taxpayer service functions. Within these

functions, administrative procedures and potential hurdles differ

somewhat from those of the income tax. Some key administrative

differences are highlighted in table V.4, followed by additional information

on these and other considerations.

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Table V.4: Summary of Some Key

Potential Impacts of a National RST on

Tax Administrators

Item Current income tax National RST

Impact on number of

returns processed

Hundreds of millions of

returns and other materials

received

Returns simplified and

number of filers

substantially reduced,

although filing likely more

frequent

Impact on refund

processing

92 million refunds issued in

fiscal year 1995

Refunding of overpayments

required and possibly

rebates to consumers

Impact on examination

approach

Tax returns matched with

information returns; fiscal

year 1995 examination

coverage at 1.36 percent,

with corporate audits taking

longer than individuals’

audits

In states, verifying taxable

and exempt sales

emphasized

Continuation of old

compliance problems

Compliance problems

related to income definition,

unreported income, and

more specific issues

identified in areas such as

transfer pricing,

depreciation, deductibility

of business expenses, small

businesses, independent

contractors, and the

underground economy

Compliance problems with

business expenses,

independent contractors,

underreporting, and

underground economy

continued; small

businesses problematic

Resolution of old

compliance problems

Not applicable Compliance problems with

characterization and timing

of income, depreciation,

and transfer pricing resolved

Creation of new

compliance problems

Not applicable Noncompliance risk raised

by possibility of high rates,

lack of withholding and

information reports, and

exemptions

Impact on collections from

tax delinquents

Millions of taxpayer

delinquent investigations

and accounts disposed of,

with most of the latter being

for individuals and most

business dispositions

covering employment taxes

Delinquencies problematic,

particularly if rate relatively

high and businesses

tempted to use tax

collections as working

capital

Impact on individuals’

questions received

Millions of taxpayer

inquiries fielded, covering a

wide variety of questions

Number of inquiries

reduced by large reduction

in number of filers

Source: GAO analysis of available information about state and proposed national RSTs.

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Registration of Vendors Administrators of a national RST might need to obtain certain information

on millions of businesses to identify expected filers and their filing

deadlines and those who file late or not at all. To this end, the states have

required businesses to provide certain information in registration

applications, as noted above. Many states attempt to identify unregistered

businesses by matching their registration files against alternative business

listings, such as telephone directories or local licensing records. Some

states use the registration system to attempt to limit misuse of business

exemption certificates. For example, New Mexico issues such certificates

only to registered vendors who apply for them and includes vendor

identification numbers on the certificates to provide a means for tracking

their use.

National administrators might ground a database of potential vendors on

state registration files and prior income tax records. However, the state

information would omit many vendors—particularly in the service

sector—that might be included in a national tax base, and federal income

tax records might not provide enough information on the nature of a

business to determine whether it makes retail sales.13 In any case, some

mechanism would be required to identify and enlist new businesses arising

in the future.

Processing of Returns A national RST would presumably entail returns processing steps similar to

those followed by the states. Some state administrators send return forms

to registered vendors shortly before their filing deadlines, which can vary

in frequency from monthly to annually depending on their sales volume.

Other states provide an annual supply of forms in a return booklet.

Typically, once returns are filed, selected return data—often only gross

sales, total deductions, taxable sales, and tax paid—are transcribed into a

computer database. Some states use optical scanning equipment to

capture all return form details. The database is used to identify delinquent

filers, create accounts receivable listings, and select accounts for audit. A

few states have contracted with banks to receive returns and process

checks. At least one state, New York, has also contracted out the

transcribing of return data.

As with the income tax, significant administrative effort under a national

RST could be required to resolve late or unfiled returns, underpayments,

and other discrepancies. For example, according to a New York tax

13See Federation of Tax Administrators, Sales Taxation of Services: An Update (Washington, D.C.:

1994); and U.S. Department of the Treasury, IRS, “Application for Employer Identification Number,”

Form SS-4, revised Dec. 1995.

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official, about 7 percent of New York’s sales tax returns for tax year 1994

required administrative follow-up owing to discrepancies detected by

computer checks.

Refunding of overpayments is also required, but less frequently than under

the income tax, where excess wage withholdings are commonly refunded.

Sales tax refunds in the states can result from inadvertent overpayments

and amended returns. In Florida, according to its Department of Revenue,

about 2 percent of returns received annually resulted in refundable credit

balances, but almost all filers chose to apply the credit against their next

tax liability.

A national RST could involve a much larger and fundamentally different

refund program than is found in the states if, as has been proposed, the

system provides for automatic tax rebates to consumers. As proposed,

such rebates—designed to reduce the sales tax burden on low-income

consumers—would generally be provided to all wage earners by adjusting

the Social Security taxes withheld from their paychecks. Other provisions

would have to be made for the unemployed.

Enforcement Efforts The general audit procedures now used by the states could also apply at

the national level. However, a national enforcement program could face

noncompliance issues that differ somewhat in nature and severity from

those encountered under either the federal income tax or state RSTs.

Audit Procedures Compared to the income tax, audits under a national RST could be focused

on a much smaller population, basically limited to businesses. State sales

tax audits emphasize verification of a vendor’s total taxable sales.

According to state officials we contacted and sales taxation materials we

reviewed, auditors typically compare reported sales against sales noted in

a business’ accounting records and verify that untaxed sales for resale are

substantiated by exemption certificates obtained from purchasers. As a

secondary check on reported sales, auditors sometimes review sales

reported on income tax returns or use purchase records to estimate sales

volume. Auditors might also try to verify the proper use of an exemption

certificate, particularly if it appears questionable, by contacting the

purchaser who used it. Substantial audit effort is also devoted to checking

a vendor’s remittance of “use” taxes and collection of local taxes.14

Auditors might need to address similar issues under a national RST—that

is, vendors’ remittance of use taxes on foreign purchases, if not considered

14Most states also administer sales taxes imposed by local governments.

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exempt business purchases, and interstate vendors’ allocation of state

taxes. Those audited are selected based on a variety of criteria, including

sales volume, compliance history, results of computer data matches, and

random selection. In allocating audit resources, state administrators are

faced with a sharp disconnect between the incidence of

noncompliance—highest among small filers—and its potential revenue

impact—greatest among large filers. Audits of small vendors are less

resource-intensive, per audit, than those of large vendors, but they are

more often complicated by the filer’s failure to keep adequate tax records.

Enforcement Trade-Offs A national RST could raise some additional enforcement hurdles, compared

to the federal income tax, while reducing others. Because businesses

would no longer have the compliance burden of income tax withholding

and information reporting under a national RST, the absence of withholding

could tend to increase evasion opportunities, and the lack of information

reporting could tend to decrease the perceived risks of detection. In

addition, businesses would generally be responsible for remitting to the

government more tax revenue than currently if an RST replaced existing

individual and corporate income taxes.15 Small businesses in particular

have been relatively noncompliant under the current system and might be

tempted to use their collections as a source of business capital.

A national RST—particularly one with few exemptions—could, however, be

simpler than the current income tax because some existing sources of

complexity, such as correctly measuring capital income, would be

eliminated. A relatively simple tax could reduce intentional

noncompliance by limiting opportunities for willful evaders to claim

misunderstanding or ignorance of the rules. In that case, would-be evaders

might be deterred by a greater risk of facing the stiffer penalties associated

with intentional evasion. A simpler, clearer tax would also tend to reduce

unintentional noncompliance resulting from misinterpretation of the rules.

The income tax gap for large corporations, estimated at $24 billion for tax

year 1992, was largely attributable to tax code complexity and ambiguity

and illustrates the impact of these factors on noncompliance. In addition,

businesses under a national RST could face a greater likelihood of being

audited, if audit resources now devoted to individual filers were applied to

businesses.

The question of whether a national RST could be enforced to a greater

degree than the current income tax on participants in the underground

15Some large retailers who have little or no income tax obligation currently could be responsible for

collecting taxes on billions of dollars in retail sales under a national RST.

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economy also requires careful consideration. The answer appears to

depend on whether the registration system and associated enforcement

efforts would be more effective than IRS’ current nonfiler program at

identifying and enlisting legal enterprises operating outside the tax system.

Illegal enterprises, however, might tend to escape identification if, for

example, their identification depended on cross-matching registration files

against licensing records and business directories.

One argument holds that a national RST would inherently capture more

underground revenue than the income tax, because underground vendors

who pay no income taxes would at least pay taxes on their purchases.

However, the tax collection point would switch from income to purchases

under a national RST. Purchases from underground vendors would be

untaxed under a national RST just as income from underground sales is

untaxed now.

Potential Noncompliance

Issues

The nature and severity of the noncompliance problems administrators

might encounter under a national RST would depend on its design,

particularly its tax rate and available exemptions. We found little data

quantifying noncompliance in the states, either in terms of rate of

occurrence or resulting revenue losses. Audit assessments, which do not

measure total noncompliance, accounted for 1 to 3 percent of sales tax

revenues in 22 of 28 states responding to a 1992 survey by the state of New

York.16 Noncompliance issues encountered in state sales tax audits include

those arising from a misunderstanding of system requirements as well as

intentional evasion.

Based on our, Treasury, and academic analyses, it appears that a relatively

high national RST rate would tend to increase evasion incentives and

associated administrative difficulties beyond those arising under state

RSTs, assuming the perceived risks of detection by administrators

remained constant. An RST also lacks certain deterrents to evasion found in

a credit VAT (see app. VI). Some commentators have suggested that the

resulting evasion would completely undermine a national system.17

However, we found no data allowing a quantified estimate of the impact of

higher RST rates on noncompliance. The impact on the incidence of

noncompliance would depend largely on the behavior of the more

16New York State Department of Taxation and Finance, Survey of State Sales Tax Compliance

Problems and Programs (Jan. 1993).

17See Joel B. Slemrod, “The Simplification Potential of Alternatives to the Income Tax,” Tax Notes, Vol.

66, No. 9 (Feb. 27, 1995), p. 1332; and Bartlett, p. 997.

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numerous small filers, while revenue effects would depend more on large

filers, who account for most potential revenues, as noted above.

Exemptions, such as for food or medicine, would add complexity and

ambiguity to a national RST and could lead to both unintentional and

intentional noncompliance. Vendors might inadvertently misapply an

exemption to an item that fell in a gray area under the statutory criteria.

For example, cashiers might face a decision on how to identify products

with medicinal value if nonprescription drugs were exempt. In other cases,

some business purchasers have intentionally misused their exemption

certificates to acquire items for personal use, and some sellers have

falsified certificates to inflate their apparent exempt sales. A study by the

state of Florida estimated that about 5 percent of tax-free business

purchases involved abuse or misuse of business exemption certificates,

based on a sample limited to selected business sectors.18

Under a national RST, a relatively high tax rate could increase incentives

for business exemptions abuse. For example, according to the Florida

Department of Revenue, “paper” businesses might be created solely as a

means of obtaining business exemption certificates and avoiding taxes on

purchases intended for personal use. Another potential difficulty is

controlling the use of business exemptions for business purchases of

services, as state experience indicates that distinguishing business

purchases of services from personal purchases can be difficult. Also,

business exemptions might be used to purchase tax-free fringe benefits for

employees in lieu of an equivalent amount of wages, raising an issue now

encountered under the income tax. This would tend to reduce the effective

tax base inasmuch as the benefits would have been taxed if purchased

directly by the employee.

While a broad-based national RST could limit the noncompliance

associated with exemptions, it could also complicate administration by

involving more service providers, including many independent

contractors, who have been particularly noncompliant under the current

income tax. State RSTs do not broadly tax service providers. However,

small vendors, particularly those operating on a cash basis, account for a

large share of the noncompliance incidents detected with some state RSTs.

Noncompliance among small vendors may be associated with state

findings that they more often fail to keep adequate records of their taxable

and exempt sales. Small vendors have also been known to use their tax

18Florida Department of Revenue, Examination of Resale Abuse/Misuse: Summary of Findings

(June 1994).

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Appendix V 

National Retail Sales Tax

collections as a source of business capital, even though the amount held in

trust currently is relatively small compared with what it would be under a

higher national rate. They may then go bankrupt or otherwise fail to repay

the “borrowed” collections.

Although small vendors could be responsible for a relatively small share of

total taxable sales, their noncompliance might nonetheless cause

significant revenue losses if it occurred frequently enough. Under the

current system, IRS estimated in 1996 that noncompliant sole

proprietorships were responsible for about $29 billion of the gross

individual tax gap for tax year 1992. Further, IRS estimated in 1993 that sole

proprietorships for tax year 1987 paid less than half their self-employment

tax liabilities.

Some administrative and compliance burdens, however, could be reduced

under a broad-based national RST that included the service sector. For

example, the requirement in many states to distinguish between untaxed

repair labor and taxable repair parts would not apply at the federal level if

repair services were taxed the same as repair parts.

Another potential noncompliance problem under a national RST could

mirror, at the international level, difficulties states have experienced with

their interstate use taxes. The states have often been unable to enforce use

taxes on sales to their residents from out-of-state vendors, including mail

order sales. Similar problems could arise under a national RST. For

example, absent an additional enforcement mechanism, residents could

escape the U.S. sales tax by shopping in other countries, such as Canada

or Mexico. Taxation of services obtained from foreign vendors through the

Internet or other electronic media could raise another enforcement

problem.

Finally, special provisions in a national RST could raise additional

enforcement considerations. For example, provisions to either limit

taxation when previously taxed preenactment savings are consumed,

exempt some level of foreign purchases, or rebate certain amounts to

individuals could all have enforcement consequences. These

consequences would depend on a specific proposal’s design. For instance,

if individuals had to apply for rebates, the tax administrator would have to

devise a mechanism to reduce the number of fraudulent applications.

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National Retail Sales Tax

Collections Based on the states’ experience, collection of late, miscalculated, and

underpaid liabilities could require a major administrative effort under a

national RST. At least one delinquency notice is required for about

13 percent of the returns due each filing period, on average, based on data

limited to 38 states and the period 1989 through 1991.19 Most states issue

two or three notices of increasing sternness before initiating collection

action, which can take the form of a lien against the delinquent’s assets.

About 10 percent of the sales tax returns processed by Florida in 1995

required assessment notices. Collection efforts in some states have

reportedly been complicated by instances where businesses “borrow”

sales tax collections when they are short of cash and are later unable to

pay their tax liabilities—a problem that could worsen under a higher tax

rate.

Taxpayer Services Taxpayer assistance under a national RST would focus on businesses, as

individuals would generally not file returns. Nonetheless, a significant

education effort may be required under a national RST owing to an infusion

of new filers—if services are taxed broadly—and the potential confusion

arising if state and federal requirements differ or special transition

provisions are introduced. Sales tax filers in the states, particularly small

businesses, require assistance to interpret exemption criteria and

understand other system requirements. Assistance is provided through

state programs to educate new filers and through toll-free telephone help

lines.

Other Issues Other aspects of a national RST could raise additional administrative

issues. These include potential transition mechanisms, the system’s impact

on state taxes, and international considerations.

Transition Issues Moving to a consumption tax, such as a national RST, could result in

unintended consequences for taxpayers, and if transition rules intended to

limit these effects were adopted, they could entail added administrative

burdens. For example, as a by-product of the transition to a national RST,

savings accrued from after-tax dollars under the income tax might be

taxed again when spent under a national RST, while savings accrued after

enactment of the RST would be taxed only when spent. Other transition

concerns might include unintended business losses owing to the

19John F. Due and John L. Mikesell, Sales Taxation: State and Local Structure and Administration, 2nd

ed. (Washington, D.C.: The Urban Institute Press, 1994), p. 187.

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National Retail Sales Tax

discontinuation of existing provisions, such as allowances for business

depreciation and net operating losses carried forward from prior years.

Transition rules designed to mitigate these effects could eliminate a

substantial portion of the RST’s tax base, thereby increasing the required

rate and the evasion incentive noted above.

Aside from these structural changes, the transition to a national RST could

also involve technical changes, such as requirements for new forms or

different data processing systems, which would entail added

administrative effort initially. These potential requirements are discussed

in more detail in appendix VI. Some requirements might not apply in the

same degree to a national RST if states are the administrators and are able

to adapt their existing systems to the requirements of a national RST.

Potential Impact on the

States

Replacing the federal income tax with a national RST could effectively

force states to abandon their own income tax systems because they

depend on the federal tax infrastructure. For example, states depend on

IRS’ information reporting, use income reported on federal returns as a

starting point on state returns, and generally rely on federal definitions.20 If

these states were forced to depend more on their sales tax revenues after

abandoning their income taxes, the combined federal-state rate would be

higher than otherwise, exacerbating any compliance and administrative

problems. However, if states maintained their own income tax systems

without a federal lead, multistate businesses might face growing

differences among the states’ laws, regulations, and policies.

Obviously, the states would face additional hurdles if they were to

administer the federal RST. These added burdens would be minimized to

the degree that federal and state tax bases and/or administrative systems

were consolidated. Even in a consolidated approach, taxpayers in different

states could be treated differently—more or less aggressively—depending

on each state’s enforcement policies.

Federal oversight might be required to minimize these differences. The

federal government, or a neighboring state, might also have to administer a

20Without federal information reporting, states attempting to develop their own systems may have no

legal basis for requiring information returns from out-of-state entities generating income for state

residents.

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National Retail Sales Tax

national RST in the five states that have no sales tax of their own or in other

states that do not agree to be the primary administrator.21

A national RST could also have some positive effects on state tax

administration. If federal and state systems were consolidated, the result

would be greater uniformity among state systems, reducing the

compliance burdens of businesses collecting taxes in multiple states. Also,

coordinating the administration of a national RST with existing state RSTs

might lead to resolution of current interstate tax allocation problems, as in

the case of mail-order sales.

International Issues A national RST, limited to taxing final consumption, would tax imports

when sold at retail in this country and would not tax exports. Foreign

income would not need to be defined. As a result, the existing tax code’s

rules for sourcing the income of multinational businesses and for

allocating expenses against this income, could be eliminated. Also, rules to

credit taxes remitted in foreign countries—currently a source of

substantial complexity—would be unnecessary. Enforcement problems

stemming from noncompliance with these rules, such as transfer pricing

abuses, would also be eliminated in this country.22

Under an RST that eliminated tax pyramiding, the border adjustments

required under a VAT as described in appendix VI would not be needed. If

pyramiding was eliminated, businesses would not pay taxes on their inputs

and, therefore, there would be no need to remove the cost of these taxes

from exports as under a VAT. However, to the degree that pyramiding

occurs in a national RST, exports would tend to carry embedded sales tax

costs, which would be difficult to quantify and extract at the border.

Most provisions of bilateral U.S. tax treaties apply only to income taxes. If

the United States eliminated its income tax, the future of these treaties

would be unclear.

21Alaska, Delaware, Montana, New Hampshire, and Oregon do not have state sales taxes and in some

cases have rejected such taxes by popular vote. Together, these states contain about 2 percent of the

U.S. population.

22However, eliminating the U.S. income tax could aggravate transfer pricing problems in other

countries by creating an incentive for multinational firms to shift more of their income into the United

States for tax purposes.

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Appendix VI 

Credit and Subtraction Value-Added Taxes

Description Value-added taxes (VAT) are consumption taxes in which taxes are paid on

the value a business adds to a product. Two forms of VAT are commonly

discussed, the credit-invoice (or credit) VAT and the subtraction VAT, which

refer to different methods for calculating the amount of tax owed. With

either the credit or subtraction VAT, a business pays tax only on the value

added at its stage in the production or distribution process. The credit VAT

is used as a major revenue source by most industrialized countries.

With either the credit or subtraction VAT, businesses of all kinds would be

responsible for reporting and remitting the tax to the tax agency, and most

tax revenue would be remitted by only a relatively few taxpayers. If a VAT

replaces the income tax, individual taxpayers would not be responsible for

reporting or remitting taxes to the government. However, individuals

generally would end up paying the tax, passed on to them by business.

With a credit VAT, the tax is calculated on the difference between the tax

the business collected on its sales and the tax it paid on business

purchases, including capital goods. The business, which sold the goods,

pays tax on its purchases and remits the difference to the tax agency.

Thus, the business’ records of the taxes collected on each transaction, or

alternatively on gross receipts, form the basis from which it can calculate

the tax collected. The business would also need its records of the taxes it

paid on transactions with other businesses.

With a subtraction VAT, the tax is calculated on the aggregate value of a

business’ transactions, rather than on the individual transactions. That is,

the business that bought and sold goods calculates the tax on the

difference between its total receipts from sales and total purchases of

goods and services (including expenditures for investment or capital

purchases), rather than on the individual transactions.

A comparison of the base under a VAT with the business tax base under the

current business income tax is shown in table VI.1. VATs are paid only at

the business level, so the individual-level elements that apply to other

taxes do not apply here. Both credit-invoice and subtraction VATs are

consumption taxes because (1) they are paid only on goods and services

that are consumed and (2) businesses’ capital investment is expensed

when it is purchased, rather than depreciated over time.

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Credit and Subtraction Value-Added Taxes

Table VI.1: Key Elements of VATs

Business-level item Current income tax

Credit and subtraction

VATs

Sales of goods and services Included Included

Sales of business assets Gain included Included

Sales of financial assets Gain included Not included

Loans and new stock issues Not included Not included

Purchases of goods and

services for business

purposes

Deducted Deducted

Purchase of capital goods Depreciated over time Deducted immediately

(expensed)

Wages paid Deducted Not deducted

Fringe benefits Deducted Not deducted

Interest paid Deducted Not deducted

Dividends paid Not deducted Not deducted

Source: Joint Committee on Taxation and GAO analysis of VATs.

The two VATs, though similar in appearance, can be quite different in

practice. For this reason, we address the credit and subtraction VATs

separately. If a simple, single-rate, broad-based VAT includes all businesses

and all goods and services, there should be little or no difference between

the credit and the subtraction methods of calculation in their economic

effects or their administration. However, if a VAT base is narrowed to

exclude some businesses or goods and services or more rates are added,

the credit and subtraction VATs are quite different in both economic effects

and ease of administration. In this report, we concentrate on the

administration issues.

Regressivity, Exemptions,

and Rates

Because a VAT is remitted by businesses rather than individuals, it cannot

readily include the type of standard deduction or personal allowance that

is available with an income tax to alleviate the tax burden on the

low-income taxpayer, and policymakers may feel the problem of

regressivity should be addressed.1

 International experience indicates that

in most countries, exemptions or lower rates for specific goods and

services are given to offset the regressivity; regressivity can also be

1

Regressivity in a tax system means low-income taxpayers pay a disproportionate share of their

income in taxes. The perceived need to address regressivity assumes the VAT is a replacement tax for

the income tax. If an income tax is retained, a variety of ways to address regressivity are available.

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Credit and Subtraction Value-Added Taxes

countered, as in Canada, by direct payments to those with low income.2 If

the VAT is complicated by exemptions or multiple rates, there can be

substantial differences between the credit and subtraction VATs. A

significant distinction between them is that only the credit VAT has the

flexibility to readily accommodate a variety of rates or exemptions

commonly used to offset regressivity, and even with the credit VAT,

compliance and administration costs escalate if multiple rates or

exemptions are used.

Credits to individuals, such as the earned income credit, which is intended

to offset taxes paid by the low-income working population, are not viable

within either VAT system—if either replaces the current income tax system.

A mechanism would have to be in place to process claims, verify

eligibility, and issue the credit. In some countries, the income tax serves

this purpose. In the United States, the employment tax could be used by

giving a credit to offset employment taxes to be paid, although another

mechanism would be needed for those not working.

Methods commonly used internationally for eliminating taxation on

businesses or on specific goods under a VAT are a business exemption and

exemption by zero-rating. A business exemption eliminates the tax by

categorizing the business as exempt. However, if taxes have been paid by

the exempt business to other businesses in the production and distribution

chain, the business would not have a way to recover them. This problem is

addressed through a mechanism known as zero-rating, which allows these

businesses to be refunded the taxes they paid to others. Zero-rating

removes the tax by charging a zero rate—that is, no tax—on the business’

sales and still allows the business to claim credit for taxes it paid on goods

and services used in the business’ production or distribution.

Three ways used for tax exemption with VATs are as follows:

• exemption by zero-rating specific goods and services at the retail or final

level, such as food or medical services;

2

In our analysis, we used data about international VATs from the Organization of Economic

Cooperation and Development and information from the International Monetary Fund and

international tax specialists. See also Tax Policy: Value-Added Tax: Administrative Costs Vary With

Complexity and Number of Businesses (GAO/GGD-93-78, May 3, 1993); Tax Policy: State Tax Officials

Have Concerns About a Federal Consumption Tax (GAO/GGD-90-50, Mar. 21, 1990); Tax Policy:

Value-Added Tax Issues for U.S. Tax Policymakers (GAO/GGD-89-125BR, Sept. 15, 1989); Tax Policy:

Tax-Credit and Subtraction Methods of Calculating a Value-Added Tax (GAO/GGD-89-87, June 20,

1989); Tax Policy: Choosing Among Consumption Taxes (GAO/GGD-86-91, Aug. 20, 1986); The

Value-Added Tax—What Else Should We Know About It? (GAO/PAD-81-60, Mar. 3, 1981); and The

Value-Added Tax in the European Economic Community (GAO/ID-81-2, Dec. 5, 1980).

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• exemption for a specific size of business, such as businesses with less than

a certain amount in gross receipts per year; and

• exemption by zero-rating goods that are exported.

The first of these exemptions is feasible with either the credit or

subtraction VAT if (1) it is applied at the retail or final level or (2) all of a

firm’s sales are zero-rated. It is practical with the credit VAT even if taxes

are applied only to some of a firm’s sales. Because a credit VAT is collected

at the point where value is added in the production chain, businesses or

goods or services can be omitted from the tax at any point in the chain

without loss of revenue. A subtraction VAT is much less flexible for making

such adjustments except at the retail level, where an item simply can be

untaxed.3

As we pointed out in 1993, the second type of exemption commonly used

may eliminate the burden for small businesses and lessen the cost of

administration.4

 Most European VATs were established with small business

exemptions. Typically, in countries with these VATs, small businesses do

not have to file returns or remit tax if their gross receipts are low, for

example, less than $25,000 per year. They may, however, have to register

with a tax agency. Exempt small businesses in these countries also lose

the opportunity to claim the credit for the tax they pay to other businesses

in the production and distribution chain. The same kind of exemption may

be used to exempt a particular type of business, such as banks, from a VAT.

In some cases, however, businesses have joined the system, if the option is

available, preferring to pay the tax so they can take the credit for taxes

paid to other businesses.

An important feature of a VAT is border adjustments for exports, the third

type of exemption. Taxing items at their place of use, rather than their

place of production, is known as the destination principle. Under this

principle, taxes are imposed on imports and rebated on exports. Under

either a credit or a subtraction VAT, businesses that export goods can claim

credit for taxes they paid on these goods by zero-rating the exported

goods. If the taxes paid on the inputs to exported goods exceed the value

of the taxes collected on domestic sales, the business can be entitled to a

credit or refund.

3

See Martin A. Sullivan, Flat Taxes and Consumption Taxes: A Guide to the Debate (New York:

American Institute of Certified Public Accountants, Dec. 1995), pp. 35, 36.

4

See GAO/GGD-93-78, p. 61.

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In 1996, the standard VAT rates in most of the world’s industrialized

countries ranged between 15 and 25 percent.5

 Most of these countries had

different rates for necessities and/or luxuries. Most of these countries also

relied on an income tax, as well as the credit VAT, for their revenues.

If the United States were to enact a VAT, it might draw on the experience of

these countries. However, if a VAT fully replaced U.S. income taxes, and

perhaps employment taxes, a higher rate than those of other countries

might be necessary to produce the amount of revenue currently generated

by those taxes. Furthermore, in most states, a VAT would be added to the

state and local sales taxes, making the combined rates still higher. For this

reason, other countries’ experiences may be less applicable in predicting

future U.S. experience with such things as tax evasion, tax collection, or

fraud. If a VAT was administered along with an income tax, the burden on

both the taxpayers and the tax agency would increase, although it

probably would not double the current level.6

Services, which now represent more than 50 percent of the U.S. economy,

can present special taxation problems. While most services probably

would be taxed with a credit VAT, international experience shows that

some services escape taxation. Because of the complexity of establishing

value for such things as life insurance premiums or financial

intermediation services, they generally are not in the system. Various ways

to accommodate these items have been considered by tax policymakers,

but during our review most countries exempted them.

Other Issues

Transition Issues If a transition were thought desirable, problems with transitioning to a VAT

could arise, as with any consumption tax. For example, since individuals

would pay the tax when they spend money, the portion of their savings,

which was taxed as income before conversion to the VAT, would be taxed

again. Special transition rules might be designed to take into account

individuals’ interest and dividends, which otherwise would be taxed

doubly, first as income (earlier), and later as consumption.

5

The exceptions were Canada, with a rate of 7 percent; Switzerland, with 6.5 percent; and New

Zealand, with a rate of 12.5 percent on a very broad base. Japan had a subtraction VAT, which is

gradually being changed and more closely resembles a credit VAT, with a rate of 3 percent, rising to

5 percent in 1997.

6

See GAO/GGD-93-78.

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Credit and Subtraction Value-Added Taxes

Also, businesses that are taking depreciation under the income tax system

would not have the opportunity to continue depreciating their capital

goods unless special provisions were made to continue it under a VAT.

Similarly, problems could arise with businesses’ carrying forward net

operating losses and recovering unclaimed tax credits.

Transition to any new tax would require both time and government

resources. Educating businesses would be important for future

compliance, and time for educating the public and the resources to do it

would be needed.

The transition effort needed for a VAT may include education of the public

about the impact at the retail level, of businesses about the legal aspects

and compliance procedures necessary, and of tax preparers. In addition to

designing new educational programs, some estimates would be needed of

the support services required once the tax took effect. Seminars,

telephone assistance, publications, and media advertisements would likely

be used to reach the public. Enlisting private trade associations and

professional groups and taking advantage of free public service

announcements and programs to assist in the education effort could help.

Federal/State Issues The interaction between federal and state governments is an important

aspect of a VAT, particularly the credit VAT. First of all, the credit VAT is a

transaction tax that appears at the retail level, which states traditionally

have considered to be their domain for tax purposes.7

 Second, many of the

state income tax systems are built upon the federal system and rely on the

income tax information reported to the federal government. If a VAT

replaced the income tax, the states would lose this source of information.

Third, five states currently do not have a retail sales tax (RST) and might

not cooperate in the administration of a VAT. (For a more complete

discussion of federal/state issues, see app. V on the national RST.)

International Issues Destination-basis VATs use border adjustments to create a level playing

field internationally for imports and exports. Border adjustments—taxing

imports and refunding taxes paid on exports—could be included in a U.S.

7

The VAT may or may not be visible to the customer, depending on the way it is established, but the

effect would be evident.

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Credit and Subtraction Value-Added Taxes

VAT.

8

 Various concerns with administering border adjustments are

discussed in the enforcement area of this appendix.

Since VATs are not levied on individuals, problems of taxing individuals’

foreign-source income or of establishing U.S. residency of foreigners are

eliminated. For businesses, some current complex laws governing U.S. and

foreign corporations operating outside their country would no longer be

necessary. The complexities of transfer pricing problems would disappear,

as well as the need for foreign tax credits.

Other problems and tax avoidance issues could be created, such as

identifying nondeductible foreign services since domestic service is

deductible. Mechanisms would be needed, as they were in Europe, to

counteract incentives to buy certain foreign, as opposed to domestic,

services to avoid paying VAT. Further, moving to a VAT, or other

consumption tax, could make the future of U.S. bilateral income tax

treaties unclear.

Credit VAT

Description The credit VAT is used throughout the world, although most developed

countries also rely on an income tax. Adopting a credit VAT would either

move our tax system to a consumption type, transaction-based system or,

if an income tax was retained, to more of a hybrid tax system. In this

appendix, we discuss the tax alternatives as replacing the current income

tax system.

As with all consumption taxes, a credit VAT would not tax saving until

spent, and it would eliminate the portions of the individual income tax that

are designed to encourage saving (IRAs and 401(k) plans). The current

business income tax, in which assets can be depreciated over a period,

would change to allow immediate expensing of all asset investments. Tax

preferences could be built into a credit VAT by imposing different rates for

different goods; this is more difficult to do with a subtraction VAT.

A credit VAT and an RST are similar in appearance—for individuals, they are

both taxes that they pay on transactions at the retail level. Certain features

8

Many economists think the border adjustments would not affect the trade balance in the long run due

to the adjustment of exchange rates; however, as noted by Sullivan, p. 63, there could be a differential

impact across industries.

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of a credit VAT are useful tax mechanisms. These features are (1) the VAT’s

crediting mechanism, whereby the tax paid is based on a cross-check of

the sales of goods or services with the records of the purchasers; (2) the

dispersion of tax collection throughout all business levels rather than

collection only by retailers, who are typically small and may go in and out

of business quickly; and (3) the ability of the credit VAT to exempt from

taxation small businesses, which are more likely to try to evade taxes, as

opposed to the RST, in which so much of the revenue is collected from

small businesses.

Credit VATs in foreign countries are imposed on the sale of taxable goods

and services by businesses. A broad-based tax may include food, housing,

medical and pharmaceutical sales and services, and educational sales.

Typically, several tax rates—a standard one, plus at least one for

necessities and one for luxury goods—are used to counter concerns about

fairness. Having only one rate, however, eases the burdens of compliance

and administration. New Zealand’s VAT is often cited by tax experts as an

exemplary tax because it is a simple VAT with a single tax rate imposed on

a very broad base of goods and services.

To offset the impact of the tax on low-income persons, some countries

exempt or zero-rate some of these items. With a credit VAT, narrowing the

base by excluding items from the tax has several effects: (1) a higher tax

rate on the remaining items is necessary to raise a given amount of money,

(2) it becomes more complex for both the taxpayer and the tax

administrator because definitional distinctions might have to be made,9

and (3) the intended population may not be the only group sharing in the

benefits.

Issues arise with a credit VAT that are not a concern with the current

income tax, such as how to tax a broad range of services. While a credit

VAT can be very broad-based, including virtually all goods and services,

some items, such as financial intermediation services, which are difficult

to tax, may or may not be included even in a broad tax base. In recent

years, issues about the taxation of international services have taken on

more importance because of the increasingly global nature of economic

interaction. Tax policymakers have been considering whether and how

international services—for example, architectural services or

telecommunications—should be taxed. Consideration of a credit VAT in the

United States might include such concerns.

9

For example, distinctions might have to be made between food that is candy and food used for home

cooking.

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Credit and Subtraction Value-Added Taxes

Potential Impact on

Taxpayers’ Compliance

Burden

A summary of some potential impacts of a credit VAT on business

taxpayers is shown in table VI.2 and elaborated on afterward.

Table VI.2: Summary of Some Key

Potential Impacts of a Credit VAT on

Business Taxpayers

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of the credit VAT

on business taxpayers

Return filing 24 million returns filed in

1995

All businesses included

unless specifically

exempted

Records kept Records supporting income

and expenses supposed to

be kept

Records of taxes paid to

other businesses and

collected from them

required; records for items

such as depreciation not

needed except for possible

transition

Calculations made Complicated calculations

included for provisions such

as depreciation, the

alternative minimum tax,

and the foreign tax credit

Fewer calculations, such as

for depreciation, required

Complexity faced Detailed rules involved;

complexity reflected in

areas such as depreciation,

the alternative minimum tax,

and the foreign tax credit;

difficulties existing in

defining and recognizing

income

Complexity possibly

reduced by simpler tax but

added by exemptions or

multiple rates; base

harmonization with state

sales taxes needed

Requirement to furnish

information returns

1.1 billion information and

withholding documents filed

Information returns

eliminated

Source: GAO analysis of available information about credit VATs.

Number of Taxpayers A credit VAT taxes all businesses, which in 1995 included about 24 million

corporations, partnerships, and sole proprietors filing returns. This is

substantially less than the 122 million taxpayers—businesses and

individuals—who recorded information and filed tax returns with IRS in

1995.

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If the United States followed the lead of many other industrialized

countries and created an exemption for small businesses, the number

remitting tax could be substantially smaller, while the dollars collected

would decrease very little because the largest corporations remit most of

the tax. For example, as described in appendix II, with the current

corporate income tax structure, 96 percent of income year 1993 corporate

revenues came from only 2 percent of the corporations. However, because

most small businesses at the retail level in the United States are familiar

with remitting state and local RSTs, small businesses may not need special

treatment under a U.S. VAT.

Information Reported and

Filing Frequency

With a credit VAT, the following information is needed by a registered

business to calculate and file its VAT return and by the tax agency to verify

the accuracy of the amount remitted:

• VAT paid on purchases of goods and services (inputs), including capital

goods, investment, and imports;

• VAT received on sales;

• amount of goods and services exported (assuming destination principle);

• any credits carried forward; and

• credits for adjustments on purchases from the previous period.

A broad-based, single-rate credit VAT replacing the current income tax

should alleviate some burden on businesses by requiring fewer records,

calculations, and information returns, whether or not small businesses are

exempted. A business paying a credit VAT would be required to maintain

sales transaction records (or records of its gross sales from which it could

figure the taxes collected) and the records of taxes it paid to other

businesses for its purchases, including investment and capital goods

purchases. The difference (i.e., taxes collected on sales minus taxes paid

on purchases) would be remitted to the tax agency, and a tax return and

accompanying records would be kept relating to that difference. In

practice, transactions between businesses would likely be aggregated over

a period (e.g., week or month) as with current billing procedures so that

one invoice might cover many transactions. In cases in which small

businesses have been required to file returns under a VAT, countries have

used simpler systems than for larger firms to try to ease compliance

burden.

Calculations of items such as depreciation, alternative minimum tax,

foreign-source income, and foreign tax credits, and accrual accounting

methods would not be necessary for a VAT. However, complexities could

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be created if there was a period of transition in which calculations for both

a VAT and an income tax would be required.

If a credit VAT replaced the current income tax, businesses, particularly in

the retail sector, might be responsible for collecting more

“over-the-counter” tax dollars than they currently do, increasing the

attendant liability and accountability, particularly for small firms. In

contrast to an RST, however, the credit VAT would spread the collection of

the tax dollars over a much broader spectrum of businesses that buy or

sell goods or services, so some of the concerns about an RST are not as

valid with a VAT.

State RSTs likely would continue to be collected by retailers, and if the

bases of the federal and state taxes were not harmonized, that is, if the

same goods and services were not given equivalent tax treatment, retailers

could be dealing with two separate taxes—each, perhaps, with its own

rates and base. The confusion could escalate the burden for both

businesses and consumers, and proper recordkeeping and reporting could

be difficult; thus, state and federal harmonization of tax bases would be

desirable. Zero-rating of goods would seem to be a bit easier to handle,

although here, also, distinctions between goods that are taxed at the state

level and goods that escape taxation at the federal level (or vice versa)

could be confusing and burdensome.

How often a business remits a VAT could vary with the size of business and

the amount of tax owed, ranging from annually to monthly to, perhaps,

more often for very large corporations. The form for filing a very simple

credit VAT might have only 16 lines of tax information on it, and as

described in the next section, filing might be more automated than it is

now. Filing of returns could be required on a less frequent timetable,

similar to current requirements, with estimated amounts to be sent

between filings. New businesses could be required to file more frequently

until a basis for estimating the tax due has been established.

Credit VAT Compliance Costs The experience of other countries with credit VATs provides some

information about their compliance costs.10 However, studies of

compliance costs, in general, have limitations similar to those discussed in

appendix III, and those mentioned here vary widely in their approach and

methodology, as well as the years they cover. The costs compared here are

based on a percentage of revenue, but a limitation of this approach is that

10Cedric Sandford, ed., Tax Compliance Costs: Measurement and Policy, (Perrymead, England: Fiscal

Publications in association with the Institute for Fiscal Studies, 1995).

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at higher tax rates, compliance costs should be a lower percentage of

revenue, unless noncompliance rises accordingly. Because VATs are

collected by businesses, individuals do not have to file, thus eliminating

their compliance burden. Some estimates of compliance costs for

businesses are 2.5 percent of tax revenue in Sweden, 3.7 percent in the

United Kingdom, and 4 percent in the Netherlands. The European VATs,

however, have multiple rates and are less simple and more costly to

operate than an ideal VAT. The Congressional Budget Office estimated

costs for a U.S. VAT designed with a single low rate to be a similar share of

revenue as European VATs.11 However, comparing costs with the current,

complex U.S. income tax is difficult. As with any consumption tax, costs of

compliance would vary depending on whether regressivity is addressed

and whether some form of an income tax is retained for a transition period

or longer.

A recurring finding of these and other studies is that compliance costs for

VATs are regressive—small businesses bear a much heavier burden than

large businesses. A 1986-87 study of United Kingdom costs showed

compliance costs for the smallest firms to be more than 200 times the

compliance costs for the largest firms.12

Potential Impact on Tax

Administrators

A summary of some potential impacts of a credit VAT on tax administrators

is shown in table VI.3 and elaborated on afterward.

Table VI.3: Summary of Some Key

Potential Impacts of a Credit VAT on

Tax Administrators

Item Current income tax Credit VAT

Impact on number

of returns

processed

Hundreds of millions of returns

and other materials received

Returns simplified; only

businesses included, and

information returns unneeded; if

a small business threshold,

large number of businesses

excluded

Impact on refund

processing

92 million refunds issued in

fiscal year 1995

Refunds for excess estimated

remittances required;

verification needed for refunds

of taxes paid on exports and for

taxes paid exceeding taxes

credited

(continued)

11Joel Slemrod, “Which Is the Simplest Tax of Them All?” in Henry J. Aaron and William G. Gale, eds.,

Economic Effects of Fundamental Tax Reform (Washington, D.C.: Brookings Institution Press, 1996),

p. 374, citing the Congressional Budget Office.

12Cedric Sandford, “The Administrative and Compliance Costs of the United Kingdom’s Value-Added

Tax,” Canadian Tax Journal, Vol. 38, No. 1 (Jan./Feb. 1990), pp. 10-12.

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Item Current income tax Credit VAT

Impact on

examination

approach

Tax returns matched with

information returns; fiscal year

1995 examination coverage at

1.36 percent, with corporate

audits taking longer than

individuals’ audits

Self-enforcing mechanism

encouraging compliance; audits

probably shorter and more

frequent

Continuation of old

compliance

problems

Compliance problems related to

income definition, unreported

income, and more specific

issues identified in areas such

as transfer pricing, depreciation,

deductibility of business

expenses, small businesses,

independent contractors, and

the underground economy

Compliance problems continued

with business and personal

expense distinctions,

independent contractors,

unreported receipts, and

underground economy; small

business possibly exempt or

audits increased

Resolution of old

compliance

problems

Not applicable Compliance problems with

transfer pricing and

depreciation eliminated

Creation of new

compliance

problems

Not applicable Compliance complicated if there

are exemptions and multiple

rates and for verifying export

claims

Impact on

collections from

tax delinquents

Millions of taxpayer delinquent

investigations and accounts

disposed of, with most of the

latter being for individuals and

most business dispositions

covering employment taxes

Collections complicated if high

rates put large cash amounts in

hands of small businesses,

unless exempted; small

business problems possibly

mirroring current employment

tax collection problems

Impact on

individuals’

questions received

Millions of taxpayer inquiries

fielded, covering a wide variety

of questions

Individuals not responsible for

filing returns

Source: GAO analysis of available information about credit VATs.

Tax Rates If a credit VAT, collected at the various stages of production and

distribution (including retail), replaced the income and employment taxes,

the rate could be as high or higher than the common rates of 15 to

25 percent currently in effect in industrialized countries.13 The rate

assessed with a credit VAT could have a major bearing on the

administrative burden. High VAT rates could complicate administration

because high rates generally raise incentives to avoid taxes, and

businesses would more likely handle large amounts of tax money that

could be diverted to their own cash flow needs. This could make tax

13See Sullivan, pp. 88-89, and Organization for Economic Cooperation and Development, Consumption

Tax Trends (Paris: 1995), p. 16.

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collection more difficult for the agency.14 However, unlike an RST, in which

collection of all tax dollars falls on the retailer, the collection points are

distributed along the production and distribution chain, and thus the

amount of taxes owed to the government is spread among more entities.

Most commonly, countries impose different rates on luxury goods than on

necessities. Multiple tax rates—that is, different rates for different goods

and services—are used in many countries to address the problem of

regressivity. However, having more than one rate complicates tax

administration and increases administrative costs, because verifications

have to be made of the taxes paid on goods and services taxed at varying

rates.

Processing of Returns If the VAT replaced the current income tax, fewer tax returns would need

processing, and this would relieve the burden on the tax agency because

only about 24 million businesses—and no individuals—would file returns.

This would be approximately 98 million fewer filers than with the current

system. Initial registration of most of these businesses probably could be

accomplished through current tax records, but additional effort would be

required to register new businesses and any others, such as nonprofit

organizations, not in the current system but included under a VAT.

Cooperation with the states could be very useful, since they may work in

concert with local governments that license businesses.

The number of returns and remittances to be processed would depend on

the number of taxpayers and how often businesses were required to file or

remit. As we noted in 1993, if small businesses with less than $25,000 in

annual gross receipts were exempt from the VAT, about 50-percent fewer

businesses would remit the VAT, thus alleviating both taxpayer and tax

agency burden and costs.15 Many countries establish a threshold for small

businesses but allow them the option of joining the system by filing and

remitting the VAT in order to receive the tax credits or refunds on taxes

they paid on purchases of goods and services. These credits or refunds, as

well as any refunds for excess estimated remittances, could require

processing and monitoring for verification of the amounts claimed,

however.

Reporting of information by the taxpayer to the tax agency could be done

less frequently than the remittance of taxes. Reporting for smaller

businesses might be done annually, as it is now with the individual income

14See GAO/GGD-93-78.

15GAO/GGD-93-78, p. 67.

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tax, while remittance frequency would likely depend on the size of

business and tax owed, similar to the current system. Higher tax rates with

a VAT and more revenues being collected by businesses might result in

more frequent remittances being required than with the current income

tax. A purpose of this would be to capture tax revenues quickly to allay the

temptation for a business to use the money to bolster its cash flow. This

would affect the administrative burden, but the estimate of 24 million

business taxpayers would seem to result in a much lighter agency

processing load than under the current system.

A tax agency collecting the VAT could use the same general process now

used for income tax returns, although it presumably could rely more on

automation. Because filers of a VAT are limited to businesses, they may be

able to accommodate automated systems. In Canada, a one-time

allowance was given to cover the additional cost to small businesses for

necessary equipment purchases. Special rules, such as a requirement for

electronic filing, might be enacted to expedite relatively error-free

processing, and scanning equipment might enter the data into the

computer system. The status of the tax systems modernization effort at the

time a new tax is put in place could have a major bearing on a tax agency’s

ability to institute and assess the tax.

Most information returns, which now are used to report earnings and also

savings and investment returns to taxpayers, would no longer be

necessary with a credit VAT since these income items would not be taxed.

This means that the processing of hundreds of millions of documents,

mostly electronic and some paper, would be eliminated.

A tax agency would also have to be prepared to process refunds and credit

claims. With a VAT, these are likely to be for exports (discussed in a later

section on these claims). If an earned income credit or other similar credit

was used to refund taxes to the low-income population, some mechanism

to do this would need to be in place.

Enforcement—Audit Enforcement with a credit VAT would be quite different from enforcement

with the current income tax. With a VAT, the taxes collected by businesses

minus those paid to other businesses are remitted to the tax agency;

however, with an income tax, business taxes are based on profits and

losses, rather than on sales and purchases. The difference makes the joint

enforcement of the taxes more problematic if both were in effect, though

for large corporations, auditing the two taxes together might be done

using information derived from auditing one to verify the other. Of course,

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certain elements of the income tax, such as depreciation, give rise to

specialized audit problems. Some issues, such as differentiating between

business and personal expenses, might be the same, while others, such as

transfer pricing issues, would disappear for the United States with a

border-adjustable VAT.

16

As we mentioned in 1993, a simple VAT, with a broad base and one rate, or

very few, and without exemptions, is by far the easiest to enforce. Efforts

to offset the regressivity of a credit VAT by having a tier of rates or by

exempting goods and services will escalate the costs to administer the

VAT.

17

The chain of tax payment and tax receipt, available only in the credit VAT,

creates a mechanism thought by some to encourage or force compliance

with the tax system.18 Because each business is required to provide

receipts for taxes paid on its sales and the business making the purchase

needs these receipts to verify that it paid the taxes, there seems to be a

self-enforcing mechanism within the system. However, there is not general

agreement in the tax literature as to the effectiveness of this approach in

preventing noncompliance. Theoretically, a tax agency could require that

all pertinent documents be turned over to it for audit purposes, but the

sheer volume of data makes it unlikely that a tax agency would attempt to

match documents. Nevertheless, businesses would need to retain gross

receipts records and records of transactions on taxes paid on purchases of

goods and services. Even Japan, which started its own unique version of a

VAT in 1989 without substantial recordkeeping requirements, recently has

started requiring businesses to maintain records that substantiate their

claims for credits.19

As we pointed out in 1993, other countries’ experiences with a credit VAT

indicate that auditing would require less time but more frequent visits by

auditors to businesses than with an income tax.20 Also, other countries’

experiences indicate that while VAT audits may be done very quickly, the

16See Joint Committee on Taxation, Impact on Small Business of Replacing the Federal Income Tax

(JCS-3-96), Apr. 23, 1996, p. 79; and Harry Grubert and T. Scott Newlon, “The International

Implications of Consumption Tax Proposals,” National Tax Journal, Vol. XLVIII, No. 4 (Dec. 1995), p.

637.

17See GAO/GGD-93-78, pp. 79-80.

18For discussion of this concept, see GAO/GGD-93-78, p. 44, and Sullivan, p. 24.

19See Alan Schenk, “Japanese Consumption Tax After Six Years: A Unique VAT Matures,” Tax Notes,

Vol. 69, No. 7 (Nov. 13, 1995), pp. 899-911.

20See GAO/GGD-93-78, pp. 42 and 46.

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time required increases if any complexity is introduced. Frequent auditors’

visits to businesses may be used to quickly capture taxes due and to

discourage businesses from using the tax funds in their cash flow. The

number and frequency of audits of small businesses, who have proven to

be the most noncompliant under the current system, might be increased by

a tax agency. Further, specially trained people may be needed for fraud

detection, particularly for verification of exports for border tax

adjustments.

The United Kingdom’s planned audit rate of VAT taxpayers was 6.5 percent

(in 1992), compared with IRS’ corporate income tax audit rate of

2.0 percent (in fiscal year 1995). Time for a VAT audit is highly variable,

depending on the size of the business. IRS’ experience with the income tax

indicates that larger firms employ tax specialists and are less likely to

make basic errors than are smaller firms.

Other Issues in Enforcement Underground Economy. No easy formula seems to exist to solve the

problem of collecting taxes from the underground economy. With a VAT,

some taxes still would escape collection, including the tax on the value

added by the labor of sole proprietors who, as mentioned in appendix II,

have had extremely poor compliance histories. A Canadian study reports

the potential for “skimming” (underrreporting) or nonreporting of

legitimate business receipts with the Canadian VAT is greatest in the

service sector, similar to the U.S. income tax.21 Similarly, illegal goods and

services would likely continue to escape taxation with a VAT, although the

amount of these is unknown.

The credit VAT has the advantage of creating incentives for businesses to

file in order to get credit for taxes they have paid. With a credit VAT, even if

sole proprietors do not file, they probably would pay some tax on goods

and services they purchase for business use.

As with the current system, the tax agency likely would want to develop

methods of audit selection, such as the scheme currently used for income

tax returns. The resulting selection might be quite different from those

now used with the income tax, and it would require some years of

experience with a U.S. VAT to develop and refine the patterns and

indicators of noncompliance.

21Statistics Canada, National Accounts and Environment Division, “The Size of the Underground

Economy: A Statistics Canada View,” Discussion Paper, Feb. 1994.

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Credits/Refunds. Because a new business’ initial costs of starting up would

probably exceed its sales for some time, it would likely have larger claims

for credits than an established business would. In this situation, the

business could claim a substantial amount of money to be refunded. Some

countries handle these claims as credits that are carried forward to be

used with the next tax due, but new businesses may need the money

quickly for operating funds. A credit or refund mechanism would need to

be established to address these possible cash flow problems, but the tax

agency would be burdened with the necessity of checking the validity of

these claims before refunding large amounts. Fraudulent claims could be a

problem for the tax agency when there are requests for speedy refunds.

As we described in 1993, border adjustments, done by zero-rating exported

goods, require special attention from auditors to ensure that the credits

claimed for exports are correct.22 Auditing, verifying, and processing these

claims so that the businesses receive their refunds in a timely manner adds

to the cost of administering a VAT. For a tax agency to make adjustments

for taxes paid on inputs to exported goods, verification of claims would be

required to ensure that the goods were, in fact, exported and that the claim

for taxes paid was correct. Most companies export only a portion of the

goods they produce, complicating the tax for the company and the agency,

because records must separate the goods sold domestically from the

goods exported to establish the proper claim for credit. Other countries’

experiences indicate that fraudulent claims could be a big problem

because they might generate large dollar refund claims. Furthermore,

quick payment of these claims could relieve the exporter of cash flow

problems, but these claims would have to be verified before payment. An

enforcement mechanism would be needed that prevents or exposes

fraudulent claims. Transaction records available with a credit VAT would

provide the needed verification, but an economy dominated by exporters

could require significant tax agency resources. The potential for

businesses to overstate claims of exports to obtain credits would have to

be addressed. The burden for this may or may not fall entirely on the tax

agency, and in the United States, the Customs Service, which currently

administers import duties, might assume that role in cooperation with the

tax agency.

Enforcement—Collections Collection functions may not change significantly from those required for

the current income tax, and whether delinquencies would increase or

decrease with a VAT is unclear. However, if a VAT replaced the income tax,

the relatively high tax rates necessary for revenue neutrality could involve

22See GAO/GGD-93-78, p. 46.

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businesses’ handling more tax revenues than they do now and, therefore,

make the collection functions more important. The temptation would exist

for businesses—as it does now with employment taxes—to divert taxes

collected to working capital, especially in times of business downturn.

Businesses, particularly smaller ones, could either move or close to escape

the tax collector and, with high rates, the benefits of doing so could be

attractive. Collections could be time-consuming and costly, and a

collecting agency may need more resources for these functions than with

the current business income tax. As described in appendix II, the most

problematic business taxes under the current collection process are

employment taxes—taxes that are collected in a way similar to how a VAT

would be collected.

Taxpayer Services Relieving individuals of the responsibility for filing returns would greatly

decrease the number of entities requiring taxpayer services but would

increase the administration burden for ensuring compliance by businesses.

Tax agency efforts during the transition to a credit VAT would be needed to

educate current taxpayers as well as new businesses, and continuing

educational services would be needed for new businesses even after the

transition. Taxpayer education programs for VATs in other countries

include such techniques as seminars, special publications targeted to

various business sectors, and automated or personal assistance through

taxpayer inquiries via telecommunications. Personal attention with visits

to individual businesses was thought to be effective in some other

countries’ transition to a credit VAT.

If special rules were used to avoid large gains or losses in the transition

between the old and new systems, such as continuing to allow

depreciation for a number of years, the tax would be complicated and

would require more extensive taxpayer education and services.

Subtraction VAT

Description A subtraction VAT is a tax on consumption, remitted to the government by

businesses; it is similar to a credit VAT but is calculated on the difference

between the total receipts from sales and total purchases of goods and

services from other businesses, including expenditures for capital

purchases. The VAT rate is then applied to this difference to determine the

tax owed.

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Even though a subtraction VAT would be levied on businesses at each stage

of production and distribution, it is the consumer who would ultimately

pay the tax. A subtraction VAT might not be as visible to the consumer as

the credit VAT because each transaction would not have to be tracked at

the retail level; but it would likely be reflected in the price charged,

nonetheless.

A subtraction VAT would be imposed on the sale of taxable goods and

services by businesses, and unlike a credit VAT, the base would have to be

very broad to be administrable. To facilitate its administration, there

should be no multiple rates nor any exemptions of goods and services

before the retail level, even for such a purpose as offsetting regressivity.

Although using multiple rates and exemptions with a credit VAT is possible,

it would be difficult administratively with a subtraction VAT. (Some think

this is an advantage because, at least theoretically, it could keep a

subtraction VAT from being subject to added complexities.) If exemptions

existed at the retail level, the tax would become more like current RSTs,

and some of the same problems, such as making definitional distinctions

between similar items with different tax rates, could be troublesome.

To be administrable, a subtraction VAT should have only one rate. Although

multiple rates add complexity to a credit VAT, with a subtraction VAT

businesses simply could not keep track of the rates paid at the

intermediate production stages. If more than one rate applied, the net

difference between sales and purchases could not be the basis for

calculating the tax. Further, if multiple rates were used with a subtraction

VAT, the tax agency administering the tax would have no reliable way to

confirm a business’ claims for the volume of goods sold at lower rates,

since the business, itself, would furnish the audit information.

A credit VAT, because it relies on records of transactions, is adaptable for

the taxation of small retail services, such as automobile mechanics or

hairdressers, which are labor-intensive. With a subtraction VAT, however, it

would be easy to understate the value added in labor for the service

provided, because the amounts reported are based on the business’ own

records, and there is no checking mechanism in the system as there is with

a credit VAT.

Enforcement advantages of a credit VAT are not present with a subtraction

VAT: (1) checks and balances of a credit VAT are not available and

(2) businesses do not have the incentive to enter the system to receive

credits for taxes paid as with a credit VAT.

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As discussed in appendix III, financial intermediation services may be

difficult to include in any consumption tax, including a subtraction VAT.

Treatment of housing is a concern with any consumption tax, and

international VATs generally tax the sale of new housing. As mentioned,

any narrowing of the base of a VAT complicates the tax and raises the cost

to both the taxpayer and tax administrator.

Consumption taxes generally tax fringe benefits by not including them in

the items that can be deducted as business purchases.23 However, any

business purchases that are used for personal consumption, such as large

gifts to employees that could be considered fringe benefits, would escape

taxation with the subtraction VAT. Business purchases might readily be

abused by claims for tax credits for items used for personal purposes.

Identifying these items in an audit could be time-consuming.

Potential Impact on

Taxpayers’ Compliance

Burden

A summary of some impacts of a subtraction VAT on business taxpayers is

shown in table VI.4 and elaborated on afterward.

23A flat tax can tax fringe benefits through the individual or through the business, depending on the

way it is set up.

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Table VI.4: Summary of Some Key

Potential Impacts of a Subtraction VAT

on Business Taxpayers

Item

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of the subtraction

VAT on business

taxpayers

Return filing 24 million returns filed in

1995

All businesses included

Records kept Records supporting income

and expenses supposed to

be kept

Reliance on normal

business recordkeeping;

records for items like

depreciation not needed

except for possible transition

Calculations made Complicated calculations

included for provisions such

as depreciation, the

alternative minimum tax,

and the foreign tax credit

Fewer calculations, such as

for depreciation, required

Complexity faced Complexity reflected in

areas such as depreciation,

the alternative minimum tax,

and the foreign tax credit;

difficulties existing in

defining and recognizing

income

Without exemptions and

multiple rates, which are

unsuitable, tax simplified

Requirement to furnish

information returns

1.1 billion information and

withholding documents filed

Information returns

eliminated

Source: GAO analysis of available information about subtraction VATs.

Number of Taxpayers A subtraction VAT taxing all businesses would include many fewer than the

122 million taxpayers (all types of businesses and individuals) that filed in

1995. As we described in a 1989 report, an exemption for small businesses

could be used with the subtraction VAT if the tax agency could be certain

the businesses indeed qualified as small.24

Information Reported and

Documents Retained

Under a subtraction VAT, a business would likely need to keep fewer

records than with either the current income tax system or a credit VAT

requiring transaction records. With a subtraction VAT, a business would

need records for the following:

• gross receipts from sales;

• gross amount of purchases of goods and services (inputs), including

capital investment;

• amount of exports (assuming destination principle);

• any credits carried forward; and

24See GAO/GGD-89-87, pp. 35-37.

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• credits for adjustments on purchases from previous period.

The tax reported and remitted would be calculated by a business on the

difference between the gross receipts from sales minus the cost of goods

and services purchased, including capital investment.25 With a subtraction

VAT, a business with good, standard accounting practices should be able to

rely on its normal cash flow recordkeeping for its tax calculations and

records and would not have to do accrual accounting calculations for tax

purposes. However, the business would have to distinguish between

purchases from other businesses, which would be deductible, and its own

internal costs, which would not be deductible. Some items would be

critical to a taxpayer’s records, specifically proof of the business’ domestic

versus foreign sales. These would be necessary for claiming refund credits

for exports and would be a likely target if the business were audited.

With a subtraction VAT, calculations no longer would be necessary for such

things as depreciation, alternative minimum tax, foreign operations, and

passive investment activity, unless they were required during a transition

period. A form for reporting to a tax agency might be similar to that of a

credit VAT, which is optimally no longer than 16 lines of tax information.

At least one study notes that a subtraction VAT would be less burdensome

to the taxpayer than a credit VAT, although “this simplification . . . comes at

the cost of increased potential for evasion and less flexibility.”26 Fiscal

responsibility would be required, particularly of a retail business taxpayer,

inasmuch as tax liability could get high very quickly if tax rates are high;

seasonally sensitive businesses could be especially subject to difficulties.

Frequency of remittance and filing would likely be similar to the current

system in which the schedules may vary from annually to semiweekly,

based on the size of a business’ liability and the type of tax. As with a

credit VAT, filing methods might be limited to electronic, since only

businesses are subject to the tax. Tax remittances probably would be

estimated and made more often than returns filed. Whether or not higher

tax rates prevailed, businesses would likely be handling more money,

creating more liability for themselves, and the filing and remittance

burdens could be more demanding than with the current income tax.

Some sole proprietors and partnerships who currently file income tax

returns and remit annually might be interacting with the tax agency more

25As with a credit VAT, interest and income from other financial flows between businesses would not

be taxed.

26Sullivan, p. 35.

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frequently, similar to the current employment tax, although without an

individual income tax, businesses’ requirements for information returns

would decline.

A transition period to the new tax could add to businesses’ recordkeeping

and tax calculations and the administrative burden and costs. If an income

tax were in effect in addition to the subtraction VAT, the recordkeeping

burden would escalate somewhat, but current accounting methods likely

could be the basis for both and be supplemented to make VAT distinctions.

Subtraction VAT Compliance

Costs

As opposed to the credit VAT, which is widely used, no country except

Japan has tried a subtraction VAT,

27 and little information is available to

judge compliance burden and costs with any precision. Since individuals

would not file returns with a subtraction VAT, they would not deal with

compliance or experience the associated costs. Similarities between the

subtraction VAT and the business tax under the flat tax indicate their

compliance costs for businesses could be similar. Based on a major

reduction in paperwork over the current system, the time necessary for

compliance would be greatly reduced, according to one estimate based on

the Arthur D. Little study, which has limitations as described in appendix

II.28

Impact on Tax

Administrators

A summary of some impacts of a subtraction VAT on tax administrators is

shown in table VI.5 and elaborated on afterward.

Table VI.5: Summary of Some Key

Potential Impacts of a Subtraction VAT

on Tax Administrators

Item Current income tax Subtraction VAT

Impact on number of

returns processed

Hundreds of millions of

returns and other materials

received

Returns simplified; only

businesses included, and

information returns

unneeded; if a small

business threshold, large

number of businesses

excluded

Impact on refund

processing

92 million refunds issued in

fiscal year 1995

Refunds for excess

estimated remittance

required; verification

needed for refunds relating

to exports and costs

exceeding sales

(continued)

27Japan’s VAT has variations that make it unlike the alternatives we consider; also, recent changes are

moving it toward a credit VAT.

28Arthur P. Hall, “Compliance Costs of Alternative Tax Systems,” Tax Notes, Vol. 71, No. 8 (May 20,

1996), pp. 1087-88.

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Appendix VI 

Credit and Subtraction Value-Added Taxes

Item Current income tax Subtraction VAT

Impact on examination

approach

Tax returns matched with

information returns; fiscal

year 1995 examination

coverage at 1.36 percent,

with corporate audits taking

longer than individuals’

audits

Self-enforcing mechanism

not available, making audits

of business’ own records

more complicated than for

credit VAT; audit frequency

possibly increased

Continuation of old

compliance problems

Compliance problems

related to income definition,

unreported income, and

more specific issues

identified in areas such as

transfer pricing,

depreciation, deductibility

of business expenses, small

businesses, independent

contractors, and the

underground economy

Compliance problems with

business and personal

expense distinctions,

independent contractors,

unreported receipts, and

underground economy

continued; collections from

small businesses

problematic but less than

under retail sales tax

Resolution of old

compliance problems

Not applicable Compliance problems with

transfer pricing and

depreciation eliminated

Creation of new

compliance problems

Not applicable Compliance complicated by

underreported sales and for

verifying export claims;

administration difficulties

increased if exemptions or

multiple rates used

Impact on collections from

tax delinquents

Millions of taxpayer

delinquent investigations

and accounts closed, with

most of the latter being for

individuals and most

business dispositions

covering employment taxes

Collections complicated if

high rates put large cash

amounts in hands of small

businesses; small business

problems possibly mirroring

employment tax collection

problems

Impact on individuals’

questions received

Millions of taxpayer

inquiries fielded, covering a

wide variety of questions

Individuals not responsible

for filing returns

Source: GAO analysis of available information about subtraction VATs.

Tax Rates As with other consumption taxes, the tax rate with a subtraction VAT

probably would be determined by the amount of revenue needed to be

raised. If a subtraction VAT replaced the current income and employment

taxes, the tax rate necessary to obtain a given level of revenue would be

greater than if it were imposed in addition to the income and/or

employment taxes. The rates, which might be levied in addition to the

state sales taxes, could complicate administration of the tax, in part

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Credit and Subtraction Value-Added Taxes

because small businesses, such as retailers and sole proprietors handling

large amounts of tax money, could be tempted to dip into them for their

own cash flow purposes.

Multiple rates, frequently used with a credit VAT to address regressivity by

imposing a variety of tax rates on such things as necessities and luxuries,

could not readily be used with a subtraction VAT except at the retail level

because it would be virtually impossible for a tax agency to administer

them. With a subtraction VAT, businesses would not be required to keep

detailed records of purchases, and if a business’ goods and services were

purchased at varying tax rates, tax administrators could find it very

difficult to ascertain the accuracy of the apportionment of the purchases

to the differing rates. Some tax policymakers think a subtraction VAT that

did not have a variety of rates would have a distinct advantage over a

credit VAT or other consumption tax that did because the tax would not be

as complex. If a lower tax rate resulted from the broader base and rate

structure, the administrative burden might be eased.

Number of Taxpayers About 24 million taxpayers—all taxpayers filing as corporations,

partnerships, and sole proprietors in 1995—would be subject to the

subtraction VAT. This number could be reduced if small businesses were

exempted, but administering a subtraction VAT that attempted to exempt

small businesses could be time-consuming and costly if the auditor had to

review an inordinate number of records to confirm the validity of the

exemption. Also, small businesses could spring up if larger companies

split up their firms for tax avoidance purposes.

Processing of Returns Processing of tax returns and remittances for 24 million businesses of all

types should require far fewer resources than the processing required for

the 122 million individual and business taxpayers in the tax system in 1995.

Because the many items that have entered the current tax code for social

and economic reasons would not be required to be reported or itemized in

a subtraction VAT, the tax would be much simpler. However, more frequent

filing and certainly more frequent remittance, probably through estimated

remittances, could be required because more dollars would be collected

by even small businesses. (Quickly retrieving tax dollars from businesses

is important when much money is at stake.) Much simpler returns would

make generally accurate data entry into the computer system possible

with scanning equipment and electronic filing since all taxpayers would be

businesses. Automated systems such as these should reduce costs and

increase the speed for processing the returns, so that auditors could

receive the necessary information in a timely manner.

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Credit and Subtraction Value-Added Taxes

Currently, hundreds of millions of information documents (Forms W-2 and

1099) reporting wages and investment income are submitted to IRS, mostly

electronically and through other nonpaper means but also by paper, and

subsequently processed. This information reporting and processing would

not be necessary with a subtraction VAT, since these items would no longer

be used in tax calculations.

Similar to a credit VAT, if refunds and credits were given, a method for

processing them would have to be designed. And as with a credit VAT,

registration would be especially important for new businesses, in order to

get them into the tax system, and for others that are not now in the tax

system but that would be included under a VAT. Incentives to register,

however, would be lacking.

Enforcement—Audit/

Collections

With a subtraction VAT, auditing a business with adequate records could be

similar to auditing a credit VAT, depending on the simplicity or complexity

of the tax design. Records of receipts or payment invoices might have to

be checked to ascertain the validity of the amounts reported. Without

multiple rates or exemptions, the tax agency burden should be limited to

straightforward verification of business records. Since these are the

audited business’ own records, as opposed to the credit VAT’s tax receipts

from other businesses, their validity may be questioned, lengthening the

audit and raising audit costs compared with those of a credit VAT.

With multiple rates or exemptions, a business could calculate the tax to be

remitted, but verification could be difficult because the records the

business used to determine its taxes would be its own accounts of

purchases and deductions. (While this also happens with the business side

of the current income tax, a much smaller proportion of tax revenues is

derived from that tax, and so the problem is not as perilous.) Tax evasion,

which appears to be easy to do with a subtraction VAT having multiple

rates or exemptions, could jeopardize large amounts of tax dollars.

Auditing a subtraction VAT with a broad base and a single rate would

probably be simpler than auditing the current income tax and its

complexities. As with the credit VAT, auditing could be less

time-consuming and done more often than with the current income tax.

The importance of having auditors visit businesses frequently to identify

any problems before large amounts of taxes become due would be similar

with both the subtraction and credit VATs. Fraud detection would require

diligence with a subtraction VAT, particularly in identifying underreported

or unreported income that could be readily hidden in a business’ books.

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Credit and Subtraction Value-Added Taxes

Also, distinguishing between business and personal expenses would still

be a problem.29

A new system would need to be developed for audit selection. Some years

of experience with a subtraction VAT might be necessary before patterns of

noncompliance could be identified, developed, and refined, particularly

since no country now has experience with one.

A subtraction VAT could have problems with businesses that do not record

their sales or that understate them. With a credit VAT, because these

businesses may want to claim the credits due them, they may record both

their sales and their purchases; however, with a subtraction VAT, there

would be little to prevent a business from ignoring or understating sales.

With a credit VAT, businesses making retail sales would be the ones chiefly

at risk of not remitting the VAT, since the businesses at the prior level in the

production or distribution chain would want to claim the credit for their

purchases and therefore would report them.

As with a credit VAT, the collection of a subtraction VAT would not fall

entirely onto the retailer, and thus the burden and liability would be

spread through all businesses. This would be a distinct advantage over a

national RST in which there are so many small retailers whose records may

be difficult to check or who may go out of business or otherwise evade

taxation. As described in appendix II, small businesses have had

significant compliance problems.

Other Issues Under

Enforcement

Underground economy. The underground economy should escape

taxation about as well with the subtraction VAT as with other systems; in

other words, there is no obvious reason that chances of collecting from

the underground economy are better here than with most tax systems. In

fact, since there is no incentive to register, as there is with the credit VAT, it

might be more difficult to collect the tax from that segment of the

economy.

Credits/Refunds. As with a credit VAT, border adjustments, which tax

imports of goods and services and refund exports by zero-rating exported

goods, could be a source of particular concern for administrators. To

make these adjustments, a mechanism would be needed for crediting or

refunding businesses with taxes paid on exports; in the United States, the

Customs Service might have responsibility for administering some of it.

Businesses that are large exporters probably would need cash refunds,

29See Joint Committee on Taxation, p. 79.

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Appendix VI 

Credit and Subtraction Value-Added Taxes

rather than credits, promptly disbursed, complicating administration.

Fraudulent claims for amounts of goods sold have presented difficulties

for other countries to identify before they paid out refunds. Auditors

would have to ensure that credits claimed by exporters were correct,

including claims made by companies who sell both domestically and

internationally, to ensure that the VAT credit claimed for the exports was

not inflated.

If a business remitted more tax than was due, a system for carrying

forward the credit or paying the refund would be needed. Large credits or

refunds claimed by new businesses to offset startup costs or claims of

capital investment costs exceeding sales would have to be verified before

payment. These claims could pose problems for a tax agency, since the

timeliness of the validation would be critical. Likewise, an exemption for

small businesses could be used with the subtraction VAT only if the tax

agency could be certain the businesses, indeed, qualified as small, which

probably would be difficult for an audit agency to pursue.

Enforcement—Collections Collections functions with a subtraction VAT might be similar to those for

the current income tax, and it is unclear whether delinquencies would

increase. However, collections could mirror current collections for

employment taxes, rather than the current income tax, because the

processes seem similar. If this were the case, collection problems and

costs could escalate, particularly with some businesses, such as sole

proprietors, who are difficult to collect from. Furthermore, noncompliance

with employment taxes was relatively low except in the self-employment

area. Collections might be more problematic because, with the high tax

rates likely needed to achieve revenue neutrality, businesses likely would

be handling more tax dollars than they currently do. Small retail

businesses, known to have a short life expectancy, could be tempted to

avoid remitting the tax and to use the funds for other purposes.

Taxpayer Services A new tax system is likely to require significant resources for educating

the public, but probably less so with a simple subtraction VAT than with the

credit VAT or more complicated tax. With a subtraction VAT, more effort

would be devoted to educating businesses than the general public, and

business associations might be enlisted to help with the effort. A tax

agency would likely target businesses through seminars and electronic and

other means. There still would be some education necessary for the

general public so that they would know what to expect at the retail level.

Measures designed to improve the transition to a subtraction VAT, such as

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Appendix VI 

Credit and Subtraction Value-Added Taxes

extension of depreciation, could complicate the taxpayer services effort

and escalate its costs.

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Appendix VII 

Flat Tax

Description The term “flat tax” as used in the current tax environment may refer to a

single, or “flat,” tax rate with either an income or a consumption tax base.

The single rate does not include what is, in effect, a zero tax rate in the

form of a standard deduction and exemption allowances. In this report,

flat tax refers to the type of tax outlined by Hall and Rabushka.1

 This

version taxes individuals and businesses at a single rate and eliminates

many specific deductions and credits. Although the individual flat tax may

appear to resemble an income tax because individuals file and pay taxes,

the flat tax is a type of consumption tax because returns on savings and

investment are not taxed and business’ investment is expensed. Unlike the

credit value-added tax (VAT) or the retail sales tax (RST), the flat tax is not

collected on individual transactions.2

The individual flat tax is a wage tax, which taxes only wages, salaries, and

pension and retirement income. Fringe benefits received by individuals

would be taxed at the business level because the employer would not be

allowed to deduct them. This type of flat tax has no tax credits and no

deductions for specific items, such as home mortgages and charitable

contributions. Instead, regressivity is addressed through personal

allowances based on the individual’s filing status and additional

deductions for dependents.

The business side of the flat tax would be remitted by businesses on their

total receipts from sales of goods and services, minus total purchases of

goods and services from other businesses, and expenditures for capital

purchases, minus wages, salaries, and pension and retirement benefits.

Fringe benefits paid to workers, other than pension and retirement

benefits, would not be deductible to businesses, and thus they would be

taxed. All businesses, including all corporations, sole proprietorships, and

partnerships, would remit the business tax. The business flat tax

resembles a subtraction VAT, as described in appendix VI, except that the

taxation of wages and salaries is shifted to the individual. Therefore, many

of the effects of a flat tax on businesses and on the tax administration of

those businesses also resemble the effects of a subtraction VAT.

3

1

Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford, Calif.: Hoover Press, 1995).

2

Variations of the Hall-Rabushka flat tax model include the “X-tax” proposed by David Bradford. The

base of both the individual and business taxes is the same with both models, but the X-tax would have

graduated rates for individuals and the tax rate for businesses would equal the top rate for individuals.

Certain deductions and credits for individual taxes could be retained. See David F. Bradford, “On the

Incidence of Consumption Taxes,” in Charls E. Walker and Mark A. Bloomfield, eds., The Consumption

Tax: A Better Alternative? (Cambridge, Mass.: Ballinger Publishing Company, 1987).

3

The flat tax also resembles the business cash flow consumption tax described in appendix III, except

that with the cash flow tax, new borrowing is taxed and wages are not taxed at the business level.

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Appendix VII 

Flat Tax

A comparison of the base under a flat tax with the base under the current

income tax is shown in table VII.1. Because a business’ investment

purchases are expensed, rather than depreciated over time, this flat tax is

a consumption tax. It is a flat tax because there is only one rate applied to

all levels of both the personal and business tax base.

Table VII.1: Key Elements of the Flat

Tax Item Current income tax Flat tax

Personal level

Wages Included Included

Interest income received Included Not included

Dividends received Included Not included

Pension income Included when received Included when received

Loan proceeds Not included Not included

Sales of assets Capital gain included Not included

New saving Generally not deducted Not deducted

Fringe benefits Not included Not included

Job expenses Certain costs deducted by

itemizers

Not deducted

Business level

Sales of goods and

services

Included Included

Sales of business assets Gain included Included

Sales of financial assets Gain included Not included

Loans and new stock

issues

Not included Not included

Purchases of goods and

services for business

purposes

Deducted Deducted

Purchase of capital

goods

Depreciated over time Deducted immediately

(expensed)

Wages paid Deducted Deducted

Fringe benefits Deducted Not deducted

Interest paid Deducted Not deducted

Dividends paid Not deducted Not deducted

Source: Joint Committee on Taxation and GAO analysis of the flat tax outlined by Hall and

Rabushka.

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Flat Tax

Taxation of Individual

Taxpayers and

Potential Impact on

Individual Taxpayers’

Compliance Burden

A summary of some of the potential impacts of the flat tax on individual

taxpayers is shown in table VII.2 and elaborated on afterward.

Table VII.2: Summary of Some Key

Potential Impacts of a Flat Tax on

Individual Taxpayers

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of the flat tax on

individual taxpayers

Return filing 116 million returns filed in

1995

Assuming withholding still

required, number possibly

lower than now, depending

on personal deductions or

allowances; separate

individual and business

returns possibly filed by

self-employed individuals

Records kept Records supporting tax

returns supposed to be

kept—e.g., receipts, proof

of payment, and

documentation supporting

deductions and credits;

burden alleviated by

information reports given to

individuals

Information returns kept as

primary source of

information for wages but

not needed for savings;

individuals responsible if

companies do not furnish

information

Calculations made Complicated calculations

for some taxpayers

included for provisions such

as dependency tests and

capital gains

Dependency calculations

still needed but

computations for eliminated

items, such as capital

gains, not needed

Complexity faced Many pages of instructions

involved and millions of

supplemental forms and

schedules filed—e.g., 33

million schedules of

itemized deductions for tax

year 1994; difficulties

existing in defining and

recognizing income;

however, in actual practice,

minimal complexity faced

by millions of individuals

Complexity reduced

because many income and

all itemized deduction items

eliminated; complexity

added if broad range of

fringe benefits taxed at

individual level; difficulties

in defining and recognizing

income reduced

Source: GAO analysis of available information about the Hall-Rabushka flat tax.

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Appendix VII 

Flat Tax

Tax Base The principal differences in the base of the individual flat tax and the base

of the individual income tax are that the Hall-Rabushka flat tax

(1) eliminates taxation of savings and investment earnings at the individual

level, including interest, dividends, and capital gains; and (2) excludes

deductions or credits, such as those for home mortgage interest, charitable

contributions, and child and dependent care.4

 The reduction in complexity

of the tax base resulting from eliminating the itemization of income items

and deductions should relieve the burden on some individual taxpayers by

ridding the system of complex rules and supplemental forms

accompanying the eliminated items.

Hall and Rabushka advocate taxing all types of nonsavings income,

particularly all fringe benefits including the employer’s Social Security

contribution, in order to have the lowest possible tax rates. The

Hall-Rabushka approach accomplishes this by not allowing a deduction for

fringe benefits at the business level. However, Hall and Rabushka advocate

that fringe benefits other than retirement benefits no longer be furnished

by businesses but, instead, be purchased by individuals. Whether the

individual’s compensation would be increased to offset this is not clear,

but Hall and Rabushka assert that “Were the tax system neutral, with equal

taxes on fringes and cash, workers would rather take their income in cash

and make their own decisions about health and life insurance, parking,

exercise facilities, and all the other things they now get from their

employers without much choice.”5

 There are, however, reasons why

businesses may want to provide fringe benefits, and whether the many

varieties of fringe benefits would, in fact, be eliminated or taxed at the

business level under a flat tax is uncertain.

Administration of these fringe benefits under the Hall-Rabushka tax could

be problematic. Tax-exempt entities might have to remit tax on the value

of employees’ fringe benefits, or if an approach not advocated by Hall and

Rabushka were adopted and the employee paid the tax on fringe benefits,

businesses could have to report their value to both the tax agency and the

taxpayer. In this report, we identify areas where the treatment of fringe

benefits might be troublesome for the taxpayer or the tax administrator.

4

Fringe benefits are taxed in the Hall-Rabushka flat tax, but not at the individual level.

5

Hall and Rabushka, p. 63. Also, one tax preparer—Vernon Hoven, “Flat Tax As Seen by a Tax

Preparer,” Tax Notes, Vol. 68, No. 6 (Aug. 7, 1995), pp. 747-55—cites as an example of the difficulties

that might be involved a parking lot purchased for use by employees—the land, which may be

deductible as a business expense, might no longer be deductible because it becomes a fringe benefit.

The question, then, could be whether the employees would be required to pay tax on the fringe benefit,

in which case their burden, as well as the burden for the business, which would have to calculate and

report the value to the individuals, and the burden for the tax administrators would be increased.

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Appendix VII 

Flat Tax

Number of Individual

Taxpayers

The individual side of the flat tax likely would include no more than the

number of individuals reporting under the current income tax—a

maximum of 116 million taxpayers (in 1995 terms), depending on the

threshold level for personal deductions and allowances. Some of these

individuals might report as businesses—sole proprietorships,

partnerships, and S corporations—under the flat tax, but they also might

want to report some part of their income as wages to obtain the personal

allowances. The individual tax could be set up so that only those with

income above a threshold level (including deductions and personal

allowances) or who are due a refund would be required to file and pay the

tax, similar to the current system. The Hall-Rabushka flat tax framework

has personal allowances of $16,500 for married couples filing jointly,

$9,500 for single filers, $14,000 for single heads of household, and a

$4,500-deduction for each dependent.6

 All are higher than the current

allowances. In 1993, the likely maximum number of filers would have been

65 million with the Hall-Rabushka allowances, based on the number of

taxpayers who had wage or pension income above the personal allowance

levels that year.

Information Reported and

Filing Frequency

Unlike the RST and the VAT, the flat tax would require individuals to keep

records, file returns, and pay taxes. However, the form for individuals

could be much simpler than the current income tax form, assuming no

specific deductions were introduced, but individuals would be required to

do the calculations necessary to claim deductions and personal

allowances. Because, however, individuals would not have to report

earnings from interest, dividends, and capital gains, their difficulties in

defining and recognizing income would be reduced. With a flat tax, an

individual would report the following:

• wages,

• salaries,

• pension income, and

• retirement benefits when received.

Retirement benefits would be included in the wage tax, but other fringe

benefits probably would be taxed under the business tax. However, if

contrary to the apparent Hall-Rabushka approach, a variety of fringe

benefits were included in individual taxes, individual taxpayers would

have to report them to the tax agency, increasing their burden and the

6

Hall and Rabushka, p. 59.

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Appendix VII 

Flat Tax

burden for businesses, which would probably be required to provide

taxpayer information to the taxpayer and the tax agency.

Information reporting by employers, which is currently done with

duplicate records of the amounts paid being sent to the taxpayer and the

government, likely would alleviate the need for further recordkeeping for

most individual taxpayers. With a flat tax of this type, a return-free filing

system possibly could be designed so that some individuals might have

only limited contact with the tax agency.

Filing and payment of a flat tax likely could be on a schedule much similar

to the current income tax—filing annually and paying through payroll

deduction or quarterly estimated taxes. With automated information

reporting by employers to individuals, probably few documents would

need to be retained. And if individuals filed simpler forms, greater

possibilities for automation advancements, such as telefile, might follow.

Tax Rates A single tax rate would be applied to all individuals having incomes above

levels of personal allowances and deductions for dependents. Individuals

would be required to make the calculations to determine deductions, and

thus, properly claiming dependents, which has proven troublesome in the

current system, would continue as a problem area.

The one rate necessary to raise the same amount of revenue as the current

multiple-rate income tax coupled with the tax base changes could result in

considerable change for some individual taxpayers.7

 However, as the

Congressional Research Service has alluded to, there would be little

compliance burden change for those individuals who currently take the

standard deduction and pay no tax or are taxed at the 15-percent rate.8

Evasion incentives would vary, depending on the impact of the changes,

but the simplicity of the tax plus information reporting of wages might

deter some evasion.

Credits/Refunds Under the Hall-Rabushka flat tax, refunds would be available for those

whose personal allowances and deductions exceed their income. For

those tax filers with salary and wage income, refunds may not be difficult

for the tax agency to verify if information returns reflect both the wages

and the taxes withheld.

7

Hall and Rabushka suggested a rate of 19 percent. Other proposals range from 17 to 20 percent.

8

Congressional Research Service, Flat Taxes: Simplification and Compliance Issues (May 10, 1996).

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Appendix VII 

Flat Tax

Taxation of Business

Taxpayers and

Potential Impact on

Business Taxpayers’

Compliance Burden

A summary of some of the potential impacts of a flat tax on business

taxpayers is shown in table VII.3 and elaborated on afterward.

Table VII.3: Summary of Some Key

Potential Impacts of a Flat Tax on

Business Taxpayers

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of the flat tax on

business taxpayers

Return filing 24 million returns filed in

1995

All businesses included

Records kept Records supporting income

and expenses supposed to

be kept

Businesses responsible for

wage reporting to

individuals; records for

items such as depreciation

not needed except for

possible transition

Calculations made Complicated calculations

included for provisions such

as depreciation, the

alternative minimum tax,

and the foreign tax credit

Fewer calculations, such as

for depreciation and

multiple rates, required;

possible fringe benefit

calculations

Complexity faced Detailed rules involved;

complexity reflected in

areas such as depreciation,

the alternative minimum tax,

and the foreign tax credit;

difficulties existing in

defining and recognizing

income

Without exemptions and

multiple rates, tax

simplified; fringe benefits

calculations complicated, if

broad range taxed at

individual level

Requirement to furnish

information returns

1.1 billion information and

withholding documents filed

Returns still needed for

wages, but not for

investment earnings;

withholding possibly still

required

Source: GAO analysis of available information about the Hall-Rabushka flat tax.

Tax Base A business remitting a flat tax would calculate, report, and remit taxes on

its gross receipts (or sales) minus the cost of goods and services (or

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Appendix VII 

Flat Tax

purchases), including investments for capital goods, minus wages, salaries,

and pensions and retirement benefits.

Number of Business

Taxpayers

A maximum of about 24 million taxpayers (as of 1995) would be included

in the business flat tax if all corporations, partnerships, and nonfarm and

farm sole proprietors remitted as businesses. Sole proprietors might want

to pay themselves a wage in order to take the personal allowance

deductions available with the individual tax, and they might take all

income earned as commissions, for example, as personal wages.

Nevertheless, most would probably file as businesses to deduct their

expenses—that is, purchases of goods and services, purchases of capital

equipment, and wages paid.

Information Reporting and

Filing Frequency

With a Hall-Rabushka style of flat tax, a business would need records for

the following:

• gross receipts from sales;

• gross amount of purchases or inputs (goods and services), including

capital investment;

• amount of employee wages and salaries; and

• amount of employee pensions and retirement benefits.

Businesses likely would be required to submit to both their employees and

the tax agency information returns, similar to the present W-2 forms,

showing employees’ wages and salaries. In addition, pensions and

retirement benefits (and perhaps other fringe benefits) would have to be

calculated and reported. With a flat tax, preparation of Forms 1099 for

investments could be eliminated for returns from savings and investments.

Furthermore, calculations of items such as depreciation, alternative

minimum tax, and foreign-source income and foreign tax credits would be

eliminated, unless there was a period of transition in which calculations

for both a flat tax and an income tax would be required. Businesses, of

course, might continue to calculate depreciation for their own financial

statements or other business reasons.

Accounting methods for a flat tax could mirror current standard

accounting methods and accrual accounting would not be required for tax

purposes. Even for self-employed individuals, reporting of the above items

would seem to duplicate information businesses should keep on hand.

However, if contrary to Hall and Rabushka, fringe benefits were taxed on

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Flat Tax

the individual level, estimating and reporting their value could be difficult

for companies, as well as tax-exempt entities, providing a wide array of

employee benefits, such as insurance, stock options, gym facilities,

parking privileges, cafeteria plans, and other items that are difficult to

evaluate.

Businesses probably would be required to file tax returns and make tax

remittances on schedules similar to the current business income and

employment tax schedules, which vary based on the type and amount of

tax. Special rules might apply to new businesses until a basis for the

amount of tax due is determined.

Tax Rates With a flat tax, one tax rate other than a zero rate would apply to both

individuals and businesses, making it generally futile for either type of

taxpayer to attempt to shift income. Businesses, however, would have an

incentive to shift income to individuals in the form of wages so the

individuals could take advantage of personal allowances.

Credits/Refunds Businesses starting or expanding operations would likely have large

capital investment expenditures deductible from their gross receipts,

which could put them into negative tax situations. Under the

Hall-Rabushka flat tax, no refunds would be given when a business’

start-up costs exceed its income, but the losses could be carried forward

indefinitely and a market rate of interest would be paid on them by the

government. End-of-year purchases of inventory also could reduce taxes

and create refund carryover situations. The tax agency would have the

burden of administering these carryover credits.

The Hall-Rabushka model is an origin-based tax, which taxes only a

business’ domestic operations and provides no border adjustments for

exports as is done now with VATs. While this does not address the

concerns of major exporters who wish to recover their export taxes, it

relieves the tax agency from administering border adjustments, a cost

saving to the administrator. (See app. VI for a discussion of administering

border adjustments with a VAT.)

Flat Tax Compliance

Costs

A flat tax requiring both businesses and individuals to file returns would

not have as great an impact on alleviating the compliance burden as would

a tax, such as a VAT, which requires only businesses to comply. If all

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Flat Tax

individuals were required to file, if only to establish personal deductions

for tax exemption, a certain amount of compliance burden would be

continued. Nevertheless, a flat tax, unencumbered by exemptions and

multiple rates, by virtue of its simplicity would offer the possibility of

substantial reduction from the current income tax in compliance burden

for both individuals and businesses—some of which might also be

possible with simplification of the current tax.

No reliable data exist with which to evaluate with any precision the

compliance burden of a potential flat tax. Slemrod estimated the

compliance costs overall at about half of his rough estimate for the current

system—cutting business compliance costs by about one-third and

personal compliance costs by 70 percent.9

 Hall estimated a lower cost than

Slemrod, using the model developed for IRS, which had the limitations

described in appendix II.10

The treatment of fringe benefits—whether or not a business or individual

has to determine the value of fringe benefits in order to pay tax on

them—would affect the degree of simplicity and costs of compliance with

a flat tax. Another concern that would influence compliance costs is the

type of transition, if any, from an income tax to a flat tax. While individuals

might not be affected by double taxation of existing savings, which could

occur with some consumption taxes, a transition period might be needed

to shelter existing capital assets of businesses. If there were a transition

period, many businesses could find themselves complying with both a new

flat tax and the remaining elements of the existing income tax.

Potential Impact on

Tax Administrators

A summary of some of the potential impacts of a flat tax on tax

administrators is shown in table VII.4 and elaborated on afterward.

9

See Joel Slemrod, “Which Is the Simplest Tax System of Them All?” in Henry J. Aaron and William G.

Gale, eds., Economic Effects of Fundamental Tax Reform (Washington, D.C.: Brookings Institution

Press, 1996), pp. 374-75.

10See Arthur P. Hall, “Compliance Costs of Alternative Tax Systems,” Tax Notes, Vol. 71, No. 8 (May 20,

1996), pp. 1088-89.

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Flat Tax

Table VII.4: Summary of Some Key

Potential Impacts of a Flat Tax on Tax

Administrators

Item Current income tax Flat tax

Impact on number of

returns processed

Hundreds of millions of returns

and other materials received

Returns simplified; assuming

withholding still required,

number of tax returns possibly

almost the same, but number

of information returns needed

much lower because interest

and dividends not taxed

Impact on refund

processing

92 million refunds issued in

fiscal year 1995

Refunds for excess payment

required for individuals;

verification needed

Impact on

examination approach

Tax returns matched with

information returns; fiscal year

1995 examination coverage at

1.36 percent, with corporate

audits taking longer than

individuals’ audits

Verifying individuals’ taxes

simplified, but auditing

business’ own records still

needed

Continuation of old

compliance problems

Compliance problems related

to income definition,

unreported income, and more

specific issues identified in

other areas such as transfer

pricing, depreciation,

deductibility of business

expenses, small businesses,

independent contractors, and

the underground economy

Compliance problems with

transfer pricing, business and

personal expense distinctions,

independent contractors, small

businesses, unreported

income, and underground

economy continued

Resolution of old

compliance problems

Not applicable Compliance problems with

depreciation and related to

income definition eliminated

Creation of new

compliance problems

Not applicable Tax avoidance encouraged for

employees paid in ways other

than cash and sales

characterized as interest

received; possible fringe

benefits audits complicated

Impact on collections

from tax delinquents

Millions of taxpayer delinquent

investigations and accounts

disposed of, with most of the

latter being for individuals and

most business dispositions

covering employment taxes

Need for collection follow-up

for individual taxpayers

reduced by less information

matching and elimination of

audit issues; small business

problems possibly mirroring

current employment tax

collection problems

Impact on

individuals’ questions

received

Millions of taxpayer inquiries

fielded, covering a wide variety

of questions

Some types of taxpayer

questions eliminated when

income and deduction items

eliminated

Source: GAO analysis of available information about the Hall-Rabushka flat tax.

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Flat Tax

Processing of Returns With a flat tax, a tax agency might process almost the same number of tax

returns as the 122 million in the current system (in 1995), since both

individuals and businesses would continue to file returns and remit taxes;

however, the level of personal allowances and deductions available could

affect that number considerably. Filing and remittance schedules could

mirror the present system, with filing required annually and remittance at

intervals, depending on the type of taxpayer and amount of tax to be

remitted. Forms, such as W-2s submitted by businesses for each employee,

would require processing and document matching. However, the

information now reported on Form 1099 would not be needed by the tax

agency because savings and investment earnings would not be taxed.

Eliminating the many deductions now itemized by some taxpayers

simplifies the return so that individual taxpayers would only submit a form

with about 12 lines, and businesses only 10 lines. Return processing should

be simpler as a result. Any variations from the Hall-Rabushka flat tax

design, by introducing other deductions or credits, could complicate the

administration of the tax.

The large numbers of taxpayers and returns would require retaining the

current emphasis on such uses of automation as scanning and electronic

filing. The much simpler form would seem to facilitate automation of data

entry and document matching, making the process less error-prone and

costly and providing timely data for auditors. As with other tax proposals,

the status of IRS’ Tax Systems Modernization at the time of the inception of

a new tax would be critical for its administration. Hall and Rabushka do

not suggest exempting small businesses from tax, as is done in some

countries’ VAT systems to alleviate taxpayer and tax agency burden. Claims

for credits might not be a significant processing item, but as discussed

above, other types of refunds or credits might be claimed by both

individuals and businesses.

Audit/Examination Given the current success in collecting taxes through withholding, tax

avoidance would seem to be difficult for individual wage earners whose

companies reported earnings and taxes withheld, thus performing a

compliance function the government would have to do otherwise. The

personal allowances and dependent deductions would seem to have less

room for cheating if Social Security numbers were required for claiming

dependents, as is done now with the income tax. Auditing could get

complicated, however, depending on the extent that the system was

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Flat Tax

circumvented by paying employees in ways other than cash or by

transforming payments into savings or investments.

Verification of businesses’ records of sales and purchases and their

payments to employees probably would be the largest component of a tax

agency’s audit effort. As in the current system, these records are kept by

the businesses themselves, and the opportunity for erroneous reporting is

present. Checking for such things as underreported sales or overreported

purchases can be time-consuming and difficult for a tax agency to audit.

As the 1995 study published by the American Institute of Certified Public

Accountants pointed out, claims of business expenses (deductible) may be

difficult to separate from personal expenses (nondeductible), similar to

the current situation.11 Validity of these expense claims has been one of

IRS’ ongoing audit and post-audit problems and probably would not be

improved with a flat tax. Depending on the prevailing tax rate, such

problems could be exacerbated. For self-employed individuals, the

self-reporting of earnings could be problematic. Reporting by sole

proprietors has been shown to be particularly troublesome in the current

system.

A scoring system, such as IRS has now for identifying which returns to

audit by looking at audit potential, would probably have to be developed

for a flat tax. Since no country has tried a flat tax similar to the

Hall-Rabushka model, the United States has no other experience to rely

upon beyond the current income tax system, and it could take some time

to fully develop a scoring system.

From a tax administration viewpoint, any complications through multiple

rates or further deductions to address regressivity or other concerns are

likely to be costly and very difficult to administer with a flat tax, similar to

a subtraction VAT, which we previously said would not function properly

with multiple rates.12 Excluding individuals with incomes below specified

levels from paying taxes, receiving refunds, and filing returns alleviates

taxpayer burdens and reduces the number of returns to be processed;

however, tax administrators may still need to verify claims for exclusion.

Conversely, if any programs such as the earned income credit were

administered, they might be delivered to low-income recipients through

the tax system, as is done here and internationally through income tax

11Martin A. Sullivan, Flat Taxes and Consumption Taxes: A Guide to the Debate (New York: American

Institute of Certified Public Accountants, Dec. 1995), p. 111.

12See Tax Policy: Tax-Credit and Subtraction Methods of Calculating a Value-Added Tax

(GAO/GGD-89-87, June 20, 1989), p. 5.

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Flat Tax

systems, increasing the number and complexity of returns filed as well as

the cost of administration. Similarly, small businesses might be excluded

from a flat tax, as is done with international consumption taxes, but

administratively, ascertaining the validity of a business’ claim for

exemption could be very difficult, similar to a subtraction VAT. None of

these variations is in the Hall-Rabushka tax design.

Enforcement efforts probably would still need to emphasize many of the

current areas of noncompliance. There is no credit/invoice system, such as

exists with a credit VAT, to give at least an appearance of automatic

enforcement. Issues of noncompliance, such as with sole

proprietors/independent contractors, now troublesome to IRS, would not

likely change much with a flat tax, and there is nothing apparent in this tax

system that would solve the current problems with underreported or

unreported income, particularly of small businesses. Abusive transfer

pricing, long an enforcement concern for IRS, also would continue to be a

problem with the flat tax, as Grubert and Newlon have noted.13 Abusive

transfer pricing occurs when prices claimed for transactions between

related companies operating in different jurisdictions are set too high or

too low, and income is, in effect, shifted from one jurisdiction to another,

resulting in tax underremittance.

New noncompliance problems could arise, similar to those found in other

consumption tax situations. For example, as alluded to in the 1996

Economic Report of the President, an incentive would exist for businesses

to characterize part of their sales as interest payments payable by buyers

by reducing the sales price (taxable) and offsetting this by raising the

interest paid (nontaxable to the businesses). Shifting sales to interest

payments would give the business a tax advantage, and detecting this

through enforcement efforts could be difficult.

An underground economy would seem to be able to operate in much the

same way with a flat tax as with the current system, because no obvious

deterrent would seem to be available to prevent both legal and illegal

transactions from occurring outside the tax system. It is difficult to

determine the impact any consumption tax would have on the

underground economy.

13Harry Grubert and T. Scott Newlon, “The International Implications of Consumption Tax Proposals,”

National Tax Journal, Vol. XLVIII, No. 4 (Dec. 1995), p. 637.

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Flat Tax

Credits/Refunds With a flat tax, as with VATs, new businesses could have purchases and

employee compensation costs exceeding sales. This could put the new

business into a negative cash flow situation, potentially detrimental to the

business’ future. Not only would the business need to be able to claim a

refund, but, as we assumed in an earlier study, it would also likely prefer

the refund to be in cash, rather than as a carry-forward credit as specified

by Hall and Rabushka.14 If, contrary to Hall and Rabushka, refunds were

allowed, a tax agency would need to have a system that could rebate the

money quickly without jeopardizing government funds.

Unlike VATs used internationally, the flat tax as outlined by Hall and

Rabushka would not include border adjustments to tax imports and rebate

taxes on exports. This would eliminate a potentially difficult

administrative responsibility, including identifying fraudulent claims of

exports that we pointed out in our 1993 VAT study.15 However, transfer

pricing, mentioned above as a large audit issue in the current system,

would remain.

Collections Collection efforts might change somewhat with a flat tax. If information

reports of earnings from savings and investments (Forms 1099) were no

longer necessary and if audit issues associated with capital gains and

itemized deductions disappeared, matches with taxpayer data and related

audit issues and findings should also decline. This, in turn, would affect

the need for collection follow-up with individuals, where most of the

collection issues have arisen.

Taxpayer Services As with any new system, taxpayer services would require an initial

education period, with additional resources required for publications,

assistance through telephones and other telecommunications, and

taxpayer education programs. The individual component of the flat tax,

however, would appear to be simple enough in many ways so that

taxpayers could have less difficulty understanding it than the current

income tax. Entire areas of questions, such as those for capital gains and

losses and medical expenses, might virtually disappear, although others,

such as those for dependents and filing status, would likely continue.

14See Tax Policy: Value-Added Tax: Administrative Costs Vary With Complexity and Number of

Businesses (GAO/GGD-93-78, May 3, 1993), p. 115.

15See GAO/GGD-93-78, pp. 33 and 57.

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Information about IRS’ current taxpayer services effort, discussed in

appendix II, shows that about 10 percent of the tax law questions received

by IRS’ technical support staff concerned the dependent or exemption or

filing status of taxpayers. Many of these questions would likely continue

with the flat tax. Some frequent stumbling blocks, such as inquiries about

capital gains and losses, could be eliminated by the flat tax.

The business part of the tax could require initial education effort and

auditor time for some period to ensure maximum clarity and, hopefully,

compliance. Education is thought by many to be the key to compliance,

and efforts along these lines should not be undervalued for any tax

change.

The transition to a flat tax likely would require taxpayer education

because a flat tax would change the way such things as capital investment

would be treated—that is, by expensing on a current basis rather than

depreciating over a longer period. If the transition occurred while features

of the income tax were still operative, taxpayers might have to comply

with both systems for a period of time and likely would require more

extensive taxpayer education and services.

Other Issues

Transition The familiarity of taxpayers with the current tax system should ease a

transition to a flat tax if a transition were desired. Nevertheless,

accounting and reporting requirements with a flat tax would require time

for businesses to convert to the new system. Furthermore, some portions

of the current system might be continued during a transition period. For

example, businesses that under the current system had been depreciating

their capital expenditures would be subject to immediate expensing with a

flat tax. However, the negative ramifications of this might be offset by

continuing to depreciate assets during a transition period, making the

transition more difficult and lengthy for the business taxpayer and

complicating auditing and collections for the tax administrator. A

transition to a flat tax also could be designed to continue carrying forward

existing net operating losses, and existing tax credits could be phased out

during a transition period. Even though earnings from savings are not

taxed with a flat tax, moving to a consumption tax could result in some

individuals’ preenactment savings being taxed when earned (as income),

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Flat Tax

and also when spent (as consumption) under the flat tax unless some

special provisions were designed for this. Such adjustments could occur

during transition.

The tax agency would need some time and resources for educating the

public about the changes, particularly for business taxpayers. If, as

proposed, wages and pensions were generally the only items taxed to

individuals, transition for individuals would be much simplified. Overall,

the flat tax, with one rate and no exemptions, would seem to be less

cumbersome to introduce than would a more complicated tax system.

Federal/State Issues Because a flat tax would operate much like the current tax system, it

probably would cause fewer areas of uncertainty than a more drastic

change to a transaction tax, such as a credit VAT, discussed in appendix VI,

or a national RST, discussed in appendix V. However, the base of the

individual tax, with only wages and pensions, would affect the amount of

collections in states that based their taxes on the current broad base of the

federal system unless they adjusted their rates to compensate for the loss.

States could devise ways to accommodate the new system, such as by

adjusting their income tax base to conform with the flat tax and raising the

rate to compensate for the narrower base.

International Issues In Hall and Rabushka’s opinion, the flat tax would be desirable because

their proposed “low” tax rate of 19 percent would attract international

businesses, even though overseas earnings of American workers and

businesses would not be taxed.16 Although Hall and Rabushka would not

tax the foreign earnings of Americans, all earnings from work in the

United States would be taxed, regardless of the worker’s citizenship.

The flat tax, as envisioned by Hall and Rabushka, uses the origin principle

for international taxation, rather than the destination principle now used

widely with VATs. Under the origin principle, imports are exempt from

taxes and exports are taxable; thus, transfer pricing problems would

continue. However, problems administering the foreign tax credit would

disappear. The future of U.S. bilateral income tax treaties would be

unclear, and other countries might consider changing their own

international taxation rules.

16Hall and Rabushka, p. 77.

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Personal Consumption Tax

Description Of the proposals that would replace the income tax with a consumption

tax, a personal consumption tax would look most like the current personal

income tax. In general, under a personal consumption tax, taxpayers add

up all the funds they have received during the year and then deduct the

amount they saved. The remaining amount is a measure of the taxpayer’s

spending on goods and services for consumption over the year, and this

amount is subject to tax.

Table VIII.1 shows some of the principal similarities and differences

between a personal consumption tax and the current individual income

tax. The most basic similarity is that both are individual taxes, so both can

include features such as a standard deduction, personal exemptions, and

graduated tax rates. The two taxes are also similar in that many types of

income now included under the current tax would also be included in the

personal consumption tax base. In particular, wages, pension income, and

interest and dividend income would be taxed under a personal

consumption tax.1

1

For additional details on personal consumption taxes, see U.S. Department of the Treasury, Tax

Reform for Fairness, Simplicity, and Economic Growth, Ch. 9, “Consumed Income Tax,” Vol. 1 (1984);

David F. Bradford and the U.S. Treasury Tax Policy Staff, Blueprints for Basic Tax Reform, 2nd ed.,

revised (Arlington, Va.: Tax Analysts, 1984); The Institute for Fiscal Studies, The Structure and Reform

of Direct Taxation: Report of a Committee Chaired by Professor J.E. Meade (London: George Allen and

Unwin, 1978); Henry J. Aaron and Harvey Galper, Assessing Tax Reform (Washington, D.C.: The

Brookings Institution, 1985); David F. Bradford, Untangling the Income Tax, Ch. 5, “Personal

Consumption Taxes” (Cambridge, Mass.: Harvard University Press, 1986); and Michael J. Graetz,

“Expenditure Tax Design,” in Joseph A. Pechman, ed., What Should Be Taxed: Income or Expenditure?

(Washington, D.C.: The Brookings Institution, 1980).

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Personal Consumption Tax

Table VIII.1: Comparison of the Current

Income Tax With a Personal

Consumption Tax

Item Current income tax Personal consumption tax

Personal level

Wages Included Included

Interest income received Included Included

Dividends received Included Included

Pension income Included when received Included when received

Loan proceeds Not included Included

Sales of assets Capital gain included Proceeds included

New saving (purchases

of assets, deposits in

qualified accounts, loan

repayments)

Generally not deducted Deducted

Job expenses (cost of

earning income)

Certain costs deducted by

itemizers

Deducted

Fringe benefits Not included Allocated to individuals by

business (if no separate

business tax)

Source: GAO analysis of a personal consumption tax.

The major difference between the two taxes lies in the treatment of saving.

Under the current income tax, saving is generally not deductible, and

borrowed funds are not taxed. Under a personal consumption tax, new

saving would generally be deductible. For example, amounts deposited in

savings accounts or used to purchase corporate stock or bonds could be

deducted. In addition, the repayment of principal and the payment of

interest on borrowed funds would be deductible as saving. However,

under most personal consumption tax proposals, borrowed funds would

be taxable because they could be used for consumption. Similarly, upon

the sale of an asset, the entire proceeds of the sale would be taxable rather

than the gain (or loss) from the sale as under an income tax.

Business purchases of consumer goods and services could pose problems

for a personal consumption tax, as they do under an income tax.2

 For

example, business purchases of automobiles, meals, entertainment, and

fringe benefits could represent consumption by the employees or owners

of the business and not really represent a cost of operating a business.

Without some rules, there would be an incentive for businesses to

purchase these kinds of goods and services for their owners and

employees in order to avoid tax under the personal consumption tax.

2

See Aaron and Galper, p. 79.

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Appendix VIII 

Personal Consumption Tax

This potential problem could be handled in two ways. First, businesses

could be required to allocate spending on such consumption items to the

individuals receiving the benefits, and the individuals could report this

amount on their consumption tax returns. The tax rate applied to this form

of consumption would then depend on the individual’s tax bracket. This

type of tax treatment is reflected in the last line of table VIII.1 for fringe

benefits.

Alternatively, all businesses could be made subject to a cash flow tax for

which consumption-type expenditures would not be deductible.3

 Under a

cash flow tax, inflows of cash would generally be taxable and outflows of

cash would generally be deductible. Inflows would include business

receipts, proceeds of sales of assets, and borrowing. As under a

consumption value-added tax (VAT), business purchases of goods and

services used for business purposes would be deductible, and purchases

of investment goods, such as plant and equipment, would be deductible

immediately rather than depreciated over time. In addition, wages,

dividends, and payments for interest and repayment of borrowed funds

would also be deductible. However, business purchases of consumption

goods without a business purpose would not be deductible, so

consumption done at the business level would effectively be taxed at the

business’ tax rate.4

Table VIII.2 compares a personal consumption tax and business cash flow

tax with the current income tax for both individuals and businesses. As

under the personal consumption tax, and unlike an income tax, the cash

flow tax would include borrowed funds and all the proceeds from asset

sales rather than only capital gain or loss. Like the VAT and flat tax, and

unlike an income tax, the purchase of investment goods would be

deductible immediately rather than depreciated over time.

3

For noncorporate businesses, the business cash flow tax rules could be reflected in the individual tax

return. For example, sole proprietorships could include the receipts and expenditures of the business

in their personal return, much like sole proprietors now report their income on Schedule C of their

personal income tax return. Alternatively, the business tax could be kept separate from the individual

tax. All businesses (corporate and noncorporate) would pay a cash flow tax and file separate returns,

as under the flat tax.

4

A business cash flow tax could serve several additional purposes. First, if transition rules are desired

in converting to a consumption tax, the business-level cash flow tax could allow businesses to claim

currently unused tax credits and deduct depreciation on existing assets and net operating losses.

Second, the tax would tax extraordinary returns to investment. Third, the tax could be used to tax

U.S.-source activity of foreign corporations operating in the United States.

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Personal Consumption Tax

Table VIII.2: Comparison of the Current

Income Tax With a Personal

Consumption Tax and Business Cash

Flow Tax System Item Current income tax

Personal consumption tax

and business cash flow

tax

Business level

Sales of goods and

services

Included Included

Sales of assets Gain included Proceeds included

Loan proceeds Not included Included

Purchases of goods and

services

Deducted Deducted

Purchase of capital

goods

Depreciated over time Deducted immediately

Wages paid Deducted Deducted

Fringe benefits Deducted Not deducted

Interest paid Deducted Deducted

Dividends paid Not deducted Not deducteda

Personal level

Wages Included Included

Interest income received Included Included

Dividends received Included Included

Pension income Included when received Included when received

Loan proceeds Not included Included

Sales of assets Capital gain included Proceeds included

New saving (purchases

of assets, deposits in

qualified accounts, loan

repayments)

Generally not deducted Deducted

Job expenses (cost of

earning income)

Certain costs deducted by

itemizers

Deducted

Fringe benefits Not included Not included

aAlternatively, the business cash flow tax could include proceeds from new stock issues and

allow a deduction for dividends paid.

Source: GAO analysis of a personal consumption tax and business cash flow tax.

Potential Impact on

Taxpayers’

Compliance Burden

Table VIII.3 summarizes how a personal consumption/business cash flow

tax could affect taxpayers, and a more detailed discussion follows.

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Personal Consumption Tax

Table VIII.3: Summary of Some Key

Potential Impacts of a Personal

Consumption and Business Cash Flow

Tax on Taxpayers Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of the personal

consumption and

business cash flow tax on

taxpayers

Burden on individual

taxpayers

Impact on individual

taxpayers

Return filing 116 million returns filed in

1995

Number of returns possibly

increased with borrowing

included in the tax base

Records kept Records supporting tax

returns supposed to be

kept—e.g., receipts, proof

of payment, and

documentation supporting

deductions and credits;

burden alleviated by

information reports given to

individuals

Additional records needed

on amounts borrowed and

amounts saved

Calculations made Complicated calculations

for some taxpayers

included for provisions such

as dependency tests and

capital gains

Calculations of capital gains

eliminated

Complexity faced Many pages of instructions

involved and millions of

supplemental forms and

schedules filed—e.g., 33

million schedules of

itemized deductions for tax

year 1994; difficulties

existing in defining and

recognizing income;

however, in actual practice,

minimal complexity faced

by millions of individuals

New rules required for

saving deduction and

inclusion of borrowing;

measurement of capital

income simplified

Burden on business

taxpayers

Impact on business

taxpayers

Return filing 24 million returns filed in

1995

Similar number of returns,

filing frequency the same

Records kept Records supporting income

and expenses supposed to

be kept

Accrual accounting and

depreciation records

eliminated for tax purposes;

additional records needed

for borrowing and lending

Calculations made Complicated calculations

included for provisions such

as depreciation, the

alternative minimum tax,

and the foreign tax credit

Accrual accounting and

depreciation calculations

eliminated for tax purposes

(continued)

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Personal Consumption Tax

Burden

Characteristics of

taxpayer compliance

burden under the current

income tax

Impact of the personal

consumption and

business cash flow tax on

taxpayers

Complexity faced Detailed rules involved;

complexity reflected in

areas such as depreciation,

the alternative minimum tax,

and the foreign tax credit;

difficulties existing in

defining and recognizing

income

Accrual accounting and

depreciation eliminated for

tax purposes; alternative

minimum tax and foreign

tax credit eliminated

Requirement to furnish

information returns

1.1 billion information and

withholding documents filed

Reporting possibly more

extensive

Source: GAO analysis of available information about a personal consumption and business cash

flow tax.

Filing Requirements Under the current income tax system, filing requirements are reflected in

rules regarding filing status, the size of the standard deduction, and

personal exemptions. The number of returns filed depends on these rules

and the extent of withholding. Currently, taxpayers file returns based on

their filing status, which can be single; head of household; married, filing

jointly; married, filing separately; or qualifying widow(er) with dependent

child. Taxpayers are not required to file a return if they received less gross

income than the applicable standard deduction amount plus the value of

the minimum number of allowed personal exemptions. However,

taxpayers with less income than these thresholds may still file a return to

claim a refund if taxes have been withheld during the year or if they are

eligible for a refundable credit such as the earned income tax credit.

Filing requirements for individual taxpayers under a personal

consumption tax could be very similar to current requirements. For

example, the rules regarding filing status could remain the same as under

current law. Similarly, taxpayers reporting less consumption (or gross

income) than the standard deduction and the value of personal

exemptions could be excused from annual filing. In general, the larger the

standard deduction and value of personal exemptions, the greater the

number of taxpayers who could arrange to have no tax withheld and

would therefore not need to file. However, taxpayers who would not

otherwise have to file could still find it advantageous to file if a refundable

credit program like the earned income credit was retained.

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Apart from possible changes in the size of the standard deduction or

personal exemptions, a change in the tax base from income to

consumption could have an effect on the number of taxpayers filing

returns unless changes in withholding were also made. For taxpayers with

primarily wage income who do little saving or borrowing, the likelihood

that they would have to file and the size of any remaining tax payment or

refund might not be very different than under the current system.

However, as the Department of the Treasury pointed out in its 1984 report

on tax reform, for taxpayers who sold assets or borrowed funds for

consumption, withholding tax on wages alone might not match their

annual tax liability as closely as under the current system.5

 Unless

taxpayers adjusted the amount of tax withheld, they might be more likely

to have to file returns or pay estimated taxes during the year. Other

taxpayers who saved significant portions of their wage income could be

entitled to relatively large refunds and therefore might have to file. This

situation could be addressed by extending withholding to asset sales and

borrowing, but this approach would put additional burden on the

businesses that would have to withhold tax.

Recordkeeping

Requirements

Moving from the current income tax to a personal consumption tax could

lead to additional recordkeeping requirements for some financial assets,

reduce some requirements to maintain records over time, and leave

recordkeeping requirements for certain deductions essentially unchanged.

Moving to a business cash flow tax could substantially change how

businesses keep records for tax purposes.

Financial Assets and Liabilities Many analysts believe that individual taxpayers would have to keep more

records under a personal consumption tax than under the current system.6

Unless information reporting was expanded, taxpayers would need to

keep records on amounts borrowed and saved during the year. Taxpayers

do not have to keep records for these items under the current system.

Some discussions of potential personal consumption taxes have suggested

that for compliance reasons, only saving done through qualified accounts

5

Treasury, pp. 202-03.

6

See Treasury, p. 201; Harvey S. Rosen, Public Finance, 3rd. ed., Ch. 20, “Taxes on Consumption and

Wealth” (Burr Ridge, Ill.: Irwin, 1992), p. 509; and Charles E. McLure, Jr., and George R. Zodrow,

“Administrative Advantages of the Individual Tax Prepayment Approach to the Direct Taxation of

Consumption,” in Manfred Rose, ed., Heidelberg Congress on Taxing Consumption (June 28-30, 1989),

p. 347.

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Personal Consumption Tax

in financial institutions should qualify for deductions.7 Qualified accounts

would be similar to IRA accounts under current law. Other forms of saving,

such as direct loans to other individuals, would not be deductible, but

repayments of such saving would not be taxed. If this approach was used,

individuals might be required to keep separate records on qualified and

nonqualified assets and liabilities.

However, as Treasury noted in 1984, the need for taxpayers to keep some

records for long periods may decrease.8

 Under current law, individuals

must keep records on the original purchase price of assets in order to

calculate capital gains tax when assets are sold. Under a consumption tax,

the original purchase price of an asset is irrelevant for tax calculations

because all sale proceeds are subject to tax, so records related to the

original purchase would not have to be kept.

Housing One of the more difficult issues for consumption taxation is the taxation of

consumer durable goods.9

 These goods can serve both as consumption

goods and as a form of saving. A significant example of this type of good is

owner-occupied housing, which generates consumption services for the

owner and is a major investment for many individuals. If housing was

treated like other saving or investment under a personal consumption tax,

the purchase of the house would be deductible as saving and the income

from the investment would then be taxable. In the case of owner-occupied

housing, the income from the investment is the value of the consumption

services received by the owner—the amount the owner would pay to rent

the house. However, since there is no rent transaction for owner-occupied

housing, a value would have to be imputed either through appraisals or

through some approximation method.10 Allowing a deduction for the

purchase of housing and ignoring the rental value of housing would

undertax owner-occupied housing relative to rental housing and other

forms of consumption.11

Most discussions of personal consumption taxes have supported a “tax

prepayment” treatment for owner-occupied housing, or a modified version

7

Treasury, p. 194.

8

Treasury, p. 196.

9

See Graetz, p. 184 and Rosen, p. 506.

10The same difficulty in taxing the return from owner-occupied housing arises in the income tax. (See

app. IV.)

11See Aaron and Galper, pp. 90-91.

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Personal Consumption Tax

of this approach.12 Under the tax prepayment approach, consumption tax

would be paid when the house is purchased because the amount borrowed

for the mortgage and the funds withdrawn from accounts for a down

payment would be taxable. The imputed rental value of the housing

services would not be taxed, and only the capital gain rather than the

entire sale price of the house would be taxable if the house was sold.

While this approach may be easier to administer than taxing imputed rent,

it would require a large one-time tax payment. A modification of this

approach would levy tax only on the down payment, but not allow a

deduction for repayment of mortgage principal or interest, reducing the

one-time tax payment. However, this modification would treat mortgage

debt and interest payments differently than other debt and interest, and

rules to define different types of debt would be necessary, as under

current law.

Before 1997 changes to the income tax, more homeowners than afterward

were required to keep records on their purchases and sales of homes over

their lifetime in order to calculate any capital gains tax they may have had

upon sale. Recordkeeping requirements under a personal consumption tax

would depend on the approach taken. If the modification of the

prepayment approach was chosen, recordkeeping requirements for

owner-occupied housing could be similar to those in effect before the

recent changes in the law.

Job and Business Expenses Some items that currently require detailed taxpayer recordkeeping would

remain issues because they concern determining whether certain

expenditures are legitimate business expenses or personal consumption.

For example, deductions for job expenses, business entertainment

expenses, moving expenses, and business use of automobiles would likely

remain issues under a personal consumption tax.

Cash Flow Business Tax Like some of the other consumption tax proposals, a cash flow tax might

simplify recordkeeping for business taxpayers. For example, businesses

would not have to keep records according to accrual accounting principles

for tax purposes. Like other purchases of goods and services, investments

in business plant and equipment or inventories would be deducted

immediately, rather than depreciated over time or deducted when sold as

under the income tax. Thus, taxpayers would not have to distinguish

between expenditures that can be deducted immediately and those that

must be capitalized and depreciated over time. However, businesses

12See Graetz, pp. 193-97; Aaron and Galper, pp. 90-91; and Laurence S. Seidman, “The USA Tax: A

Friendly Critique of Its Design,” Tax Notes, Vol. 73, No. 7 (Nov. 18, 1996), pp. 834-37 for discussions of

this treatment.

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Personal Consumption Tax

would probably still calculate depreciation on capital assets for financial

statements and other business purposes.

However, unlike the VAT or the business tax component of the flat tax, a

cash flow tax would include financial transactions in the base of the tax.

Borrowed funds would be included and repayments of loans and interest

would be deductible. A VAT would be simpler than a cash flow tax in this

sense because fewer transactions would have to be accounted for in

computing tax liability. However, to accomplish this simplification, rules

would have to be written to differentiate purely financial transactions

from the sale of goods and services.13 A cash flow tax would include more

transactions in its base but not require such rules.

Calculations Needed to

Compute Tax Liability

While, as mentioned above, the need for recordkeeping may expand in

some areas under a personal consumption tax, the need for taxpayers to

do calculations may decrease in others. For example, although the need to

compute net savings would be introduced, calculating capital gain or loss

from the sale of an asset would no longer be necessary. Taxpayers who

sell assets would have to keep records on the proceeds of the sale, but all

the proceeds of the sale would be taxable, not only capital gain or loss.

More generally, businesses and individuals would not have to differentiate

between the return of capital (original amounts invested or saved) and the

return on capital (income earned from saving or investment). Under an

income tax, the return of capital is not taxed, but the income earned from

capital is taxed. Under a consumption tax, this distinction is not necessary

because saving and investment is deducted immediately and both the

return of capital and the return on capital are subject to tax.

One area in which a personal consumption tax would be simpler than a

reformed income tax involves the need to make adjustments for inflation.

Many analysts believe that inflation adjustments should be made in the

income tax because the measurement of income can be significantly

distorted when inflation is high. The current income tax does not have

such adjustments explicitly and requiring them might significantly

complicate the income tax. In contrast, a personal consumption tax would

not need to include inflation adjustments.14 Therefore, consumption tax

13Transactions involving interest payments, installment sales, and leases can feature both an exchange

of goods and services and borrowing and lending funds between the parties.

14See McLure and Zodrow, pp. 344-45 and Treasury, p. 197.

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Personal Consumption Tax

proponents argue that relative to an income tax that measures income

correctly, the consumption tax would require far fewer calculations.

Potential Impact on

Tax Administrators

Table VIII.4 summarizes some of the ways in which a personal

consumption and business cash flow tax could affect tax administrators,

and a more detailed discussion follows.

Table VIII.4: Summary of Some Key

Potential Impacts of a Personal

Consumption and Business Cash Flow

Tax on Tax Administrators Item Current income tax

Personal consumption

and business cash flow

tax

Impact on number of

returns processed

Hundreds of millions of

returns and other materials

received

Possibly more individual,

information returns

Impact on refund

processing

92 million refunds issued in

fiscal year 1995

If withholding done only on

wages, savers more likely to

get refunds, borrowers less

likely to get refunds

Impact on examination

approach

Tax returns matched with

information returns; fiscal

year 1995 examination

coverage at 1.36 percent,

with corporate audits taking

longer than individuals’

audits

Potentially expanded

matching of tax returns with

information returns; auditing

cash flow calculations

possibly easier than

auditing accrued income;

more focus on identifying

unreported income

Continuation of old

compliance problems

Compliance problems

related to income definition,

unreported income, and

more specific issues

identified in areas such as

transfer pricing,

depreciation, deductibility

of business expenses, small

businesses, independent

contractors, and the

underground economy

Compliance problems

continued with certain

business expenses,

unreported income or

receipts

Resolution of old

compliance problems

Not applicable Disputes concerning

deduction or capitalization

of business purchases

eliminated, identification of

nonfilers improved if

expanded information

reporting

Creation of new

compliance problems

Not applicable Increased incentive to not

report asset sales,

incentives created to not

report borrowing and to

overstate amounts saved

(continued)

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Personal Consumption Tax

Item Current income tax

Personal consumption

and business cash flow

tax

Impact on collections from

tax delinquents

Millions of taxpayer

delinquent investigations

and accounts disposed of,

with most of the latter being

for individuals and most

business dispositions

covering employment taxes

More delinquent taxpayers

possibly identified by more

information reporting and

matching

Impact on individuals’

questions received

Millions of taxpayer

inquiries fielded, covering a

wide variety of questions

Most issues generating

questions continued; new

questions concerning

deduction of saving and

inclusion of borrowing likely;

capital gains no longer

relevant

Source: GAO analysis of available information about a personal consumption and business cash

flow tax.

Processing of Returns As under the current tax administration system, the tax agency would

need to process returns from individuals and businesses under a personal

consumption tax and business cash flow tax. Since individuals would

continue to file returns, moving to all-electronic filing and processing

would be more difficult than for a business-only tax. The other core tasks

of returns processing, such as sorting returns, transcribing return

information to taxpayer accounts, and maintaining those accounts, could

remain the same as under the current system.

The number of information returns could increase because the tax base

for a personal consumption tax includes many of the items now subject to

information reporting and also includes some additional items. First,

expanding information reporting to include loans may be necessary since

loans would be included in the tax base. Second, funds that are saved

would also generate a deduction, so it may also be useful for compliance

reasons to require information reporting on amounts saved. However,

additional information returns would add to the processing workload and

would add to the compliance burden of the businesses completing and

filing the returns.

Enforcement and

Compliance

Unlike the VAT and the retail sales tax, little direct evidence on compliance

with a personal consumption tax exists because neither the United States

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Personal Consumption Tax

nor any other country currently uses this tax. However, some relevant

evidence does exist from experience with the current income tax because

it shares many features with a personal consumption tax. For example, the

proper reporting of sales of assets would be a major concern because the

incentive to underreport sales is much less under the income tax than it

would be under the personal consumption tax. Under the consumption

tax, the entire proceeds of the sale would be subject to tax, not just the

gain. In its 1984 review of a consumption tax, the Treasury Department

(citing IRS estimates) reported that 40 percent of capital gains transactions

were not reported.15

Because many types of income now subject to tax and information

reporting would also be taxed under a personal consumption tax,

information reporting and the matching of information returns with tax

returns could continue to be a major activity for tax administration. To

ensure sufficient compliance, information reporting could be expanded to

include borrowed funds and amounts saved in qualified accounts. While

information reporting would reduce the need to audit for underreported

borrowing and overreported deductions for saving, an expansion in the

number of information returns would clearly increase administration

costs.

Such expanded information reporting might improve the identification of

delinquent nonfilers. Self-employed individuals without interest or

dividend income are less likely to be identified to IRS now through

information returns, and therefore, information returns on borrowed funds

and repayment of debt could identify these individuals. This could create

more taxpayer delinquent accounts and investigations for the tax

administrator, but it could also decrease the number of delinquent

nonfilers and increase amounts collected from nonfilers.

The personal consumption tax and the business cash flow tax would offer

some simplifications that would ease enforcement relative to the current

tax. For example, (1) ascertaining whether repayment of debt is principal

or interest, (2) determining whether business purchases of goods and

services should be deductible or represent the acquisition of an asset that

should be depreciated over time, or (3) determining the type of interest

expense may not be necessary. As a result of these simplifications, audit

focus under a personal consumption tax can concentrate on the

underreporting of cash inflows and overstatement of deductions.

15See Treasury, p. 203.

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As mentioned above, determining whether certain expenditures are

legitimate business expenses or personal consumption would remain

issues under a consumption tax. For example, deductions for job

expenses, business entertainment expenses, moving expenses, and

business use of a car would likely remain audit issues under a personal

consumption tax.

Taxpayer Services IRS data on the questions asked of an IRS official over the telephone are not

detailed enough to show clearly how the taxpayer assistance workload

would change if a personal consumption tax was adopted. However, the

data that do exist indicate that about 17 percent of the workload may be

affected by the change since these questions deal with income definition

and calculation issues. Seventy-nine percent of the questions involve

procedural questions, refunds, notices, and other account issues, and

4 percent concern filing information and filing status and rules for

dependents and other exemptions. Questions concerning capital gains and

pensions, representing 4 percent of the workload, might no longer be

relevant. Individuals would likely have additional questions about the

calculation of the deduction for net saving.

IRS has more detailed data from its Tele-tax telephone assistance service,

which provides recorded telephone information on about 150 tax topics.

While some topics would no longer be relevant if a consumption tax

replaced the income tax, many of the questions asked now would still be

relevant because they concern the mechanics of filing returns, IRS

procedures, or the types of income that might still be difficult items under

a consumption tax. For example, often-asked questions on (1) medical and

dental expenses, (2) the earned income credit, (3) business entertainment

expenses, (4) moving expenses, (5) child and dependent care credits, and

(6) business use of automobiles all might still be issues under a personal

consumption tax.

Several analyses of consumption taxes have pointed out that additional

taxpayer education would probably be needed, especially concerning the

inclusion of loans in the tax base and the deduction for saving.16 The

inclusion of loans and the sales proceeds of assets in the tax base are very

different from current practice, and taxpayers would probably have to be

instructed to think in terms of consumption taxation rather than income

taxation.

16See McLure and Zodrow, p. 347; Graetz, p. 183; and Treasury, p. 201.

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Personal Consumption Tax

Other Issues

Transition Issues The transition from the current income tax to a personal consumption tax

would likely raise difficult policy and administrative issues. For the

personal consumption tax and business cash flow tax, issues would arise

regarding the treatment of existing saving, capital gains, borrowing, and

deductions for existing assets.

If a personal consumption tax was enacted without transition rules, any

saving done before the switch would be taxed twice, once when funds

were originally saved and again when they are used for consumption. For

example, individuals who saved by depositing funds in bank or other

accounts would pay consumption tax on all funds when they are

withdrawn. Individuals who saved by purchasing stock or other assets and

who sold the assets after the consumption tax was implemented would

have to pay tax on all sale proceeds, rather than only the gain from the

sale. Individuals who saved by lending funds to others or purchasing

bonds would have to pay consumption tax on both principal and interest

income paid to them by borrowers. If an income tax were retained, these

savers would not have to pay income tax on the original amounts

deposited, used to purchase assets, or lent. Thus, a consumption tax could

be particularly burdensome for individuals who saved before the switch

from the income tax to the consumption tax.17 In contrast, borrowers

would be able to deduct repayments for many types of loans in full under

the consumption tax; if the income tax was retained, they could not

deduct repayments of principal and might not be able to deduct payments

of interest.

If policymakers want to limit such windfall gains and losses, transition

rules would have to be devised and administered so that saving done

before the switch was treated as it would have been treated under the

income tax. Under such rules, distinctions between the return to saving

(taxed) and the return of saving (not taxed) would have to continue to be

made. In addition, the forms of saving that are granted preferential tax

treatment under the current tax (certain IRA accounts and pensions) would

have to be separately tracked. All distributions from these accounts should

be subject to tax because contributions were originally deducted. Similar

17As Treasury pointed out, taxpayers would have an incentive to attempt to avoid double taxation by

selling assets and hoarding cash until the consumption tax became effective. To prevent this, a new

system of money and foreign exchange controls might be necessary. See Treasury, pp. 210-11, for a

discussion of transition problems and options.

Page 188 GAO/GGD-98-37 Alternative Taxes
Appendix VIII 

Personal Consumption Tax

distinctions for debt issued before and after the switch would have to be

made, and administrators would have to be able to track assets shifted

among different accounts.

Businesses with assets that have not been fully depreciated and with other

unused tax deductions and credits could stand to lose substantially

without transition rules. Since all businesses file returns under a cash flow

tax, the tax could be used for transition. One option would be to allow

businesses to continue to deduct depreciation on existing assets as they

would have under the income tax. This would require the continuation of

recordkeeping and auditing that is done currently. However, businesses

would still face a windfall loss because the value of existing assets would

fall relative to new assets, which could be deducted immediately. This

situation creates incentives for the current owners of assets to sell; new

owners could deduct the full cost immediately as new investment.

Developing rules to prevent this and administering them could be difficult.

Another option would be to allow businesses to deduct the remaining

value of their not fully depreciated assets immediately or over a few years.

This type of transition would limit the incentive to sell assets and eliminate

the need to keep depreciation records and audit this issue in the future.

However, the revenue loss from this type of transition might be

substantial. If tax rates have to be substantially higher to raise sufficient

revenue, noncompliance might be increased in other areas.

Federal/State Issues The states could follow the federal government and replace their income

taxes with a personal consumption tax and a business cash flow tax. Such

a state tax should be administrable because expanded information

reporting required at the federal level could be relied upon by the states,

and federal tax audits would cover similar issues. States would be free to

choose a rate structure and add other features if they desired.

It would be difficult for states to stay with an income tax base without

effectively imposing potentially large compliance burdens on businesses.

Much of the simplification achieved by switching from the federal income

tax to a cash flow tax would be negated if businesses continued to be

required to compute income for state tax purposes. In addition, states

would not be able to benefit from federal tax audits concerning capital

income issues because of the change in the federal tax base.

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Personal Consumption Tax

International Issues As an individual-based tax, the personal consumption tax would apply to

U.S. residents or citizens. This would mean that foreigners “consuming” in

the United States (tourists, for example) would not be taxed. The tax

would probably be formulated to tax the consumption of U.S. residents

wherever it takes place. Unlike a value-added tax or retail sales tax,

individuals could be taxed on their consumption regardless of whether it is

done domestically or overseas.

To do this, cash flows from abroad (income from investments and

proceeds from asset sales) would be subject to tax, and funds saved or

invested abroad would be deductible. In contrast to the current income

tax, complex rules to account for income earned abroad but not

repatriated (brought back to the United States) might not be as important

if unrepatriated income could not be readily used for consumption. In

such a system, foreign taxes would implicitly become deductible, and the

foreign tax credit would be eliminated.18

For compliance purposes, tax administrators would need to be able to

identify instances where borrowing was done abroad. Without such

information, individuals who redeposited funds would be able to get a

deduction for saving and might be able to deduct the repayment of the

loan as well. Tax administrators would need information to ensure that

either the proceeds of borrowing done abroad are included in the tax base

or repayments of the foreign borrowing are not deducted.19

Some analysts have also stated that a wealth transfer tax would be needed

for individuals who have accumulated assets in the United States but

intend to emigrate.20 Without such a tax, individuals could accumulate

wealth tax-free in the United States and consume it tax-free abroad.

Unlike typical value-added taxes, a cash flow tax would not feature border

tax adjustments. Sales of exports would be taxable like domestic sales,

and business purchases of imports would be deductible. No border tax

administration would be necessary.

18This discussion is based on James R. Hines, Jr., “Fundamental Tax Reform in an International

Setting,” in Henry J. Aaron and William G. Gale, eds., Economic Effects of Fundamental Tax Reform

(Washington, D.C.: The Brookings Institution, 1996), pp. 490-92.

19See Treasury, pp. 204-05.

20See Treasury, p. 205; Aaron and Galper, p. 77; and Graetz, p. 253 for discussion of this tax need.

Page 190 GAO/GGD-98-37 Alternative Taxes
Appendix IX 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Lawrence M. Korb, Evaluator-in-Charge, Tax Policy and Administration

 Issues

Mary G. Phillips, Senior Evaluator

Robert R. Floren, Senior Evaluator

Edward J. Nannenhorn, Senior Economist

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