November 2005

Simple, Fair, & 

Pro-Growth: 

Proposals to Fix America’s Tax System

Report of the President’s Advisory 

Panel on Federal Tax Reform

November 2005

The President’s Advisory Panel 

on Federal Tax Reform

Panel Members

Chairman Connie Mack

Vice-Chairman John Breaux

Members William E. Frenzel

Elizabeth Garrett

Edward P. Lazear

Timothy J. Muris

James M. Poterba

Charles O. Rossotti

Liz Ann Sonders

Executive Director Jeffrey F. Kupfer

November 1, 2005

Secretary of the Treasury

The Department of the Treasury

1500 Pennsylvania Avenue

Washington, DC 20220 

Dear Mr. Secretary:

 President George W. Bush formed this Panel to identify the major problems 

in our nation’s tax code and to recommend options to make the code simpler, fairer, 

and more conducive to economic growth. The Panel heard from nearly 100 witnesses 

and received thousands of written comments. Together, these witnesses and these 

comments described the unacceptable state of our current tax system. Yet this tax code 

governs virtually every transaction in the world’s largest economy, affecting the daily 

lives of nearly 300 million people.

 Our tax code is rewritten so often that it should be drafted in pencil. Each 

year, the tax code is adjusted to meet multiple policy goals – some are broadly shared, 

but many are not. Myriad tax deductions, credits, exemptions, and other preferences 

may be a practical way to get policy enacted, but it is a poor way to write a tax code. 

Whether the government spends more or extends a special tax break, the effect is the 

same: everyone else must pay higher taxes to raise the revenue necessary to run the 

government. 

 During the past few decades, panels have been formed repeatedly, legislation 

introduced annually, and hearings scheduled regularly to study our tax code and 

recommend changes. In 1986, a bipartisan effort yielded the last major tax reform 

legislation. But because of the ever-present tendency to tinker with the tax code, we 

must redouble our efforts to achieve fundamental reform.
 Since the 1986 tax reform bill passed, there have been nearly 15,000 changes 

to the tax code – equal to more than two changes a day. Each one of these changes 

had a sponsor, and each had a rationale to defend it. Each one was passed by Congress 

and signed into law. Some of us saw this firsthand, having served in the U.S. Congress 

for a combined 71 years, including 36 years on the tax-writing committees. Others 

of us saw the changes from a different perspective – teaching, interpreting, and even 

administering the tax code. In retrospect, it is clear that frequent changes to the tax 

code, no matter how well-intentioned, ultimately undermine the integrity of the code 

in real and significant ways.

 As we moved forward with recommendations for reform, we followed the 

President’s instructions to emphasize simplicity, fairness, and to remove impediments 

to growth. Achieving all of these principles is no easy task. We recognized from the 

start of our meetings that while it is relatively straightforward to point out flaws in a 

tax system and to express a desire for change, it is much more challenging to settle on 

a specific solution. There are difficult trade-offs. While we have differed at times and 

we may not all agree with every word in this report, we all fully endorse it.

 We unanimously recommend two options to reform the tax code. We refer 

to one option as the Simplified Income Tax Plan and the other option as the Growth 

and Investment Tax Plan. Both of them are preferable to our current system. Both 

satisfy the President’s directive to recommend options that are simple, fair, and progrowth.

 The Simplified Income Tax Plan dramatically simplifies our tax code, 

cleans out targeted tax breaks that have cluttered the system, and lowers rates. It 

does away with gimmicks and hidden traps like the alternative minimum tax. It 

preserves and simplifies major features of our current tax code, including benefits for 

home ownership, charitable giving, and health care, and makes them available to all 

Americans. It removes many of the disincentives to saving that exist in our current 

code, and it makes small business tax calculations much easier. It also offers an updated 

corporate tax structure to make it easier for American corporations to compete in 

global markets. 

 The second recommended option, the Growth and Investment Tax Plan 

builds on the Simplified Income Tax Plan and adds a major new feature: moving the 

tax code closer to a system that would not tax families or businesses on their savings 

or investments. It would allow businesses to expense or write-off their investments 

immediately. It would lower tax rates, and impose a single, low tax rate on dividends, 

interest, and capital gains. 

 As directed by the President, our recommendations have been designed to 

raise approximately the same amount of money as the current tax system. The issue of 

whether the tax code should raise more or less revenue was outside of our mandate. 

Regardless of how one feels about the amount of revenue required to fund our 

government, all should agree that the tax system needs a solid and rational foundation.
 We recognize that our report is just the beginning of the process to fix 

our broken tax system. The hardest work lies ahead. As a bipartisan Panel, we have 

heard from witnesses and elicited proposals from members of both major parties. 

We hope that the Administration and the Congress will carry forward this spirit of 

bipartisanship. 

 The effort to reform the tax code is noble in its purpose, but it requires 

political willpower. Many stand waiting to defend their breaks, deductions, and 

loopholes, and to defeat our efforts. That is part of the legislative process. But the 

interests of a few should not stand in the way of the tax code’s primary goal: to raise 

funds efficiently for the common defense, vital social programs, and other goals of 

shared purpose. If we agree the goals serve us all, we must also agree that the costs 

must be fairly borne by all. 

 This report aims to give voice to the frustrated American taxpayer and to 

provide a blueprint for lasting reform. We look forward to a national debate and a 

better tax system.

Table of Contents

Executive Summary ....................................................................... xi

Chapter One: The Case For Reform .............................................. 1

Chapter Two: How We Got Here ............................................... 11

Chapter Three: Tax Basics ............................................................ 19

Chapter Four: Our Starting Point ................................................ 41

Chapter Five: The Panel’s Recommendations .............................. 59

Chapter Six: The Simplified Income Tax Plan ........................... 107

Chapter Seven: The Growth and Investment Tax Plan ............. 151

Chapter Eight: Value-Added Tax .............................................. 191

Chapter Nine: National Retail Sales Tax ................................... 207

Appendix .................................................................................... 223

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Executive Summary

President George W. Bush created the President’s Advisory Panel on Federal Tax 

Reform in January 2005. The President instructed the Panel to recommend options 

that would make the tax code simpler, fairer, and more conducive to economic growth.

Since then, the Panel has analyzed the current federal income tax system and 

considered a number of proposals to reform it. During the course of the Panel’s work, 

some themes emerged that guided its deliberations:

• We have lost sight of the fact that the fundamental purpose of our tax system is 

to raise revenues to fund government.

• Tax provisions favoring one activity over another or providing targeted tax 

benefits to a limited number of taxpayers create complexity and instability, 

impose large compliance costs, and can lead to an inefficient use of resources. 

A rational system would favor a broad tax base, providing special treatment 

only where it can be persuasively demonstrated that the effect of a deduction, 

exclusion, or credit justifies higher taxes paid by all taxpayers.

• The current tax system distorts the economic decisions of families and 

businesses, leading to an inefficient allocation of resources and hindering 

economic growth. 

• The complexity of our tax code breeds a perception of unfairness and creates 

opportunities for manipulation of the rules to reduce tax. The profound lack of 

transparency means that individuals and businesses cannot easily understand 

their own tax obligations or be confident that others are paying their fair share.

• The tax system is both unstable and unpredictable. Frequent changes in the tax 

code, which often add to or undo previous policies, as well as the enactment 

of temporary provisions, result in uncertainty for businesses and families. This 

volatility is harmful to the economy and creates additional compliance costs.

• The objectives of simplicity, fairness, and economic growth are interrelated and, 

at times, may be at odds with each other. Policymakers routinely make choices 

among these competing objectives, and, in the end, simplification is almost 

always sacrificed. Although these objectives are often in tension, meaningful 

reform can deliver a system that is simpler, fairer, and more growth-oriented 

than our existing tax code. 

With these themes in mind, the Panel evaluated a number of reform proposals to find 

out whether they would meet the President’s goals for current and future generations 

of Americans. After 12 public meetings in five states and Washington D.C., the Panel 

reached consensus to recommend two tax reform plans. The Panel’s recommended 

plans, labeled the Simplified Income Tax Plan and the Growth and Investment Tax 

Plan, include the following major features:
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• Simplification of the entire tax system and streamlined tax filing for both 

families and businesses.

• Lower tax rates on families and businesses, while retaining the progressive 

nature of our current tax system.

• Extension of important tax benefits for home ownership and charitable giving 

to all taxpayers, not just the 35 percent who itemize; extension of tax-free 

health insurance to all taxpayers, not just those who receive insurance from 

their employers.

• Removal of impediments to saving and investment.

• Elimination of the alternative minimum tax, which is projected to raise the 

taxes of more than 21 million taxpayers in 2006 and 52 million taxpayers by 

2015.

The two plans differ in the taxation of businesses and capital income. Although they 

use different approaches, the plans share a common goal of providing simple and 

straightforward ways for Americans to save free of tax and lower the tax burden on 

productivity-enhancing investment by businesses.

A table outlining both tax reform plans follows this summary. 

The Panel also developed and considered a progressive consumption tax plan that 

would be administered using the infrastructure of our familiar tax system, but was 

unable to reach a consensus to include it as a recommendation. The Panel also 

considered ideas for a value-added tax and a national retail sales tax, and decided not 

to recommend either approach.

The Simplified Income Tax Plan and the Growth and Investment Tax Plan put 

forward by the Panel achieve the goals set by the President in a number of ways.

They reduce complexity by: 

• Allowing every taxpayer to use a simple tax form, which is less than half the 

length of the current Form 1040. 

• Combining 15 different tax provisions for at-work saving, health saving, 

education saving, and retirement saving into three simple saving plans.

• Eliminating a complicated set of phase-outs that leave taxpayers wondering 

whether they are eligible to benefit from numerous provisions. 

• Replacing a confusing, full-page worksheet for seniors reporting Social 

Security income with a simple computation that is no more than six lines. 

• Replacing the complicated rules for small business with a system that is based 

on the records their owners already keep.
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Executive Summary

They improve fairness by:

• Ensuring that tax benefits are easily understood and accessible, thereby 

increasing confidence in the tax system.

• Making most tax benefits available to all taxpayers, not just the 35 percent who 

itemize.

• Shifting some tax preferences from deductions, which tend to benefit highincome households, to tax credits, which benefit all taxpayers equally.

• Reducing marriage penalties by ensuring that the rate brackets, the Family 

Credit, and the taxation of Social Security benefits for married couples are 

twice the amounts for singles.

• Transforming the earned income tax credit and savers credit into provisions 

that are more accessible and beneficial to low income taxpayers. 

• Closing loopholes and eliminating special tax breaks that allow the welladvised to avoid paying their fair share.

• Maintaining the progressive nature of our tax system.

They promote economic growth by: 

• Reducing the double-tax on corporate profits earned in the United States. 

• Promoting savings throughout our economy, especially at the household level.

• Equalizing the tax treatment of several forms of corporate financing, raising 

the incentives for companies to issue equity rather than debt to finance growth.

• Lowering the top marginal rates on individuals and large businesses.

• Reducing the likelihood that households or businesses will alter economic 

behavior because of special tax preferences or benefits. 

• Reducing the paperwork burden for small businesses, and providing them an 

immediate write-off for all purchases of new tools and equipment.

• Updating our international tax system.

These benefits will follow only from a fundamental reform of the tax code. In 

isolation, some of the recommended pieces may be controversial, but, taken as 

a whole, they accomplish the Panel’s objectives. Each plan is designed to be 

comprehensive and should be viewed as an integrated package. The Panel believes 

that without large-scale changes, and continued commitment to avoiding complexity 

and special tax breaks, the tax code will become even more confusing, unfair, and 

damaging to our economy. We urge the Administration and Congress to consider 

these recommendations carefully and to move forward with reform.
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The Current Tax System

Provisions Current Law (2005)

Households and Families

Tax Rates Six tax brackets: 10%, 15%, 25%, 28%, 33%, 35% 

Alternative minimum tax Affects 21 million taxpayers in 2006; 52 taxpayers million in 2015

Personal exemption $3,200 deduction for each member of a household; phases out with 

income

Standard deduction $10,000 deduction for married couples filing jointly, $5,000 deduction for 

singles, $7,300 deduction for heads of households; limited to taxpayers 

who do not itemize

Child tax credit $1,000 credit per child; phases out for married couples between $110,000 

and $130,000 

Earned income tax credit Provides lower-income taxpayers refundable credit designed to encourage 

work. Maximum credit for working family with one child: $2,747; with 

two or more children: $4,536

Marriage penalty Raises the tax liability of two-earner married couples compared to two 

unmarried individuals earning the same amounts

Other Major Credits and Deductions

Home mortgage interest Deduction available only to itemizers for interest on up to $1.1 million of 

mortgage debt

Charitable giving Deduction available only to itemizers

Health insurance Grants tax-free status to an unlimited amount of premiums paid by 

employers or the self-employed. 

State and local taxes Deduction available only to itemizers 

Education HOPE Credit, Lifetime Learning Credit, tuition deduction, student loan 

interest deduction; all phase out with income

Individual Savings and Retirement

Defined contribution plans Available through 401(k), 403(b), 457, and other employer plans

Defined benefit plans Pension contributions by employers are untaxed

Retirement savings plans IRAs, Roth IRAs, spousal IRAs – subject to contribution 

and income limits

Education savings plans Section 529 and Coverdell accounts

Health savings plans MSAs, HSAs, and Flexible Spending Arrangements 

Dividends received Taxed at 15% or less (ordinary rates after 2008)

Capital gains received Taxed at 15% or less (higher rates after 2008)

Interest received (other than tax-exempt 

municipal bonds)

Taxed at ordinary income tax rates 

Social Security benefits Taxed at three different levels, depending on outside income; marriage 

penalty applies

Small Business

Rates Typically taxed at individual rates

Recordkeeping Numerous specialized tax accounting rules for items of income and 

deductions

Investment Accelerated depreciation; special small business expensing rules allow 

write-off of $102,000 in 2005 (but cut by 3⁄4 in 2008)

Large Business

Rates Eight brackets: 15%, 25%, 34%, 39%, 34%, 35%, 38%, 35%

Investment Accelerated depreciation under antiquated rules

Interest paid Deductible

Interest received Taxable

International tax system Worldwide system with deferral of business profits and foreign tax credits

Corporate AMT Applies second tax system to business income
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Executive Summary

 How the Tax Code Would Change

Provisions Simplified Income Tax Plan Growth and Investment Tax Plan

Households and Families

Tax Rates Four tax brackets: 15%, 25%, 30%, 33% Three tax brackets: 15%, 25%, 30%

Alternative minimum tax Repealed

Personal exemption Replaced with Family Credit available to all taxpayers: $3,300 credit for married couple, $2,800 credit for unmarried 

with child, $1,650 credit for singles, $1,150 credit for dependent taxpayer; additional $1,500 credit for each child and 

$500 credit for each other dependent 

Standard deduction

Child tax credit

Earned income tax credit Replaced with Work Credit (and coordinated with the Family Credit); maximum credit for working family with one 

child: $3,570; with two or more children, $5,800

Marriage penalty Reduced. All tax brackets, Family Credits, and taxation of Social Security benefits for couples are 

double those of individuals 

Other Major Credits and Deductions

Home mortgage interest Home Credit equal to 15% of mortgage interest paid; available to all taxpayers; mortgage limited to average regional 

price of housing (limits ranging from about $227,000 to $412,000)

Charitable giving Deduction available to all taxpayers (who give more than 1% of income); rules to address valuation abuses

Health insurance All taxpayers may purchase health insurance with pre-tax dollars, up to the amount of the average premium 

(estimated to be $5,000 for an individual and $11,500 for a family)

Education Taxpayers can claim Family Credit for some full-time students; simplified savings plans

State and local taxes Not deductible

Individual Savings and Retirement

Defined contribution plans Consolidated into Save at Work plans that have simple rules; AutoSave features point workers in a pro-saving direction

Defined benefit plans No change

Retirement savings plans Replaced with Save for Retirement Accounts ($10,000 annual limit) – available to all taxpayers

Education savings plans Replaced with Save for Family Accounts ($10,000 annual limit); would cover education, medical, new home costs, and 

retirement saving needs; available to all taxpayers; refundable Saver’s Credit available to low-income taxpayers Health savings plans

Dividends received Exclude 100% of dividends of U.S. companies 

paid out of domestic earnings 

Taxed at 15% rate

Capital gains received Exclude 75% of corporate capital gains from U.S. 

companies (tax rate would vary from 3.75% to 8.25%)

Taxed at 15% rate

Interest received (other than 

tax exempt municipal bonds)

Taxed at regular income tax rates Taxed at 15% rate

Social Security benefits Replaces three-tiered structure with simple deduction. Married taxpayers with less than $44,000 in income 

($22,000 if single) pay no tax on Social Security benefits; fixes marriage penalty; indexed for inflation

Small Business

Rates Taxed at individual rates (top rate has been lowered to 33%) Sole proprietorships taxed at individual rates 

(top rate lowered to 30%);

Other small businesses taxed at 30%

Recordkeeping Simplified cash-basis accounting Business cash flow tax

Investment Expensing (exception for land and buildings under the Simplified Income Tax Plan)

Large Business

Rates 31.5% 30%

Investment Simplified accelerated depreciation Expensing for all new investment

Interest paid No change Not deductible (except for financial institutions)

Interest received No change Not taxable (except for financial institutions)

International tax system Territorial tax system Destination-basis (border tax adjustments)

Corporate AMT Repealed 

Chapter One

The Case for Reform

If you were to start from scratch, the current tax code would provide a guide on what 

to avoid in designing an income tax system. Instead of a sleek and simple system 

designed to raise revenue for our national defense, social programs, and other vital 

public services, we have a system so complex that almost $150 billion is spent each 

year by U.S. households, businesses, and the federal government, just to make sure 

taxes are tallied and paid correctly. This is more than the sum spent each year on 

televisions, household electricity, or cereal. Instead of a system that ensures that all pay 

their fair share, we have a system so confusing that two million taxpayers collectively 

paid over $1 billion more in taxes by making a wrong decision about the basic choice 

of itemizing or taking the standard deduction, according to a recent study. Instead of 

a tax system that draws revenue efficiently from the base of the nation’s considerable 

economy, we have a tax code that distorts basic economic decisions, sets up incentives 

for unwise or unproductive investments, and induces people to work less, save less, and 

borrow more. By some estimates, this economic waste may be as much as $1 trillion 

dollars each year.

The father of modern economics, Adam Smith, said the free market is the “invisible 

hand” guiding every economic event. In today’s U.S. economy, the tax code is the true 

force. The tax code penalizes savings, contributes to the ever-increasing cost of health 

insurance, and undermines our global competitiveness. The tax code touches all of 

life’s major events: It tells us the best time to be born, the best time to marry, and the 

best time to retire. 
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In short, our current tax code is a complicated mess. Instead of clarity, we have opacity. 

Instead of simplicity, we have complexity. Instead of fair principles, we have seemingly 

arbitrary rules. Instead of contributing to economic growth, it detracts from growth. 

Time and again, witnesses told the Panel about these failings in the tax code.

Complexity

There is no clearer proof of the complexity of the tax code than the collective anxiety 

felt by Americans every April as the tax filing deadline approaches. For many, filing 

taxes consists first of procrastination. Then there is the inevitable search for slips of 

paper containing once-meaningful but now unintelligible financial transactions. Then 

comes the maze of lengthy instructions complex enough that even highly schooled 

professionals have to reread the directions several times. Those directions send taxpayers 

on a search through baffling schedules and detailed worksheets requiring many illogical 

and counterintuitive computations. And in the end, most taxpayers give up, and visit a 

tax preparer who promises to make sense of the whole process - for a price.

No matter how much you earn, chances are you do not clearly understand how to 

figure out your taxes. A recent poll of those with an annual income of $20,000 or less 

(usually the families with the simplest tax forms) showed that about 80 percent found 

the tax system either very complex or somewhat complex. That figure rises to nearly 

100 percent for taxpayers with incomes exceeding $150,000. The process is so bad 

that one-third of Americans surveyed believe that completing the annual tax return is 

more onerous than actually paying large amounts of money in taxes.

To determine something as basic as figuring out the tax implications of having 

a child, you need to review numerous rules and complete many separate sets of 

computations. Figuring out whether you can claim the child tax credit, for example, 

requires the skills of a professional sleuth: You need to complete eight lines on a tax 

form, perform up to five calculations, and fill out as many as three other forms or 

schedules. Further research, reading, and computation may be needed to determine 

whether you can claim head of household filing status, an exemption for a dependent, 

the child and dependent care credit, the earned income tax credit, or tax credits 

related to your child’s education, to name only some of the possibilities.

Last year, Americans spent more than 3.5 billion hours doing their taxes, the 

equivalent of hiring almost two million new IRS employees – more than 20 times 

the agency’s current workforce. If the money spent every year on tax preparation and 

compliance was collected – about $140 billion each year or over $1,000 per family – it 

could fund a substantial part of the federal government, including the Department of 

Homeland Security, the Department of State, NASA, the Department of Housing 

and Urban Development, the Environmental Protection Agency, the Department of 

Transportation, the United States Congress, our federal courts, and all of the federal 

government’s foreign aid. On average, Americans spend the equivalent of more than 

half of one work week – 26 hours – on their taxes each year (not to mention the 

amount of time they work to pay the taxes themselves). 
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Chapter One

In 2003, about 60 percent of household filers gave up trying to do the work 

themselves and hired a preparer. About a quarter relied on a computer and purchased 

software. A small fraction got help from volunteers. And 13 percent of Americans 

completed their own calculations and filed their taxes the old-fashioned way: with 

pen and paper. 

Complying with the tax code is frequently more burdensome for those with the least 

ability to pay. For example, the earned income tax credit (EITC) is an important 

initiative, provided through our tax code to help low-income working families move 

out of poverty. The EITC differs from other entitlement programs in that it is only 

available to lower-income workers. Initially, EITC benefits increase as an individual’s 

earnings increase, but then the benefits phase out at higher income levels. These 

rules are so complex that nearly three-quarters of those families claiming it hire a tax 

preparer. This makes little sense: These families typically earn less 

than $35,000. The extra cost of paying a preparer to claim the 

EITC benefit may offset a significant portion of the benefit itself 

– and to the family struggling to stay out of poverty, those dollars 

are scarce. Policy experts regularly praise the EITC’s effectiveness, 

but as a matter of tax administration, it is complicated and 

inefficient.

The tax code places an undue burden on another critical sector 

of our society: these small businesses that create a majority of 

new jobs in our economy. The 31 million taxpayers who reported 

self-employment income or employee business expenses spent an 

average of 60 hours and $363 in out-of-pocket compliance costs, 

compared with 14 hours and $75 in out-of-pocket costs for the 94 

million Americans who did not report self-employment income. 

Studies have found that the smaller the business, the higher the 

cost of complying with the tax code per dollar of revenue. 

Confusion and Unfairness

Did I pay too much? Did I pay too little? Who will notice? These three questions 

play out in the minds of all taxpayers when they file their forms by April 15 each year. 

And as journalists and tax analysts have repeatedly shown over the years, rarely will 

two tax preparers working on the same tax return come up with the same amount 

of taxes due. There is little confidence that we really know how much we should be 

paying in taxes in any given year. It is not just a matter of doing arithmetic. According 

to a recent survey, more than two-thirds of respondents incorrectly answered basic 

filing questions about the tax implications of selling a home, claiming a dependent, 

saving for education and retirement, receiving capital gains, and paying the alternative 

minimum tax. To be sure, some of these issues are complex. But our tax code should 

aspire to be clear and transparent, not allow confusion to multiply. Taxpayers should 

be able to understand the tax code’s basics.
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The result of this fog of ignorance typically isn’t overpayment, which occurs 

occasionally, but underpayment, which happens regularly. This underpayment is 

measured by what is known as the “tax gap.” The tax gap represents the difference 

between the tax that taxpayers should pay and what they actually pay on a timely 

basis. The IRS estimates that in 2001, between $281 and $322 

billion went unreported on individual and business tax returns. 

This translates to a tax hike of more than $2,000 each year for 

honest taxpayers. Research shows non-compliance has been 

steadily rising over the past two decades, a troubling indicator that 

our tax code’s growing complexity is inviting more cheating.

But taxpayers think that with the myriad of targeted exclusions, 

deductions, and credits, others may not be paying their fair 

share – so why should they? Some call this “the cheat or chump 

syndrome.” In addition, clever tax advisors mine the complexity of 

the tax code to develop and market tax shelters and other schemes 

clearly designed to manipulate the tax code’s hidden loopholes for their clients’ 

exclusive benefit. The perception that the tax code is unfair and easily manipulated 

undermines voluntary compliance – the foundation of our tax system. 

An Arbitrary and Unequal System

A tax code, like any law, should rest squarely on the notion that it will remain largely 

the same, from year to year, from person to person. In a court of law, there is an 

expectation by the judge, jury, and all other parties that the law will be equally and 

fairly applied based on well-established and consistent judicial principles. Yet our tax 

code shares few, if any, of these features.

Taxpayers cannot plan ahead: The tax system is a kaleidoscope of shifting credits, rates, 

and benefits because many of the tax code’s most prominent features – the tax rate 

for ordinary income, the child tax credit, the lower tax on dividends and capital gains 

– may shift wildly from one year to the next, and in some cases simply expire. For 

example, tax relief passed by Congress in 2001 and 2003 is scheduled to fade away. 

While some believe Congress will not allow this to happen, no one can say for sure. 

As Box 1.1 indicates, all individual tax rates are scheduled to rise. The lowest bracket, 

currently set at 10 percent, will disappear and the top tax rate will climb from 35 to 

39.6 percent after 2010. The child tax credit and the deduction for IRA contributions 

will be cut. Taxpayers have recently seen their taxes on dividends and capital gains 

reduced but will see them sharply increased in 2008, when those taxes are scheduled 

to rise again. 
5

Chapter One

Box 1.1. Commonly Applicable Income Tax Provisions Scheduled to Expire

• Reduced Individual Tax Rates on Ordinary Income

• Marriage Penalty Relief

• Increased Child Tax Credit 

• Increased IRA Contribution Limit

• Reduced Individual Tax Rate on Dividend Income

• Reduced Individual Tax Rate on Capital Gains

• Investment Incentives for Small Business

This uncertainty has clear effects. If you own a small business and are contemplating 

an investment in new equipment, the tax provision that quadruples the portion of that 

investment that can be written-off immediately is an incentive to go forward with the 

investment. Yet because of the scheduled expiration in 2007 of this provision, your 

decision to invest may be rushed. Such an investment – timed as it is to a provision in 

the tax code rather than to economic fundamentals – may turn out to be ill-advised 

and waste economic resources. In any case, the tax code’s constant phase-ins and 

phase-outs are a nuisance at best, and a negative force at worst, in the daily economic 

lives of American families and businesses.

The tax code treats similar taxpayers in different ways: Taxpayers with the same income, 

family situation, and other key characteristics often face different tax burdens. Such 

differing treatment creates a perception of unfairness in our tax code. For example, 

taxpayers in states with high state and local income and property taxes receive higher 

deductions than taxpayers who live in lower-tax states with fewer state-provided 

services. Taxpayers with substantial employer-provided health insurance benefits 

receive in-kind compensation that is not taxed, while taxpayers who buy the same 

health insurance on their own usually pay tax on the income used to purchase the 

insurance. And Social Security benefits are taxed at a higher rate for married seniors 

than for those not married. How much or little taxpayers pay in tax is sometimes 

dependent on where they happen to live, the choices made by their employers, and 

whether they are married. 

The differences in treatment are not always set by design. Rather, the different 

amounts similarly situated taxpayers often pay is sometimes a reflection of the tax 

code’s complexity. While some taxpayers may take advantage of special provisions that 

are available to them, others do not. Someone who claims legal credits and deductions 

has done nothing wrong, yet unequal outcomes suggest that our tax code unfairly 

benefits those with the time and resources to make sense of it. This situation conflicts 

with basic principles of equity and erodes public confidence in the system.

The tax code treats similar income differently: As part of our system of progressive 

taxation, income is taxed at increasing rates as a taxpayer’s annual income increases. 

This creates a tax rate called the “marginal rate.” The marginal tax rate is the rate paid 

on the last dollar of income earned – it measures how much tax you pay on additional, 
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or marginal, income. The basic tax rate schedule taxes the first $7,300 of taxable 

income for single individuals at a 10 percent rate. The next $22,400 is taxed at a 15 

percent rate. Each block of income is taxed at a higher marginal rate, until a taxpayer 

reaches the $326,451 level, above which income is taxed at the highest rate of 35 

percent. 

At first glance, this appears to be a fairly straightforward approach to taxation, but it 

is not so simple in reality. The effective marginal tax rate can differ substantially from 

the schedule of basic tax rates described above. This element is complicated by various 

exclusions, deductions, and credits, and the web of accompanying phase-ins and 

phase-outs. Some credits and deductions are available to people only when they earn 

more or less than a certain amount of income. The idea behind setting a limitation on 

the income one can earn before claiming certain deductions and credits is to target 

the benefits to those perceived to have the greatest need. But that creates a set of 

counterintuitive and counterproductive economic consequences that may keep many 

families from trying to earn more than they currently do.

Let’s say you are just offered a great job at $120,000 a year. You are married with one 

child and your current salary is $80,000. You take the job, right? Not necessarily. The 

increase in salary might cause you to lose some of the child credit – and subject you 

to other provisions that increase your total tax bill even more, such as the alternative 

minimum tax. In all, the pre-tax jump in your new salary may be $40,000, but it could 

end up costing you an extra $9,203 in tax – meaning that your salary would rise by 

50 percent while your tax liability would increase by 140 percent. Not surprisingly, 

some workers figure this out quickly and avoid taking on work that may pay more, 

simply because of how the tax code penalizes that extra effort. 

Two charts below illustrate the problem for a hypothetical taxpayer – a single mother 

with two children. Figure 1.1 shows how she would face a gradually increasing tax 

rate as she earned additional income if the tax system consisted only of our current 

schedule of basic tax rates described above, plus the standard deduction and personal 

exemption. 

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7

Chapter One

In contrast to this system, Figure 1.2 illustrates the reality of our current system. 

Low-income taxpayers face very high marginal tax rates, even higher than those with 

substantially larger incomes. Moreover, even small changes in income can cause large 

changes in marginal tax rates. For example, our single mother with two children 

enjoys a negative tax rate on each extra dollar of earnings up to $11,000 because she 

receives a $40 tax credit for every $100 earned through the EITC. As she earns more, 

however, her tax rate rises sharply. At an income level of $25,000, she pays $31 of tax 

on each additional $100 earned. So instead of receiving $140 in total wages and tax 

benefits for each extra $100 earned, she now receives only $69 on every extra $100 

of earnings. Figure 1.2 shows how this taxpayer's tax rate shifts as she moves up the 

economic ladder – and not always in the way you would imagine.

This shifting treatment of one’s last dollar of income – far more complex than 

the basic tax rate schedule – catches many taxpayers by surprise. Yet this shifting 

treatment does not affect only low-income workers. For example, a married couple with 

$80,000 of income – somewhat above the national average – and a child in college would 

be eligible for a tax credit, known as the HOPE credit, to offset education expenses. But 

if this family earns an additional $10,000 in income by selling stock to pay tuition, they 

would no longer be eligible for the HOPE credit. Guided by a tax advisor, this family 

could hold off on selling the stock to maintain HOPE credit eligibility. That is clearly 

to the family’s benefit: The HOPE credit’s value, at up to $1,500, is certainly a tidy 

return on the $10,000 they keep in their investment account for an extra year. Because 

the tax code uses income to determine a family’s eligibility for federal assistance – and 

views wealth as immaterial – this family receives a benefit that a less well-advised 

family does not.

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8

Federal Tax Reform

The President’s Advisory Panel on

It could be that some well-meaning lawmaker wanted to avoid handing out federal 

tax credits to high-earning families. But even the best intentions cannot guard 

against the law of unintended consequences. One such consequence is handing a tax 

credit to a family that didn’t really need it and would have sent their child to college 

anyway. In this case, the government spent money on a tax benefit that did not 

change the behavior that it was designed to affect – and thus provided a windfall to 

the family. Another unintended consequence is that these credits may lead to a higher 

cost of education for those who do not receive the credits. There is some evidence, for 

instance, that the credit may encourage colleges and universities to increase tuition, 

thereby capturing some of the benefit of the credit. A third consequence is that 

everyone else’s taxes are higher.

The Tax Code in Our Lives

Earlier in this chapter, we referred to the “invisible hand,” as described by Adam 

Smith. He observed that the invisible hand of free markets is the force through which 

individuals and businesses put economic resources to their greatest value. The tax 

code, however, gets in the way of free commerce and reduces our economic capacity 

in countless ways. Take health care, for instance. Our tax code treats health care 

benefits with great deference; they are not treated as income, so those companies that 

offer health insurance coverage do so as a tax-free benefit to their employees. But that 

generosity removes many incentives for cost controls, driving up health care costs for 

everyone, including those whose employers do not offer 

the same benefits. With virtually no low-cost option for 

health insurance available, many go without. This situation 

– a nation divided between those with “Cadillac” insurance 

coverage and those with none – is exacerbated by our tax 

code. 

The tax code reaches into daily events, and by multiplication 

of rules and conditions, makes itself into an economic 

hazard. Yet there are examples of the tax code’s failure to 

account for economic progress when it does occur. In the 

case of our technology industries, we have a sector of the 

economy larger in size than health care, and crucial to future 

job growth and living standards. These technology-based industries depend heavily on 

how our tax code defines the useful life of all technology. These definitions, laid out 

in depreciation schedules, permit purchasers of computers and other high-technology 

equipment to take a deduction against their income for the cost of that equipment 

over a period of time. The depreciation schedules for technology have always been a 

source of some controversy; companies routinely discard new computers and other 

technological equipment after only three years while the depreciation schedules call 

for a five-year lifespan. Why? Congress based the current depreciation schedule for 

computers on studies of the useful lives of surplus government typewriters from the 

late 1970s. Only in our tax code can a late-1970s typewriter be viewed as the same as 

a high-end, multimedia laptop.
9

Chapter One

Consider the tax code’s impact on savings and consumption: Jack and Jill both earn 

a dollar and pay 25 cents in taxes on it. Jack spends his 75 remaining cents, while Jill 

saves it. If Jill’s savings gather interest of 20 cents over the next ten years, she will have 

95 cents in her savings account. But she will have to pay taxes on the interest income 

of 20 cents – an extra 5 cents in taxes. In short, Jack pays 25 cents in taxes on his 

money, while Jill ends up paying 30 cents – simply because she saved while he did not. 

While the difference may not matter much, spread throughout a $12 trillion economy 

and tens of trillions of economic decisions (including decisions about how to save for 

education, health, and retirement), the tax penalty on savings has enormous effects. 

The nation’s personal savings rate, for example, is less than 2 percent. The low savings 

rate can be explained by many factors, and the tax code is hardly the sole culprit. 

However, if we want to improve the savings rate, eliminating the tax penalty on 

savings might be an obvious place to start.

In short, the tax code presents an obvious target for change. Its complexity, lack 

of clarity, unfairness, and disproportionate influence on behavior lead taxpayers to 

frustration and many reformers to other lines of work. But we cannot leave this work 

undone. Without reform, the tax code will consume more energy, more time, more 

worry, and more economic resources. The effort to reform this complicated mess 

starts with understanding how we got here. Our tax code has been shaped by goals 

other than simplicity, by intentions other than helping the taxpayer plan ahead, and 

by objectives other than expanding our economy. Years of active meddling may have 

left our tax code in shambles, but it has taught us a valuable lesson: If we are not 

simplifying our tax code, it is likely to become more complex, more unfair, and less 

conducive to our economy’s future growth. Reform is the only thing that works. 

Box 1.2. The Alternative Minimum Tax: A Cautionary Tale

The Alternative Minimum Tax (AMT) is a vivid example of why our tax code is dysfunctional. The minimum income tax, the 

predecessor to today’s AMT, was first enacted in 1969 after reports showed a few hundred very wealthy Americans not 

paying income taxes. Like the minimum income tax of 1969, the AMT is intended to ensure that taxpayers pay at least some 

income tax and share in the cost of maintaining our government. 

But the AMT has a significant flaw: Its definition of high income was never indexed for inflation. Thus, the threshold for 

AMT liability in 2006 – $45,000 in income for married couples after allowing for AMT deductions and exemptions – is nearly 

the same as the $40,000 threshold that was in place in 1982, when the AMT first came into effect. If this figure had been 

inflation–adjusted, the exemption would be $82,000. Today, many middle-income Americans are now above that $45,000 

exemption level. 

The failure to index AMT income levels for inflation is significant. The AMT, whatever its original strengths and weaknesses, 

was for many years only a problem for a few thousand high-income families. Now, it is a headache for nearly four million 

American families and, as shown in the chart below, is projected to affect more than 50 million taxpayers by 2015.

The AMT constitutes a second, parallel tax structure that has its own exemptions, tax rates, and tax credits, and that 

employs a definition of income broader than that of the regular income tax. Certain deductions available in the “regular” tax 

code are not available to AMT taxpayers. Taxpayers who have families are especially hurt by the AMT; the marriage penalty 

is worse under the AMT, and the child deductions are lower. 
10

Federal Tax Reform

The President’s Advisory Panel on

Because of the growing reach of the AMT, millions of taxpayers must now fill out a 12-line worksheet, read 8 pages of 

instructions, and complete a 55-line form to determine whether they must pay the AMT. Only after making this separate set 

of calculations to see which tax-owed figure is higher, can a taxpayer file a return – paying the higher amount. Not surprisingly, 

many taxpayers seek expertise in navigating this maze – 75 percent of AMT taxpayers hire a professional to do their returns 

for them.

So far, lawmakers have dealt with the problem by passing temporary fixes or “patches” to the AMT to limit its reach on most 

American middle-income families. But after 2005, when the current fix expires, the number of taxpayers projected to be 

affected by the AMT will rise sharply from 4 million in 2005 to 21.6 million in 2006. Not only will these taxpayers be required 

to make a second set of calculations to determine their AMT liability, but they will also pay an average of $2,770 more in taxes. 

By 2015, 52 million taxpayers -- 45 percent of all taxpayers with income tax -- are projected to be affected by the AMT. 

The AMT will increasingly affect upper-middle-income taxpayers -- 13 percent of taxpayers with incomes between $100,000 

and $200,000 will pay their taxes under the AMT system in 2005, but just one year later, more than 75 percent of taxpayers 

in this income group will do so. 

Perhaps not surprisingly, the individual AMT has failed to achieve its goal of making sure all well-to-do Americans pay taxes. 

The Treasury Department projects that in 2006, in spite of the AMT over 6,600 taxpayers with income greater than $200,000, 

and over 1,300 taxpayers with income over $700,000, will pay no tax through various combinations of legitimate tax avoidance. 

What began as a vehicle to focus fairness on a handful of taxpayers has turned into a complex, unfair, and inefficient burden 

on millions of Americans; and few, if any, of those paying the AMT are the intended targets of the tax. The AMT is a salient 

example of a policy or government program gone astray with unintended consequences carrying malign impacts. 

In addition, the corporate AMT subjects many corporations to a second, parallel tax. Like the individual AMT, the corporate 

AMT has been used to pare back, rather than repeal, tax benefits by partially penalizing businesses that claim tax incentives. 

Under the corporate AMT, corporations are required to keep an entirely different set of books and records and to calculate 

their tax liability under two very different complex sets of rules -- the regular income tax rules with rates up to 35 percent and 

the corporate AMT rules with rates up to 20 percent -- and then pay the larger of the two amounts.

The corporate AMT is an accounting and administrative nightmare that requires businesses to recompute many deductions 

using less generous rules. Two witnesses described to the Panel how the existence of these two radically different tax codes 

with dozens of complex differences between them makes rational tax planning, administration, and compliance exponentially 

more difficult. In addition, the corporate AMT may exacerbate economic downturns by making corporations that are realizing 

losses under the regular income tax pay additional taxes when they are losing money.

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Chapter Two

How We Got Here

The tax system is closely intertwined with American society; it not only reflects events 

of the day, but also shapes the society in which we live. It has broad effects – some 

intentional and some accidental, some short term and some long term. Over the years, 

many trends have contributed to the problems in our current system. To appreciate the 

Panel’s options for reforms, it is useful to understand the broad historical outlines of 

the U.S. tax system.

Among the most important trends that have marked the federal income tax since its 

inception have been its ever growing reach; not only has it steadily affected increasing 

numbers of Americans, but it is now used to carry out a multitude of policy objectives 

that go well beyond merely collecting revenues needed to fund our government. 

And as the tax code has developed, little effort has been given to comprehensively 

examining the system to make sure that it is simple, efficient, and transparent. 

There are already many comprehensive histories of the tax code, and this report 

does not attempt to duplicate, or even summarize, those works. Instead, this chapter 

highlights historical developments relevant to the Panel’s work.
12

Federal Tax Reform

The President’s Advisory Panel on

For much of its history the United States did not have an income tax. Except for a 

brief period during and immediately after the Civil War, the nation relied almost 

exclusively on tariffs – taxes on imported goods – to support government functions. 

A lively constitutional debate, including a decision by the Supreme Court in 1895, 

weighed against the creation of an income tax.

But in 1913, the Sixteenth Amendment was ratified, ending all debate about whether 

an income tax was constitutional. A few months later, 

Congress enacted an income tax. At its inception, less than 

1 percent of Americans paid the individual income tax. 

Most Americans were exempt from paying the tax because 

their income did not exceed a relatively high threshold, 

and even those who were subject to the tax paid at modest 

rates. By the 1920s, tax rates had increased and a majority 

of government revenue came from income taxes, which 

helped fund what was still a small federal government. 

The income tax was initially a “class tax” paid mostly by 

wealthy Americans. But during the 1930s, the federal 

government established withholding of payroll taxes in 

order to fund the new Social Security system, thereby 

creating a means to collect income tax from the many 

Americans who receive wages from an employer. 

World War II created a pressing need for greater 

government revenues, and the income tax was greatly 

expanded to fill the shortfall. The threshold for paying taxes 

was dramatically reduced, subjecting millions of families to 

the income tax for the first time. At the same time, wage 

withholding was expanded to require employers to collect 

not only Social Security taxes, but also income taxes on 

employees’ wages. By the end of World War II, almost 75 

percent of Americans were subject to the income tax, compared with only 5 percent 

in 1939. The income tax had been transformed from a “class tax” on the wealthiest 

Americans into a “mass tax” paid by most Americans to fund what had become a 

substantially larger federal government. 

Unlike the aftermath of previous wars, such as the Civil War and World War I, when 

income taxes were either abolished or reduced, the end of World War II did not 

prompt the federal government to lower tax rates. Instead, the federal government 

continued to use receipts from the income tax to maintain much of its wartime size. 

The income tax remained a major factor in America’s economy, and unintended 

consequences became a hallmark of tax policy. 

1913 Form 1040
13

Chapter Two

During the war, the National Labor Relations Board followed an earlier IRS 

ruling that excluded employer-paid health insurance from income and exempted 

employer-paid health insurance from wage and price controls. As a result of this 

decision, employers looking to attract and keep talented workers made greater use 

of health insurance benefits and other non-cash wages. When World War II ended 

and price controls were removed, health insurance remained a tax-favored form of 

compensation for the vast majority of Americans. The 

decision to exclude health care benefits – originally 

made when the tax code affected only a small fraction of 

Americans – had far-reaching consequences, which are 

detailed later in this report. 

Starting in the 1960s, another broad trend in tax policy 

accelerated: the use of the tax code to achieve policy goals 

other than raising government revenue. Rather than 

the largely unintended consequence of some earlier tax 

writing efforts, this trend reflected a deliberate intent. It 

strengthened throughout the 1960s and 1970s, with the 

creation of individual retirement accounts (IRAs) in 1974; 

the earned income tax credit (EITC), which provides 

low-income working Americans with a tax benefit, in 

1975; and 401(k) retirement accounts in 1978.

Tax changes motivated by non-tax economic or social 

policy goals became so commonplace that, beginning 

in 1974, provisions in the tax code to promote these 

goals were tracked in a “tax expenditure budget.” A tax 

expenditure is a tax incentive that provides special tax 

treatment to a particular type of activity. Many of these 

tax incentives could have been structured as a direct 

government spending program. Either way, it costs the 

government money to provide benefits, and it must be 

financed with higher taxes elsewhere. Over the past 

several decades, the number and estimated cost of tax 

expenditures has grown considerably. 

Even when Congress and the Administration corrected 

certain problems in the tax code, they often created other 

problems at the same time. For example, in 1981, Congress 

passed and President Reagan signed a tax bill that indexed tax brackets for inflation, 

ending what was called “bracket creep.” Bracket creep occurred when inflation 

pushed up taxpayers’ wages. Because tax brackets were not adjusted for inflation, this 

amounted to an inflation-aided tax hike every year, even if a taxpayer’s purchasing 

power stayed the same or actually fell. Furthermore, lawmakers were able to spend the 

proceeds from the higher taxes without having to actually vote to increase rates. 

Internal Revenue Service, Statistics of Income, 1920
14

Federal Tax Reform

The President’s Advisory Panel on

While fixing the bracket creep problem, the 1981 tax bill also included various 

narrowly tailored tax incentives, and these special interest provisions, including further 

benefits for real estate investment, helped drive greater use of tax shelters. By 1982, 

one poll showed that 86 percent of Americans believed that most higher-income 

people got out of paying much of their taxes by hiring tax accountants and lawyers who 

showed them how to use loopholes in the tax law, while lower and middle-income 

people simply took the standard deduction and paid what they owed. 

In his 1984 State of the Union address, President Reagan called on the Treasury 

Department to prepare a plan to overhaul the entire tax code. After two years of 

analysis, debate, and bipartisan compromise, President Reagan signed the Tax Reform 

Act of 1986. The 1986 Act reduced the top marginal individual tax rate from 50 

percent to 28 percent and increased the standard deduction for married couples. The 

top corporate tax rate was reduced from 50 percent to 34 percent. 

The 1986 Act broadened the tax base by repealing more tax preferences than had 

been eliminated in all tax legislation enacted between 1913 and 1985, including the 

long-term capital gains exclusion, the investment tax credit, the two-earner deduction, 

state and local sales tax deductions, and the deduction for credit card interest. 

Deductions for passive losses, medical expenses, business meals and entertainment, 

and miscellaneous expenses also were limited. These changes and others made by the 

1986 Act simplified the tax code, broadened the income tax base, allowed for lower 

marginal tax rates, and curtailed the use of individual tax shelters. 

While the 1986 Act was a historic event, it did not produce a lasting transformation 

of the tax system. The 1986 Act left in place or added various complicated tax 

benefits, including such items as exclusions for employer-provided fringe benefits, 

state and local tax deductions, tax-deferred annuities, new mortgage interest 

deduction rules, and complicated rules for determining alternative minimum tax 

liability. Many point to the 1986 Act as the high point of contemporary tax reform 

– and they may well be right – but its limitations suggest that truly sweeping 

comprehensive reform faces formidable political obstacles.

The reforms of the 1986 Act were intended to create a simpler, more stable, and progrowth federal income tax system based on lower rates and more uniform taxation of 

all sources of income, while retaining a progressive tax rate structure. But since 1986, 

the promise of a more simple and sustainable system has been undone. Throughout 

the 1990s, income tax rates rose, and many special individual and business tax 

provisions were enacted, narrowing the tax base. The piecemeal addition of these new 

benefits was shaped by new budget rules aimed at forcing lawmakers to limit the 

scope of tax legislation. Rather than limiting the number of new provisions, however, 

the budget rules led to a greater use of phase-outs, restrictions, and eligibility criteria 

that compounded the complexity of the tax code. 
15

Chapter Two

During the 1990s, the EITC was revised to account for family size and was extended 

to cover low-income single workers with no children. A higher level of Social Security 

benefits became subject to tax, and a complicated three-tier system was enacted for 

calculating how much would be taxed. On the business side, Congress increased the 

corporate tax rate from 34 percent to 35 percent and either created or extended a 

number of special provisions for the energy sector, low income housing, research and 

development, and tax-free employee fringe benefits.

In 1997, Congress again enacted new tax credits for children and for education. A 

new type of retirement vehicle – called a Roth IRA – was created along with a new 

education savings account. Joining the medical savings accounts created in 1996, 

these accounts were the first of a slew of new provisions to promote savings, each 

with its own rules and limitations. The piecemeal addition of savings incentives with 

complicated rules made it increasingly hard for ordinary Americans to navigate the 

system while still allowing for well-advised taxpayers to take advantage of the code’s 

many loopholes. 

A number of significant changes to the tax code have been made in the last few 

years. Tax relief passed in 2001 lowered individual tax rates across the board, doubled 

the child tax credit, raised limits for retirement plan contributions, and introduced 

a deduction for college expenses and yet another education savings account. Two 

years later, further tax relief was signed that reduced the taxation of both dividends 

and capital gains to a uniform top rate of 15 percent, and increased the amount of 

depreciation or expensing that companies could take for business purchases. All of 

these provisions – rates and others – are temporary and expire over the next six years, 

substantially undermining the durability of the tax code and the certainty taxpayers 

need for planning.

Just last year, Congress enacted a “use it or lose it” tax holiday to encourage 

multinationals to bring back previously untaxed foreign earnings, and a special 

tax deduction targeted at domestic manufacturing. The manufacturing deduction 

is another example of a provision that is targeted at a specific type of activity, but 

that creates complexity for everyone. The provision allows businesses to deduct net 

income from the sale of goods, software, and film and sound recordings if they are 

manufactured or produced within the United States. To take advantage of the benefit, 

businesses need to allocate all of their receipts and expenses between those activities 

that are eligible for the preference and those that are not. Provisions like these are 

also difficult to administer. One witness observed that the prohibition on movies 

with sexually explicit content places IRS agents in the awkward position of screening 

movies to determine whether they qualify for the deduction. 

Even as the Panel was conducting its deliberations, lawmakers continued to enact 

additional tax breaks for certain industries. Yet again, greater value was placed on 

creating targeted tax breaks than on establishing broad-based provisions that would 

apply to all businesses.
16

Federal Tax Reform

The President’s Advisory Panel on

Today, our tax system bears 

little resemblance to the 

simple, low-rate system 

promised by the 1986 reform 

effort. Since 1986, there has 

been nearly constant tinkering 

– more than 100 different 

acts of Congress have made 

nearly 15,000 changes to 

the tax code, as shown in 

Figure 2.1. A number of 

new credits, deductions, 

and exemptions have been 

extended or layered on top 

of long-standing incentives 

in the tax code for such 

goals as encouraging savings, 

charity, and homeownership. 

A growing maze of tax rules 

and incentives target narrow 

classes of individuals; phaseouts, contribution limits, and 

complicated eligibility criteria 

circumscribe the scope of 

older programs. Changes in the global economy, including increasingly sophisticated 

financial instruments, the free flow of capital across borders, a globally competitive 

marketplace, and the expanding role of intangible assets in producing business 

income, have also made it harder to establish the rules required to accurately measure 

tax liability and fairly enforce the income tax. 

Our tax code is in dire need of reform. Not only has it failed to keep pace with our 

growing and dynamic economy, frequent changes have made it unstable and unpredictable. History demonstrates that in the absence of a concerted effort to reform the 

tax system, it will become more complex and ungainly. Meaningful reform requires 

a comprehensive and forward-looking examination of our tax system. The Panel has 

been presented with a historic opportunity to do just that. The following chapters 

describe the Panel’s findings, along with proposals designed to put our country on a 

path towards a better tax system for current and future generations.

Figure 2.1. Tax Law Changes Since 1986

1988

1990

1993

1996

1997

2001

2003

2004

2005

1987

2,500

0

5,000

7,500

10,000

12,500

15,000
17

Chapter Two

Box 2.1. International Trends 

A wave of tax reforms has swept across the world in the last two decades. Since the 

United States reformed its tax system in 1986, almost every major developed economy 

has engaged in fundamental tax reform. The Panel heard that a common theme of these 

reform efforts was an attempt to lower tax rates and broaden the tax base.

Some countries have adopted flatter personal income tax systems by reducing the number 

of tax brackets in their systems. A number of countries in Eastern Europe – including 

Estonia, Georgia, Latvia, Slovakia, and Russia -- have adopted a single uniform rate for 

taxing personal income. Other countries, such as Finland, Norway, and Sweden have 

moved towards dual personal income tax systems under which wage income is taxed at 

progressive rates and capital income (dividends, interest, etc.) is taxed at a lower single 

rate. Countries have also lowered their corporate income tax rates and provided other tax 

relief for capital income. Finally, almost all developed economies and many developing 

ones have adopted a modified sales tax known as a value added tax, or VAT.
18

Federal Tax Reform

The President’s Advisory Panel on
Chapter Three

Tax Basics

As the Pulitzer Prize-winning cartoon that opens this chapter suggests, our income 

tax system has become a running joke. Many Americans do not understand what 

determines their tax liability and why it may differ from their neighbors’ tax bill. Few 

can understand why our tax returns require us to make the calculations that they do. 

Tax lawyers and scholars who testified at our meetings conceded even they do not 

understand the inner workings of the tax system. But understanding the mechanics 

of tax computation – under either our current system or other potential systems – is 

crucial to reforming the tax code. This chapter explains how to analyze the tax code 

– not just from the perspective of the government, but from the point of view of the 

taxpayer. It goes through the basic steps involved in calculating a tax bill (shown in 

Figure 3.1) to explain our current tax code and alternative tax systems. This brief tour 

will introduce important concepts used throughout the remainder of the report. 

Designing a tax system involves choices. Defining the “tax base,” or what will be taxed, 

setting a rate structure, and deciding how taxes will be collected determines much 

more than how much an individual or family pays. These decisions have consequences 

Courtesy of www.jeff-macnelly.com
20

Federal Tax Reform

The President’s Advisory Panel on

TAX BASE:

What is taxed?

Multiply by Tax Rate

TAX LIABILITY

Pay Tax to Collector

Figure 3.1.Calculating 

the Taxpayer’s Bill

for how different economic activities are taxed or “what is taxed,” how the tax burden 

is distributed across taxpayers, what are the administrative and compliance costs of 

the system, and how our tax system interacts with our $12 trillion economy. 

The Tax Base

The tax base is the pool of economic activity from which tax revenue is gathered. All 

else being equal, the broader the tax base, the more revenue a tax system will collect at 

a given tax rate.

A comprehensive income tax base, which is perhaps the broadest tax base, would 

include all forms of income. Most people think of income strictly in terms of wages. 

But a comprehensive measure of income also includes anything that allows you to 

spend more, either now or in the future. Capital gains and losses, dividends, rental 

income, and royalties all represent income that does not come in the form of wages.

Income can also include noncash increases to wealth, such as health care insurance 

or other fringe benefits provided by an employer. Some components of income are 

accruals that do not involve any current cash flows. For example, a stock that has 

risen in value allows its owner to spend more in the future, and so the increase in 

value every year should be considered income even if the asset has not been sold. In 

a comprehensive income tax base, the increase in value of all assets, including homes, 

would be subject to taxation. In the case of housing, homeowners would also have to 

declare as income the value they receive by living in their houses rather than renting 

them out – something economists call “imputed rental income.” All expenses incurred 

in earning income would be subtracted from the base. Most agree that this construct 

– recognizing income not just as real but as potential – makes the comprehensive 

income tax base extremely difficult to implement in practice.

Comprehensive taxation of business income is similarly complex and difficult to 

implement. Businesses would include all sources of income (receipts from sales, 

returns on financial assets, etc.) and subtract all expenses incurred to earn income. 

While it is relatively easy to measure and subtract the cost of inputs that are used up 

during the year they are purchased, it is much more difficult to properly account for 

the cost of durable inputs, like machinery, that last for more than one tax period. A 

consistent definition of income would require that the business be allowed to subtract 

the decrease in economic value of machinery and other assets including “intangible” 

assets, such as advertising and copyrights. After all, this decrease in value, called 

economic depreciation, represents an economic cost to the firm. Measuring economic 

depreciation for different assets is extremely difficult and is one of many intractable 

complexities encountered when using income as a tax base. 

Is income the only possible tax base? Income is only one way to define a tax base. 

Another approach is to tax the value of goods and services that individuals purchase 

or consume. This approach is referred to as using a conprehensive consumption tax 

base. The major distinction between a consumption tax base and an income tax base 

is the treatment of savings. Under the comprehensive consumption tax base, people 

are not taxed until they spend. Under the comprehensive income tax base, they are 
21

Chapter Three

taxed from the moment they earn anything – including the returns on saving and 

investment. As a result, many experts view the comprehensive consumption tax base 

as better for saving and capital formation, a key determinant of labor productivity and 

future living standards. 

Some proponents of the comprehensive consumption tax base call it a “neutral tax 

system” because it treats a dollar spent today the same as a dollar saved and spent 

tomorrow. An individual who earns a dollar today, pays taxes on those wages, and 

then consumes the after-tax proceeds will not pay any further taxes. The earnings 

would be taxed only once under the consumption tax. In contrast, under an income 

tax, someone who earns the same amount today and pays the same taxes on wage 

income, but then decides to save the after-tax proceeds will be subject to a future tax 

on the investment income generated by this saving. 

Under a consumption tax, businesses would subtract the cost of all purchases from 

other businesses, including an immediate write-off, known as “expensing,” for all 

business assets. Similar to an individual’s treatment under a consumption tax base, 

businesses would not include returns on financial assets, nor would they deduct their 

financing costs. As is explained later in this chapter, this is one way, but not the only 

way to tax consumption.

What tax base does the U.S. system use? Our tax base does not follow either model. 

As illustrated in Chapter One, it most closely resembles an income tax base system, 

but does not include certain forms of both cash and noncash income that would 

be part of a comprehensive income tax base. For example, employer contributions 

to health plans are not taxed in our current system. These exclusions significantly 

narrow the base. For example, the value of all noncash employee benefits in 2002 

was approximately $1.1 trillion – equal to about 10 percent of the total size of the 

economy. Only a small fraction of that amount was subject to tax. 

The current system also deviates from a pure income tax by excluding significant 

amounts of investment income through tax preferences for savings. This feature 

of our tax system resembles, or moves it towards, a consumption tax. In fact, over 

one-third of the proceeds from household savings are effectively exempt from 

taxation – meaning that these financial assets receive the equivalent of consumption 

tax treatment (see Box 3.1).The other two-thirds of household savings are taxed 

as they would be under an income tax. Several economists who testified before the 

Panel said that the current tax system is based on neither a pure income nor a pure 

consumption tax, but is really a hybrid tax system – a tax system with both income tax 

and consumption tax features.
22

Federal Tax Reform

The President’s Advisory Panel on

There are also some features of the current tax system that are inconsistent with both 

an income tax and a consumption tax. The lack of taxation on the implicit rental value 

of owner-occupied housing is an example. This tax provision is consistent with neither 

income nor consumption taxation. The double taxation of corporate profits - once 

when earned at the corporate level and again at the individual level when received by 

shareholders - is another example.

As summarized in Figure 3.2, our hybrid tax system has a much smaller tax base than 

it would under either a comprehensive income tax or a comprehensive consumption 

tax. Various exclusions, deductions, and credits leave the current hybrid tax base 

about half as large as a broadly defined income tax base. Our tax system also relies 

on depreciation rules that generally provide a more rapid, or accelerated, write-off of 

investment than on rules that try to replicate economic depreciation.

Box 3.1. Taxes and the Return on Household Financial Assets

Relative to a pure income tax, the current U.S. tax system reduces the tax on the return to 

saving through tax-preferred savings accounts (e.g., IRAs, pensions, and college savings 

accounts), faster write-off of investment (e.g., expensing and accelerated depreciation), 

and lower tax rates on dividends and capital gains. As shown below, over one-third of the 

return on household financial assets is effectively exempt from taxation (excluding the 

effects of the corporate tax).

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23

Chapter Three

Calculating Tax Liability in Our Current System

As the history of our tax code suggests, calculating tax liability in our current system 

is not as simple as the four-box diagram shown in Figure 3.1. Figure 3.3 is a more 

accurate representation of the many steps involved in calculating taxes owed under 

the current personal income tax system. Taxpayers start by adding up their taxable 

income from different sources: wages and salaries, taxable dividends, taxable interest, 

rents, royalties, capital gains, business income (or losses), taxable pensions and 

annuities, taxable Social Security benefits, etc. This income, called gross income, is 

the starting point for the tax calculation. Arriving at each of these components often 

involves its own set of calculations. Under current law, taxpayers are allowed to deduct 

certain expenses, such as the costs of moving for a new job or their contributions to 

individual retirement accounts, from gross income. After taking into account these 

adjustments, sometimes called “above-the-line” deductions, the taxpayer takes the 

resulting amount, called adjusted gross income (AGI), and applies further adjustments 

to calculate taxable income.

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24

Federal Tax Reform

The President’s Advisory Panel on

Tax Base

Include wages and compensation, interest, 

dividends, capital gains (or loss), business income 

(or loss), pensions, farm income (or loss), rents, 

royalties, Social Security benefits, etc.

Subtract

“Above-the-line” Deductions

Adjusted Gross Income

Subtract Exemptions

Compare Larger of: 

Standard Deduction 

or

Itemized Deductions

Taxable Income

Apply Tax Rates

Tax Liability Before Credits

Subtract Tax Credits

Regular Tax Liability

(Start over to determine AMT Tax Liability 

using AMT base. Pay larger of Regular Tax 

Liability and AMT Liability)

Pay Tax or Claim Refund

Child tax credit,

additional child tax credit,

EITC,

HOPE and Lifetime 

Learning credit,

electric vehicles credit,

foreign tax credit,

health coverage tax credit,

adoption credit,

mortgage interest credit,

retirement savings 

contribution credit,

child and dependent care 

credit,

credit for the elderly or the 

disabled,

D.C. First-Time 

homebuyer’s credit,

Charitable 

contributions, home 

mortgage interest, state 

and local taxes, medical 

expenses in excess of 

7.5% of AGI, casualty 

and theft losses, nonreimbursed employee 

expenses

Phase-out with income

Income base does not include 

employer contributions to health 

and retirement plans, returns to 

tax-preferred savings accounts, 

unrealized capital gains, interest 

on state and local bonds, imputed 

rent from owning a home and 

other durable goods, in-kind 

services, gifts, and inheritances Trade or business expenses, 

moving expenses, educator 

expenses, self-employed health 

insurance premium payments, 

student loan payments, tuition 

and fees,alimony paid, etc.

Six ordinary rates 

(10, 15, 25, 28, 33, 35) 

Tax schedule differs by 

filing status

Special rates for dividends 

and capital gains

Phase-out with income

Incur additional compliance, 

administration, and efficiency costs

Differs by filing status

 Single or married filing 

separately 

Head of household

 Married filing jointly or 

qualifying widow(er)

Figure 3.3. Individual Tax Computation 

Under the Current System

Phase-out with income
25

Chapter Three

How is taxable income determined? Taxable income, in mathematical terms, equals AGI 

minus applicable exemptions and deductions. Exemptions and deductions remove 

a further amount of income from the tax base. In certain cases, these tax provisions, 

or tax preferences, are in place to encourage certain kinds of economic activity, such 

as the purchase of homes. In other cases, these preferences are in place to generate 

a certain kind of social good, such as charitable giving. In still other cases, these 

preferences are in place to provide assistance to low or moderate-income Americans, 

especially those with children, by lowering their taxes. Finally, some tax preferences, 

like the personal exemption discussed in the next paragraph, are designed to reflect 

a taxpayer’s ability to pay taxes. Tax preferences have varying effects and success in 

achieving their goals.

What is an exemption? Most taxpayers in our system are eligible to exclude a certain 

amount of income from taxes. This exemption depends on family size. For example, 

a single taxpayer claims one exemption and married taxpayers with two children (or 

other dependents) claim four exemptions. Taxpayers with AGI below the exemption 

amount will not pay any income tax. Not every taxpayer is allowed to claim an 

exemption. Personal exemptions are phased out for higher income taxpayers with 

AGI in excess of certain amounts. The personal exemption is an example of a tax 

preference designed to adjust tax liabilities for family size that, for revenue reasons, is 

not available to higher-income taxpayers. 

What are deductions? Deductions, like exemptions, are subtracted from AGI to 

determine taxable income. Taxpayers are allowed to choose whether to subtract a 

standard deduction amount determined by filing status – such as single or married 

– or to subtract the total of their itemized deductions. It is up to taxpayers to calculate 

their itemized deductions and claim them if the total is greater than their standard 

deduction.

Only specific expeditures may be claimed as itemized deductions. Many of the most 

prominent tax preferences, including deductions for charitable contributions, home 

mortgage interest, and state and local taxes, come in the form of itemized deductions. 

The benefits of these deductions are not spread evenly among taxpayers for several 

reasons. First, most taxpayers do not itemize their deductions, and those who do tend 

to have higher incomes than those who do not. The Internal Revenue Service reports 

that only 34 percent of taxpayers claimed itemized deductions in 2003. Among the 

taxpayers who did so, over 60 percent had AGI of more than $50,000. By comparison, 

only 12 percent of taxpayers claiming the standard deduction had AGI of more than 

$50,000 in 2003. 

Second, the value of a deduction (or exclusion) is worth more to a taxpayer in a higher 

tax bracket than to a taxpayer in a lower tax bracket. The reason is simple: A $1,000 

deduction reduces taxes owed to the government by $350 for someone in the top 35 

percent tax rate bracket; but it reduces taxes by only $150 for a taxpayer in the 

15 percent tax bracket. 
26

Federal Tax Reform

The President’s Advisory Panel on

Although deductions are worth more to taxpayers in higher tax brackets, the tax code 

has been written to phase out most deductions when a taxpayer reaches a certain 

income level. These trigger points are typically at different levels of income and vary 

based on filing status. Phase-outs add a significant amount of complexity to the 

process of filling out tax returns and lead to the very complicated and unpredictable 

set of marginal tax rates depicted in Chapter One, Figure 1.2. 

Setting the Tax Brackets

Some low-income taxpayers have zero taxable income after subtracting exemptions 

and deductions from their adjusted gross income. Nevertheless, these taxpayers must 

complete the tax form to determine if they are eligible for benefits from several 

refundable tax credits (as explained later in this chapter). For taxpayers with positive 

taxable income (that is, positive income after subtracting exemptions and deductions), 

tax is imposed by applying a tax rate schedule with six tax rate brackets that range 

from 10 percent to 35 percent. The applicable rate depends on the taxpayer’s family 

filing status. Table 3.1 summarizes the 2005 tax rates for single and married taxpayers. 

Table 3.1. Tax Rates for Single and Married Taxpayers Filing Jointly in 2005

 Tax Rate Single Married Filing Jointly

10% Up to $7,300 Up to $14,600

15% $7,301 - $29,700 $14,601 - $59,400

25% $29,701 - $71,950 $59,401 - $119,950

28% $71,951 - $150,150 $119,951 - $182,800

33% $150,151- $326,450 $182,801 - $326,450

35% $326,451 or more $326,451 or more

Applying the relevant tax rates to taxable income produces the taxpayer’s liability. 

However, certain portions of a taxpayer’s income, such as dividends and capital gains, 

are taxed at special rates that may be lower than the rate that would be paid on an 

additional dollar of ordinary income – requiring yet another set of calculations. 

What is a tax credit? Like deductions, exemptions, and exclusions, tax credits provide 

taxpayers with a tax benefit. However, tax credits are applied after the taxpayer’s tax 

liability is calculated; they are subtracted, just like a coupon at the supermarket.

 Depending on how a tax preference is designed – as a deduction, exemption, or 

credit – it can have different impacts on taxpayers at different income levels. For 

example, we have already seen how tax deductions and exemptions are more valuable 

to higher-income taxpayers. Since tax credits provide a dollar-for-dollar decrease in 

tax liability for all taxpayers who pay tax, they provide an equal benefit to taxpayers at 

all income levels. Tax credits can also be made refundable. A refundable tax credit is 

like a gift certificate that can be exchanged for cash. Even if a taxpayer has too little 

income to actually owe income taxes, he or she may be able to claim a refund equal 

to the amount of the tax credit that exceeds tax liability. The earned income tax credit 

(EITC) and the child tax credit are two examples of refundable credits. 
27

Chapter Three

In recent years, lawmakers have enacted rules that phase out some tax credits for 

higher-income taxpayers. This limits the cost of tax credits, but also raises the 

marginal tax rate, or the tax paid on a taxpayer’s last dollar of income, above the rate 

normally paid by the taxpayer. Consider, for example, a taxpayer in the 28 percent 

bracket who claims credits that begin to phase out at a rate of $5 for every extra $100 

earned. By this measure, each additional $100 earned by the taxpayer increases tax 

liability by $28, but decreases the value of tax credits by $5. The tax on the additional 

$100 of earnings is not $28, but $33, and the taxpayer’s marginal tax rate (the rate 

applied to the last dollar earned by the taxpayer) is not 28 percent ($28/$100), but 33 

percent ($33/$100).

Phase-outs are so pervasive in our system that one recent study found that more 

than one out of every five taxpayers faced actual marginal tax rates (called “effective 

marginal tax rates”) higher than their statutory rates in 2003. This was even more 

common among higher-income households: More than half of taxpayers with AGI of 

$100,000 or above faced effective marginal tax rates greater than the statutory rate.

Box 3.2. The Cost of Tax Preferences

Because of the rising use of special tax provisions, policymakers maintain a “tax expenditure 

budget” to track tax preferences, whether in the form of credits, deductions, exclusions, or 

exemptions. The tax expenditure budget lists the subsidy cost of tax preferences – what the 

government would collect in revenue if any given tax preference did not exist. There does 

not appear to be any institutional process to evaluate on a regular basis the effectiveness of 

these tax preferences. 

The most recent budget lists 146 tax expenditures, most of which relate to the individual 

income tax system. The largest tax expenditures, grouped by major category, are the 

exclusion from income for employer-provided health insurance, incentives for home 

ownership, tax-preferred retirement savings, the deduction for charitable contributions, the 

child tax credit, the EITC, the step-up in basis of capital gains upon death, and state and 

local tax deductions. 

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28

Federal Tax Reform

The President’s Advisory Panel on

Double-checking: Does the Alternative Minimum Tax apply? After all these calculations, 

a taxpayer arrives at the moment of truth: the final tax bill. However, many taxpayers 

still need to consider whether they owe more taxes under the AMT. As explained 

in Chapter One, the AMT uses a different definition of the tax base, a higher level 

for exemptions, and fewer tax preferences than the regular income tax. And because 

the threshold for paying the AMT has never been indexed to inflation, more and 

more Americans are forced to consider whether they face a higher tax bill under this 

secondary tax system.

Paying the Tax

Because of exclusions, exemptions, deductions, and credits, a large percentage of 

income is never taxed, and most low-income families pay little, if any, income taxes. 

In some cases, refundable credits provide these families with an additional amount 

of money that helps offset other federal taxes paid, such as payroll taxes. As detailed 

in Table 3.2, a typical family of four will pay no income tax in 2005 on the first 

$41,000 of income it earns. The amount of income at which a family starts to pay 

tax is sometimes called the tax threshold and has important implications for how the 

burden of the tax is distributed and how people participate in the tax system and 

support the federal government.

Table 3.2. Components of Income Tax Thresholds for 2005

Single,

no children

Single,

two 

children

Married,

two children

Standard deduction $5,000 $7,300 $10,000

Personal exemptions $3,200 $9,600 $12,800

Income not subject to tax 

before credits $8,200 $16,900 $22,800

Tax threshold: Income not 

subject to tax after earned 

income and child tax credits $9,737 $34,620 $41,000

Source: Department of the Treasury, Office of Tax Analysis.

In 2002, over 30 percent of taxpayers who filed a tax return – 39 million of 130 

million returns filed – either owed no tax or received a refundable credit. An 

additional 15 million Americans earned less income than the total of the standard 

deduction and personal exemption and, therefore, were not required to file a return. In 

all, approximately 40 percent of Americans paid no income tax directly. 
29

Chapter Three

It is worth noting that taxpayers do not stay permanently in the status of having 

a negative, zero, or positive tax liability. As their family and income circumstances 

change, even from year to year, taxpayers can move in and out of these negative, zero, 

or positive tax situations. A Department of the Treasury study that followed taxpayers 

over multiple years suggests that about two-thirds of taxpayers in the bottom (zero 

rate) bracket in the first year had moved to a higher bracket after 10 years, the vast 

majority moving to either the 10 or 15 percent tax brackets. This fluidity is important 

because simply taking people “off the rolls” may not take them out of the system for 

any significant length of time. 

Who really pays the tax? When the calculation is complete and the tax owed (or the 

refund due) is finally determined, the taxpayer signs the tax form and 

sends it to the Internal Revenue Service (either electronically or through 

the mail). In the case of the income tax, the amount of tax owed is paid 

directly to the federal government. Not all taxes imposed on individuals are 

remitted directly from individuals to the government, however. 

One of the most important concepts in understanding how taxes work 

is that who remits the tax has no relevance on who bears the ultimate 

burden of the tax or how the tax affects the economy. For example, the legal 

burden of the payroll tax (Social Security, Medicare, and unemployment 

insurance) is shared between employers and employees. Economists have 

found, however, that the burden of the employer’s portion of the payroll 

tax is largely passed on to employees in the form of lower wages. The 

economic incidence is on workers even though the legal incidence of the 

payroll tax is shared. Box 3.3 explains how market forces, and not who is 

legally responsible for remitting the tax, determine who bears the economic 

burden of any tax.

Box 3.3. Determining Who Bears the Burden of a Tax

Imagine that the government imposed a special tax on ice cream sold from ice cream 

trucks. If the ice cream truck drivers are able to pass on the tax to their customers in the 

form of higher prices, the economic incidence of the tax would be on their customers. In 

this case, the price of ice cream sold from trucks would increase by exactly the amount of 

the tax. If customers resisted the price increase by buying their ice cream in stores to avoid 

the tax, and ultimately the only way the truck driver could sell ice cream was by matching 

the retail price at the store, then the truck driver would bear the economic burden of the tax. 

In this case, the legal incidence and economic incidence of the tax would be identical. 

Understanding the difference between the economic and legal incidence of taxes is important 

in analyzing both taxes and subsidies. Take the example of tax credits for low-income 

housing that could be claimed by low-income taxpayers. If the price of low-income housing 

increases by the amount of the credit, the credit would provide no benefit whatsoever to 

the low-income household, but enormous value to builders of low-income housing. In this 

case, market forces would have passed the full benefit of the credit to builders.
30

Federal Tax Reform

The President’s Advisory Panel on

Paying a “Fair Share” 

How a tax system is designed determines how the tax burden is distributed. In a 

progressive tax system, the household’s tax burden, measured as tax liability divided 

by household income, increases as household income rises. Graduated tax rates, 

exemptions, the standard deduction, and refundable credits all contribute to the 

progressivity of our tax system. 

Another measure of how the burden of our tax system is distributed involves 

calculating how much of total tax revenue is collected from different income groups. 

This type of analysis is produced routinely by government organizations, nonprofit 

organizations, academics, and other groups. 

There are many assumptions involved in tax burden analysis and, not surprisingly, 

different organizations use different methodologies. All analyses start by ranking 

taxpayers according to a measure of economic well-being intended to approximate 

“ability to pay.” The Treasury Department uses a measure called “cash income,” 

based on the income of each household. Cash income consists of wages and salaries, 

business or farm net income, taxable and tax-exempt interest, dividends, rental 

income, realized capital gains, cash transfers from the government, and retirement 

benefits. Employer contributions for payroll taxes and the federal corporate income 

tax are also added to cash income calculations.

The Treasury Department constructs distribution tables by dividing the entire 

population of households into income quintiles or cash income levels. Taxes paid 

are then calculated for each group. The distribution of cash income across quintiles 

(and the top 10 percent, 5 percent, and 1 percent of taxpayers, as well as the bottom 

50 percent of taxpayers) and across cash income levels is shown in Figures 3.4 and 

3.5. Figure 3.4 shows that the top 20 percent of households earn about 60 percent of 

all income and the bottom 20 percent of all households earn about 2 percent of all 

income.

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31

Chapter Three

The Treasury Department’s quintile analysis showing the distribution of all current 

federal taxes (individual and corporate income taxes, payroll taxes, excise taxes, 

customs duties, and estate and gift taxes) across cash income quintiles is shown in 

Figure 3.6. Not surprisingly, given the progressive nature of our tax system, most 

federal taxes are paid by upper-income taxpayers. Taxpayers in the top 20 percent of 

the distribution pay 70.6 percent of all federal taxes, while taxpayers in the bottom 20 

percent pay 0.4 percent. More than half of federal taxes are paid by taxpayers in the 

top 10 percent of the distribution. Figure 3.7 provides detail on the distribution of all 

federal taxes across cash income groups. 

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The Panel has considered reforms to two important components of the federal tax 

system: the individual income tax and the corporate income tax. The distribution 

of these taxes alone is shown in Figures 3.8 and 3.9. Taxpayers in the lowest two 

quintiles actually receive more in refunds from the federal government than they pay 

in income taxes and, as a result, have negative tax income burdens. Those taxpayers 

in the third and fourth quintile pay a relatively small share of the income taxes, 3.8 

percent and 13.4 percent, respectively, while those in the top quintile pay over 84 

percent of federal income taxes.

As mentioned previously, a number of assumptions are required to produce these 

estimates. For example, one must make an assumption about how the employer 

portion of the payroll tax is distributed and how corporate taxes are distributed. The 

note under Figure 3.6 describes the incidence assumptions used by the Treasury 

Department. The following discussion focuses on the assumption for the incidence of 

the corporate income tax since it may have an important effect on the analysis of the 

Panel’s reform plans. 
32

Federal Tax Reform

The President’s Advisory Panel on

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34

Federal Tax Reform

The President’s Advisory Panel on

Only people can bear the burden of taxation. While corporations do remit tax 

payments to the federal government, the economic burden of the corporate income 

tax can fall only on people – specifically, shareholders, employees, or customers. The 

question for those who are trying to analyze the distribution of the corporate income 

tax is how this burden is divided. Economists at both the Treasury Department and 

the Congressional Budget Office assume that the burden of the corporate income 

tax is borne entirely by owners of capital. This means that all individuals who earn 

capital income (dividends, interest, rents, and capital gains) from both corporate and 

noncorporate sources are assumed to pay part of the corporate income tax. While this 

assumption may be reasonable in the short run, the implication is that most of the 

corporate income tax burden will be borne by high-income households because they 

are the ones who earn most capital income. 

Over time, however, some of the burden of corporate taxes is likely to be shifted 

to workers and consumers. Because capital owners can choose to invest in the 

United States or in other nations, when the U.S. raises tax burdens on capital, 

some investment is likely to flow elsewhere. As the stock of capital in the United 

States contracts, the return on that capital rises. The smaller stock of capital leads 

to reduced productivity, however, and lower real wages and correspondingly higher 

prices. A 1998 survey asked public finance economists from the leading economics 

departments in the United States what percent of the burden of the corporate tax falls 

on capital and what percent falls on labor. Although responses varied considerably, 

the median response was that only 40 percent of the corporate tax is borne by capital 

owners and the remaining 60 percent is borne by labor.

Three Burdens of the Tax System

The vast majority of taxpayers either hire a paid tax preparer (about 60 percent 

in 2003) or buy software (more than 25 percent in 2003) to help them complete 

their tax return on their computer. These costs are examples of one of three types 

of burdens beyond the cost of the tax itself that a tax system imposes on taxpayers, 

the government, and the economy as a whole. Taxes create administrative costs for 

the government, compliance costs for taxpayers, and efficiency costs for the national 

economy. 

What are administrative costs? Administrative costs are perhaps the easiest costs to 

understand because they represent the direct costs incurred by the government 

to manage and administer the income tax system. These costs include the budget 

of the Internal Revenue Service and other parts of the Treasury Department that 

help maintain the income tax system, as well as relevant expenses incurred by other 

government agencies. These costs total more than $10 billion per year.
35

Chapter Three

Box 3.4. The Tax Gap

Included in the taxes Americans pay is the hidden cost of noncompliance. On average, the 

“tax gap” – a term used to describe the difference between the total tax that should have 

been paid and what taxpayers actually paid on time – costs honest and careful taxpayers 

an extra $2,000 each year. In its most recent study, the IRS estimates that the gross tax 

gap for individual and self-employment taxes was between $248 and $290 billion in 2001. 

The IRS expects to eventually recoup less than $55 million of this amount through late 

payments and enforcement. 

The overall noncompliance rate for the individual income tax is between 17.5 and 20.1 

percent. Compliance rates are highest where there is third-party information reporting or 

withholding. For example, less than 1.5 percent of wages reported by employers to the IRS 

are misreported on individual tax returns. By contrast, individual compliance is lowest in the 

“cash economy,” where sources of income often are not reported to the IRS. For example, 

two-thirds of the individual tax gap is attributable to self-employed taxpayers where there 

is minimal information reporting. The net effect is a subsidy to some individuals and 

businesses at the expense of others. The subsidy, therefore, distorts the choice about 

whether to invest or work in the cash or noncash sector. 

The IRS has not measured noncompliance among partnerships and corporations for 

many years, but estimates based on research from older studies suggest that the tax gap 

for corporations could be as large as $32 billion, with an overall noncompliance rate of 

approximately 18 percent.

An important aspect of designing a tax system is how it is administered, since this affects 

the overall level of compliance. Noncompliance is an issue of fundamental fairness 

because it forces taxpayers who play by the rules to foot the bill for others who fail to 

pay. It also erodes confidence in the tax system and undermines voluntary compliance. 

The tax gap is caused by a variety of factors, such as inadvertent mistakes, technical tax 

shelters, and outright evasion. Although some cheating is inevitable, the complexity of 

our tax system is a large part of the problem. A less complicated tax code with more 

information reporting would reduce the tax gap by making it easier for taxpayers to 

understand and comply with their tax obligations and would improve the administration of

the tax system.

What are compliance costs? Compliance costs represent the time and resources 

expended by taxpayers to interact with the income tax system. These costs include 

the value of individuals’ time spent learning about the tax law, maintaining 

records for tax purposes, completing and filing tax forms, and responding to any 

correspondence from the IRS or to an IRS audit. Compliance costs also include 

amounts paid to others to conduct any of these tasks on behalf of an individual or 

a business. 

Individuals are estimated to spend a total of 3.5 billion hours each year complying 

with the income tax system. On average, individuals spend 26 hours annually 

on their taxes, and $166 per return on out-of-pocket costs for the services of tax 

professionals, filing fees, and software purchases. Total yearly compliance costs 

are difficult to estimate, in part because estimating the value of the time people 

spend on their tax returns is difficult. Nevertheless, the Treasury Department 

estimates that total costs for complying with the individual income tax amount to 
36

Federal Tax Reform

The President’s Advisory Panel on

almost $100 billion per year. In addition, businesses are estimated to spend over three 

billion hours complying with the tax system, at a total yearly cost of $40 billion. This 

total cost of approximately $140 billion means that one dollar is spent on compliance 

costs for every seven dollars collected in federal income taxes. Other estimates of total 

compliance costs are somewhere between $100 billion to $200 billion. 

What are efficiency costs? Finally, the income tax imposes efficiency costs on the 

economy. These costs arise when high tax rates discourage work, savings, and 

investment; distort economic decisions of individuals and businesses; and divert 

resources from productive uses in our economy. Our tax code contains all kinds of 

incentives for taxpayers to favor activities or goods that are taxed less than others. 

Provisions for the taxation of wages, of gains on the sale of securities and homes, or 

of other economic activities influence how much people work and save. As one small 

business owner explained to the Panel, the tax code affects almost every business 

decision he makes: where to invest, when to invest, how much to invest, what kinds of 

machines and equipment to use in production, how to finance investment, etc. 

When taxpayers change their behavior to minimize their tax liability, they often make 

inefficient choices that they would not make in the absence of tax considerations. 

These tax-motivated behaviors divert resources from their most productive use and 

reduce the productive capacity of our economy. Economic growth suffers as taxpayers 

respond to the tax laws rather than to underlying economic fundamentals. These 

distortions waste economic resources, reduce productivity, and, ultimately lower living 

standards for all. 

These effects are profound. Recall the ice cream truck tax example in Box 3.3. If 

a higher ice cream tax results in higher ice cream prices at ice cream trucks, some 

consumers will pay that higher cost, but others will not. They will switch to other 

ways to get their frozen treats – like getting in their car and driving to an ice cream 

shop that does not have to charge the tax. That decision, and the loss of time spent 

driving to an ice cream store instead of having it served up in one’s front yard, may 

seem trivial. But if multiplied millions of times throughout the economy, the effects 

on economic efficiency are enormous. Economists call this the “excess burden” of 

taxation. Its very name indicates that the true cost of a tax exceeds the tax bill people 

pay or the revenue that is collected.

Federal Reserve Board Chairman Alan Greenspan explained to the Panel that 

the excess burden, or cost, of the tax code grows more than proportionately as tax 

rates increase. In fact, economic theory suggests that if you double the tax rate, you 

quadruple the excess burden. This means that high tax rates have disproportionately 

high economic costs associated with them. 

A recent study estimated that the excess burden associated with increasing the 

individual income tax by $1.00 is between $.30 and $.50 cents, so the total cost of 

collecting $1.00 in additional tax revenue is between $1.30 and $1.50, before taking 

into account compliance or administrative costs. All else being equal, a tax with a 

lower excess burden is preferable to one with a higher excess burden. The size of 

the economic pie will be larger, for example, if it costs only $1.05 to raise a dollar of 
37

Chapter Three

revenue instead of $1.30. To put this into perspective, some studies have suggested 

that a tax system that removes the penalty against savings by switching the current 

structure to a progressive consumption tax could potentially increase the size of the 

economic pie by between 3 and 7 percent.

It would be difficult, however, to imagine a tax system that has no excess burden. 

Excess burden arrises from people adopting less efficient behavior. A tax that does not 

induce people to alter their behavior would be one that does not depend on behavior 

at all. For example, a tax imposed on anyone with green eyes would be impossible to 

avoid for someone with green eyes. A real-life example of this was the poll tax, or flat 

charge on all adults living in a jurisdiction, which was highly efficient in collecting 

revenue, but perceived as extremely unfair because it applied equally to all people, 

regardless of wealth. As a result, these types of taxes have been rejected as revenue 

raising devices. 

For this reason, it is clear that that raising revenue through taxation requires some 

distortions in the economy. One goal of good tax policy is to minimize these 

distortions within a “fair” tax structure. The trade-off between fairness and efficiency 

in raising revenue is one of the central challenges of designing a tax system. Economic 

analysis can describe the efficiency cost of different taxes, but fairness is much more 

difficult to define and different policymakers may have different views of what 

constitutes tax fairness.

Is There Another Way?

As discussed earlier, the design of a tax system begins with the choice of a tax base. 

Our current tax system includes a variety of provisions that exempt capital income 

from taxation and, as a result, move our tax system from a pure income tax base 

towards more of a hybrid approach. This section briefly explores tax systems that 

adopt a consumption tax base.

There are several different tax systems built around the taxation of spending or 

consumption: a retail sales tax, a value-added tax (VAT), a Flat Tax, and a “consumed 

income” tax. A retail sales tax would tax final sales of goods and services to consumers, 

with no tax imposed on sales to businesses. Retailers collect this tax and remit tax 

proceeds to the government. The VAT is a modification of a sales tax in which tax is 

collected from businesses at each stage of the production process. A Flat Tax is a twopart VAT in which tax is imposed at both the business and individual levels. Wages 

are deductible at the business level and taxed at the individual level. The consumed 

income tax is imposed at the household level only, by taxing only the income left after 

subtracting savings. A discussion of each of these consumption taxes follows.

The four taxes can differ in many respects. They may have different impacts on the 

share of the tax burden borne by different groups, on the economy, and on compliance 

and administrative costs. The timing of tax collection differs across the types of taxes. 

The Flat Tax and consumed income tax operate on a “pre-pay” basis, so that the tax is 

collected when wages are earned but no further tax is due at the time of consumption. 

The VAT and retail sales tax, in contrast, operate on a “post-pay” basis so that tax is 
38

Federal Tax Reform

The President’s Advisory Panel on

paid when money is spent. Although there are some differences, all four consumption 

taxes share a common feature: As explained in more detail in Chapter Seven, all 

consumption taxes exempt from taxation what economists refer to as “normal returns” 

from saving and investment. As a result, consumption taxes do not discourage saving 

and investment, nor do they distort saving and investment decisions. 

The Retail Sales Tax

A retail sales tax is imposed when households purchase goods or services from 

businesses. This form of consumption tax is familiar to most Americans since many 

state and local governments raise revenue through retail sales taxes. In a wellfunctioning retail sales tax system, purchases by businesses are not taxed because these 

purchases are “inputs”: goods or services used to produce other goods or services 

for sale to households. In terms of our simple box diagram, the tax base consists of 

taxable goods and services, the tax rate is the applicable sales tax rate, and the tax 

collector is the retailer. Although the retailer pays the tax directly to the government, 

the burden is borne by individuals. And, just as with our current income tax system, 

there are administrative and compliance costs, as well as distributional consequences 

to consider when evaluating the desirability of this tax. These issues are discussed 

further in Chapters Eight and Nine.

The Value-Added Tax

A commonly used variation of a retail sales tax is the value-added tax (VAT). More 

than 135 countries use VATs to raise a portion of total national government tax 

revenues. The United States is the only major industrialized country that does not 

impose a VAT. 

The VAT can be thought of as a retail sales tax that is collected in small increments 

throughout the production process. The tax is calculated at each stage of production: 

Each business’s tax base is calculated from its sales minus its purchases from other 

businesses. Wages are not deducted. It is easiest to understand the VAT, and its 

relationship to a retail sales tax, through an example.

A boot maker makes and sells custom-made cowboy boots. He buys leather and other 

supplies enough for one pair from a leather shop at a cost of $200 before taxes. The 

boot maker then sells each pair of boots he makes for $500 before taxes.

If a 10 percent retail sales tax were in place, the boot maker would add on the tax to 

the cost of the $500 pair of boots, and the consumer would pay $550 per pair. In the 

meantime, the leather shop would not have imposed a retail sales tax on its sale to the 

boot maker because such a business-to-business transaction would not be treated as a 

retail sale. 

Under a VAT, the tax calculation works differently. Because the VAT is charged on all 

sales of goods and services, and not just sales to consumers, the leather shop would 

collect a VAT of 10 percent, or $20 on the $200 of supplies purchased by the boot 

maker. The boot maker would pay the leather shop $220, and the leather shop would 

TAX BASE: 

Household Purchases of 

Goods and Services

Multiply by Tax Rate

Figure 3.10. How a 

Retail Sales Tax Works

TAX LIABILITY

Pay Retailer
39

Chapter Three

send the $20 to the government. When the boot maker sells the boots, he computes 

the VAT as $50, and charges the shoe buyer $550 for the boots. However, instead 

of sending $50 to the government, the boot maker would subtract the $20 of VAT 

already paid to the leather shop and remit $30 to the government. The government 

would receive $50 total: $20 from the leather shop and $30 from the boot maker. The 

government receives the same revenue under a VAT and a retail sales tax, and from 

the boot buyer’s perspective the taxes look identical. 

There is also an alternative method of calculating the VAT. Under the “subtraction 

method,” the boot maker and the leather shop would pay the 10 percent VAT on the 

difference between their pretax sales and purchases. The boot maker would pay $30 

(10 percent of the difference between the $500 of sales and $200 of purchases), and 

the leather shop owner would pay $20 (10 percent of the difference between sales 

and purchases). In practice, the subtraction method may be less reliable because it is 

harder to verify the amount of tax paid on purchases.

Administrative and compliance costs, as well as the progressivity of VATs are 

discussed in Chapter Seven. 

The Flat Tax

The Flat Tax collects part of the consumption tax directly from workers. As is the 

case with a VAT, businesses take the total value of their sales and then subtract the 

total value of purchases from other businesses. However, under a Flat Tax, businesses 

also subtract the wages and other compensation paid to workers. Thus, the tax base 

is total revenues from sales minus purchases from businesses and compensation 

to employees. Employees pay a separate tax on their wages (and other forms of 

compensation) at the household level. 

Consider the boot maker in the VAT example above. Assume that the boot maker 

pays a worker $200 per pair of boots. Recall that under the VAT, the boot maker’s 

tax liability was $30, since the difference between sales and purchases from other 

businesses equals $300 and the VAT rate was 10 percent. Under the Flat Tax, the boot 

maker’s tax liability would be only $10, since both purchases from businesses ($200) 

and compensation to employees ($200) are subtracted from pretax sales ($500). The 

worker would pay tax at the individual level on his compensation. If there were no 

personal exemptions, the worker would have a Flat Tax liability of $20. 

As the example demonstrates, unlike the VAT, the Flat Tax uses a structure that is 

similar to the one we have today and, therefore, is familiar to Americans. Workers 

fill out an annual return as an accounting matter, and the same payroll withholding 

of our current system is used to collect government revenues throughout the year. 

Businesses also file annual returns.

As one of the main proponents of the Flat Tax has commented, the Flat Tax “name 

is brilliant marketing, but it fails to convey the central feature of the idea relative to a 

VAT—the Flat Tax is progressive.” The Flat Tax is progressive because the individual 

tax applies only above an exemption amount. Low-income workers, therefore, do 

TAX BASE:

Wages and salaries,

pensions and other

forms of compensation.

Subtract Personal 

Exemption

Taxable Income

Apply Tax Rates

Pay Tax or Claim Refund

Figure 3.11. 

Individual Tax 

Computation Under A 

Flat Tax
40

Federal Tax Reform

The President’s Advisory Panel on

not pay tax on their compensation to the extent it falls below the exemption amount. 

The Flat Tax is most commonly proposed using a single tax rate that applies to both 

businesses and workers above the exemption level. However, the Flat Tax can be 

made even more progressive by using multiple graduated rates at the individual level. 

Economists refer to one proposal that incorporates a progressive rate structure as 

an X-tax system. The basic X-tax system, developed by the Treasury Department in 

the late 1970s, works exactly like a Flat Tax at the business level. The only difference 

occurs at the individual level where there is a progressive tax bracket structure with a 

top rate equal to the business tax rate.

The Consumed Income Tax

The consumed income tax is collected directly from households. But the tax is 

collected only from a base of the household’s spending. To calculate consumption, a 

household would add up wages and other forms of labor compensation, investment 

proceeds that are spent, and net borrowing. To calculate savings, which would not 

be taxed, a household would add up the net increase in bank accounts, the purchase 

of financial assets such as stocks and bonds, the purchase of business assets, and the 

purchase of owner-occupied housing. Generally, a consumed income tax base would 

exempt a certain level of consumption and use a graduated tax rate schedule to 

promote progressivity. There is no need for a corporate tax under a consumed income 

tax – retained corporate earnings would be a form of saving, and dividends would be 

taxable to shareholders unless saved. 

Conclusion

This chapter described the major elements of any given tax system, as found in 

both our current tax code and some well-known alternatives. Understanding these 

elements is a critical step in reforming the current tax system. It may be possible to 

reform some current tax provisions in a way that enhances the objectives of simplicity, 

efficiency, and fairness. In other cases, changes to a particular provision may promote 

only one or two of these objectives. The goal of the Panel’s work is to identify 

proposals that taken together will advance all three objectives. 

It is simply not enough to use this knowledge to create a tax system that remedies the 

shortcomings of our current system. Any reform proposal must take into account the 

expected revenue collected by our current tax system, as well as the way the code has 

shaped our economy. Chapter Four explores the constraints the Panel faced, both in 

terms of the President’s Executive Order and the realities of our $12 trillion economy. 
Chapter Four

Our Starting Point

With a firm understanding of the problems in our current tax code, the Panel 

evaluated numerous proposals to reform the individual and corporate income tax 

system. The Executive Order directed the Panel to recommend options that would 

make the tax code simpler, fairer, and more conducive to economic growth, while 

recognizing the importance of home ownership and charity in American society. 

Fulfilling all of these objections is challenging. For example, reforms that make the tax 

system more conducive to economic growth may shift the tax burden toward lowerincome households, which some might view as unfair. Improving the fairness of the 

tax code may require complicated rules and increased data collection, which might 

work against the goal of simplicity.

In addition to ensuring that the Panel’s reform options satisfied these criteria, there 

were several other constraints that affected the Panel’s work. This chapter discusses 

those constraints, as well as the approaches the Panel took to manage them. 

Courtesy of Marina Sagona
42

Federal Tax Reform

The President’s Advisory Panel on

Revenue Neutrality

The most important constraint on the Panel’s recommendations is the Executive 

Order’s direction that all of the Panel’s reform options be “revenue neutral.” In simple 

terms, this means that the Panel’s options should be designed to collect roughly the 

same amount of money that the federal government projects it will collect under the 

current tax system. Although this may seem straightforward, it is not. Numerous 

projections and assumptions about future policy and behavior must be made – and 

they all have very important ramifications.

The first building block is setting a 

baseline; which is the projection of future 

federal tax revenues. Different branches of 

government make different assumptions 

about future policies and economic 

data and, therefore, have different 

baseline estimates. The Panel used the 

Administration’s baseline, which projects 

that $17.4 trillion in federal individual 

and corporate income tax revenue will 

be collected over the next ten years. The 

Panel used this baseline because the 

Panel anticipated that the Secretary of 

the Treasury and the Administration 

would use its own baseline in evaluating 

the Panel’s reform options. It is worth 

noting that the Congressional Budget 

Office baseline, which assumes current 

law, predicts a relatively similar level of revenues (within approximately one percent) 

during the ten-year budget window.

The decision to use the Administration’s baseline has a number of important 

implications. First, the baseline assumes that the 2001 and 2003 tax cuts will be 

made permanent. Second, it assumes that a current law provision limiting the reach 

of the Alternative Minimum Tax (AMT) will expire as scheduled after the 2005 tax 

year. As described in Chapter One, the AMT is a parallel tax system that is steadily 

affecting more and more taxpayers. The combination of these two assumptions results 

in a revenue baseline equal to roughly 18 percent of GDP, which is consistent with 

the historical average for this ratio over the last half century. The Administration has 

acknowledged the problems caused by the growth of the AMT, and has made it clear 

that a long-term solution to the AMT problem is an important aspect of the overall 

tax reform effort. 

Photo by Ken Cedeno
43

Chapter Four

The Burden of the Alternative Minimum Tax

The AMT is estimated to generate over $1.2 trillion in tax revenue over the next ten 

years. Including anticipated revenues from the AMT in the baseline of future tax 

receipts makes the Panel’s work particularly challenging. Repealing the AMT in a 

revenue-neutral way requires the Panel to replace the $1.2 trillion of revenue from 

the AMT with other changes to the tax code. Recouping AMT revenues inevitably 

involves other offsetting changes, such as higher tax rates, eliminating tax preferences, 

or some combination of both. It is important, therefore, that American taxpayers 

understand that a tax reform proposal that does not repeal the AMT effectively 

results in a hidden, but real, future tax hike. The AMT currently affects nearly four 

million American families and is projected to affect more than 50 million taxpayers 

by 2015. 

The Treasury Department estimates that collecting the $1.2 trillion of AMT revenue 

by simply raising current tax rates would require an 11 percent across-the-board rate 

increase. This should result in taxpayers in the 15 percent tax bracket paying tax at a 

rate of about 17 percent, and those in the 35 percent tax bracket paying tax at a rate 

of about 39 percent. Figure 4.1 shows the rate schedule that would be needed to raise 

the same revenue as the income tax and the AMT, but with only the income tax. 

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44

Federal Tax Reform

The President’s Advisory Panel on

As readers consider the specific rates that are outlined in the Panel’s reform options, 

they should compare those rates to the rates in the above table, which are higher than 

those in current law. Those higher rates, or some other configuration of higher rates, 

are the real baseline for the Panel’s work, because they are the rates that taxpayers will 

effectively face if the AMT is left in place. If only changes in the top four brackets 

were used to raise the same revenue under the income tax alone, each rate would have 

to be increased by 18 percent. Under this scenario, replicating federal revenues while 

repealing the AMT would require that the top tax rate be increased from 35 percent 

to 41 percent. 

At the same time, many Panel members recognize that lawmakers are unlikely to 

allow the full effects of the AMT to hit American families. Congress has extended 

an AMT “patch” for the past few years, effectively limiting the reach of the AMT. 

Many observers, therefore, believe that a more realistic starting point for the Panel 

would assume the continued extension and indexing of the AMT patch. Indeed, there 

are several proposals currently before Congress that would repeal the AMT without 

requiring any offset of tax revenues. If these are adopted, the reach of the AMT 

may be limited, but the federal government would collect far less revenue to pay for 

necessary government programs in the coming decades.

The Treasury Department estimates that extending and indexing the AMT patch 

would cost $866 billion during the next ten years. If the Panel did not need to 

account for that revenue in its recommendations, individual tax rates could be reduced 

even further. Later in the report, the Panel will present the lower rates for each 

recommendation.

Limitations of Revenue Estimates

The next question is how to determine the specific dollar cost or savings of a 

particular proposal. The Treasury Department’s Office of Tax Analysis uses what 

is commonly referred to as “conventional” or “microdynamic analysis” to score tax 

proposals. In making their revenue estimates, the Treasury Department’s economic 

models account for the fact that taxpayers respond to changes in tax law, for example, 

by changing the timing of decisions or changing the mix of assets they purchase. 

However, these estimates do not account for how those behavioral changes will affect 

the size of the overall economy. Instead, the Treasury Department holds constant 

its projections for the future size of the economy. That means, for instance, that 

even if a reform option caused the total size of the economy to increase due to more 

favorable investment incentives, conventional estimates would not incorporate the 

corresponding increase in revenues. 
45

Chapter Four

There are many commentators who are troubled by the limitations of conventional 

scoring, and thus advocate a different method, often referred to as “dynamic” 

or “macroeconomic” analysis, particularly for proposals that envision broad or 

fundamental changes in the tax system. This approach provides estimates of the effect 

of tax reform on the overall economy. 

While dynamic analysis conveys useful information, it is important to remember 

that the estimation of dynamic effects is also subject to much uncertainty. Dynamic 

scoring relies on numerous assumptions and the estimates may be quite sensitive to 

changes in these assumptions. A dynamic scoring model needs to predict, among 

other things, the effects of tax changes on interest rates, equity prices, labor supply 

responses, saving, investment, and national income. Building such a model requires 

economists to make a large number of assumptions concerning how individuals and 

businesses respond to tax policy and how these responses filter into changes in the 

macroeconomy and in tax revenues. 

Given the number of assumptions and modeling decisions necessary to produce 

dynamic estimates, it is no surprise that different modeling strategies yield alternative 

estimates. In fact, when the Congressional Budget Office and the Joint Committee 

on Taxation perform dynamic analysis, they both report estimates from a range of 

different macroeconomic models and they include sensitivity analyses to show how 

their predictions are affected by alternative modeling assumptions. 

Some Panel members strongly felt that dynamic analysis should be utilized, but 

the Panel did not want its tax policy recommendations to be overshadowed by a 

controversy about the validity of its scoring methodology. Other Panel members 

believed that there are shortcomings to more dynamic estimating techniques that 

hamper their usefulness. Therefore, the Panel has relied on conventional estimates as 

supplied by the Treasury Department to meet the mandate of revenue neutrality. At 

the same time, the Panel requested that the Treasury Department provide a dynamic 

analysis of the reform options. This analysis, which is based on three different models 

(described in the Appendix), suggests that the options could have positive effects on 

the economy.
46

Federal Tax Reform

The President’s Advisory Panel on

Using a ten-year period to gauge revenue neutrality requires assumptions about 

economic conditions that are subject to considerable uncertainty and likely to change 

substantially over the course of a decade. It is difficult to predict growth in the economy a 

year from now, let alone the strength of the economy over a longer time horizon.

At the same time, picking any particular budget horizon may provide an incomplete 

perspective on the revenue consequences of some tax reforms. This problem 

can be illustrated with two specific reform provisions included in the Panel’s 

recommendations. One proposal is to expand the use of a particular type of taxpreferred savings and retirement accounts – commonly referred to as Roth-style 

accounts. Taxpayers make after-tax contributions to these accounts, and then can 

Box 4.1. The Effect of Nominal versus Present Value Estimates

The Treasury Department’s ten-year revenue target is based on the nominal sum of annual 

revenues. In other words, Treasury first estimates the amount of revenue for each year, and 

then adds those numbers together to arrive at a total amount of revenue for the period. There 

is no discount for the time value of money. This approach differs from standard business 

practice – which does use present value discounting. The reason for discounting future 

revenues is simple: A dollar received at a future date is worth less than a dollar today because 

a dollar today can be invested to earn interest and deliver more than a dollar in the future.

The use of the convention of summing annual revenues without discounting future cash 

flows has implications for the Panel’s proposals. Here is why: Under the Treasury baseline, 

the annual revenue generated by the AMT rises during the ten-year budget window. The 

Panel’s proposals, on the other hand, generally have a much more stable flow of revenue. 

If one were to picture the revenue flow over the budget window it would be an upward 

sloping line; the Panel’s proposals would flatten out that line. For both the baseline and the 

Panel’s proposals, there will be the same total nominal flow of revenues over the relevant 

period; however, a tax reform proposal that generates a more stable flow of revenues over 

the budget window, rather than a more rapidly rising flow, will raise more revenue than the 

baseline if the future revenue flows are discounted. Thus, revenue-neutral tax reforms that 

repeal the AMT would require lower tax rates if the baseline were calculated using present 

discounted values instead of nominal values.

The “Budget Window”

Another dimension of revenue neutrality concerns the relevant time horizon for 

revenue estimates. The Panel used a ten-year period, which is the current standard 

in the federal budget process. The use of any budget window raises a number of 

issues. Under standard conventions, the revenue effect of a proposal is simply the 

sum of nominal predicted revenues over the budget window – no attempt is made to 

discount future revenues for the time value of money. Box 4.1 discusses the effect of 

nominal versus present value estimates on revenue neutrality.
47

Chapter Four

withdraw the earnings, subject to certain limitations, without paying any additional 

tax on the income earned on the deposits. Another proposal would allow businesses to 

immediately write off, or “expense,” capital expenditures rather than taking depreciation 

deductions for the value of their investments over a defined period of time.

The Treasury Department estimates that introducing or expanding Roth-style 

accounts results in a slight reduction in tax revenues during the ten-year budget 

window. This estimate may, however, understate the overall revenue cost of the 

accounts for a number of reasons. First, the proposal would allow taxpayers to transfer 

money from traditional IRAs into these new savings vehicles. The revenue estimate 

assumes that many taxpayers will transfer their savings, producing revenue gains 

during early years as they pay taxes on money withdrawn from traditional IRAs in 

return for the benefit of tax-free withdrawals later. Because the taxes on the money 

in these accounts would have been collected eventually under the current system, but 

often more than ten years into the future, this transfer of assets has a favorable effect 

on tax revenues within the next ten years, but it does so at the expense of revenues in 

future years. 

Second, a substantial share of the revenue loss from the reduced taxation of future 

capital income for each dollar contributed to these accounts occurs outside the tenyear window. When a taxpayer holds assets that would otherwise have been held in 

a taxable account in a Roth-style account, the Treasury loses revenue from taxes on 

interest, dividends, and capital gains. This revenue cost accrues for as long as assets 

are held in these accounts, which may be several decades if the accounts are used for 

retirement saving. As is summarized in Box 4.2, a rough analysis suggests that for 

retirement accounts, the revenue cost during the ten-year budget window is roughly 

one-third of the total revenue cost of this program; two-thirds of the revenue loss is 

not reflected in the revenue tables provided in this report. For other savings accounts 

in which the assets are likely to be held for a shorter period of time, the ten-year 

budget cost is likely to account for a higher fraction of the overall cost. Policymakers 

should consider the magnitude of these long-term costs.

Box 4.2 also shows that for other provisions, such as expensing of capital 

expenditures, the revenue estimate for the ten-year budget window may overstate the 

revenue loss. This is because expensing moves all of the tax deductions associated with 

a long-lived asset into the ten-year budget window, while traditional depreciation 

allowances for long-lived assets reduce revenues for a longer time period, in many 

cases as long as three decades. If one compares the costs of expensing a plant versus 

taking a hypothetical 30-year straight-line depreciation deduction, using a ten-year 

budget window may overstate the present value of the tax cost by nearly 25 percent.
48

Federal Tax Reform

The President’s Advisory Panel on

Box 4.2. Examples of Long-Term Revenue Costs 

The long-term revenue cost of a retirement account contribution depends on several key 

parameters. The first is the investment horizon of the taxpayer. Assume, conservatively, that 

each dollar contributed to a retirement account remains in the account for 30 years. For 

regular savings accounts, the holding period is likely to be shorter.

A second key parameter is the amount of the retirement savings account’s investment that 

would otherwise have been held in a taxable account. This illustration assumes that half of 

the retirement savings account’s balance represents such a transfer.

A third parameter is the investment mix of the retirement savings account’s assets. This illustration 

assumes that 60 percent of the saving in the absence of the retirement savings accounts would 

have been invested in equities, with 40 percent invested in fixed income assets. 

The last key parameter is the tax treatment of saving outside the retirement savings account. 

Assume that the average tax burden on equity investments is 10 percent, recognizing the 15 

percent marginal tax rate on dividends and realized capital gains, as well as the opportunity 

to defer realization of capital gains, and set the marginal tax rate on interest income at 25 

percent.

If equities yield a total return of 8 percent, while bonds yield 5 percent, the taxes that would 

have been paid on a $1,000 contribution to a retirement savings account in the first year of 

this contribution equal $4.90. In the absence of the retirement savings account, the assets 

that would have been saved would have grown through time as the after-tax income was 

reinvested in stocks and bonds. If the investor’s asset mix remained 60 percent stocks and 

40 percent bonds at all times, then the after-tax return on the whole portfolio would be 

5.82 percent. Thus the nominal tax receipts if the saving assets were held outside a regular 

savings or retirement savings account would rise by 5.82 percent per year. 

To find the present discounted value of this revenue flow over the entire 30-year period when 

assets are held in a retirement savings account, one discounts the foregone tax revenue 

stream, which grows at 5.82 percent each year, by the government discount rate. If we 

use a discount rate of 5 percent, thereby assuming that the government can discount the 

uncertain stream of future tax receipts using a riskless interest rate, the present value of 

the foregone revenue over the 30-year life of the retirement savings account’s investment 

is $164.92. This is 33.7 times the first-year revenue cost of $4.90. The present discounted 

value of the revenue cost over the first ten years is $50.76, or roughly one-third of the lifetime 

present value cost. For saving accounts where assets are likely to remain in the accounts 

for a shorter time period, the ten-year budget cost would account for a larger fraction of the 

lifetime cost. 

While retirement savings accounts have larger long-term than ten-year revenue costs, other 

tax provisions may have smaller revenue costs from a long-term perspective than from a ten 

year vantage point. Proposals to expense investment in plant and equipment, for example, 

have a ten year revenue cost that is larger than their permanent cost. Consider switching 

from straight-line deprecation over a 30-year lifetime to immediate expensing. The present 

discounted value of the depreciation allowances over a 30-year horizon, assuming again a 5 

percent annual discount rate, is 53.8 percent of the plant’s purchase cost. The present value 

component over the first ten years is 43 percent of the purchase cost. This implies that the 

revenue cost of expensing over the first ten years, which equals 57 percent of the asset’s 

purchase price (100 minus 43), overstates the long-horizon present discounted value, 46.2 

percent of the asset’s purchase price, by nearly 25 percent.

Revenue Estimates Are Not Precise

The sources of uncertainty in revenue estimates as discussed earlier, and many others 

that arise from the difficulty of accurately forecasting the behavioral responses of 

millions of Americans to tax changes, make projections of the revenue yield of tax 
49

Chapter Four

reform plans inherently uncertain. The Panel recognizes that revenue estimates are 

imprecise. Accordingly, upon the advice of the Treasury Department, the Panel has 

decided to define “revenue neutrality” as being within one-half of one percent of the 

projected revenue baseline for the next ten years. Some Panel members, however, 

believe that two percent or more would be reasonable.

Tax Reform, Progressivity, and the Distribution of the Tax Burden

The Executive Order directed the Panel to recommend options for reform that were 

“appropriately progressive.” As discussed in Chapter Three, the current income tax 

system is progressive, as it provides exemptions and deductions that shield some 

income from tax and applies a graduated set of tax rates. All members of the Panel 

endorsed the goal of a progressive tax structure. Some Panel members felt that the 

current system has gone too far in removing lower-income taxpayers from the tax 

rolls and that higher-income taxpayers pay too large a share of federal income taxes. 

Other Panel members were comfortable with the current distribution or believed 

that the income tax should be more progressive, with higher-income taxpayers 

bearing more of the overall income tax burden, because of a concern about substantial 

inequality of wealth in the country that has grown in the last decades. In the end, the 

Panel concluded that the appropriate burden of taxation was an issue that elected 

officials should resolve – and so the Panel decided to design reform options that 

would remain relatively close to the current distribution of tax burdens.

The Panel relied on “distribution tables” to measure the allocation of tax burdens 

across households. Such tables are a necessary tool for evaluating tax proposals, but 

like revenue estimating, creating distribution tables is an imprecise art. Distribution 

tables are based on an assortment of projections and assumptions about the way 

various taxes affect the economy and, in particular, how they affect the pretax incomes 

of various taxpayers. 

As explained in Chapter Three, just because someone writes a check to the 

government, it does not necessarily follow that he or she shoulders the burden of 

that tax. The Treasury Department prepares distribution tables that generally assume 

that the corporate income tax is paid by all owners of capital. However, many public 

finance economists believe that at least some portion of the corporate income tax 

is shifted from owners of capital (or investors) to labor (or workers) and reflected 

in lower real wages and living standards. This assumption can make a significant 

difference in any distributional analysis of corporate income tax reform. Furthermore, 

the distribution table for 2006 will look different from that for 2015, and a table that 

assumes no relief from the AMT will differ from a table that assumes either repeal or 

a patch of the AMT.

This report shows distribution tables for the first year of a proposal, the last year of the 

budget window, and the average of the ten-year budget window. The Panel presents 

tables that distribute half of the corporate tax to owners of capital and half to labor. 
50

Federal Tax Reform

The President’s Advisory Panel on

Box 4.3. Thinking about Long-Term Distribution

The distribution tables shown in this report allocate the tax burden across households, and 

group households by their current-year income. This approach offers important information 

on the distribution of tax burdens, but for some households, current income is an unreliable 

measure of long-term economic well-being. College students, for example, may report low 

current income, but their long-term earning prospects would place them much higher in the 

distribution of lifetime earnings. Elderly people with substantial wealth but limited income 

from their assets may also appear in a low-income category, even though they have been 

economically prosperous throughout their careers. A taxpayer who separates from a firm and 

receives a large one-time severance payment, in contrast, may have a current-year income 

substantially greater than his long-term average or than his future prospects.

Estimates from the Treasury Department, reported in the 2003 Economic Report of the 

President, suggest that taxpayers exhibit a considerable amount of fluidity across tax rate 

brackets. Treasury Department researchers calculated the statutory tax rate bracket taxpayers 

would have faced in 1987 and in 1996 had the Economic Growth and Tax Relief Reconciliation 

Act of 2001 been in place in those years. The table below reproduces the results from this 

study. The shaded cells report the percentage of taxpayers in each tax bracket in 1987 (year 

1) that remained in the same bracket in 1996 (year 10).

Taxpayers by Rate Bracket Using a Panel of Taxpayers

Year 1

tax 

bracket 

(percent)

Year 10 tax bracket (percent)

Returns 

in year 10 

(thousands)

0 10 15 25 28 33 35

Taxpayers by rate bracket (percent distribution)

0 33.8 24.7 32.1 7.7 0.8 0.5 0.3 10,360

10 20.1 29.3 40.8 8.8 0.6 0.3 0.1 15,370

15 8.6 13.3 53.4 22.9 1.2 0.4 0.2 50,059

25 3.9 5.1 29.9 51.4 6.7 2.2 0.8 31,427

28 3.3 2.8 11.6 35.9 24.0 14.7 7.5 2,682

33 4.7 2.6 9.1 21.0 18.9 23.9 19.8 1,096

35 5.1 1.9 5.7 10.4 8.8 19.0 49.1 633

Note. Tabulations from 1987-1996 panel of taxpayers. Tabulations include only non-dependent taxpayers present in all years 

of the panel data set. Each cell entry indicates the percent of taxpayers in a rate bracket in the last year of the panel (i.e., 

column entry) relative to the number of all taxpayers in that rate bracket in the first year of the panel (i.e., row sum). 

Source. Council of Economic Advisers, based on tabulations provided by the Treasury Department

The table demonstrates that there is a substantial amount of movement across rate brackets. 

More than half of taxpayers were in a different tax bracket at the end of the period than they 

were in at the beginning of the period (the proportion of taxpayers not on the diagonal). 

The table also shows that the chance that a taxpayer moves from the highest income tax 

brackets to the lowest, or vice versa, is relatively low. While this evidence suggests that there 

is value in constructing distribution tables that categorize households based on a longer-term 

measure of income and economic status, the standard approach to distributional analysis still 

focuses on annual income, and so that is the approach followed by the Panel. 
51

Chapter Four

Simplicity

The Executive Order also directed the Panel to recommend options that would 

simplify the tax code to reduce compliance costs and administrative burdens. The 

objective of simplicity is related to, and at times is at odds with, the objectives of 

fairness and economic growth. Unfortunately, our tax code has steadily grown more 

complex as lawmakers in recent years have almost always sacrificed simplicity in 

choosing among these competing objectives.

Complexity in our current code arises from a number of sources. Some of the 

complexity is the result of attempts to make our tax system fairer. Many provisions 

adjust for taxpayers’ ability to pay, but the price is greater complexity. Another 

significant cause of complexity is the numerous tax preferences in the form of 

deductions, credits, exclusions, and special rates. Each of these tax preferences requires 

special computations, eligibility rules, and recordkeeping. Mechanisms designed to 

target tax benefits to specific taxpayers or limit the amount of tax benefits available – 

such as phase-outs, caps, floors, and the AMT – are yet another source of complexity. 

Further compounding these sources of complexity in recent years has been the 

volatility of changes to the code and the increased reliance on temporary and expiring 

provisions, which are often the consequence of budget rules seeking to restrain loss of 

revenue through tax expenditures.

Complexity also affects different groups of taxpayers differently. The Panel analyzed 

the most significant sources of complexity affecting particular types of taxpayers. For 

example, complex eligibility rules for refundable credits affect low-income taxpayers; 

recordkeeping burdens and accounting rules are especially onerous for small 

businesses, and international rules create significant complexity for multinationals. As 

discussed in the following chapters, each of the Panel’s options addresses these areas 

of complexity.

Recognizing the importance of simplicity, the Panel determined to make 

simplification a priority. In many cases, the Panel elected to make features of its options 

simpler, even though a more complicated design could have been used to better target 

the provision to provide benefits to specific taxpayers or to achieve other goals.

Illustrating the Constraints: A Policy Experiment

The previous discussion describes the many constraints facing the Panel. At the 

request of the Panel, the Treasury Department ran a number of policy experiments 

using income and consumption tax bases, to demonstrate the trade-offs between the 

choice of the tax base, tax rates, and the distribution of the tax within revenue-neutral 

policy reforms. The experiments are quite useful in understanding the range of 

choices available to the Panel in reforming the tax code. The analysis discussed 

below was presented at the Panel’s July 20 meeting. The estimates differ slightly 

from those in other sections of the report because they were created using Treasury 

Department tax models that had not been updated for the annual mid-session review of 

the policy baseline.
52

Federal Tax Reform

The President’s Advisory Panel on

The Panel first asked the Treasury Department to determine the required rate 

structure to achieve revenue neutrality with a “broad” income tax base. The broad 

individual income tax base would retain only the standard deduction and personal 

exemptions. All credits, above-the-line deductions, itemized deductions, and other 

special preferences in our tax code would be eliminated. The broad base would also 

eliminate the AMT. 

The individual and corporate tax systems would be integrated so that income taxed at 

the business level would not be taxed again at the individual level; meaning that the 

double tax on corporate profits would be eliminated. All capital gains would be taxed 

at ordinary rates, and tax-favored savings or retirement vehicles would be eliminated. 

The broad corporate income tax base would eliminate corporate tax preferences. 

Depreciation deductions would allow taxpayers to deduct the actual decline in 

the value of a capital asset over the taxable period (which is known as “economic 

depreciation”). The top rates for the individual income tax and corporate income tax 

would be equal.

The Treasury Department estimated that adopting this broad base would make 

it possible to reduce tax rates across the board by about one-third. As Figure 4.2 

shows, the lowest individual rate, currently at 10 percent, could be lowered to 6.6 

percent, and the highest rate (which also applies to corporate income), 35 percent, 

could be lowered to 23 percent. Alternatively, the Treasury Department found that 

the graduated rate structure could be replaced with a single rate of 15 percent and 

maintain revenue neutrality.

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Chapter Four

The Treasury Department also estimated the impact of the broad base on the 

distribution of the tax burden. As shown in Figure 4.3, taxpayers in the highest 

quintile would pay a smaller proportion of total federal taxes, while taxpayers in each 

of the other four quintiles would pay a greater proportion of the tax burden.

To evaluate the cost of current tax expenditures in terms of both the higher tax rates 

they necessitate and the distribution of the burden, the Treasury Department ran an 

experiment that added the top individual and corporate tax expenditures to the broad 

base. These tax expenditures include the tax exclusion for employer contributions 

for health insurance and pensions, retirement savings preferences, the mortgage 

interest deduction, charitable deductions, the EITC, and the child tax credit for 

individuals; and accelerated depreciation, oil and gas preferences, the manufacturer’s 

deduction, progressive corporate rates, and the research and experimentation credit 

for corporations. Figure 4.4 shows that adding these tax expenditures to the broad tax 

base requires tax rates nearly as high as those under current law to collect the same 

amount of revenue. Figure 4.5 shows that adding the top tax expenditures to the 

broad base provides a distribution of tax burden that is close to current law. 

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The President’s Advisory Panel on

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Chapter Four

Using a Consumption Tax Base

The Panel was also interested in understanding how moving to a consumption tax 

base would affect tax rates and the distribution of taxes. To answer these questions, 

the Panel asked the Treasury Department to estimate a revenue-neutral Flat Tax, a 

prominent consumption tax prototype. The Treasury Department’s estimate allowed 

taxpayers a personal exemption, but eliminated all other tax preferences and the 

AMT. As described in Chapter Three, the business portion of the Flat Tax is based on 

cash flow taxation. Businesses do not receive a deduction for interest expense, and can 

write off all of their capital investments immediately.

The Treasury Department estimated that a Flat Tax imposed on a broad consumption 

tax base would require a 21 percent tax rate to preserve revenue neutrality. The 

estimates also showed that the distribution of the tax burden under a standard Flat 

Tax would be less progressive than the current tax system. Figure 4.6 shows that a 

standard Flat Tax would significantly increase the portion of the tax burden borne by 

the first through fourth cash income quintiles relative to the current distribution of 

the tax burden. 

Consumption taxes can be made more progressive by including graduated rates at 

the individual level. The Panel asked Treasury to replace the single, flat rate of 21 

percent described above with three tax brackets with rates of 15 percent, 25 percent, 

and 35 percent. The same standard deduction and personal exemption parameters 

would apply. To even further augment progressivity, the Panel asked the Treasury 

Department to also include the EITC. As shown in Figure 4.7, with the introduction 

of progressive rates, the distribution of the tax burden more closely resembles the 

distribution of the tax burden under current law. Notably, the overall tax burden on 

families in the first four quintiles increases to a lesser extent than under the standard 

Flat Tax, and the burden on families in the top quintile is reduced less significantly.

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Federal Tax Reform

The President’s Advisory Panel on

The Panel then asked the Treasury Department to estimate the tax rates that would 

be required to implement a revenue-neutral progressive consumption tax with the 

top individual and corporate tax expenditures. In particular, the Treasury Department 

added back the exclusion for employer contributions for health insurance, the 

mortgage interest deduction, charitable deductions, and the child tax credit for 

individuals; and oil and gas preferences, the manufacturer’s deduction, progressive 

corporate rates, and the research and experimentation credit for corporations. 

Retirement savings preferences and accelerated depreciation were not included 

because the tax base is consumption.

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57

Chapter Four

Figure 4.8 shows that tax rates must be substantially higher to support a progressive 

consumption tax that also includes the top tax expenditures. To keep the same 

exemption amounts and bracket structure while adding the top tax expenditures, 

the top tax rate would have to rise from 35 percent to 42 percent, the middle rate 

would rise from 25 percent to 30 percent, and the lower bracket would rise from 15 

percent to 18 percent. These large increases in tax rates highlight the importance of a 

broad tax base for maintaining low tax rates. Figure 4.9 compares the distribution of 

tax burden under the Flat Tax, the progressive consumption tax, and the progressive 

consumption tax with the top tax expenditures. Adding the top tax expenditures to 

the tax base increases the proportion of taxes paid by the highest quintile, decreases 

the proportion paid by the second through fourth quintiles, and has little effect on the 

lowest quintile.

These policy experiments demonstrate the trade-offs that are inherent in any effort to 

reform the tax system. Lower rates can be achieved by broadening the tax base – but 

once the major tax preferences are added back to the tax code, maintaining revenue 

neutrality means that rates need to rise almost to their current levels. Similarly, any 

major changes in the tax base or the inclusion of certain tax expenditures causes 

significant changes in the current-law distribution of taxes. It is important to 

recognize these constraints and trade-offs in evaluating the Panel’s options for reform.

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58

Federal Tax Reform

The President’s Advisory Panel on
Chapter Five

The Panel’s Recommendations

The Executive Order creating the Panel called for reform options that would deliver a 

simpler, fairer, and more pro-growth tax system. The Panel has chosen to put forward 

two options that achieve these goals, but accomplish them in different ways. 

The Panel’s options use different designs that represent a range of policy choices to 

simplify the tax code, remove impediments to saving and investment, and broaden 

the tax base. The first option, the Simplified Income Tax Plan, is a streamlined version 

of our current tax system that would reduce the size and costs of the tax code. The 

second option, the Growth and Investment Tax Plan, would take our tax system in a 

new direction by reducing the tax burden on saving and investment to boost economic 

growth without fundamentally changing how the tax burden is distributed. It would 

move our tax system closer to a consumption tax and impose a reduced flat rate tax on 

capital income received by individuals. 

Courtesy of Marina Sagona
60

Federal Tax Reform

The President’s Advisory Panel on

As the Panel pursued its work, it became clear that both reform proposals shared a 

common set of goals that could be achieved with identical recommendations. This 

resulted in a set of common elements in the two proposals that are described in the 

first part of this chapter. 

The Panel recommends creating only two credits related to family 

status, a Family Credit and a Work Credit, that would simplify tax filing by 

consolidating family, child, and work-related tax benefits, such as the standard 

deduction, personal exemption, child tax credit, head of household filing status, 

earned income tax credit, and refundable child tax credit.

The Panel recommends simplifying tax benefits for charitable giving, home 

ownership, and health coverage and making these benefits fairer by ensuring 

they are available to all taxpayers. 

The Panel recommends eliminating the personal and corporate AMT.

The Panel recommends simplifying the tax treatment of Social Security 

benefits by replacing the complicated three-tier calculation with a simple 

deduction.

The Panel recommends reducing marriage penalties by making all tax 

brackets and other tax provisions for married couples equal to twice the amount 

for unmarried taxpayers.

Both of the Panel’s two recommendations would remove impediments to saving and 

business investment, but would do so using different approaches. For example, the 

treatment of savings and business investment under the Simplified Income Tax Plan 

would be closer to our current tax system, while the treatment in the Growth and 

Investment Tax Plan would be more far-reaching. The different approaches to reform 

rely on similar principles, which are discussed in the second part of this chapter:

Providing simple and straightforward ways for Americans to save free of tax.

Simplifying the tax code for small businesses.

Moving as far as possible to eliminate the double taxation of corporate 

earnings and providing a more level playing field for different types of business 

investment.

Updating our international tax rules to reduce economic distortions and 

improve fairness by creating a more level playing field that promotes U.S. 

competitiveness.

•

•

•

•

•

•

•

•

•
61

Chapter Five

Table 5.1 summarizes the Panel’s reform options for households. 

 Table 5.1. Summary of Tax Reform Plans for Households

Provisions Simplified Income Tax Plan Growth and Investment Tax Plan

Households and Families

Tax Rates Four tax brackets: 15%, 25%, 30%, 33% Three tax brackets: 15%, 25%, 30%

Alternative minimum tax Repealed

Personal exemption Replaced with Family Credit available to all taxpayers: $3,300 credit for married couple, $2,800 credit for unmarried 

with child, $1,650 credit for singles, $1,150 credit for dependent taxpayer; additional $1,500 credit for each child and 

$500 credit for each other dependent 

Standard deduction

Child tax credit

Earned income tax credit Replaced with Work Credit (and coordinated with the Family Credit); maximum credit for working family with one 

child: $3,570; with two or more children, $5,800

Marriage penalty Reduced. All tax brackets, Family Credits, and taxation of Social Security benefits for couples are 

double those of individuals 

Other Major Credits and Deductions

Home mortgage interest Home Credit equal to 15% of mortgage interest paid; available to all taxpayers; mortgage limited to average regional 

price of housing (limits ranging from about $227,000 to $412,000)

Charitable giving Deduction available to all taxpayers (who give more than 1% of income); rules to address valuation abuses

Health insurance All taxpayers may purchase health insurance with pre-tax dollars, up to the amount of the average premium 

(estimated to be $5,000 for an individual and $11,500 for a family).

Education Taxpayers can claim Family Credit for some full-time students; simplified savings plans

State and local taxes Not deductible

Individual Savings and Retirement

Defined contribution plans Consolidated into Save at Work plans that have simple rules; AutoSave features point workers in a pro-saving direction

Defined benefit plans No change

Retirement savings plans Replaced with Save for Retirement Accounts ($10,000 annual limit) – available to all taxpayers

Education savings plans Replaced with Save for Family Accounts ($10,000 annual limit); would cover education, medical, new home costs, and 

retirement saving needs; available to all taxpayers; refundable Saver’s Credit available to low-income taxpayers Health savings plans

Dividends received Exclude 100% of dividends of U.S. companies 

paid out of domestic earnings 

Taxed at 15% rate

Capital gains received Exclude 75% of corporate capital gains from U.S. 

companies (tax rate would vary from 3.75% to 8.25%)

Taxed at 15% rate

Interest received (other than 

tax exempt municipal bonds)

Taxed at regular income tax rates Taxed at 15% rate

Social Security benefits Replaces three-tiered structure with simple deduction. Married taxpayers with less than $44,000 in income 

($22,000 if single) pay no tax on Social Security benefits; fixes marriage penalty; indexed for inflation
62

Federal Tax Reform

The President’s Advisory Panel on

Similarly, Table 5.2 summarizes the Panel’s reform options for businesses.

Table 5.2. Summary of Tax Reform Plans for Businesses

Provisions Simplified Income Tax Plan Growth and Investment Tax Plan

Small Business

Rates Taxed at individual rates (top rate has been 

lowered to 33%)

Sole proprietorships taxed at individual rates 

(top rate lowered to 30%);

Other small businesses taxed at 30%

Recordkeeping Simplified cash-basis accounting Business cash flow tax

Investment Immediate expensing (exception for land and buildings under the Simplified Income Tax Plan)

Large Business

Rates 31.5% 30%

Investment Simplified accelerated depreciation Expensing for all new investment

Interest paid No change Not deductible (except for financial institutions)

Interest received No change Not taxable (except for financial institutions)

International tax system Territorial tax system Destination-basis (border tax adjustments)

Corporate AMT Repealed 
63

Chapter Five

COMMON ELEMENTS

The following common elements serve as the starting point in both of the Panel’s 

reform options. They represent simple and straightforward ideas for reforming the tax 

code. 

A Better Way to Ensure Progressivity - New Family and 

Work Credits

R E C O M M E N D A T I O N S

Consolidate the standard deduction, personal exemptions, child tax credit, 

and head of household filing status into a single Family Credit. 

Consolidate the earned income tax credit and refundable child tax credit 

into a single Work Credit.

√

√

The tax code separately provides a standard deduction, personal exemptions, the 

child tax credit, the head of household filing status, the earned income tax credit 

(EITC), and a refundable child tax credit, which together are designed to serve the 

important goals of ensuring the tax burden is shared in a progressive manner and 

removing disincentives to work. As summarized in Figures 5.1 and 5.2, the first of the 

Panel’s common solutions would simplify filing for individuals by transforming these 

duplicative and overlapping provisions into just two credits – a Family Credit and a 

Work Credit. 

Figure 5.1. Family-Related Tax Benefits (amounts for 2005 tax year)

Standard 

Deduction

Provides a deduction for the first $10,000 of income 

earned by a married couple. The amount is $5,000 for 

unmarried taxpayers.

Personal 

Exemption

Provides a deduction of $3,200 for each member of a 

household. The personal exemption is phased out for 

taxpayers with higher incomes.

Child Tax 

Credit

Provides a credit of $1,000 for each child. The credit is 

phased out for taxpayers with higher incomes.

Head of 

Household 

Filing 

Status 

and Tax 

Bracket

Increases the amount of the standard deduction to 

$7,300 (from $5,000) and provides more generous 

tax bracket thresholds for unmarried taxpayers who 

maintain a household for a dependent.

Family 

Credit
64

Federal Tax Reform

The President’s Advisory Panel on

Figure 5.2. Work-Related Tax Benefits

EITC

Provides lower-income taxpayers a 

refundable credit designed to encourage 

work. The amount of the credit increases 

as additional income from work is earned 

before phasing out above a specified level.

Refundable 

Child Tax 

Credit

Provides lower-income taxpayers a 

refundable credit for each child. Like 

the EITC, the refundable child credit is 

designed to encourage work by increasing 

as additional income from work is earned 

before phasing out above a specified level.

The provisions to adjust for family size and to encourage work in the current code 

are redundant and unnecessarily complex. For example, four of the provisions contain 

different phase-outs (each at a different income level) and require lengthy worksheets 

and reference tables to calculate benefits. Phase-outs act as hidden tax hikes at certain 

income levels, as described in Chapter Three. Although some phase-outs have been 

justified as a way to target tax benefits to lower-income Americans, lawmakers have 

also adopted phase-outs to avoid raising other taxes or to reduce the budgetary cost of 

tax benefits they supported. 

Eligibility rules that vary by provision add even more complexity and are a source of 

filing errors. For example, the maximum age for a qualifying child is 16 for the child 

tax credit, but is 23 for the EITC. Millions of taxpayers claim both of these benefits, 

but are required to determine their eligibility under two sets of rules. Recent efforts 

to simplify and bring conformity to eligibility rules across family-related provisions 

culminated in legislation enacted last year to create more uniform rules regarding 

when a child may be claimed for the dependent exemption, the child tax credit, the 

EITC, and the head of household filing status. 

The Panel recommends further simplification that would build upon these efforts. 

The Panel’s objective is not to fundamentally change the amount or availability of 

these benefits, but to ensure that these provisions serve their intended purposes as 

efficiently as possible and with greater simplicity and transparency. This solution 

provides (1) a uniform and consistent structure that will replace the existing 

patchwork of overlapping and duplicative provisions, (2) a process for computing the 

amount of tax benefits that is straightforward and simple for all households, and (3) 

more consistent rules that do not require taxpayers to jump through several different 

hoops just to claim a tax benefit.

Work 

Credit
65

Chapter Five

The first of these credits, the new Family Credit, would be available to all filers. The 

second, the Work Credit, like the EITC it replaces, would provide a strong incentive 

for low-income taxpayers to work and, therefore, is limited to these taxpayers. 

The New Family Credit

Computing the Family Credit would be easy – start with a base amount for 

household type and add amounts for each child and other dependent members of a 

household. Table 5.3 shows the base Family Credit amounts.

Table 5.3. Family Credit Base Amounts

Household Type Base Credit

Married Couples $3,300

Unmarried Taxpayers With Dependent

Children $2,800

Single Taxpayers $1,650

Dependent Taxpayers $1,150

Each family would add to the base credit amount $1,500 for each child and $500 for 

each dependent. The Family Credit amounts would be adjusted annually for inflation. 

To demonstrate the simplicity of the Family Credit, the Panel developed the simple 

Family Credit schedule shown in Figure 5.3.
66

Federal Tax Reform

The President’s Advisory Panel on

Figure 5.3 Family Credit Schedule

The Family Credit provides a uniform tax benefit for all taxpayers. It does not 

phase out for taxpayers who have certain amounts or types of income, nor does it 

disproportionately benefit upper-income taxpayers in higher tax brackets. Unlike 

the current system where a taxpayer must choose between the standard deduction 

and itemized deductions for such expenses as home mortgage interest and charitable 

contributions, the amount of the Family Credit would be available regardless of 

whether a taxpayer claims other deductions or tax benefits.

Like the current system, the Family Credit would exempt most earnings of lowerincome taxpayers from income tax. It is designed to provide a benefit that is 

equivalent to the provisions that it replaces, along with the current-law ten percent tax 
67

Chapter Five

bracket. The amount of income that would not be subject to federal income tax under 

the Family Credit would be similar to the amount not subject to tax under current 

law. Most importantly, the Family Credit structure would streamline tax filing for 

every American household by eliminating a number of steps from our complicated 

tax filing process, as summarized in Figure 5.4. 

Figure 5.4. Tax Filing Using the Family Credit vs. Current Law

Family Credit Personal Exemption

Determine 

eligibility.

Compute total 

allowable credit.

Subtract Family 

Credit from tax 

due.

√

√

√

Determine eligibility.

Compute total allowable exemptions.

Compute personal exemption phase-out 

(known as “PEP”).

Subtract the personal exemptions (after phaseout, if applicable) from adjusted gross income 

to compute income subject to tax.

X

X

X

X

Child Tax Credit

Determine eligibility.

Compute total allowable exemptions.

Compute child tax credit phase-out.

Subtract child tax credit from tax due.

X

X

X

X

Standard Deduction

Determine eligibility.

Determine standard deduction amount.

Choose the larger of the standard deduction 

or itemized deductions (after computing 

the phase-out of itemized deductions, if 

applicable).

Subtract the standard deduction from adjusted 

gross income to compute income subject to 

tax.

X

X

X

X

Head of Household Filing Status

Determine eligibility.

Determine increased standard deduction 

amount.

Compute tax using head of household tax 

bracket.

X

X

X
68

Federal Tax Reform

The President’s Advisory Panel on

The New Work Credit

The EITC and the refundable child tax credit have been effective tools in getting 

low-income workers into the workforce and out of poverty. Unfortunately, the current 

system for computing the EITC and the refundable child tax credit is complex. The 

eligibility rules and lengthy computations make it difficult for lower-income taxpayers 

to claim the credit without the help of a tax professional. More than 70 percent of 

the recipients of these benefits use a paid preparer, which reduces the amount of 

available benefits. Even though the use of paid preparers is widespread, the error rates 

for taxpayers who claim the EITC and refundable child tax credit are substantial. The 

IRS estimates that the EITC overclaim rate was 27 percent in 1999, the most recent 

year for which an estimate is available. At the same time, studies suggest that between 

15 and 25 percent of eligible individuals do not claim the EITC – the underclaim 

rate is likely due to a variety of factors along with the complexity of the eligibility 

rules and the credit computation.

The Panel recommends replacing the EITC and refundable child tax credit with a 

Work Credit that builds on the Family Credit. The new Work Credit is designed 

to maintain a work incentive comparable to that of the current system by providing 

approximately the same maximum credit as the combined amount of the current-law 

EITC and the refundable child tax credit. As under the current system, the Work 

Credit amount would increase as the amount of earnings from work (wages and 

self-employment income) increases, and the rate and maximum credit amount would 

be higher for workers who live with qualifying children. For the first year, the Work 

Credit maximum amount would be $412 for workers with no children; $3,570 for 

workers with one child; and $5,800 for workers with two or more children. The Work 

Credit would be adjusted annually for inflation. 

The computation of the Work Credit would be coordinated with the Family Credit 

computation. Taxpayers would be instructed that they might be eligible for the 

Work Credit if their income is below the Work Credit income thresholds or if the 

amount of their Family Credit exceeds their tax liability. Taxpayers would have the 

option of allowing the IRS to compute the Work Credit based on information 

provided on the tax return and Family Credit schedule, thus eliminating the need for 

them or their tax return preparer to compute the Work Credit. Although taxpayers 

might elect to have the IRS compute the current-law EITC, the process would be 

markedly simpler under the Panel’s Work Credit. Additional details regarding the 

Work Credit, including a sample Work Credit worksheet and instructions, can be 

found in the Appendix.
69

Chapter Five

Box 5.1. Why Does the Work Credit Phase Out Based on Income?

Under current law, the EITC and refundable child tax credit use income limits and phaseouts to target tax benefits to encourage individuals to enter the workforce and work more. 

The benefit of this structure is that it rewards work among those not working or who would 

work less in the absence of an incentive. The downside of this approach is that it adds 

complexity and creates sharp increases in marginal tax rates as workers earn more income 

and lose the benefit of the credit. 

The Panel carefully considered whether the goals of the Work Credit could be effectively 

achieved without phasing out the credit at higher earnings levels. The Panel designed and 

evaluated an alternative structure that included a Work Credit without a phase-out and an 

additional tax rate that, together, would provide marginal tax rates that increase steadily 

as taxpayers earn more, instead of the marginal tax rate spikes found in the current EITC 

structure. Under the alternative structure, all taxpayers would have been eligible to receive 

the Work Credit, but would have been required to separately compute the credit amount.

The Panel ultimately rejected this approach because it concluded that the compliance 

costs and additional burden imposed on all taxpayers outweighed the potential benefits of 

simplicity and smoother increases in marginal tax rates for eligible Work Credit recipients.

Some Panel members also expressed the concern that a Work Credit structure that did not 

phase out would increase the number of individuals who would not pay income tax.

More Uniform Eligibility Rules

Virtually all eligibility rules would be the same for both the Family and Work Credits. 

Maintaining nearly identical eligibility rules has clear advantages, including the fact 

that it makes it much easier for individuals to determine whether they qualify for 

the credits. Under current law, rules frequently differ among the various tax benefits 

for families. For example, the maximum eligible age is 16 for the child tax credit, 

but is 18 for the dependent exemption and EITC, unless the child is a full-time 

student, in which case the maximum age is 23. The Panel recommends setting the 

maximum eligible child age for both the Family Credit and the Work Credit at age 

18 (age 20 if a full-time student), and removing any age eligibility standard if the 

child is permanently disabled. For other family members, including students over age 

20 but under age 24, a family would be entitled to claim the benefit for a nonchild 

dependent using rules that are similar to those for the current-law dependent 

exemption.

In just a few cases, the Panel recommends different rules for the Family and Work 

credits. For example, unlike the Family Credit, which would be generally available to 

everyone who pays U.S. taxes, the Work Credit would be limited to U.S. citizens and 

residents, and would not be available to someone who is claimed as a dependent on 

another taxpayer’s return. In addition, if a taxpayer wanted to claim the higher Work 

Credit for a child, the child would be required to live with the taxpayer in the United 

States for more than half of the year. Additional information regarding the Panel’s 

recommended eligibility rules is provided in the Appendix.
70

Federal Tax Reform

The President’s Advisory Panel on

A Cleaner Tax System that is Simpler, Fairer, and More Efficient

The Panel began its consideration of options for reform by considering a tax base that 

was free of exclusions, deductions, and credits. The Panel recommends the retention 

of some features of the existing tax system, especially those that promote widely 

shared and valued goals, such as home ownership, charitable giving, and access to 

health care. However, when the Panel retained a tax preference, it did not simply 

replicate the current design of these features. Instead, the Panel first determined 

whether each preference was optimally designed or could be improved. Specifically, 

the Panel would maintain tax benefits that provide incentives to change behavior 

in ways that benefit the economy and society, rather than representing a windfall 

to targeted groups of taxpayers for activity they would be likely to undertake even 

without a tax subsidy. 

A key objective in reforming these tax incentives was making them simpler and more 

widely available to taxpayers. Under current law, a number of incentives are limited to 

the 35 percent of taxpayers who itemize deductions instead of claiming the standard 

deduction. The Panel’s recommendations represent a fundamental shift in the way 

taxpayers compute their taxes – every taxpayer would receive a Family Credit that 

provides a base amount of tax benefits similar to the current law standard deduction 

and personal exemption. Taxpayers would then be able to claim these newly-designed 

tax benefits in addition to the Family Credit. 

Provisions Affecting Home Ownership

Housing Tax Benefits under Current Law

The housing sector is highly favored by the tax code. Taxpayers are allowed to deduct 

interest paid on up to $1 million of mortgage debt secured by the taxpayer’s first or 

second home. In addition, homeowners may deduct interest on home equity loans of 

up to $100,000. Other provisions allow taxpayers to deduct state and local property 

taxes and to exclude some or all of the capital gains on the sale of a 

primary residence. Together, these benefits provide a generous tax subsidy for 

taxpayers to invest in housing because the purchase and maintenance of a home 

is subsidized and a substantial amount of appreciation is not taxed. But there is a 

question whether the tax code encourages overinvestment in housing at the expense 

of other productive uses. 
71

Chapter Five

As Figure 5.5 illustrates, the economy-wide tax rate on housing investment is close to 

zero, compared with a tax rate of approximately 22 percent on business investment. 

This may result in too little business investment, meaning businesses purchase less 

new equipment and fewer new technologies than they otherwise might. Too little 

investment means lower worker productivity, and ultimately, lower real wages and 

living standards. While the housing industry does produce jobs and may have 

other positive effects on the overall economy, it is not clear that it should enjoy such 

disproportionately favorable treatment under the tax code.

The tax preferences that favor housing exceed what is necessary to encourage home 

ownership or help more Americans buy their first home. For example, the $1 million 

mortgage limit may encourage taxpayers to purchase luxury residences and 

vacation homes. In addition, the deduction for home equity loan interest may 

encourage taxpayers to use their houses as a source of tax-preferred financing for 

consumer spending. 

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Federal Tax Reform

The President’s Advisory Panel on

The benefits of current tax incentives for housing are not shared equally among all 

taxpayers. Under current law, the tax benefits for housing, which are larger than the 

entire budget of the Department of Housing and Urban Development, mostly go 

to the minority of taxpayers who itemize deductions. These taxpayers typically are 

drawn from higher-income groups. Over 70 percent of tax filers did not receive any 

benefit from the home mortgage interest deduction in 2002. According to the Joint 

Committee on Taxation, more than 55 percent of the estimated tax expenditure for 

home mortgage interest deductions went to the 12 percent of taxpayers who had cash 

income of $100,000 or more in 2004. Figure 5.6 demonstrates how households with 

higher income receive a disproportionate benefit from the home morgage interest 

deduction.

Although the deduction for home mortgage interest is often justified on the grounds 

that it is necessary for promoting home ownership, it is unclear to what extent rates 

of home ownership depend on the subsidy. According to the Census Bureau, there are 

more than 123 million homes in America, with a home ownership rate of 69 percent. 

There are many countries that do not allow any home mortgage interest deductions 

for tax purposes, including the United Kingdom, Canada, and Australia. The rate 

of home ownership in the United States is higher than that in some countries 

(approximately 66 percent in Canada), lower than that in others (approximately 70 

percent in Australia), and comparable to that in still others (the United Kingdom). 

Thus, it appears that the level of subsidies provided in the United States may not be 

necessary to ensure high rates of home ownership.

Despite the concerns described above, housing is an important value in our society, 

and for this reason, the Panel recommends that tax benefits for home mortgage 

interest be retained, but shared more evenly. 

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73

Chapter Five

R E C O M M E N D A T I O N S

Replace the deduction for mortgage interest with a Home Credit for all 

taxpayers equal to 15 percent of interest paid on a principal residence.

Establish the amount of mortgage interest eligible for the Home Credit 

based on average regional housing costs.

Lengthen the time a taxpayer must own and use a principal residence 

before gains from the sale of the home can be exempt from tax.

√

√

√

The Panel recommends that the deduction for mortgage interest be replaced with a 

Home Credit available to all homeowners. The Home Credit would be equal to 15 

percent of mortgage interest paid by a taxpayer on a loan secured by the taxpayer’s 

principal residence and used to acquire, construct, or substantially improve that 

residence. The Panel recommends that the deduction for interest on mortgages on 

second homes and interest on home-equity loans be eliminated.

To encourage home ownership without subsidizing overinvestment in housing, the 

Panel recommends limiting the amount of the Home Credit. To adjust for variations 

in housing markets, the Panel recommends the Home Credit limit be based on the 

average cost of housing within the taxpayer’s area. 

The Panel considered various ways to accomplish this, and determined the limit 

should be based on average area home purchase prices as determined using data 

from the Federal Housing Administration (FHA). The IRS currently uses a similar 

methodology to provide average purchase price guidelines for other tax provisions. 

The FHA insures loans of up to 95 percent of the median home sale price in a given 

metropolitan area, subject to certain minimum and maximum levels. To estimate 

average home purchase prices, the Panel considered a mortgage interest cap that was 

125 percent of the median sale price for each county (this amount is approximately 

31 percent higher than the FHA amount after grossing up the FHA median values 

from 95 to 100 percent). This would result in current limits between approximately 

$227,147 and $411,704. Estimates suggest that between 85 and 90 percent of 

mortgages originated in 2004 would have been unaffected by the proposed Home 

Credit mortgage limit (using the regional limits that would have been applicable for 

2004). 

The Home Credit would encourage home ownership, not big homes. More 

Americans would be able to take advantage of tax benefits for owning a home, while 

the current subsidy for luxury and vacation homes would be curtailed. In addition, 

the Home Credit would reduce the incentive to take on more debt by eliminating the 

deduction for interest on home equity loans.

As under current law, mortgage lenders would be required to report the amount of 

interest eligible for the Home Credit to borrowers on annual information returns. 

The Home Credit would simplify tax filing because taxpayers would not need to 
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The President’s Advisory Panel on

determine whether they are better off claiming the standard deduction or itemizing 

and claiming the home mortgage interest deduction. 

More importantly, under the proposal, millions of Americans would be able to claim 

a tax benefit for home mortgage interest for the first time, which would make owning 

a home more affordable. Currently, only 54 percent of taxpayers who pay interest 

on their mortgages receive a tax benefit. As detailed in Figure 5.7, approximately 

88 percent of taxpayers who pay mortgage interest would receive a benefit for 

home ownership under the Panel's recommendations. Lower-income taxpayers, in 

particular, would do better under the Panel’s recommendations than under the current 

system. For example, the percentage of taxpayers with adjusted gross income between 

$40,000 and $50,000 who have mortgages and receive a tax benefit for mortgage 

interest paid would increase from less than 50 percent to more than 99 percent. 

Depending on the year, between 77 and 94 percent of taxpayers with adjusted gross 

income over $100,000 who would receive a lesser subsidy under the Home Credit 

would have paid higher taxes under the AMT, which would be eliminated under the 

Panel’s options. 

The Panel recognizes that limiting the amount of the current tax subsidy for mortgage 

interest could adversely affect individuals who purchased or refinanced homes 

assuming they would be able to deduct interest on up to $1.1 million of mortgage 

debt. To be fair to those who relied on current tax law in making important financial 

decisions, the options provide for a gradual phase-in of the cap over a five-year period 

for preexisting home mortgages. Additional information regarding the Home Credit, 

including the proposed transition relief can be found in the Appendix. 

Under current law, up to $500,000 of capital gains on a home that a taxpayer has 

owned and used as his principal residence for two out of the last five years may be 

excluded. Although the Panel believes the exemption for gains from the sale of a 

principal residence should be retained for most homeowners, it also believes that the 

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75

Chapter Five

length of ownership and use required to obtain this benefit is too short. The Panel 

recommends that the length of time an individual must own and use a home as a 

principal residence to qualify for the tax exemption be increased from two out of five 

years to three out of five years.

Improving Tax Benefits for Charitable Giving

To strengthen incentives for charitable giving and to improve tax administration, 

the Panel recommends a number of changes to simplify the deduction for charitable 

contributions and make charitable incentives available to more taxpayers, while 

reducing opportunities for abuse of the deduction.

Providing Better Incentives to Give to Charity

The current-law deduction for charitable contributions provides an incentive for 

taxpayers who itemize to give to charity, providing an important source of funding 

for charitable organizations that serve the public good. Because the deduction for 

charitable contributions is limited to taxpayers who itemize deductions, its benefits 

are not shared equally by all taxpayers. According to the Joint Committee on 

Taxation, more than three-fourths of the estimated tax expenditure for the charitable 

contribution deduction went to the 12 percent of taxpayers who had cash income of 

$100,000 or more in 2004.

Americans by their nature are generous and have always supported charitable causes 

– not only as a regular routine of giving back to the community, but also in response 

to times of great need or natural disasters. This support is likely to continue, even if 

changes in law affect the tax benefits of giving. Research has shown, however, that 

taxpayers are sensitive to the tax rules on charitable giving. Because of the importance 

of these incentives and the fact that they are not currently enjoyed by most lowerand middle-income households, the Panel recommends retaining a tax benefit for 

charitable deductions, but making it available to all taxpayers who give to charity, 

not just to taxpayers who itemize. The Panel also recommends that the tax benefit be 

structured as a deduction to provide incremental incentives to higher-income donors, 

an important source of charitable donations.

R E C O M M E N D A T I O N

Create a deduction for charitable contributions that exceed one percent 

of income. The deduction would be available to all taxpayers.

√

The Panel recommends that all taxpayers be entitled to deduct charitable 

contributions exceeding 1 percent of income. This level is based on the observation 

that most taxpayers already contribute more than 1 percent of their income to charity. 
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In 2003, approximately 74 percent of individual taxpayers who claimed a deduction 

for charitable giving contributed more than 1 percent of current-law adjusted gross 

income. Using a fixed percentage of income as the threshold for the deduction would 

ensure a uniform incentive to contribute, regardless of income. 

The Panel’s recommendation also would reduce the recordkeeping burden and the 

potential for cheating on small deductions, which are not cost-effective for the IRS to 

verify. Taxpayers who give less than 1 percent of their income would not need to keep 

any records. 

R E C O M M E N D A T I O N

Allow tax-free distributions from IRAs to be made directly to qualified 

charitable organizations.

√

The Panel also recommends allowing taxpayers over age 65 to make tax-free gifts 

from their traditional IRAs directly to qualified charities. Under current law, a 

taxpayer who donates assets from an IRA to a charity must include the amounts in 

income and separately claim a charitable deduction. This treatment may discourage 

some taxpayers from contributing their IRA assets to charity because they may not be 

able to claim a charitable deduction for the entire amount. This is especially true if the 

taxpayer does not itemize deductions or is subject to limitations that cap the amount 

of the deduction to a percentage of income. 

Improving Recordkeeping for Charitable Gifts

R E C O M M E N D A T I O N

√ Require information reporting for large charitable contributions.

The IRS currently has no way to verify a claimed charitable deduction, short of 

performing an audit. To improve the accuracy of charitable contributions claimed 

as deductions, the Panel recommends that charities be required to report large gifts 

directly to the IRS and to the taxpayer, thereby assisting taxpayers in claiming correct 

amounts and allowing the IRS to verify deductions. 

To minimize the burden on charities who accept small donations, the Panel 

recommends the reporting threshold be set at $600 or higher. Additional information 

about the Panel’s recommendation for information reporting for charitable 

deductions can be found in the Appendix.
77

Chapter Five

Reducing Controversy and Uncertainty in Valuing Gifts of Property

Under current law, taxpayers are entitled to deduct the full fair market value of gifts 

of some types of property. Determining the value of donated goods can be difficult 

because it is so fact-intensive. Valuation is especially difficult for unique property that 

does not have an established market value. In addition, the IRS does not have a costeffective way to verify the value of donated property. This provides an opportunity 

for some taxpayers to overstate the value and inflate the amount of the tax deduction 

claimed. In recent years, a number of abuses involving contributions of used 

automobiles or partial interests in real estate have come to light. These transactions 

relied on inflated valuations. In some cases, middlemen and brokers used by charities 

to sell donated property received more benefit than the charities themselves.

The Panel recognizes that current-law rules for donations of noncash property 

provide an added incentive for taxpayers to give to charity and, therefore, recommends 

that current-law rules be retained. However, the Panel recommends that current rules 

for valuing donated property be tightened and made more explicit to prevent abuses. 

R E C O M M E N D A T I O N

√ Allow taxpayers to sell property and donate the proceeds to charity.

The Panel recommends that taxpayers be allowed to sell property without recognizing 

gain and receive a full charitable deduction if the entire sales proceeds are donated 

to a charity within 60 days of the sale. This rule would apply to the same extent 

that the property would be eligible for a charitable contribution deduction equal to 

fair market value under current law (other than items of personal property that are 

eligible because they are related to the charity’s purpose or function). The donor of 

the proceeds would not be required to pay capital gains taxes on the appreciation of 

the property. The charitable contribution deduction would be available to the extent 

that the donor’s total contributions exceed the 1 percent of income threshold. To be 

eligible, the sale of property would need to be an arm's-length sale to an unrelated 

party. 

This proposal would remove an impediment under current law to selling appreciated 

property and donating cash proceeds, which are more useful to charities. The sale 

would provide an objective measure of the market value of the property and reduce 

the charity’s cost and the burden of selling the property. If donors are better able to 

get top dollar for their donations, charities will enjoy larger gifts. 
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The President’s Advisory Panel on

R E C O M M E N D A T I O N

√ Improve rules for valuing gifts of property to charities.

In cases where property is donated to charities, the Panel believes that it is necessary 

to implement better standards for appraisals. The Panel recommends (1) new rules 

requiring clearer standards for appraisals; (2) information reporting by appraisers to 

the IRS, the donor, and the charity of the appraised value of property; and (3) new 

penalties for appraisers who misstate the value of property. Additional information 

regarding the Panel’s recommendations for appraisal standards can be found in the 

Appendix.

The Panel is also concerned that the current rules for contributions of used clothing 

and household items create the potential for overvaluation and cheating on small 

deductions. The current system of self-reporting has led to the use of “do it yourself ” 

receipts and third-party valuation guidelines that sometimes provide overly generous 

values. The Panel suggests that consideration be given to curbing the use of “do it 

yourself ” receipts and inflated valuations by allowing deductions only when the 

taxpayer receives a price list and an itemized receipt from the charity. 

Better Oversight of Exempt Organizations

R E C O M M E N D A T I O N

Effective action should be taken to ensure better oversight and 

governance of exempt organizations.

√

The Panel believes that it would be appropriate and desirable for lawmakers to review 

the types of organizations that qualify for tax-exempt status. A tax exemption, which 

is paid for by all Americans, should be extended only to organizations that are truly 

serving the public interest. The Panel recommends that Congress review the standards 

for qualifying and maintaining status as a charitable organization. Although the Panel 

does not make specific recommendations for changes to rules governing exempt 

organizations, the Panel recommends that effective action be taken to ensure greater 

oversight and better governance of exempt organizations. 

Incentives for Health Insurance Coverage

Under current law, several provisions provide benefits for health care spending. 

First, compensation paid to workers in the form of employer-paid health insurance 

premiums is excluded from taxable income and payroll taxes. Second, to the extent 

that an employee pays a portion of the health insurance premiums, these payments 

may be shielded from income and payroll taxation through so-called cafeteria plans, 
79

Chapter Five

which permit employees to put pretax dollars into benefits of their choosing. Third, 

many employers now offer flexible spending accounts that are funded with pretax 

dollars and can be used to pay uninsured medical costs. Fourth, medical expenditures 

above a certain level can be deducted from taxable income as itemized deductions. 

Finally, the introduction of health savings accounts, coupled with health insurance 

covering major medical events (such as catastrophic coverage), has given taxpayers 

another way to use pretax dollars on health care expenses.

Taken together, tax preferences for health care represent the largest tax expenditure 

and have an outsized impact on health care spending in America. The United States 

has the highest per capita health care spending in the world – $1.5 trillion, or $5,400 

per person in 2002. Tax benefits associated with health care will cost approximately 

$141 billion, or 12 percent of all federal income tax revenue in 2006. The largest 

component of this cost is the employee exclusion for employer-provided health 

insurance and medical care, a tax expenditure of $126 billion. As illustrated in Figure 

5.8, even after adjusting for inflation, the cost of this exclusion has tripled since 1986. 

The large cost of this tax preference is due, in part, to the fact that employment-based 

health insurance is the primary source of health insurance for Americans. In 2003, 64 

percent of individuals under age 65 were covered by a health plan sponsored by their 

employer or the employer of a family member. In contrast, 17 percent of taxpayers 

were covered by a government health plan (e.g., Medicaid, Medicare, or military 

health care programs), and only 7 percent purchased health insurance directly. 

Employer-provided health insurance now constitutes a substantial proportion of a 

worker’s total compensation. Employees and employers ultimately share the burden of 

rising health insurance premiums; these rising costs tend to come out of the pool of 

cash available for all worker compensation, including cash wages.

As with housing-related tax subsidies, tax benefits related to health care tend to 

benefit higher-income households more than lower-income households. This is true 

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The President’s Advisory Panel on

not only because a health-care-related deduction or exclusion is worth more to a 

higher-income taxpayer in a progressive income tax system, but also because higherincome people are more likely to have insurance. In 2004, families earning more 

than $100,000 received 27 percent of the tax benefits for health spending. Figure 5.9 

demonstrates how health tax expenditures disproportionately benefit higher-income 

taxpayers.

The current structure of the health insurance exclusion creates incentives that lead 

to inefficiencies in the market for health care. Because of the tax-preferred status of 

health insurance, people are more likely to buy health insurance that provides more 

coverage than they would in the absence of the incentive. Workers who purchase 

more health insurance may, in turn, use more health services, thereby increasing 

overall health spending. Estimates are imprecise, but removing subsidies for 

employer-provided health insurance could lower private spending on healthcare by 5 

to 20 percent.

In addition, these tax subsidies for higher-income taxpayers may raise premiums 

for lower-income people thereby increasing the number of uninsured Americans. 

Ultimately, the tax treatment worsens disparities in insurance coverage, in use of care, 

and potentially in health outcomes. 

R E C O M M E N D A T I O N S

Make tax benefits for health insurance fairer by allowing a deduction 

for the purchase of health insurance in the individual market.

Limit the exclusion for employer-provided health coverage to the 

average cost of health coverage.

√

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81

Chapter Five

The Panel evaluated whether the exclusion for employer-provided health insurance 

should be retained in each of its options. Although the current exclusion for 

employer-provided health insurance is costly and has some negative impact on the 

market for health care, the Panel concluded that an immediate elimination of tax 

incentives for health insurance would adversely affect many Americans who currently 

receive health coverage through their employer. In addition, several members of the 

Panel felt that some incentive for health insurance should be provided through the tax 

code. 

The Panel also recognizes that a strong system of employer-provided health insurance 

provides many benefits and may lead to a greater percentage of the population with 

health insurance. In addition, employer-sponsored group coverage reduces transaction 

costs and may lower premiums for some by pooling the risks of large numbers of 

individuals.

The Panel recommends that employers continue to be able to deduct the cost of 

employee compensation, whether in the form of cash compensation or health 

insurance premiums, and that employees be allowed to receive a base amount of 

health insurance free of tax. To level the playing field between workers who have 

access to employer-provided health insurance plans and those who do not, the 

Panel recommends that workers be allowed to purchase insurance either through 

their employer or on their own with pretax dollars up to the average cost for health 

insurance. Taxpayers who, for example, do not have access to employer-provided 

plans would be allowed a new deduction for health premiums equal to the exclusion 

enjoyed by workers whose employers provide health insurance.

To ensure that the tax benefits for health insurance are distributed more evenly, 

however, the Panel recommends that the amount of tax-free compensation an 

employee could receive in the form of health insurance be limited. The exclusion for 

employer-provided health insurance would be limited to $11,500 for families and 

$5,000 for single individuals, which is the national average annual amount projected 

to be spent on health insurance premiums in 2006. These amounts are also roughly 

equal to the maximum amount of tax-free health insurance coverage provided to 

members of Congress and other federal employees. 

Figure 5.10 shows that if the exclusion for employer-provided health insurance 

were completely eliminated, there would be an across the board tax rate cut of 

approximately 14 percent. A lower cap also would allow for lower rates. For example, 

capping the exclusion for health insurance to $8,400 – about 75 percent of the 

amount proposed by the Panel – would result in a 3 percent across the board rate cut. 
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The Panel discussed whether the limit for health insurance would be indexed based 

on increases in the cost of health care or increases in overall inflation. The Panel 

recommends that the limit for health insurance be indexed for annual increases in 

overall inflation like other inflation-adjusted amounts in the tax code.

The Panel’s objective is to preserve the incentive for firms to maintain health 

insurance for their employees without encouraging them to provide excessively 

generous – or “Cadillac” – health insurance plans. Under the current system, an 

individual in the top tax bracket tends to prefer to receive additional compensation 

in the form of health insurance, rather than cash, even if the individual values health 

insurance at only two thirds of its purchase price. This is because health insurance 

is not taxed, while cash is. Placing a cap on the tax preferences for health insurance 

coverage would likely make workers more cognizant of the amount they spend on 

health insurance. This increased visibility might, in turn, lead some workers to reduce 

the amount of insurance purchased and pay more health care costs directly. For 

example, the insured might have higher co-pays and deductibles, or pay a greater 

share of the bill for lab tests and brand-name pharmaceutical drugs. This change 

would help stem the out-of-control costs of health care in America, which is making 

basic insurance harder for more Americans to afford. 

Most importantly, under the Panel’s proposal, some currently uninsured Americans 

would have a new tax deduction so they could finally afford health insurance. The 

Treasury Department estimates that the Panel’s recommendation to cap the health 

insurance amount at the average premium and provide an equal deduction to all 

taxpayers would reduce the number of uninsured Americans by 1 to 2 million people.

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83

Chapter Five

Making the Tax System Easy to Understand, Effective, and 

Reliable 

The Panel’s recommended options for reform incorporate a cleaner and broader tax 

base that eliminates many of the tax benefits available only to a minority of taxpayers. 

Starting with a clean tax base also eliminates numerous phase-outs, complicated 

eligibility rules, worksheets, and other tax forms that accompany many of these tax 

benefits. 

The Panel concluded that a rational tax system would favor a broad tax base, 

providing special treatment only where it can be persuasively demonstrated that the 

effect of a deduction, exclusion, or credit justifies higher taxes paid by all taxpayers. 

The Panel recognizes that taxpayers who receive these benefits will not want to 

see them eliminated. Policymakers may not share the Panel’s views about whether 

particular preferences should be retained, and as the tax reform process continues, 

choices about tax preferences will be subject to much debate. However, the Panel 

believes that in reforming our tax system, tax preferences should be treated like any 

direct spending program, and should be evaluated by policymakers based on objective 

criteria, such as their cost, the distribution of their benefits, overall effectiveness, and 

the appropriateness of administering them through the tax system. 

The Panel did not separately review every tax preference in the tax code. Instead, the 

Panel’s goal was to start with the broadest possible tax base. Using a clean tax base will 

allow policymakers to focus on the basic design and elements of the Panel’s options. 

Some of the tax preferences that have been eliminated – the deduction for state and 

local taxes, tax benefits for education expenses, and employee fringe benefits – are 

specifically discussed below. A number of other tax preferences enjoyed by a small 

minority of taxpayers were not included in the Panel’s options and are not separately 

discussed. 

The State and Local Tax Deduction

R E C O M M E N D A T I O N

√ Repeal the deduction for state and local taxes.

The Panel recommends eliminating the itemized deduction for state and local taxes. 

This deduction provides a federal tax subsidy for public services provided by state 

and local governments. Taxpayers who claim the state and local tax deduction pay for 

these services with tax-free dollars. These services, which are determined through the 

political process, represent a substantial personal benefit to the state or local residents 

who receive them – either by delivering the service directly or by supporting a better 

quality of life in their community. The Panel concluded that these expenditures should 

be treated like any other nondeductible personal expense, such as food or clothing, 

and that the cost of those services should be borne by those who want them – not by 

every taxpayer in the country. 
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The state and local tax deduction forces residents of low-tax jurisdictions to subsidize 

government services received by taxpayers in high-tax jurisdictions. As with many 

other tax benefits, the state and local tax deduction requires higher tax rates for 

everyone, but the benefits of the deduction are not shared equally among taxpayers. 

The deduction is limited to itemizers, and households with higher income and tax 

rates receive a greater share of the benefit from the deduction. Even among itemizers, 

the benefits of the deduction are not shared evenly, as the AMT is increasingly 

erasing the benefit of the state and local tax deduction for many middle-class 

taxpayers. Depending on the year, between 64 and 70 percent of taxpayers with 

adjusted gross income over $100,000 who would no longer receive a deduction for 

state and local taxes also would have paid higher taxes under the AMT, which is 

repealed under the Panel’s options.

Education Benefits

R E C O M M E N D A T I O N

Simplify tax preferences for higher education by having the Family 

Credit cover some full-time students and permitting tax-free saving 

for education costs.

√

Under current law, there are a number of duplicative and overlapping tax benefits for 

higher education costs, including the HOPE credit, the lifetime learning credit, and 

the tuition deduction. Overall, the structure of the tax benefits for education expenses 

generally provides the largest benefit to families with students who attend schools 

with higher tuition. These tax benefits may allow educational institutions to increase 

tuition and fees because a portion of these costs is offset through the tax code.

The differing definitions, allowable amounts, eligibility rules, and phase-outs that 

accompany these education benefits have added tremendous complexity for middleclass families. Not surprisingly, this complexity leads to taxpayer confusion. One 

recent study found, based on a sample of tax returns, that more than one fourth of 

taxpayers eligible to claim one of these benefits failed to do so. Other taxpayers have 

no idea whether they are entitled to claim a tax benefit until they sit down to do their 

taxes and figure out which provisions might apply. It is not clear that the structure 

of these benefits actually encourages individuals to obtain more education than they 

would have in the absence of these tax benefits.

The Panel recommends that tax preferences for education be simplified by replacing 

the current credits and deductions with a full Family Credit allowance of $1,500 for 

all families with full-time students age 20 and under. The Panel also recommends that 

all families be allowed to save for future education expenses tax-free, as described later 

in the report.
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Chapter Five

Fringe Benefits

R E C O M M E N D A T I O N

Put all taxpayers on a level playing field by eliminating tax-free fringe 

benefits except for certain in-kind benefits provided to all employees at 

the workplace.

√

Current law allows taxpayers to exclude the value of a number of fringe benefits 

received from employers. In addition to health insurance (described above), these 

fringe benefits include educational assistance, childcare benefits, group term life 

insurance, and long-term care insurance. Although these provisions are designed 

to satisfy a worthwhile goal of encouraging employers to provide employees with 

benefits, the practical effect is favored treatment for some workers at the expense of 

higher rates for all taxpayers, including those who do not receive these benefits at 

work.

The favorable tax treatment of fringe benefits results in an uneven distribution of 

the tax burden as workers who receive the same amount of total compensation pay 

different amounts of tax depending on the mix of cash wages and fringe benefits. 

Employees who have these employer-provided fringe benefits receive better tax 

treatment than employees who pay for these expenses out of their own pocket. 

Among workers for whom the benefit is available, more of the benefits go to highincome taxpayers, even though they are paid for with higher tax rates for everyone.

The Panel recommends that the cost of employer-provided fringe benefits, such as 

childcare, life insurance premiums, and education costs, not be subsidized through the 

tax code. The Panel’s options would eliminate most current-law tax preferences for 

fringe benefits. 

The Panel recommends that certain in-kind benefits provided to all employees at the 

work place, such as meals at a company cafeteria, remain untaxed to the same extent 

as under current law, but only if provided to all employees. Although employees who 

work for firms that provide this type of fringe benefit generally receive greater tax 

benefits than other employees, it would be administratively difficult or impracticable 

for employers to determine the value of the benefits provided to each employee.

Repeal the AMT

R E C O M M E N D A T I O N

√ Eliminate the AMT.

The AMT is an entirely separate tax system with its own definitions, exclusions, 

deductions, credits, and tax rates. It is the most vivid example of the wasteful 
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The President’s Advisory Panel on

complexity that has been built into our system to limit the availability of some tax 

benefits. The AMT was conceived as a way to make all Americans pay tax, regardless 

of their tax shelters and avoidance efforts. But over time, the AMT’s simple mission 

has been made more complex and less effective. For example, as part of the 1986 tax 

reform effort, lawmakers who eliminated the state sales tax deduction nonetheless 

preserved an itemized deduction for state and local property and income taxes – but 

only for those paying under the regular tax system. For those subject to the AMT 

system, the income and property tax deductions were eliminated as well. At that time, 

this rule had little significance for most taxpayers, but it is increasingly relevant as the 

reach of the AMT, which is not indexed for inflation, has grown.

Eliminating the AMT would free millions of middle-class taxpayers – 21.6 million 

in 2006 and 52 million in 2015 – from filing the forms, preparing the worksheets, 

and making the seemingly endless calculations required to determine their AMT 

liability. In 2004, an individual had to fill out a 12-line worksheet to see if he needed 

to file Form 6251, a 55-line form with eight pages of instructions. Those eight pages 

of instructions also tell the individual to redo many regular tax forms and schedules, 

including Forms 4952 (Investment Interest Expense Deduction), 4684 (Casualties 

and Thefts), 4797(Sales of Business Property), and Schedule D (Capital Gains and 

Losses) using the AMT rules. The individual may also have to fill out and file Forms 

8582 (Passive Activity Loss Limitation) and 1116 (Foreign Tax Credit) on an AMT 

basis. The taxpayer also has to fill out a 48-line form (Form 8801) to determine 

whether he is entitled to credits for prior AMT payments. Finally, the instructions 

warn that if the taxpayer claimed the standard deduction for regular taxes, he should 

recalculate his regular and AMT taxes using itemized deductions because while the 

standard deduction is not available under the AMT, some itemized deductions are, 

but only if the individual itemizes for purposes of the regular tax. 

Under both of the Panel’s recommendations, millions of taxpayers would no longer 

have to undertake this painful and complex series of calculations nor complete the 

complicated worksheets just to determine whether they are entitled to a tax benefit or 

whether it is taken away by the AMT.
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Chapter Five

Box 5.2. Why Not Eliminate the Regular Tax Instead of the AMT?

As described in Chapter One, the AMT is projected to grow rapidly over the next ten years. 

The Treasury Department estimates that by 2013, the AMT alone would actually raise more 

revenue than the regular tax. Some commentators have pointed to this trend and suggested 

that the tax code should be reformed by eliminating the regular tax instead of the AMT on 

the basis that the AMT has a broader base and flatter tax rates.

Adopting the AMT as the only tax system would dictate a number of policy changes from 

current law that may not be desirable. First, the AMT tax base is both broader and narrower 

than the regular tax base. The AMT starts with the same base as the regular tax, and 

broadens it by denying a number of tax benefits, such as personal exemptions and state 

and local tax deductions. However, for lower-income taxpayers, the AMT base is narrower 

because of the large AMT exemption.

Second, the AMT has only two statutory tax rates, 26 and 28 percent, but is less flat 

than it appears. The phase-out of the AMT exemption at higher income levels actually 

creates two additional marginal tax rates – and a resulting tax rate schedule of 26, 32.5, 

35, and 28 percent. These rates, along with the AMT exemption, would significantly alter 

the current distribution of the income tax. Relative to the current system, many middleincome taxpayers would face higher marginal tax rates, while lower- and very high-income 

taxpayers would face lower marginal tax rates.

Third, the AMT contains a number of fundamental flaws not present under the regular 

income tax system and that would likely need to be fixed if the AMT were a stand-alone tax 

system. The AMT is not indexed for inflation, contains steep marriage penalties, and does 

not provide an adjustment for family size because personal exemptions are not allowed. 

Fixing each of these flaws would reduce the amount of revenue generated by the AMT and 

may require higher rates.

Instead of starting with the AMT and making changes to adjust for these differences, the 

Panel determined that a more straightforward approach was to reform the regular income 

tax by broadening the base. A broader tax base also would eliminate the need for the 

AMT. 

A broader tax base and the clear, straightforward rules in the Panel’s two 

recommendations would make fixtures like the AMT unnecessary. For example, 

even though the Panel recommends the elimination of the AMT, the Treasury 

Department estimates that the Panel’s recommendations would cut the number of 

returns showing adjusted gross income in excess of $200,000 but no U.S. income tax 

by more than 50 percent. Tax returns showing adjusted gross incomes in excess of 

$700,000 but no U.S. income tax would be cut by more than 80 percent. 

Simplification of the Treatment of Social Security Benefits

Under current law, Social Security beneficiaries must work through a convoluted 

series of computations in a full-page, 18-line worksheet to determine the amount 

of their benefits subject to tax. Current rules effectively phase out the preferential 

treatment of Social Security benefits based on a complicated, three-tier approach. 

For example, if taxpayers who receive Social Security choose to continue working, 

a portion of their Social Security income becomes taxable. Depending on the tier, 
88

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The President’s Advisory Panel on

taxpayers may be required to include 0, 50, or 85 percent of Social Security benefits 

in their taxable income. To find out which of these tiers applies, taxpayers who receive 

Social Security benefits must compute their income a second time by adding back a 

number of items that normally are not taxed. 

Not only is the tiered structure complicated, two of its features represent some of the 

worst aspects of our current tax system – a phenomenon known as "bracket creep" 

and a marriage penalty. Bracket creep is a term coined by tax analysts to describe what 

happens when inflation triggers increases in income that lead to automatic annual 

tax increases. In the case of Social Security benefits, Congress chose not to index for 

inflation the thresholds above which taxpayers are required to include 50 percent and 

then 85 percent of Social Security benefits in their taxable income. This means that as 

the income of Social Security recipients grows with inflation each year, they are more 

likely to be above the thresholds and be required to pay more tax. 

The current-law rules for Social Security benefits also treat married couples more 

harshly than singles. The 50 percent and 85 percent inclusion thresholds for married 

couples are only about 30 percent larger than the threshold for single taxpayers. 

Because the threshold level for married taxpayers is less than twice the amount for 

single taxpayers, the current-law tax treatment of Social Security benefits creates a 

marriage penalty under which the income tax liability of two individuals as a married 

couple may be greater than their combined liability would be if they filed separately as 

single individuals.

R E C O M M E N D A T I O N

√ Simplify the tax treatment of Social Security benefits.

The Panel recommends simplifying the taxation of Social Security benefits by 

replacing the complex three-tier computation with a straightforward deduction that is 

easy to compute. Under the proposal, Social Security recipients would not be taxed on 

any of their Social Security benefits if their income is less than $44,000 for married 

couples and $22,000 for singles. These thresholds would eliminate marriage penalties 

and would be indexed annually for inflation. Taxpayers above the income threshold 

would include between 50 and 85 percent of their benefits in their taxable income 

depending on their income level. The computation of taxable Social Security benefits 

will be dramatically simpler than it is today. A copy of the new simpler and shorter 

worksheet taxpayers would use to compute the taxable amount of Social Security 

benefits under the Panel’s recommendations is shown in Figure 5.11.
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Chapter Five

Reducing Marriage Penalties

R E C O M M E N D A T I O N

Reduce marriage penalties by making tax benefits for married couples 

twice the amount for single filers.

√

A “marriage penalty” exists when the income tax liability of a married couple is 

greater than their combined tax would be if they had filed as unmarried individuals. 

Couples find it hard to understand why they should pay more in tax after they get 

married than they would have paid if they had remained single.

The Panel’s recommended options would make all marginal tax rate brackets, the 

Family Credit for married couples, and the Social Security benefits deduction 

thresholds exactly twice the amount for singles. By providing marriage penalty relief, 

the Panel’s options help reduce the barriers faced by potential second earners.

COMMON PRINCIPLES

In addition to incorporating the common elements described above, the Panel’s 

options use different approaches to achieve the goal of a simpler, fairer, and more 

growth-oriented tax system. The differing design of each option represents different 

approaches to achieving the similar, or common, principles described below.

Reducing Disincentives to Save

Household saving is crucial to the health of our economy and to the financial health 

of American families. An income tax reduces the return to saving because it taxes 

the income that saving generates. An individual who earns a dollar today pays taxes 

on those wages. If he then consumes the after-tax proceeds, he will not pay any 

further taxes. In contrast, someone who earns the same amount today, pays the same 

taxes on his wage income, but then decides to save the proceeds will be subject to 

additional tax in the future on the investment income generated from savings. A 

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Social Security Benefits Worksheet—Line 13 Keep for Your Records

1. Is the amount on 1040-SIMPLE, line 9, less than $22,000 ($44,000 if married)?

Yes. STOP Enter the amount from 1040-SIMPLE, line 7, on 

1040-SIMPLE, line 13.

No. Enter the amount from 1040-SIMPLE, line 7 . . . . . . . . . . . . . . . . . . . . . . . . . 1.

2. Enter the amount from 1040-SIMPLE, line 9 . . . . . . . . . . . . . . . . . . . . 2.

3. Enter $22,000 ($44,000 if married) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.

4. Subtract line 3 from line 2. If zero or less, enter -0-. . . . . . . . . . . . . . . 4.

5. Multiply the amount on line 4 by 50% (.50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.

6. Subtract line 5 from line 1. Enter the result here and on 1040-SIMPLE, line 13 . . . 6.
90

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person weighing whether to spend money today or save it for the future may compare 

how much he can buy today against what he will be able to buy in the future with 

his savings. If the return on savings is subject to tax, current consumption will be 

less expensive than future consumption financed from savings. The tax on savings 

therefore operates like a penalty for those who choose to save.

In contrast, under a consumption tax regime, wages would either be taxed when 

earned and no further tax would be imposed on the return from savings, or an 

individual would not pay tax until wages and returns from savings are spent on goods 

or services. This distinction corresponds to the difference between what is commonly 

referred to as “prepayment” or “postpayment” consumption taxes. Although the 

impact on the decision to save or consume is the same under either approach, the 

timing of tax payments is different. In either case, a consumption tax would be 

imposed only on the amount the taxpayer consumes.

Compounding the tax penalty on savings under our current system is the complexity 

created by the different treatment of similar investments. For example, the tax 

treatment of bonds varies dramatically depending on whether the issuer of the bond 

is a corporation (where interest is taxable), a state and local government (where 

interest is tax-free), or the federal government (where some interest is taxable and 

some is tax-free). Likewise, investments in stock are treated differently depending 

on the size of the stock’s issuer, whether the issuer pays dividends, and how long the 

stock is held. Table 5.4 illustrates how almost no two investment alternatives are 

treated the same under the current code. 

Table 5.4. Different Tax Treatment of Investments Under Current Law

Investment Type Tax Rate When Taxes 

Are Due

Bonds

 Municipal

 Federal 

 Federal Savings Bonds 

(not for education)

 Corporate

Tax-Free

Regular Rates 

Regular Rates

Regular Rates

Never

Yearly

Time of Sale

Yearly

Savings Account or Certificate of 

Deposit Regular Rates Yearly

Corporate Stock

 Capital Gains

 Dividends

Capital Gains Rate

Dividend Rate

Time of Sale

Year Received

Small Business1 Regular Rates Yearly

Housing Tax-Free up to 

$500,0002 Time of Sale

Annuities and Whole Life Insurance Regular Rates Year Received

1

 Most small businesses are not corporations and their earnings are taxed on owners’ returns. 2 Capital gains above $500,000 

($250,000 for singles) are taxed at the capital gains rate. 
91

Chapter Five

To help reduce the penalty our current income tax places on savings, incentives 

have been added over the years to promote savings for retirement, education, and 

health care. Generally, each of these incentives follows a basic strategy to reduce the 

tax on savings. First, create a special savings vehicle for certain approved purposes 

where funds can be deposited; second, permit those dollars to grow tax-free until 

they are withdrawn; third, specify whether those funds are taxed when they are 

withdrawn. In the case of a traditional IRA account, deposits are generally deductible 

and withdrawals are generally taxed, while in the case of a Roth IRA or Coverdell 

education savings account, deposits are not deductible, and withdrawals are tax 

exempt if made under appropriate circumstances. In the case of a Health Savings 

Account, the deposits are deductible and withdrawals to pay health expenses are 

exempt; other withdrawals are taxable. This lack of uniformity is a major source of 

complexity for Americans.

Box 5.3. The Decline in U.S. Savings

At the same time that tax-free saving options have been added to the tax code, Americans 

have been saving less of their income for the future. Over the last three decades, the net 

U.S. savings rate, which equals household savings plus retained earnings plus the surplus 

or deficit of the government sector, has fallen from about 9 percent of Gross Domestic 

Income to about 2 percent of Gross Domestic Income. Americans are saving so little that 

by some measures net tax subsidies for savings actually exceeded the amount of savings 

by Americans due to loans against and withdrawals from these accounts. The reported 

savings rates should be viewed with some caution, however, because they do not include 

appreciation in the value of some assets, such as housing and stocks, which may contribute 

to increases in wealth without increasing the reported savings rate.

Although the magnitude of the decline in savings is debatable, there is widespread agreement 

that the overall level of investment and long-term savings is important to the health of the 

economy. Savings flows into investment, and increased levels of investment are generally 

associated with greater productivity and, ultimately, higher living standards. To offset low 

domestic savings, the United States has borrowed heavily from foreign lenders.

Taxing saving more heavily than current spending lowers the rate of return on saving, which 

in turn lowers the actual level of savings. One economist explained to the Panel that, a small 

increase in the rate of return of 10 percent – for example, from 5 percent to 5.5 percent 

– could increase the amount of new saving by Americans by between one and five percent. 

Some recent research suggests that a broad-based tax system that is neutral between 

savings and current spending could increase the national savings rate by 12 to 31 percent 

over a period of 14 years.

One professional financial advisor described to the Panel how investors become 

paralyzed by the range of tax-preferred savings choices. He said that ultimately these 

potential investors may choose to spend their money instead of saving it for the future 

simply because it is an easier decision. His views were confirmed by some members 

of the Panel, who said they often rely on professionals to help them make informed 

decisions – and even after seeking advice, they often remain confused. 

The Panel doubts that taxpayers need or value the overwhelming number of options 

for tax-preferred savings. For example, the National Taxpayer Advocate explained to 
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The President’s Advisory Panel on

the Panel how, in the area of retirement savings alone, there are at least a dozen taxpreferred options. Different tax-preferred retirement savings accounts are subject to 

different eligibility rules (depending on income and employment), contribution limits, 

permissible withdrawals, and circumstances when individuals can borrow against their 

accounts. There is no good explanation for why so many different types of plans are 

necessary. 

Although choosing the right tax-preferred retirement savings vehicle is complex, the 

tax-preferred treatment of savings for education is even more confusing. In recent 

years, accounts known as Coverdell education savings accounts and Section 529 

plans have been added to the tax code. Choosing between these options is not easy 

because, like other tax-preferred savings incentives, they have almost no common 

rules or features. Making matters even worse, Section 529 plans have proliferated 

– there are now more than 100 separately sponsored Section 529 plans from which to 

choose, each with its own contribution limits, investment options, costs, and penalties 

for noneducational use. Yet another level of complexity is created because the taxfree withdrawal feature of Section 529 plans is scheduled to expire in 2010, forcing 

families to pay tax on earnings even if the funds are used for educational purposes.

For many individuals, it is virtually impossible to decipher the rules for each plan or to 

determine which education savings vehicle confers the greatest benefit. In addition to 

complex choices between the different tax-preferred savings vehicle, the plans interact 

with other tax and nontax incentives for education, further clouding families’ ability to 

determine the best way to pay for higher education. The tax code has made financial 

planning for higher education so complex that even professional tax planners disagree 

on the best course to follow. Not surprisingly, only three percent of all households 

actually use an education savings account. Among households that do take advantage 

of the accounts, the benefits go mostly to higher-income families. 

In addition to retirement and education, tax-preferred savings accounts are available 

for health care purposes. These include Medical Savings Accounts (MSAs), Health 

Savings Accounts (HSAs), and Flexible Spending Arrangements (FSAs), which 

allow taxpayers to pay or save for health care in different ways, and each comes with a 

different set of rules. 

Box 5.4. Comparison of U.S. Savings Rate to the Rates of Other Countries

Not only has personal 

savings in the United States 

been declining over time, it 

is low compared with other 

industrialized nations. The 

following figure shows that 

as a fraction of household 

income, household savings 

in the United States lags 

significantly behind many 

developed countries.

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93

Chapter Five

R E C O M M E N D A T I O N

Simplify and expand opportunities for tax-free savings for retirement, 

health, education, and housing.

√

Both of the Panel’s recommended options would remove existing disincentives to 

save. These options would provide opportunities for Americans to save in a simple 

and efficient manner by replacing the tax code’s plethora of savings incentives with a 

unified system that would make tax-free savings for education, health, a new home, or 

retirement flexible, convenient, and straightforward. The tax code’s redundant savings 

incentives and accounts would be combined into three simple and flexible accounts 

for savings. The creation of these three simple saving opportunities significantly 

reduces the bias against saving and investment that exists under the current system. 

In addition, the Panel proposes changes to the administrative rules for some employer 

plans that would point workers in a pro-saving direction. The plans would allow most 

Americans to prepare for their future financial security free of tax. Not only would 

these accounts provide simpler and expanded opportunities to save, the playing field 

for tax-preferred savings would be leveled by eliminating exclusions under current 

law that allow some taxpayers to save an unlimited amount tax-free through life 

insurance, annuities, and executive deferred compensation arrangements. The Panel’s 

plans also would include a refundable Saver’s Credit that would give low-income 

Americans a strong incentive to save by matching contributions to savings accounts. 

The Simplified Income Tax Plan also would nearly eliminate the double tax on 

corporate profits by excluding dividends paid out of income earned in the U.S. In 

addition, 75 percent of capital gains on sales of stock in U.S. corporations would be 

excluded from income. 

Under the Growth and Investment Tax Plan, the return to savings not held in these 

tax-preferred savings accounts would be subject to a flat rate tax of 15 percent. In 

addition, the simplified employer-sponsored accounts would use a “Roth IRA,” or 

prepayment approach, while the Simplified Income Tax Plan would use a “traditional 

IRA,” or postpayment approach. These two approaches provide similar incentives 

for savers, but they have different near-term tax revenue consequences. The overall 

tax burden on capital income would be lower under the Growth and Investment Tax 

Plan than under the Simplified Income Tax Plan, although some types of capital 

income might have a lower tax burden under the Simplified Income Tax Plan.

These approaches would diminish the need for taxpayers to hire tax professionals to 

help them navigate the tax code’s multitude of incentives. Americans would be able 

to make investment decisions based on their preferred investment strategy and no 

longer would be required to jump through hoops to make sure that they maximize 

their after-tax returns. Taxes would play a less prominent role in household savings 

decisions. 
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Small Business Rules Designed with Entrepreneurs in Mind

The tax rules for businesses, like those for households, have become a complicated 

mess. These rules force many businesses to engage in elaborate and burdensome 

recordkeeping to comply with the tax code’s arcane accounting for income and 

deductions, especially when businesses have inventories or depreciable assets. 

These rules do not apply only to large corporations. In fact, since the proportion of 

business profits that flows to individuals is continuing to rise, the tax rules on business 

are having an outsized impact on household filers. As shown in Table 5.5, in 2004, 

an estimated 31 million individuals – nearly one-fourth of filers – received business 

income from sole proprietorships, rental activities, partnerships, limited liability 

companies (LLCs), or S corporations and paid tax on this income on their individual 

returns. Over one-third of taxes on business profits are paid by owners of passthrough businesses when they file their individual tax returns.

Table 5.5. Owners of Pass-Through Businesses (2004)

Type of Business Returns (Millions)

Sole Proprietorships 18.8

Individuals with rental activities 9.4

Partnerships and LLCs 4.2

S Corporations 3.6

Farm Proprietorships 2.1

Total 30.9*

* Total is less than components because some taxpayers own more than one type of business. 

Source: Department of the Treasury

For small businesses, the compliance burden is especially heavy, as compliance costs 

are large relative to income. Most small business owners track the profitability of 

their business during the year based on the balance in their checking account. The tax 

code’s detailed business rules force many entrepreneurs to create and maintain several 

different sets of books and records for the sole purpose of filling out a tax return. 

Reforms that lower the burden of tax compliance on small businesses by reducing 

recordkeeping and paperwork will lead to increased entrepreneurial activity and a 

stronger economy. 

R E C O M M E N D A T I O N S

Simplify recordkeeping for small businesses by basing it on cash receipts 

and expenses.

Expand expensing of small business assets.

√

√
95

Chapter Five

The Panel recommends that most small businesses file taxes the same way they pay 

their bills – with their checkbook. Under the Panel’s options, most small businesses 

would report income as cash receipts minus cash business expenses. This rule reduces 

compliance costs by relieving small businesses from keeping a second (or sometimes 

even a third) set of books for tax reasons and allowing them to use records they 

already keep for their businesses. 

Both of the Panel’s options would allow unlimited expensing for most asset purchases 

by businesses with less than $1 million in annual receipts. The Simplified Income Tax 

Plan would allow immediate expensing for all assets other than land and buildings, 

which would retain current-law treatment. The Growth and Investment Tax Plan 

would adopt a business cash flow tax that would allow businesses of all sizes to write 

off all purchases from other businesses immediately, including all new investment in 

equipment, structures, inventories, and land. This treatment represents an expansion 

of current-law rules, which for 2004, allowed small businesses to write off the cost of 

the first $102,000 of their purchases of tools and equipment. This inflation-adjusted 

provision is temporary and is scheduled to be cut to $25,000 in 2008 – less than 

one-fourth of its current size. In addition, the current-law provision does not allow 

expensing of intangibles, which the Panel’s options would. Using the cash method 

of accounting for small businesses would allow them to write off the cost of their 

purchases of tools, equipment, and other long-lived assets immediately, which would 

encourage new investment and capital formation by growing businesses. 

In addition, the Panel’s options would not require businesses with less than $1 million 

in annual receipts to use an inventory accounting method. All inventory costs would 

be deductible when incurred. 

Proposals to Boost Business Investment

Our business tax system is inefficient and hopelessly complex. It is littered with 

provisions for special rates, deductions, and credits that are designed to encourage 

particular conduct or business activity. Under the patchwork of rules that tax some 

business income twice, some once, and some not at all, firms have an incentive to 

rearrange their affairs in ways motivated by taxes, rather than by the underlying 

economics of business decisions. This inefficient shifting of resources away from 

business investment and innovation hinders economic growth. 

The Panel’s recommendations would improve several aspects of the current business 

tax code for medium-sized and large businesses. First, the Panel’s options would 

simplify the current treatment of, and lower the tax burden on, returns on new 

business investment. Second, the Panel’s recommendations would make our tax code 

more efficient by leveling the playing field between different types of business entities 

and investment. Both of the Panel’s options also would reduce the differences in the 

combined individual and corporate tax on dividends and interest on corporate debt. 

Third, both of the options would replace our international tax regime with a system 

that reflects the realities of our global economy. Finally, the Panel’s recommendations 

would eliminate the corporate AMT.
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Simplifying and Encouraging Business Investment

The tax treatment of new business investment under our tax code is based on asset 

classifications that are outdated, do not account for new industries and technologies, 

and favor some assets while penalizing others. The classification of assets into recovery 

periods has remained largely unchanged since 1986, and most asset classifications 

date back at least to 1962. Entirely new industries have developed in the interim, 

and production processes in traditional industries have changed. These developments 

are not reflected in the current cost recovery system, which does not provide for 

updating depreciation rules to reflect new assets, new activities, and new production 

technologies. 

A 2000 Treasury Department report on depreciation concluded that it is not 

known with any degree of certainty what the depreciation rates should be, even on 

average, for many classes of investment. For example, the Panel was told how the 

current depreciation schedule for computers is based on studies of the depreciation 

of surplus government typewriters from the late 1970s. Although computers can 

operate mechanically for a number of years, it should be no surprise that they lose 

their usefulness quickly as newer technology becomes available. The actual pattern of 

depreciation of computers is not accounted for under current estimates. 

Accounting for the value of assets that have been depreciated under our current 

system creates complexity and an additional recordkeeping burden. Most businesses 

are required to measure the current value of an asset in at least three different ways: 

(1) the historic cost of the asset for financial accounting purposes, (2) the adjusted 

basis of the asset for tax purposes, (3) and the basis of the asset for corporate AMT 

using the AMT-specific depreciation method. Some states require that assets be 

tracked based on yet another method of depreciation. 

More costly than the recordkeeping cost of our depreciation system is the impact 

it has on new investment. If tax depreciation is not neutral – because it does not 

appropriately match the economic decline in value of physical assets – capital will be 

allocated inefficiently. This distorts business decisions because companies will invest in 

tax-favored equipment over other alternatives (even if such alternatives may be better 

suited to the company’s operations and competitive needs). The cost of an inefficient 

allocation of capital is fewer goods and services being produced than otherwise might 

be possible.

The Panel learned how the current system creates distortions that alter investment 

choices. Our current depreciation system creates large variations in tax rates across 

different types of business assets. Table 5.6, which assumes that the 2001 and 2003 

tax cuts are permanent, shows how some corporate assets have marginal effective tax 

rates that are one-fourth of other assets.
97

Chapter Five

Table 5.6. Effective Marginal Tax Rates on Capital Income of 

Corporations by Asset Type

Asset Type Effective Tax Rate

Computers and peripheral equipment 36.9

Inventories 34.4

Manufacturing buildings 32.2

Land 31.0

Commercial buildings 30.4

Automobiles 29.7

Software 29.1

Hospitals and special care 28.4

Educational buildings 28.4

Office and accounting equipment 28.4

Electric transmission and distribution 24.9

Residential buildings 23.8

Farm tractors 22.7

Service industry machinery 22.2

Mining and oilfield machinery 21.9

Farm structures 20.8

Medical equipment and instruments 20.4

Agricultural machinery 20.2

Railroads 20.1

Metal-working machinery 19.0

Photocopy and related equipment 18.8

Light trucks (including utility vehicles) 18.2

Communications equipment 17.8

Household appliances 17.5

Construction tractors 17.4

General industrial equipment 17.3

Communication structures 17.0

Construction machinery 16.7

Ships and boats 16.5

Fabricated metal products 15.5

Aircraft 14.5

Railroad equipment 11.4

Mining structures 9.5

Petroleum and natural gas structures 9.2

Source: Congressional Budget Office 
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The effective tax rates listed in Table 5.6 help measure how taxes may distort 

investment and other economic activity. The effective tax rates cannot be found in the 

tax code. They represent a combination of statutory tax rates and other features of the 

tax system, such as the depreciation schedule for the asset. The higher the effective tax 

rate, the more likely it is that the tax system would discourage investment. The greater 

the differences in the effective tax rates across types of investments, the more likely it 

is that the tax system distorts investment choices.

R E C O M M E N D A T I O N S

Lower the tax burden on business investment.

Simplify recordkeeping for purchases of new assets.

√

√

To encourage new investment, the Panel recommends changes to the tax treatment 

of business investment in each of its options. The Simplified Income Tax Plan 

would improve investment incentives by lowering the tax rate on business income 

and overhauling the current depreciation system. This proposal would reduce the 

compliance headaches associated with the tax treatment of business investment 

for large and mid-size businesses. The new depreciation system would collapse 

the number of asset classes and methods, making fixed asset accounting more 

straightforward. 

The Simplified Income Tax Plan also would reduce the top business tax rate from 35 

to 31.5 percent – a 10 percent reduction in the tax burden. The lower tax rate would 

reduce the tax on income earned from new investment projects and would encourage 

businesses to invest in new assets that improve productivity.

The Growth and Investment Tax Plan would take a more dramatic approach 

to business investment. This option would replace the system of depreciation 

allowances with a system that combines complete expensing of business investment 

and the equal treatment of debt and equity business financing. Giving businesses 

an immediate write-off for purchases of new assets and denying deductions for 

debt financing would provide the same treatment for different types of business 

investment. By allowing an immediate write-off for the cost of a project, the return 

on investment would be the same after tax as it was before tax, assuming the 

business is able to use the expensing deductions. This would encourage firms to make 

investments that would not be undertaken under today’s tax code. 
99

Chapter Five

Reducing Distortions Created by the Corporate Income Tax

The double tax on corporate earnings – once at the corporate level and again at 

the individual level when distributed as a dividend or realized from a sale of stock 

– discourages investments in corporate equity in favor of other investments that 

are not taxed as heavily. This may discourage new corporate investment, encourage 

existing corporations to use debt financing instead of equity financing, and encourage 

corporate managers to retain profits or distribute profits only in a tax-advantaged 

manner, such as paying bonuses to owners or issuing stock options.

The tax bias against using the corporate form is clearly demonstrated by the rapid 

growth in business entities not subject to the corporate income tax, such as LLCs 

and S corporations, which provide legal benefits of limited liability, but are taxed 

only once on the individual owners’ tax returns. For example, since 1980 the number 

of S corporations has grown from 528,100 to 3,612,000, while the number of C 

corporations has remained largely unchanged – from 2,115,000 in 1980 to 2,190,000 

today. As shown in Figure 5.12, much of the tax on business profits is now being paid 

on the individual tax returns of shareholders in S corporations, LLCs, and other flowthrough entities, as total business net income from these entities recently exceeded 

total business net income from C corporations.

Not only does the corporate income tax discourage new investment in corporate 

equity, it also encourages existing corporations to finance new projects with debt 

rather than issuing new stock. If a corporation raises funds for investment by issuing 

stock, the dividends paid are not deductible at the corporate level, creating a double 

tax on the corporation's earnings. Income from debt-financed corporate investment, 

on the other hand, is largely untaxed at the corporate level because corporations may 

deduct interest payments. Although interest income is taxed at individual tax rates 

of up to 35 percent, the individual tax rate is often lower than the corporate rate, 

and a substantial portion of interest income is received by tax-exempt or low-taxed 

taxpayers (e.g., pension funds, IRAs, foreigners) and so bears little or no tax. 

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Because corporate equity financing is treated less favorably than debt financing for 

tax purposes, it often costs less for corporations to borrow funds than to issue stock. 

As shown in Figure 5.13, the average economy-wide effective income tax rate on 

equity-financed investment is close to 40 percent – a 35 percent corporate-level tax 

plus a composite 4 percent tax rate at the individual level, representing the average 

of dividends and capital gains taxed at the 15 percent maximum rate and those taxed 

at lower rates or in tax-free accounts. By contrast, the average tax rate on debtfinanced investment is negative (-15 percent), as deductions for interest, together with 

deductions for items such as accelerated depreciation, more than offset the income 

generated from debt-financed investment. Debt-financed investment thus is slightly 

subsidized by the tax system, meaning that the reward for such investment is greater 

than if there were no taxes at all.

The tax bias against corporate equity encourages firms to rely on debt more than 

they would if the tax system imposed no such bias. The use of higher debt levels by 

corporations, known as “leveraging,” may increase the risk of bankruptcy and financial 

distress during temporary industry or economy-wide downturns. This heightened 

bankruptcy risk can make the entire economy more volatile. In addition, the 

differential taxation of debt and equity may favor investment by firms or industries 

that have easier access to debt. The distinction between debt and equity also creates 

opportunities for tax planning and tax sheltering.

The corporate income tax also impacts firms’ decisions about the level, timing, and 

form of distributions to shareholders. If firms retain earnings to avoid taxes, the 

resulting allocation of capital across firms and industries may be less efficient than 

it would be if the earnings were paid to shareholders, who could redeploy the funds 

towards their most productive use. 

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The tax system also encourages U.S. corporations to distribute earnings in taxpreferred transactions. For example, privately held corporations often pay bonuses at 

year end to employee-shareholders to eliminate the corporate income tax. Another 

increasingly popular technique is to use employee stock options to eliminate double 

taxation. A corporation that issues stock options essentially borrows from its 

employees and “repays” them with stock, generating tax deductions for compensation 

that can eliminate a substantial portion of a company’s tax liability. In 2000, total 

deductions for stock options were 10 percent of total pretax income for the 100 

largest U.S. companies. However, for high-technology companies in the NASDAQ 

100 stock index, tax deductions for employee stock options exceeded the total pretax 

income of these companies. 

In 2003, the top tax rate paid on dividends earned by individuals was lowered to 15 

percent. This rate reduction substantially reduced corporations' incentive to retain 

earnings or distribute them in a tax-preferred way. Since then, more corporations 

have begun paying dividends, and corporations that historically paid dividends have 

increased their dividend payout, making more and lower-cost capital available for 

other businesses. Figure 5.14 summarizes the increase in the dividends paid per share 

for companies in the Standard & Poor's 500 (S&P 500) index since the May 2003 

dividend tax cut. Since 2003, more than 30 additional S&P 500 companies began 

paying dividends. In fact, 2003 marked the first year that there was an overall increase 

in dividend initiations among S&P 500 companies since 1994. The reduced tax rate 

on dividends is temporary, however, and is scheduled to expire in 2008, unless it is 

extended.

Overall, the double tax of corporate earnings has a significant impact on the economy 

because it results in a misallocation of capital away from the corporate sector and into 

the noncorporate sector. Corporate investment projects require a higher pretax rate of 

return than noncorporate business investment projects to obtain the same after-tax 

rate of return. If less capital is allocated to the corporate sector, some corporations will 

fail to undertake investments that would be profitable if the burden on corporate and 

noncorporate investments were the same. 

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The elimination of the double taxation on corporate earnings would remove many 

of the distortions in our current system, including the incentive to invest in noncorporate businesses instead of corporate businesses and the incentive to use debt or 

retained earnings instead of equity financing of corporate investment. Removal of 

these distortions would likely lead to increased investment and thus further economic 

gains from stronger growth and job creation.

R E C O M M E N D A T I O N

Reduce the double tax on corporate earnings and provide a more level 

treatment of debt and equity financing for large businesses.

√

Both of the Panel’s options would remove the bias against investing in America’s 

businesses by providing a more neutral tax treatment among corporate and 

noncorporate businesses. Both options are designed to change the rules that lead to 

many of the inefficient choices made by businesses. In addition, the options would 

help level the playing field between business projects financed by debt and those 

projects financed with equity.

The Simplified Income Tax Plan would provide a full exclusion for individual and 

corporate taxpayers of dividends paid by U.S. corporations out of domestic earnings. 

To help level the playing field between businesses that pay out their earnings as 

dividends and businesses that retain their earnings, the Simplified Income Tax Plan 

would exclude 75 percent of capital gains on the sale of stock of U.S. corporations. 

The Growth and Investment Tax Plan would apply a uniform tax on all business 

cash flow because businesses would not deduct payments of interest and dividends. 

At the individual level, a flat rate tax of 15 percent would be imposed on all interest, 

dividends, and capital gains received by households, resulting in a uniform tax burden 

on business investment. 

Reforming the Taxation of International Business Activity

Our current tax system subjects U.S. multinational corporations to tax on both 

their domestic- and foreign-source income. When foreign income is earned by the 

active business operations of a foreign subsidiary, however, U.S. tax on the parent 

corporation is deferred until the income is repatriated to the United States. Under our 

so-called worldwide tax system, U.S. multinationals are generally taxable on the active 

business earnings of their foreign subsidiaries only when those earnings are returned 

to the United States in the form of dividends or realized by the U.S. owner of the 

foreign subsidiary in the form of gains from the sale of shares. A credit for foreign 

income taxes paid by the foreign subsidiary can reduce U.S. tax on repatriated foreign 

earnings, subject to various limitations.
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Although this “worldwide” approach to the taxation of cross-border income was 

once more prevalent, it is now used by less than half of the world’s major developed 

economies. Instead, many of these countries now use predominantly “territorial” tax 

systems that exempt all or a portion of foreign earnings from home-country taxation. 

Under a pure worldwide system, all foreign earnings would be subject to tax by the 

home country as they are earned. To prevent double taxation, a tax credit would be 

allowed for all income taxes paid to foreign governments. Under this pure system, 

the marginal after-tax return on an identical investment project at home would never 

be higher than in any country abroad. From the perspective of worldwide economic 

efficiency, this feature may be attractive because it ensures that business location 

decisions of multinationals are not influenced by tax considerations. Under a pure

territorial system, on the other hand, only income earned at home would be subject to 

home country tax. This feature has the benefit that all those investing in a particular 

country face a level playing field from a tax perspective, regardless of the tax rate in 

the investors’ home country. Unless tax rates and tax systems are identical around 

the world, it is impossible to simultaneously ensure that business location decisions 

of multinationals are not influenced by tax considerations and that all investors in a 

particular country are treated the same from a tax perspective. 

Efficiency, competitiveness, and revenue concerns, as well as considerations such as 

fairness and administrability, all influence international tax policymaking and often 

are in conflict. Thus, countries with predominantly worldwide systems do not subject 

all foreign source income earned by foreign subsidiaries of multinational corporations 

to immediate home country taxation, largely so that home-based companies are 

not at a disadvantage investing in countries with lower tax rates, and they do not 

provide unlimited foreign tax credits, because doing so could wipe out government 

revenues from taxing domestic as well as foreign source income. Similarly, to prevent 

tax avoidance and to maintain government revenues, countries with predominantly 

territorial systems typically do not exempt certain foreign earnings of foreign 

subsidiaries, including earnings generated from holding mobile financial assets, from 

home-country taxation. 

In both worldwide and territorial systems, the rules that determine which types of 

foreign income are taxed, when the income is taxed, and what credits are available 

to reduce that tax are complex and can be the source of a great deal of tax planning 

activity. Nevertheless, some systems may create fewer distortions and produce better 

incentives than others.

Two features of the U.S. international tax system illustrate some of the problems 

associated with our current rules. First, because the active business income of foreign 

subsidiaries of U.S. parent corporations generally is not taxable at home until it 

is distributed as dividends, the U.S. tax on dividend payments can be thought of 

as elective, much like the tax on capital gains. Due to the “time value of money” 

advantage of postponing tax payments, this deferral of U.S. tax allows foreign business 

income to be taxed at a lower effective rate than it would be if it were earned in 

the United States. This creates an incentive for the foreign subsidiary to retain the 

earnings as long as possible and distorts other business and investment decisions.
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Another feature of the U.S. system that can produce undesirable incentives involves 

the mechanism to prevent the double taxation of corporate income. The foreign tax 

credit is limited to the amount of U.S. tax that would be due if the foreign income 

were earned in the United States. This limit is intended to prevent the company from 

using foreign tax credits to reduce U.S. tax on domestic income. Many complicated 

rules determine how companies calculate these credits. These rules further limit the 

use of credits in many situations, but also allow companies to arrange their affairs so 

that they can avoid taxes on income earned abroad if they are able to simultaneously 

repatriate certain income that has been subjected to high rates of foreign tax and 

other income that has been subject to low rates of foreign tax. 

The deferral and credit features of our current tax system make the tax consequences 

of investment abroad dependant on the circumstances of the taxpayer. For instance, 

certain corporations may be able to set up their operations in a way that either avoids 

the repatriation of foreign profits through deferral or avoids U.S. tax on repatriated 

foreign profits through the credit. Both approaches may effectively allow corporations 

to obtain territorial tax treatment for active business income through “self-help,” and 

some corporations may be able to receive tax treatment that is even more favorable. 

Establishing repatriation of a dividend as the taxable event distorts business decisions. 

U.S. tax must first be paid to redeploy earnings in the United States unless tax 

planning has ensured that sufficient tax credits are available or other tax planning 

techniques have been used to avoid the U.S. tax. Further, as explained in Chapter 

Six, the tax planning opportunities engendered by the complicated rules surrounding 

deferral may allow some corporations to help themselves to results that are more 

favorable than territorial taxation. As a result, the active foreign income of some 

multinationals is taxed more heavily under the current system than it would be in a 

predominantly territorial system, while similar income earned by other multinationals 

is functionally exempt from U.S. tax through “self-help.” Meanwhile, the income 

of a third group of multinationals may be taxed at a negative rate. The result of this 

complexity is that the actual rates of tax paid by U.S. companies on their worldwide 

income vary widely from year to year, and from company to company, based on the 

range of foreign operations and the sophistication of their tax planning.

The current system likely distorts economic decisions to a greater extent and is 

more complex than a system that simply exempted active foreign business income 

from U.S. tax. Despite its complexity, the current U.S. system raises relatively little 

revenue, at a high cost, from the foreign income of U.S. multinational corporations. 

Further, arranging affairs to avoid U.S. taxation of foreign earnings is costly for U.S. 

multinational corporations, and these costs differ across companies. The result is a 

system that distorts business decisions, treats different multinationals differently, and 

encourages wasteful tax planning. 
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R E C O M M E N D A T I O N

√ Update our system of international taxation.

The Panel concluded that our international tax rules are in need of major reform. 

Income taxes and consumption taxes raise different international tax questions, 

and the Panel’s Simplified Income Tax Plan and Growth and Investment Tax Plan 

include different international tax components. However, each proposal is intended 

to reduce economic distortions and improve the fairness of the U.S. international tax 

regime by creating a more level playing field that supports U.S. competitiveness.

The Simplified Income Tax Plan would exempt dividends paid from the active 

earnings of controlled foreign corporations and foreign branches of U.S. corporations 

from U.S. taxation to provide a simpler and more even treatment of cross-border 

investment by U.S. multinational corporations. Under the new system, territorial 

taxation of active foreign business income would be available to all U.S. multinational 

corporations, not just those that are able to "self-help" themselves to this result or 

its functional equivalent. The new system is designed to make U.S. businesses more 

competitive in their foreign operations, while reducing the extent to which tax 

planning allows some multinationals to achieve more favorable result than others. 

The Growth and Investment Tax Plan would use domestic consumption as a tax base. 

This tax system is designed to improve incentives for foreign multinationals to invest 

in the United States, just as it would improve incentives for domestic investment by 

domestic investors more generally. The system also levels the playing field between 

domestic production and imports by assuring that all goods and services consumed 

in the United States face the same consumption tax burden. Using domestic 

consumption as a tax base strengthens tax administration by helping to prevent tax 

avoidance schemes involving foreign parties. 

Elimination of an Inefficient Tax – The Corporate AMT

R E C O M M E N D A T I O N

√ Eliminate the Corporate AMT.

As with taxes for individuals, many corporations are subject to a second, parallel tax 

– the corporate AMT. Like the individual AMT, the corporate AMT has been used 

to pare back the cost of certain tax benefits. Under the corporate AMT, corporations 

are required to keep two different sets of books and records, and calculate their tax 

liability under two very different sets of rules – the regular income tax rules with rates 

of up to 35 percent, and the corporate AMT rules at rates of up to 20 percent – and 

then pay the larger of the two amounts. The existence of these two radically different 

tax codes with dozens of complex differences between them makes rational tax 
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planning, administration, and compliance geometrically more difficult. In addition to 

its complexity, the corporate AMT may exacerbate business cycles during economic 

downturns by making corporations that are realizing losses under the regular income 

tax pay additional taxes under the AMT.

The Panel recommends the repeal of the corporate AMT, an inefficient tax that 

imposes enormous compliance costs on corporations relative to the amount of tax 

revenue it actually generates. Both of the Panel’s options for reform would provide a 

clean tax base that is free of special breaks targeted to specific industries or business 

activities. Accordingly, none of the Panel’s options include a second, parallel tax 

system like the AMT to pare back tax benefits for certain taxpayers. 

Conclusion

The common elements and common principles provide a solid foundation for the 

Panel’s reform options. The reform options described in the next chapter represent 

comprehensive packages that build on these common features to provide a range of 

approaches to making our current tax code simpler, fairer, and more efficient.
Chapter Six

The Simplified Income Tax Plan

The President directed the Panel to submit at least one option using the current 

income tax system as a starting point for reform. The Panel developed the Simplified 

Income Tax Plan to meet this objective. This chapter describes the Simplified Income 

Tax Plan and the impact it would have on taxpayers and the economy. It begins 

with an explanation of the provisions of the plan, and how they would simplify the 

tax system for individuals and businesses. Next, it summarizes the effect of the plan 

on issues of tax fairness, such as tax burden and distribution. Finally, this chapter 

closes with a discussion of the expected impact on the economy, including improved 

economic output and reduced compliance and administrative costs.

The Simplified Income Tax Plan would simplify the process of filing taxes and 

would make it easier to predict tax consequences when planning for the future. It 

would consolidate and streamline a number of major features of our current code 

– exemptions, deductions, and credits – that are subject to different definitions, limits, 

and eligibility rules. It would make the tax benefits for home ownership, charitable 

giving, and health coverage available to more taxpayers, simpler to calculate, and 

Courtesy of Marina Sagona
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more efficient. It would repeal the AMT. It would lower tax rates, ensuring that 

individuals would not pay more than one-third of their income in federal income tax. 

And it would nearly eliminate taxes paid by individuals on income from corporate 

investments that are taxed in the United States. 

Table 6.1. Simplified Income Tax Plan for Households

Provisions Simplified Income Tax Plan

Households and Families

Tax Rates Four tax brackets: 15%, 25%, 30%, 33%

AMT Repealed

Personal exemption Replaced with Family Credit available to all taxpayers: $3,300 credit for 

married couple, $2,800 credit for unmarried with child, $1,650 credit for 

singles, $1,150 credit for dependent taxpayer; additional $1,500 credit for 

each child and $500 credit for each other dependent 

Standard deduction

Child tax credit

Earned income tax credit Replaced with Work Credit (and coordinated with the Family Credit); 

maximum credit for working family with one child: $3,570; with two or 

more children, $5,800

Marriage penalty Reduced. All tax brackets, Family Credits, and taxation of Social Security 

benefits for couples are double those of individuals 

Other Major Credits and Deductions

Home mortgage interest Home Credit equal to 15% of mortgage interest paid; available to all 

taxpayers; mortgage limited to average regional price of housing (limits 

ranging from about $227,000 to $412,000)

Charitable giving Deduction available to all taxpayers (who give more than 1% of income); 

rules to address valuation abuses

Health insurance All taxpayers may purchase health insurance with pre-tax dollars, up to the 

amount of the average premium (estimated to be $5,000 for an individual 

and $11,500 for a family).

Education Taxpayers can claim Family Credit for some full-time students; simplified 

savings plans

State and local taxes Not deductible

Individual Savings and Retirement

Defined contribution plans Consolidated into Save at Work plans that have simple rules; AutoSave 

features point workers in a pro-saving direction

Defined benefit plans No change

Retirement savings plans Replaced with Save for Retirement Accounts ($10,000 annual limit) 

– available to all taxpayers

Education savings plans Replaced with Save for Family Accounts ($10,000 annual limit); would cover 

education, medical, new home costs, and retirement saving needs; available to 

all taxpayers; refundable Saver’s Credit available to low-income taxpayers Health savings plans

Dividends received Exclude 100% of dividends of U.S. companies paid out of domestic earnings 

Capital gains received Exclude 75% of corporate capital gains from U.S. companies (tax rate would 

vary from 3.75% to 8.25%)

Interest received (other than 

tax exempt municipal bonds)

Taxed at regular income tax rates

Social Security benefits Replaces three-tiered structure with simple deduction. Married taxpayers 

with less than $44,000 in income ($22,000 if single) pay no tax on Social 

Security benefits; fixes marriage penalty; indexed for inflation
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Chapter Six

The Simplified Income Tax Plan includes a comprehensive proposal to replace the 

maze of rules for saving for retirement, education, and health care with a simple 

structure that would allow most Americans to save tax-free. The savings proposal 

would consolidate the numerous savings-related provisions in our current code into 

three simple savings plans – Save at Work, Save for Retirement, and Save for Family 

accounts. Low-income taxpayers would receive a match for retirement savings 

contributions through a refundable credit. The savings package also would ensure 

that income earned outside these savings accounts would be taxed the same as other 

income by providing for more uniform tax treatment of financial income.

For businesses, the Simplified Income Tax Plan is designed to simplify tax filing and 

provide a more even tax treatment of business activities for businesses of all sizes. 

For small businesses, the Simplified Income Tax Plan would substantially simplify 

taxes by allowing them to use an accounting methodology that reflects the way 

most entrepreneurs manage and conduct their businesses. Ninety-five percent of 

all businesses – those with receipts under $1 million – would report their business 

income based on what goes into and out of their checking account: business receipts 

minus business cash expenses (other than purchases of land and buildings). Mediumsized businesses – those with more than $1 million but less than $10 million in 

receipts – would report on the same cash basis as small businesses, but would be 

required to depreciate rather than expense the purchase of new assets and, in some 

cases, maintain inventories. 

Table 6.2. How the Tax Code Would Change for Businesses

Provisions Simplified Income Tax Plan

Small Business

Rates Taxed at individual rates (top rate has been lowered to 33%)

Recordkeeping Simplified cash-basis accounting

Investment Expensing (exception for land and buildings under the 

Simplified Income Tax Plan)

Large Business

Rates 31.5% 

Investment Simplified accelerated depreciation

Interest paid No change

Interest received No change

International tax system Territorial tax system

Corporate AMT Repealed 

Under the Simplified Income Tax Plan, large businesses would be taxed at a single 

rate of 31.5 percent, significantly lower than the 35 percent rate that currently applies 

to most corporate income. The Simplified Income Tax Plan would provide simpler 

rules for business investment and eliminate many of the special tax preferences in the 

current code. Indeed, over 40 special provisions would be eliminated. It would also 
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eliminate the double tax on corporate profits earned in the United States. Finally, 

it would provide a simpler and more efficient international tax system to reduce 

complexity and help American businesses of all sizes compete globally.

The Simplified Income Tax Plan also would greatly reduce compliance costs and the 

time and money spent doing taxes. As explained in more detail later in this chapter, 

the tax returns that would be filed under the Simplified Income Tax Plan would be 

much simpler and more straightforward. Most taxpayers would file a one-page tax 

return that could even fit on the front and back of a postcard. Some taxpayers would 

have to file additional forms or schedules, but those would be much simpler than the 

maze of paperwork that many taxpayers face under our current system. Because taxes 

would be easier to compute and file, cheating and other forms of noncompliance 

would be more difficult. 

The Simplified Income Tax Plan would be as progressive as the current income tax. 

Under the Simplified Income Tax Plan, most taxpayers would pay about the same in 

taxes as they are expected to pay under current law. Some specific taxpayers may pay a 

bit more or a bit less, but most taxpayers would find that their actual tax bill is about 

the same. The difference is that all taxpayers would face significantly less hassle and 

uncertainty.

Finally, several aspects of the Simplified Income Tax Plan would promote economic 

growth. First, the plan would provide simplified and expanded opportunities for taxfree saving. Second, the double tax on corporate profits would be nearly eliminated. 

Third, there would be simplified accounting and improved investment incentives 

for millions of small businesses. Lastly, there would be lower marginal tax rates on 

individuals and businesses.

How it Works: Streamlining the Tax Process for All Taxpayers

A Simpler Tax System for Families

Under our current tax code, many families struggle with complex forms as they seek 

to pay their taxes accurately. Under the new system, almost half of all taxpayers would 

be able to file their entire tax return on a single page. The Simplified Income Tax Plan 

would make the process far more streamlined and simpler to understand, and would 

allow a family to compute their taxes after following a few easy steps:

1. Compute income from wages, interest, and dividends by copying amounts 

from annual forms sent to the taxpayer by employers and payers, such as W-2 

or 1099 forms. 

2. Compute tax by looking up the tax liability that corresponds to income in a 

table. Almost three-quarters of all households will pay tax on their income at 

the lowest tax rate. 

3. Compute the value of the taxpayer’s Family Credit amount based on family 

size; subtract that value from the tax due to find out the amount owed or to be 

refunded.
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There are exceptions to this relatively simple process; but only three would affect 

substantial numbers of taxpayers, and these would not require complex calculations. 

These provisions cover newly designed ways to provide tax benefits for home 

ownership, charitable giving, and health insurance coverage. As described in Chapter 

Five, the Panel recommends restructuring these tax benefits to make them simpler 

and fairer. For the Home Credit and charitable deduction, taxpayers would be sent 

forms by mortgage lenders and charities, and many taxpayers would do little more 

than copy the amounts from the forms onto their tax returns. Tax benefits for health 

insurance coverage also would be available to all taxpayers through a new deduction 

for health insurance. The majority of workers would not have to deal with claiming 

the deduction on their returns because tax-free health insurance received on the job 

would already be excluded from taxable wages reported to them by their employers.

Two newly designed provisions would apply only to lower-income taxpayers. Lowerincome workers would be eligible to receive the refundable Work Credit described 

in Chapter Five, and lower-income savers would be eligible to receive the new 

refundable Saver’s Credit, which is described below. These refundable credits would be 

targeted to taxpayers who have little or no federal income tax liability. 

In addition, the Simplified Income Tax Plan would provide a much simpler way to 

measure the taxable amount of Social Security benefits. Married taxpayers who have 

less than $44,000 in income and single taxpayers with less than $22,000 in income 

would not pay tax on their Social Security benefits – about 60 percent of Social 

Security recipients would fall below these thresholds. As described in Chapter Five, 

taxpayers with income above the thresholds would include between 50 and 85 percent 

of their benefits in their taxable income depending on their income level – but unlike 

the current system, that computation would be straightforward. In addition, the new 

rules for calculating tax on Social Security benefits would eliminate the marriage 

penalties and the automatic, inflation-induced tax increases that our current code 

imposes. 

Tax would be computed using four marginal tax rates – 15, 25, 30, and 33 percent 

– instead of the six rates that exist under current law. As summarized in the Table 6.3, 

the rate brackets for married taxpayers would be twice the amounts for unmarried 

taxpayers, which would reduce marriage penalties.

Table 6.3. Tax Rates Under the Simplified Income Tax Plan 

Tax Rate Married Unmarried

15% Up to $78,000 Up to $39,000

25% $78,001 - $150,000 $39,001 - $75,000

28% $150,001 - $200,000 $75,001 - $100,000

33% $200,001 or more $100,001 or more
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Under the Simplified Income Tax Plan, the most complicated fixtures of our current 

system would be eliminated. Almost every tax benefit currently available to taxpayers 

comes with strings attached – the benefits are reduced when taxpayers reach a 

specified income level. Rules that target benefits to a limited number of taxpayers 

through phase-outs create tremendous complexity. Almost no two benefits are 

phased out the same way: Phase-outs use different threshold amounts (the amount 

of income at which benefits begin to fade), phase-out rates (the speed at which 

benefits disappear), and definitions of “income.” These differing rules effectively cause 

taxpayers to compute their income multiple ways to find out how much of the tax 

benefits they lose. Under the Simplified Income Tax Plan, most taxpayers would not 

have to worry about making numerous, complex calculations to determine whether 

they are eligible for a particular tax preference or applying other complicated rules 

designed to restrict who can claim a tax benefit. The Simplified Income Tax Plan 

eliminates almost all of these phase-outs.

One of the most conspicuous complexities in our current system is the AMT. As 

discussed previously, the AMT is a parallel tax structure that requires taxpayers to 

recompute their tax liability using a new definition of income, different exemption 

amounts, different deductions and credits, and separate tax rates. The AMT takes 

back tax benefits that have previously been given to taxpayers through a complicated 

and deceptive mechanism. The AMT also makes it difficult for taxpayers to predict 

their tax liability in advance. If not repealed, millions more middle-class Americans 

will face a tax increase each year, as well as additional complexity and compliance 

costs. Under the Simplified Income Tax Plan, taxpayers would only be required to 

make one straightforward set of computations to determine their share of the cost of 

government. The Simplified Income Tax Plan would not rely on a backstop or second 

set of rules like the AMT. 

Simpler and more straightforward rules would result in simpler tax returns and forms. 

The new Form 1040-Simple that would be used under the Simplified Income Tax 

Plan is easy to understand and involves calculations that are intuitive. As shown in 

Figure 6.1, the Form 1040-Simple would be no longer than one page. It would be a 

tremendous simplification as compared to the current Form 1040. 
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Figure 6.1. Form 1040-Simple
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For the approximately 38 percent of taxpayers who have children and other 

dependents, the Family Credit would be claimed on new Schedule A, which would 

assist taxpayers in making the straightforward computation. Computation of the 

refundable Work Credit would follow from the simple Family Credit computation 

on Schedule A. Taxpayers could even indicate their desire for the IRS to calculate the 

Work Credit for them by checking a box on new Schedule A. In total, 75 percent of 

current law filers would file, at most, the Form 1040-Simple and Schedule A.

The proposed tax forms take into account both the Panel’s reform proposals and a 

number of other refinements that would reduce compliance burdens and streamline 

return processing. The Panel recognizes that some of these refinements reflect a 

departure from the way the IRS currently constructs and processes Form 1040. 

This simplification would have a real impact on millions of Americans. The Simplified 

Income Tax Plan would reduce the time individuals spend doing their taxes and 

the records they have to keep. The Simplified Income Tax Plan also would reduce 

taxpayers’ out of pocket costs for help with tax preparation and allow more taxpayers 

to prepare their own tax returns if they so choose. More importantly, under the 

Simplified Income Tax Plan, taxpayers would have a better understanding of how 

their taxes are computed.

Perhaps more valuable would be the greater confidence a simplified system would 

engender in our tax code. Taxpayers could file their taxes knowing they had 

determined their tax liabilities correctly. Taxpayers would feel more confident that 

they had not overlooked tax benefits available to them and that others are paying 

their fair share. The simpler and more transparent tax system also would be less 

susceptible to tax avoidance. 

The greater transparency under the Simplified Income Tax Plan also would allow 

taxpayers to make better and more efficient economic decisions. Planning for the 

future – how much to save, for example – would no longer be complicated by the 

tax code’s current set of elaborate rules. In addition, there would be fewer unpleasant 

surprises each April because taxpayers would not be caught off guard by phase-outs 

and the AMT that force them to pay more taxes than anticipated. 

A Comprehensive Proposal To Remove Impediments to Saving 

As described in Chapter Five, the current tax system discourages saving by imposing a 

higher tax on those who choose to save than those who spend. The Simplified Income 

Tax Plan includes a comprehensive package of savings proposals designed to allow 

Americans to save in a simple and efficient manner. The savings proposal consists of 

three parts. First, it would replace the current tax code’s plethora of savings incentives 

with a unified system of expanded savings opportunities. Second, it would provide 

a refundable credit as an incentive for lower-income taxpayers to save. Third, it 

would introduce a more consistent treatment of savings held outside of tax-preferred 

accounts. The Panel believes that all components of this package should be considered 

together, and would not necessarily recommend adoption of some components 

without the others.
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Flexible, Convenient, and Straightforward Savings Opportunities

The first component of the Simplified Income Tax Plan’s savings proposals would 

combine the tax code’s panoply of savings incentives and accounts into three simple 

and flexible opportunities: (1) Save at Work plans; (2) Save for Retirement accounts; 

and (3) Save for Family accounts. The Save at Work plans would incorporate changes 

to the way plans are administered, referred to as “AutoSave,” that are designed to 

point workers in the direction of savings. The creation of these three opportunities 

would allow most Americans to save for their future financial needs, such as 

education, health costs, a new home, or retirement, free of tax. They would also largely 

eliminate the need for taxpayers to hire tax professionals to help them navigate the tax 

code’s multitude of savings incentives. Americans would be able to make investment 

decisions based more on their preferred investment strategy, rather than the effects 

that certain tax-preferred investment vehicles have on their tax liability.

Save at Work

For millions of Americans, employer-provided retirement plans have been an integral 

part of retirement security. Over 90 million workers utilize some type of tax-preferred 

retirement savings plan at work. The benefits of employer-sponsored retirement 

savings accounts are not evenly distributed among the population, however. Taxpayers 

whose employer offers a retirement plan pay less tax on their income than those 

whose employers who do not. In addition, employees who work for employers that 

offer tax-free matching contributions receive more favorable treatment than those 

whose employers do not offer a match.

The rules covering tax-preferred retirement savings are among the most complex in 

the tax code and may be a barrier to additional retirement saving by workers. Current 

law provides a number of different plans, including 401(k), SIMPLE 401(k), Thrift, 

403(b), governmental 457(b), SARSEP, and SIMPLE IRA plans, that offer different 

kinds and amount of benefits to employees and are subject to different rules and 

standards. This variation and complexity creates high administrative and compliance 

costs. Those costs often prove to be a deterrent to employer sponsorship of retirement 

plans, making such tax-preferred savings unavailable to many workers. Only about 

53 percent of private employers offer a defined contribution retirement plan to their 

workers. Administrative costs are a particular problem for small firms – less than 25 

percent sponsor any retirement plan. 

Small employers, which employ about 40 percent of American workers, can choose to 

offer either a 401(k) or SIMPLE IRA plan to employees, but each provides different 

rules governing employee eligibility, contribution amounts, catch-up amounts, and 

employer matching limits, among other features as summarized in Table 6.4. These 

different rules create significant obstacles for small employers because they find it difficult 

to determine which plan best fits the needs of their employees at the lowest cost. 
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Table 6.4. Example of Variation in Small Employer Retirement Plans

401(k) Plan SIMPLE IRA Plan

Pre-tax Contribution 

Amount $14,000 in 2005 $10,000 in 2005

Catch-Up Amounts $4,000 in 2005 $2,000 in 2005

Employer Matching May be matching and/

or nonelective

Either a full match on elective 

contributions up to 3% of pay or 2% 

nonelective contribution

Nonelective 

Contributions

Matching not limited 

to 3% and match may 

be less than full

Nonelective contributions limited to 

2% of pay

Discrimination Testing Yes No

Vesting Vesting schedule may 

be added Full vesting of employer contribution

Top Heavy 

Contributions May be required Not Required

Plan Loans Permitted Not permitted

Other Plans May adopt other 

qualified plans

May not sponsor any other SIMPLE 

plan or qualified plan

Pooling of Plan Assets

May pool §401(k) 

contributions into a 

single trust invested by 

trustee

Individual assets within IRAs invested 

by employees

Eligibility

Eligibility may exclude 

employees with less 

than 1,000 hours of 

service

Eligibility must include employee who 

earns $5,000 or more during calendar 

year

ERISA Applicability Protects benefits from 

creditors Not applicable

Required Return Form 5500 annual 

filing No Form 5500 filing
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The complexity of employer-sponsored retirement savings plans also affects 

employees. Account holders have to negotiate convoluted rules when changing jobs, 

for example. Given that job change is a feature of today’s workforce, complexity in 

handling retirement savings disrupts workers’ retirement savings patterns. It is not 

uncommon for a worker to have multiple 401(k) accounts spread out among past 

employers, each holding modest amounts. It is also not uncommon for separated 

workers to withdraw funds from a 401(k) plan, pay tax and an additional penalty, 

and spend what is left – instead of moving the funds into a new tax-preferred savings 

vehicle. The most recent studies suggest as of 1996, a sizable majority of workers 

who receive a lump-sum distribution of $5,000 or less from their former employer’s 

retirement plan do not roll it over to another qualified plan or IRA, reducing the 

funds set aside to support the employee’s future retirement. 

The employer-provided Save at Work retirement plan would combine 401(k), 

SIMPLE 401(k), Thrift, 403(b), governmental 457(b), SARSEP, and SIMPLE IRA 

plans into a single type of plan that could be easily established by any employer. To 

encourage employers to make the Save at Work accounts available to their employees, 

a single set of administrative rules would be established. Save at Work plans would 

be less expensive for employers to administer, reducing compliance costs. In addition, 

the AutoSave features described below would change the administrative rules to 

encourage greater savings by workers. Save at Work plans would follow the existing 

contribution limits and rules for 401(k) plans, but the plan qualification rules would 

be greatly simplified. 

Under current law, there are a number of complicated rules that ensure that highly 

compensated employees do not enjoy undue benefits from tax-deferred saving plans. 

These rules, known as “nondiscrimination requirements” generally apply a set of tests 

that ensure that highly compensated employees do not receive disproportionately 

high benefits relative to other employees. To simplify administration, Save at Work 

plans would apply a single test to ensure that employee contributions are not skewed 

towards highly compensated employees. In addition, an alternative rule would be 

provided to allow employers to avoid nondiscrimination testing altogether if the Save 

at Work plan is designed to provide consistent employer contributions to each plan 

participant, regardless of their compensation.

The Save at Work option also would include rules for small businesses to help reduce 

costs and encourage them to offer plans. Small employers with 10 or fewer employees 

could contribute to a Save at Work account largely controlled by the employee and 

similar to current-law SIMPLE IRAs. Like current-law SIMPLE IRAs, small 

business owners would not be required to file annual returns for these accounts and 

would not be subject to the same legal liability rules that apply to larger employersponsored plans. 
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AutoSave

The Save at Work plan would be accompanied by a number of features, referred to 

as AutoSave, that are designed to point workers in the direction of sound saving 

and investment decisions. Firms would be permitted, but not required, to include 

AutoSave as part of their retirement plan structure. The Panel’s recommendation 

would remove restrictions that may currently discourage employers from 

implementing AutoSave. The AutoSave program would incorporate the following 

features:

• Automatic Enrollment in Save at Work - Employees would automatically 

become participants in their employer’s Save at Work plan unless they actively 

choose not to participate. 

• Automatic Growth in Save at Work Contributions – The employee 

contribution percentage would automatically increase over time – either 

through scheduled periodic increases or increases conditioned on pay raises 

over time – to boost the proportion of earnings set aside and total accumulated 

retirement savings.

• Automatic Investment of Save at Work Contributions – Employee 

contributions would be invested in balanced, diversified alternatives with 

low fees, such as broad index or life-cycle funds, unless the employee elects 

different investment alternatives. 

Box 6.1. Eliminating Impediments to Saving 

Through Better Retirement Plan Design

Employer-provided retirement plans are designed to eliminate impediments to saving by 

reducing the tax on returns to savings. But studies have found that the return on savings 

is not the only factor that influences savings decisions: The structure of retirement savings 

plans and the way employers present them to employees affects their decisions to save. 

Currently, participation in most employer-sponsored plans is dependent on the worker 

actively choosing to participate. Until recently, most believed that the voluntary aspects of 

employer-sponsored retirement savings had little to do with participation. In fact, a number 

of recent studies show the exact opposite result.

One study, focusing on firms that automatically enrolled their employees in the savings 

program unless the employee actively chose not to participate found significant increases 

in employee participation and contribution levels. In some cases, participation rates doubled 

to more than 90 percent. Employees also tended to adopt the default contribution amount 

and asset allocations, which invested employee contributions in balanced and diversified 

investment funds. 

In another study, employees were given the option to commit a share of future salary 

increases to savings. Nearly 80 percent of employees who were offered the plan chose to 

participate and savings rates for participants more than tripled in just 28 months.

The study also found that default rules for disbursement when employees leave their jobs 

influence decisions to continue saving. If cash disbursement of retirement balances is the 

default option, employees tend to accept cash instead of putting the funds back into a tax-free 

savings account. On the other hand, employees whose default option was to automatically 

move the funds into an IRA or other retirement plan continued to save these funds.
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• Automatic Rollover – Upon leaving a job, an employee’s Save at Work plan 

balance would be retained in the existing plan or would be automatically 

transferred to a Save at Work account with their new employer, or to a rollover 

Save for Retirement account. Automatic rollover would ensure that amounts 

put aside for retirement continue to grow. 

None of the AutoSave features would be mandatory and employees would be able to 

opt out of AutoSave at any time. Furthermore, employers would choose which default 

to use. The AutoSave features do not dictate choices, but merely point workers in a 

pro-saving direction when they fail to indicate their saving preferences. Provisions to 

ensure that employees retain control over enrollment and investment decisions would 

be incorporated. AutoSave plans would be required to provide participants with 

advance notice and an adequate opportunity to make their own, alternative choices 

before proceeding with the default option. 

The Panel recommends that the following provisions be adopted as part of its 

AutoSave proposal. First, current law should be clarified to confirm that federal 

laws permitting automatic payroll deductions for retirement plans supersede any 

state laws that might prohibit this practice. Second, fiduciary liability protection 

against investment losses would be extended to sponsors of Save at Work plans that 

incorporate AutoSave features to the same extent provided by current law to all plans 

in which the employee exercises control over the investment of plan assets. Third, 

AutoSave plans would be entitled to discrimination testing that is less stringent than 

current law. Finally, to demonstrate leadership in this area, the Panel also recommends 

that the federal government adopt Auto-Save for its Thrift Savings Plan.

Save for Retirement

Save for Retirement accounts would allow taxpayers to supplement their Save at 

Work retirement savings by putting up to an additional $10,000 (or the total amount 

of earnings, if less) in tax-free accounts. The annual contribution amount would be 

indexed annually for inflation. No income limits would apply to Save for Retirement 

accounts. 

The Save for Retirement accounts would replace existing IRAs, Roth IRAs, 

Nondeductible IRAs, deferred executive compensation plans, and tax-free “inside 

buildup” of the cash value of life insurance and annuities. Contributions would be 

made with after-tax dollars like current law Roth IRAs and earnings would grow taxfree. 

Roth IRAs would be automatically converted to Save for Retirement accounts. 

Existing traditional IRAs (including those to which nondeductible contributions 

were made) could be converted into a Save for Retirement account by subjecting 

the value of those accounts to taxes once, similar to a current-law conversion of a 

traditional IRA account to a Roth IRA account. No income limits would restrict 

conversions. Similarly, upon separation, Save at Work plans could be rolled directly 

from an employer plan into a Save for Retirement account by paying income tax 

on the rollover amount. Existing traditional IRAs not converted into a Save for 
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Retirement account would continue to exist, but new contributions would have to be 

made to Save for Retirement accounts.

The Save for Retirement accounts are intended to supplement, not replace, retirement 

savings incentives provided through Save at Work accounts. The Save for Retirement 

accounts are proposed as part of a savings package that includes the Save at Work 

and AutoSave proposals, which are designed to ensure that the cost to employers 

of sponsoring a plan would be low and that more workers participate in employersponsored retirement plans. 

To increase the likelihood that money set aside for retirement would not be spent 

early, Save for Retirement accounts would restrict distributions. Tax-free distributions 

from Save for Retirement accounts could be made only after age 58, or in the event 

of death or disability. Earlier distributions would be treated as taxable income and 

would be subject to an additional 10 percent tax, similar to the penalty paid on early 

withdrawals from Roth IRAs under current law. No minimum distribution rules 

would apply.

Under current law, there are exceptions for early withdrawal for education, first-time 

home buyer expenses, and medical expenses. These exceptions would no longer be 

necessary under the Simplified Income Tax Plan because Save for Family accounts, 

described below, would provide a separate vehicle to save for these important family 

needs.

Save for Family

The Simplified Income Tax Plan would provide flexible Save for Family accounts that 

could be used by taxpayers for retirement, health, education and training, or a down 

payment on a home. Save for Family accounts would allow every taxpayer to save 

$10,000 each year for these major expenditures, and would replace existing education 

and medical accounts, including Coverdell Education Savings Accounts, Section 529 

Qualified Tuition Plans, Health Savings Accounts, Archer Medical Savings Accounts, 

and employer-provided Flexible Spending Accounts. In addition, Save for Family 

accounts could be used to supplement retirement savings. 

All Americans, regardless of income, age, family structure, or marital status, could 

have a Save for Family account. Contributions would be made on an after-tax basis, 

and like current-law Roth IRAs, earnings would grow tax-free. Existing education 

and health savings plans could be converted to Save for Family accounts. Existing 

accounts that are not converted would continue, but all new contributions would be 

made to Save for Family accounts.

Tax-free withdrawals from Save for Family accounts could be made at any time to 

pay qualified expenditures for health or medical costs, education or training expenses, 

and purchases of a primary residence. As with Save for Retirement accounts, funds 

would be available tax-free at any time to taxpayers who are 58 or older. 

To provide taxpayers even greater flexibility and to reduce record-keeping burdens, 

taxpayers would be able to withdraw up to $1,000 tax-free each year from Save for 
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Save for Retirement Accounts 

($10,000 annual contribution limit)

Save for Family Accounts 

($10,000 annual contribution limit)

Family accounts for any reason. Distributions in excess of $1,000 that are not for 

qualified expenditures would be treated as taxable income and would be subject to an 

additional 10 percent tax, similar to the penalty paid on early withdrawals from Roth 

IRAs under current law. No minimum required distribution rules would apply.

Figure 6.2. Summary of Simplification Created by New Save 

for Retirement and Save for Family Accounts

Retirement Accounts

Description Contribution Limit

IRAs2 $4,000 ($5,000 in 2008) 1

Roth IRAs1 $4,000 ($5,000 in 2008) 1

Health Incentives

Description Contribution Limit

Health Savings Accounts 

(HSAs) 2 $2,600 single/$5,150 family

Archer MSAs2 (small 

businesses and selfemployed)

75 percent of deductible for high 

deductible 

health plan

Flexible Spending 

Arrangements2

Unlimited (but portion may 

be forfeited if not used within 

prescribed time periods)

Education Savings Incentives

Description Contribution Limit

Coverdell Savings Accounts $2,000 (per student) 1

Qualified Tuition Programs 

(529s) Effectively unlimited

Savings Bonds Interest excludible up to qualified 

higher education expenses1

Other Tax Preferred Savings

Description Contribution Limit

Life Insurance Unlimited

Executive Deferred 

Compensation Unlimited

1

 Contribution limit may phase out based on income.

2

 Contributions made to these accounts are excluded from income.
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The New Refundable Saver’s Credit

The Simplified Income Tax Plan savings proposals are designed to increase the 

likelihood that taxpayers will save more and to help establish a habit of saving and 

familiarity with the financial markets. As noted in Chapter Three, the progressivity of 

our current income tax relieves many lower-income Americans from paying any tax. 

The tax-free features of the Save at Work, Save for Retirement, and Save for Family 

accounts therefore would provide little, if any, additional tax benefit if these taxpayers 

save for their future. The second component of the Simplified Income Tax Plan’s 

savings proposal would provide a subsidy for lower-income taxpayers to save.

Under current law, taxpayers with low to moderate incomes are eligible to receive the 

credit for qualified savings contributions (sometimes referred to as the “saver’s credit”). 

The saver’s credit provides a credit for 10, 20, or 50 percent of contributions of up to 

$2,000 made to an Individual Retirement Account (IRA) or an employer-sponsored 

defined contribution plan. The credit is phased out as the taxpayer earns more. 

This credit is scheduled to expire after 2006. In addition, it has several design flaws 

that make it less effective than it could be in encouraging low-income taxpayers to 

save. Because the credit is nonrefundable, lower-income taxpayers who do not have 

tax liability receive no benefit from the credit. The combination of nonrefundability 

and income phase-outs as taxpayers earn more means that many taxpayers are 

unable to receive the full amount of the credit. The maximum credit of 50 percent 

is available to married couples with adjusted gross income (AGI) up to $30,000, 

head of household filers with AGI up to $22,500, and single filers with AGI up to 

$15,000, but quickly phases down to 10 percent once the taxpayer earns income above 

these thresholds. Head of household and single taxpayers are unable to receive the 

maximum $1,000 credit because their tax liability over the range where the 50 percent 

credit is applicable is always below $1,000. The complexity of the credit, its limited 

benefit to the targeted taxpayer group, and a lack of awareness of the credit have all 

contributed to its underutilization.

Recent studies suggest that lower-income taxpayers are responsive when given 

clear incentives to contribute to retirement accounts. These studies suggest that the 

presence of a meaningful match that is presented at the time of tax preparation can 

have a sizeable impact on the percentage of lower-income taxpayers who save and the 

amounts saved.

The Simplified Income Tax Plan would replace the current law credit with a new 

refundable Saver’s Credit that would be available to more lower-income taxpayers. 

The maximum annual contribution eligible for the credit would be $2,000 and the 

credit rate would be 25 percent, making the maximum credit amount $500. This 25 

percent credit would effectively provide an implicit government match rate of 33 

percent: a $2,000 contribution reduces the taxpayer’s income tax liability by $500, so 

the taxpayer’s net contribution of $1,500 results in an account balance of $2,000.

The amount of the new Saver’s Credit is calculated on a per-person basis. Although 

eligibility for the new Saver’s Credit would be gradually reduced as taxpayers earn 
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more than $30,000 if married and $15,000 if single, it would be fully refundable. 

The credit would phase-out smoothly at a rate of 5 percent: each additional $100 

of earnings would reduce the credit amount by $5. The credit would be completely 

phased out at income levels of $40,000 for married couples and $25,000 for single 

taxpayers. To help encourage new savings and prevent taxpayers from merely shifting 

savings from one tax-preferred account to another, the credit would be required to 

be deposited into a Save for Retirement or a restricted Save for Family account. The 

restricted Save for Family account would not permit annual $1,000 unrestricted 

withdrawals. If the taxpayer has not qualified for a match in five years, the funds in 

the restricted Save for Family account could be transferred to a regular, unrestricted 

Save for Family account.

It is also important that the taxpayer would not, by reason of depositing savings that 

qualify for the Saver’s Credit, lose eligibility for other means-tested programs, such as 

food stamps, temporary assistance for needy families, or Pell Grants. Thus, the Panel 

recommends that these assets be ignored for purposes of determining whether the 

taxpayer is eligible for a means-tested federal assistance program.

Leveling the Playing Field for Savings

An important element of the savings proposals included in the Simplified Income 

Tax Plan would provide a more neutral treatment for financial income earned outside 

of Save for Retirement, Save for Work, or Save for Family accounts. Currently, 

there are no annual limits on the tax benefits for certain deferred compensation 

arrangements and increases in the cash-value of annuities and life insurance. The 

Panel recommends that new rules be put in place to treat these arrangements like 

other investments. 

Some life insurance policies and annuities allow for nearly unlimited tax-free savings. 

Currently, there is no taxable income until the policy is cashed in, even though the 

policyholder is receiving the benefit of increases or “inside build-up” in the value of 

the policy or annuity. In addition, withdrawals from policies are taxed favorably. 

Under the Simplified Income Tax Plan, the increase in value in those policies would 

be treated as current income, and therefore would be subject to tax on an annual 

basis, just like a savings account. As with other financial investments, such as stocks 

or bonds, whole-life insurance policies and deferred annuities could be purchased 

through tax-deferred Save for Retirement and Save for Family accounts, subject to 

the same dollar limits. Life insurance that cannot be cashed out and annuities that 

provide regular, periodic payouts of substantially equal amounts until the death of the 

holder (known as life annuities) would not be taxed on an inside build-up, the same 

treatment as under current law. 

The Simplified Income Tax Plan also would eliminate the ability of some taxpayers to 

save tax-free through the use of executive deferred compensation plans. These plans 

allow executives to elect to defer a portion of their compensation in order to receive 

an amount later that has grown tax-free. Recently enacted legislation tightened 

the rules applicable to deferred executive compensation, but retained a number of 
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exceptions that allow tax-free growth on deferred wages. The Simplified Income Tax 

Plan would require all amounts deferred under a nonqualified deferred compensation 

plan to be included in income to the extent these amounts are not subject to a 

substantial risk of forfeiture and were not previously included in income.

Annuities, life insurance arrangements, and deferred compensation plans that 

currently are in existence would continue to be taxed under current-law rules. 

Currently, interest earned on tax-exempt bonds is not taxed. Providing an incentive 

for investment in public infrastructure is seen as sensible public policy that is widely 

valued. Similar to preferences for home ownership, charitable giving, and health 

coverage, the Panel chose to maintain current law treatment of state and local taxexempt bonds for individual investors. The Panel recommends, however, that because 

of the flexibility businesses have to deduct interest, the exclusion from business 

income for state and local tax-exempt bond interest be eliminated. Although current 

law disallows interest paid by businesses to buy or carry tax-exempt bonds, the rule is 

difficult to administer and easy to avoid. 

As under current law, individual investors would be able to deduct the amount of 

interest incurred to generate taxable investment income. The deduction for investment 

interest would be limited to the amount of taxable investment income reported by a 

taxpayer.

Taxing Corporate Earnings Once 

The Simplified Income Tax Plan also would improve the environment for business 

investment by reducing the double taxation of corporate income earned in the United 

States. In our current system, business income is taxed twice – once when earned by 

the corporation and a second time when shareholders receive dividend distributions 

out of profits or realize capital gains from the sale of stock. The Simplified Income 

Tax Plan would allow shareholders to exclude from income the value of dividends 

received from corporations that are paid out of profits on which tax is paid in the 

United States. 

Under the Simplified Income Tax Plan, corporations would notify shareholders of 

the portion of dividends that would be subject to tax – this would be based on the 

proportion of income not subject to U.S. taxation during the prior year. Shareholders 

would pay tax only on the reported proportion of dividends not based on income 

taxed in the United States during the prior year. For example, if in the prior year a 

firm reported taxable income of $800 in the United States out of total worldwide 

income of $1,000, shareholders would be taxed only on 20 percent ($200 divided 

by $1,000) of dividends received during the following year. Requiring corporations 

to publicly report to their shareholders and the IRS the proportion of profits that 

were taxed in the United States also would make the tax system more transparent 

by directly informing shareholders how much of their income is taxed in the United 

States.
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The Panel considered, but rejected, extending the exclusion for corporate dividends to 

amounts paid by U.S. corporations out of income earned abroad. Under the territorial 

system recommended as part of the Simplified Income Tax Plan, earnings from active 

foreign operations of U.S. corporations would be excluded from U.S. tax. 

A dividend exclusion for foreign earnings of U.S. corporations would require raising 

revenue elsewhere, thereby causing U.S. taxpayers to subsidize foreign operations of 

U.S. corporations. In addition, dividends received by U.S. shareholders from foreign 

corporations would not receive an exclusion. The Panel considered extending the 

exclusion for dividends paid from U.S. corporations to dividends paid from foreign 

corporations, but concluded that it would not be possible to implement a workable 

plan to determine the portion of dividends paid out of profits of foreign corporations 

on which U.S. tax had been paid. 

Of course, dividends are not the only way shareholders benefit from corporate 

earnings. Earnings that are not distributed to shareholders as dividends, but are 

retained by corporations and reinvested in new projects, increase the value of the 

corporation’s stock. Shareholders realize this increase in value as capital gains when 

they sell their shares. To reduce double taxation of corporate earnings retained by U.S. 

corporations, the Simplified Income Tax Plan would exclude 75 percent of capital 

gains received by individuals on sales of U.S. corporations if the individual held the 

stock for more than one year. This treatment would lower the capital gains rate on 

sales of corporate stock to a maximum of 8.25 percent. For example, if a shareholder 

recognizes $100 of capital gain on the sale of stock, only 25 percent, or $25, would 

be subject to tax at ordinary rates. A taxpayer in the top 33 percent tax bracket would 

pay $8.25, or 8.25 percent, in tax, while a taxpayer in the lowest 15 percent tax bracket 

would pay $3.75, or 3.75 percent, in tax.

The Panel considered more complicated regimes that would more precisely track 

the amount and timing of dividends and capital gains that should be exempt from 

shareholder-level tax based on the amount of income on which U.S. tax was paid 

at the business level. These regimes would require shareholders to track increases 

in the basis of their stock on an annual basis to more accurately level the playing 

field between dividend distributions and retained earnings. The Panel rejected these 

more complicated regimes in favor of the 100 percent dividend exclusion and the 75 

percent exclusion of capital gains on stock sales because these approaches provide 

simpler ways of reducing the double tax on earnings of U.S. corporations. The 

treatment represents an area where the Panel made a tradeoff in favor of simplicity 

over more precise calculations. 

Taken together, the exclusion from income for domestic dividends and 75 percent of 

capital gains from U.S. corporate stock sales would substantially reduce the tax rate 

on investment in America’s companies. It also would introduce greater efficiency in 

the way American investors deploy their capital and choose between corporate and 

non corporate investments. It would likely result in increased investment in corporate 

equity. Additional information regarding the treatment of corporate dividends and 

capital gains can be found in the Appendix.
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Capital Gains

The sale of corporate stock is just one way individuals can earn capital gains. 

Individuals also realize capital gains when they sell other kinds of assets. Under 

current law, capital gains of both corporate and non-corporate investments are taxed 

at a maximum rate of 15 percent (the rate is 5 percent for taxpayers in lower tax 

brackets). By providing a special rate for all capital gains, the current tax code fails 

to fully eliminate the double tax on corporate retained earnings, while providing a 

generous tax break on other kinds of gains. 

The Simplified Income Tax Plan would tax all gains, other than those on the sale of 

stock of U.S. corporations, at the taxpayer’s regular tax rates. The Simplified Income 

Tax Plan would therefore raise the tax rate on some capital gains for higher-income 

individuals, while lowering the rate for all investors in corporate stock. This treatment 

would greatly simplify reporting of income from capital gains and the separate 

provisions described above would achieve the objective of reducing the double 

taxation of corporate retained earnings. Taxing capital gains at the same tax rate that 

applies to other income also would eliminate the need for a host of complex rules for 

the recapture of tax on the sales of assets by small businesses that take advantage of 

the new simplified and expanded expensing of investments described below. 

One type of capital gain that receives special treatment under our current tax system 

is the gain on the sale of housing. Under current law, taxpayers may exclude a 

substantial amount of the gains on the sale of their primary residences from income 

(the exclusion amount is up to $500,000 if the taxpayer is married and up to $250,000 

if single) if the home was owned and used as a principal residence for two or more of 

the preceding five years. Gains in excess of this amount are taxed at the capital gains 

rate, which is up to 15 percent under current law. Taxing capital income at the same 

rate as other income may mean that some taxpayers would pay a higher tax rate on 

capital gains from selling their homes than they do under current law. To help ensure 

that there is not an increase on the overall taxation of owner-occupied housing, the 

Panel recommends that the current law exclusion be increased to $600,000 ($300,000 

for singles), an amount roughly equal to the current-law exclusion if it had been 

indexed for inflation since its enactment in 1997. As described in Chapter Five, 

the Panel recommends that the exclusion would apply only if a home was used as 

a principal residence for at least three of the preceding five years, instead of two of 

the preceding five years under current law. The $600,000 figure would be indexed 

annually for inflation. This proposal would ensure that capital gains on the sale of a 

home would be free from taxation for a great majority of American home sellers.

A Simpler Tax System for Businesses

The tax imposed on a business under current law turns on a number of factors, 

including the legal form of the business, the type of business activity, and the type of 

investment a business makes. The result is a tax system for businesses that is overly 

complex and inefficient. The Simplified Income Tax Plan would simplify the tax 

system for all businesses, remove subsidies for favored industries and activities, and 
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Chapter Six

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replace the current system with one that taxes business income more uniformly and 

lowers the overall tax burden.

Small Business Rules Designed for Small Businesses

As described in Chapter Five, small business owners bear disproportionately higher 

compliance costs as a result of the complexity of our tax system. Under the Simplified 

Income Tax Plan, businesses with less than $1 million in receipts would no longer 

be required to maintain their books and records using the multitude of complex 

accounting rules found in our tax code. This would provide greater simplicity for 

more than 22 million small businesses, which account for more than 95 percent of 

all businesses. Under the Simplified Income Tax Plan, noncorporate small businesses 

would report income based on cash receipts less cash business expenses. Simplified 

cash accounting would be extended 

to almost all items of income and 

deductions, except for purchases of 

land and buildings.

This expanded cash accounting 

would make tax filing extremely 

straightforward for most small 

businesses. They would simply 

use their existing records as a 

basis for establishing their income 

and expenses. By comparison, 

today’s rules require many small 

businesses to separately track and 

compute depreciation, amortization 

schedules, inventory, capitalized 

expenditures, and other items that 

require special accounting for taxes. 

In addition, abolishing the AMT 

would eliminate another set of 

complex tax computations. Figure 

6.3 shows the new simple form 

that millions of sole proprietors 

would use to report their business 

income.

As described in Chapter Five, 

small-business owners would have 

greater flexibility to immediately 

write-off purchases of new assets, 

such as new tools, software, and 

equipment – extending and 

expanding current-law rules that 
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The President’s Advisory Panel on

give small business an incentive to purchase productivity-enhancing assets. Similarly, 

these small businesses would no longer be required to make difficult determinations 

about whether a particular expenditure can be immediately deducted or must be 

capitalized and amortized. The current-law treatment of land as a nondeductible 

expense and the depreciation of buildings and structures would continue to apply. 

Medium-sized businesses – those with receipts of more than $1 million, but less than 

$10 million – would also be allowed to use simplified and expanded cash accounting. 

These medium-sized businesses would use the cash method for small business 

described above, but would be required to depreciate the cost of equipment and other 

capital expenditures (in addition to land and buildings). The Simplified Income Tax 

Plan also would make permanent administrative practice that requires only mediumsized businesses in inventory-intensive industries to use inventory methods for 

physical inventories. 

For purposes of classifying a business as small, medium-sized, or large, gross 

receipts would be measured using the average over the prior three years. A business 

that crosses a particular gross receipts threshold would continue to be treated as a 

medium-sized or large business, even if its receipts later fall below the applicable gross 

receipts thresholds. 

To improve recordkeeping and compliance, the Simplified Income Tax Plan would 

require that small and medium-sized businesses use designated business bank 

accounts into which they would deposit all receipts and from which they would 

make business expenditures. Businesses would be prohibited from making personal 

expenditures out of, or from commingling personal and business funds in, these 

segregated business bank accounts. To aid small businesses in filing their returns and 

to improve compliance, banks would be required to provide small businesses with an 

annual summary of account inflows and outflows. This summary would be reported 

directly to the IRS by the financial institution maintaining the account. Similarly, 

the Simplified Income Tax Plan would require that issuers of debit and credit cards 

report to businesses and the IRS payments for credit and debit card purchases of their 

cardholders. Although taxpayers who fail to deposit cash receipts into segregated 

accounts would still present a compliance issue, simpler accounting rules and more 

detailed information reporting would make such willful evasion easier to detect.

The Panel also recommends that the tax treatment of small business entities be 

simplified. Under current law, owners of sole proprietorships, LLCs and partnerships, 

and S corporations report business income from these entities on their tax returns. 

Although these three separate regimes are designed to provide a single level of tax, 

there are a number of differences between them that make choosing a legal business 

form and tax compliance unnecessarily complex. In light of the recommendations 

that would provide for a single level of tax on profits of large businesses earned in 

the United States, the Panel recommends that the rules applicable to pass-through 

entities be simplified and streamlined. For example, greater uniformity among the 

rules for contributions, allocations of income, distributions, and liquidations would 

eliminate confusion and simplify choice of entity considerations. The Panel also 
129

Chapter Six

recommends that the current-law rule that treats an unincorporated business that is 

jointly owned by a married couple as a partnership be modified to permit the couple 

to treat the business as a sole proprietorship and report business income on Schedule 

C instead of a separate partnership tax return.

One Set of Rules for Large Businesses

The Simplified Income Tax Plan contains rules for larger businesses that, like the 

rules for small and medium-sized businesses, are designed to provide a more uniform 

and consistent treatment of business activity. Gone from the tax code would be most 

of the special preferences and rates that often apply to such large businesses. This 

would result in a system that taxes large business entities with more than $10 million 

of receipts more uniformly and at a lower 31.5 percent tax rate. Business entities with 

less than $10 million in receipts would be free to report income and to be taxed as 

a corporation if they so chose; if they did so, their owners would obtain the benefits 

of the 100 percent exclusion for domestic dividends and the 75 percent exclusion of 

capital gains on the sale of their corporate stock. 

Large business entities would be taxed at the entity level like corporations. Owners of 

these entities would not be subject to tax when they receive distributions of income 

earned in the United States and would exclude 75 percent of the capital gains on 

the sale of an interest in these entities. For large businesses that currently are taxed 

as flow-through entities, such as partnerships, LLCs, and S-corporations, domestic 

earnings would be subject to tax at the business level. Passive investment vehicles, 

such as regulated investment companies (RICs) and real estate investment trusts 

(REITs), would continue to be treated the same as under current law. Distributions 

and capital gains would be subject to the rules applicable to corporations.

Currently, there are only about 150,000 active U.S. businesses that have more than 

$10 million in receipts. Requiring all large entities, including partnerships, to abide by 

the same business tax rules would provide fewer opportunities for tax shelters and less 

exploitation of loopholes. For example, a consistent treatment of income from large 

businesses would shrink opportunities to use a partnership structure to avoid taxes. 

Many recent tax shelters were designed to exploit the complicated partnership rules. 

The uniform treatment of large businesses under the Simplified Income Tax Plan also 

would greatly simplify the individual income tax returns of their owners, who now must 

cope with complex distributions of various categories of business income and expenses 

that are reported to them on complicated partnership and S corporation forms.

Over the years, numerous special preferences for business activities have been 

added to the tax code. Some of these preferences are substantial in size and affect a 

significant percentage of businesses, while others are much smaller and affect only a 

few businesses. Each item on the long list of tax preferences requires complex rules 

and regulations to define who is entitled to get these preferences. These rules are an 

enormous source of controversy and confusion for taxpayers and the IRS. In addition, 

these preferences have the effect of raising the rates for all businesses. 
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The President’s Advisory Panel on

Like the individual income tax provisions, the Simplified Income Tax Plan begins 

with a clean tax base for large businesses by eliminating all tax preferences other than 

accelerated depreciation. Over 40 business tax breaks would be eliminated, including 

the research and experimentation credit, the rehabilitation investment credit, and the 

newly-enacted deduction for domestic production activities. To level the playing field 

between large businesses that pay tax at the entity level and small business owners 

who pay tax on business income on their individual returns, the deduction for state 

and local income taxes would be eliminated for large businesses under the Simplified 

Income Tax Plan. 

This clean tax base would permit the business tax rate to be reduced from 35 to 31.5 

percent – a 10 percent across-the-board reduction – while enormously simplifying the 

tax code. Eliminating special preferences that many large businesses use to reduce or 

avoid paying tax also would reduce the need to more closely track a business’s taxable 

income for purposes of the 100 percent exclusion of dividends paid out of domestic 

earnings.

The tax treatment of investment by businesses also would be significantly improved. 

Currently, our tax system favors a strategy of financing corporate growth by issuing 

debt rather than by issuing stock. This is because distributions out of corporate profits 

are taxed twice, while interest on debt is deductible, and is often received by taxexempt parties. The result is a corporate sector that disproportionately uses debt to 

finance future growth, retains earnings rather than distributing them as dividends, 

and favors unincorporated entities over corporations. The single-rate, business-level 

tax paid by all large business entities coupled with the proposal to nearly eliminate the 

tax on domestic earnings of large business entities at the individual level would reduce 

the tax burden on business investment and provide a more even treatment across 

types of business financing. As illustrated in Figure 6.4, there will be a lower and more 

even tax burden on the returns to investment.

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131

Chapter Six

The Panel also evaluated a proposal to tax large entities based on net income reported 

on financial statements instead of requiring a separate calculation of income for tax 

purposes. Although the Panel has not included that proposal as part of the Simplified 

Income Tax Plan, the Panel recommends that it be studied further. 

A Simplified Cost Recovery System

Under current law, taxpayers are allowed to take depreciation deductions 

for new investments under the Modified Accelerated Cost Recovery 

System, or MACRS. Under MACRS, each asset is assigned a recovery 

period (the number of years over which depreciation allowances are 

spread), a recovery method (how depreciation allowances are allocated 

over the recovery period), and an applicable convention that establishes 

when property is deemed to have been placed in service during the 

year. Under the asset classification systems that date back to 1962 and earlier, assets 

are assigned to one of nine specific recovery periods. Recovery methods range from 

straight line, which provides even depreciation allowances over the recovery period, to 

double declining balance, which provides more generous deductions in the early years.

Under MACRS, most investments in equipment are assigned a recovery period that 

depends on the taxpayer’s industry. Equipment is assigned to one of seven recovery 

periods, ranging from three years to 25 years, but most are assigned to the five or 

seven-year recovery periods. Investments in buildings are recovered on a straight-line 

basis over 27.5 years for residential buildings or 39 years for nonresidential buildings.

Under the Simplified Income Tax Plan, all businesses would benefit from simplified 

rules for recovering the cost of new assets. As described above, small businesses 

would be able to take an immediate deduction for the cost of new tools, equipment, 

and other assets. These businesses would not have to worry about complicated asset 

classifications, asset class lives, depreciation methods, or depreciation tables, except for 

purchases of buildings. 

A simplified cost recovery system would be adopted to reduce the compliance 

hassles associated with the tax treatment of business investment. The new simplified 

depreciation system would replace the nine different asset class lives, three different 

recovery methods, and three different applicable conventions with a simple system 

involving only four asset categories. This system would provide roughly the same cost 

recovery deductions as current law, but would greatly simplify the process. It would 

eliminate much of the accounting and recordkeeping burden imposed by our current 

system. It also would eliminate many of the inter-asset distortions created by the 

antiquated classification of assets in our current system. For example, there would no 

longer be different recovery periods for similar assets just because they are used in 

different industries.
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Under the simplified depreciation system, taxpayers would increase the balance in 

each property account by the amount of new purchases and be allowed a uniform 

allowance each year. Depreciation would be computed by multiplying the account’s 

average balance by the depreciation rate applicable to the specific asset category. As 

summarized in Table 6.5, there would be only four categories of assets.

Table 6.5. Asset Categories Under the Simplified Depreciation System

Category I Category II Category III Category IV

Type of Assets Assets used in the 

agricultural, mining, 

manufacturing, 

transportation, trade, 

and service sectors 

Assets used for 

energy production, a 

few other relatively 

long-lived utility 

properties, and most 

land improvements

Residential 

buildings

Non-residential 

buildings and 

other long-lived 

real property

Annual Recovery 

Percentage

30 percent 7.5 percent 4 percent 3 percent

Medium-size businesses (and small businesses that depreciate buildings and 

structures) would be allowed to use a much simpler accounts-based system under 

which the amount of new assets would simply be added to the existing balance in 

each asset account. Unlike current law, separate accounts for assets placed in service 

in each year would not be required. The new depreciation system also would provide 

a more simple treatment of asset dispositions by not requiring adjustment of the 

account upon sale, retirement or other disposition of an asset. Depreciation would be 

allowed for the account balance and, if all assets in a category were disposed of, the 

remaining adjusted basis in an account would be deducted. Any proceeds received 

from an asset disposition would be included fully in the taxpayer’s gross income. 

These rules would relieve businesses from detailed tracking of individual assets for tax 

purposes.

Large businesses would continue to track assets as they do under current law, but 

would benefit from the simpler process of categorizing assets into one of four asset 

classes and claiming depreciation deductions based on the simplified method. 

Simplifying the Taxation of International Business

The Simplified Income Tax Plan would update our international tax regime by 

adopting a system that is common to many industrial countries. As explained in 

Chapter Five, our tax system taxes all income of U.S. corporations regardless of 

where it is earned and provides a limited tax credit for income taxes paid to foreign 

governments. Many of our trading partners use “territorial” tax systems that exempt 

some (or all) of business earnings generated by foreign operations from home country 

taxation. France and the Netherlands, for example, exempt foreign dividends. Canada, 

on the other hand, exempts foreign dividends from countries with which it has 

tax treaties from home taxation. Canada effectively administers a territorial system 

because it has tax treaties with many countries.
133

Chapter Six

To understand the tax implications of territorial and worldwide systems, consider a 

simple example. A French multinational company and a U.S. multinational company 

both have subsidiaries with active business operations in another country, Country 

X, that imposes a 20 percent tax on corporate income. The U.S. corporate income tax 

rate is 35 percent. Assume that both companies earn $100 from their operations in 

Country X and immediately send the profits home as a dividend. 

Both the U.S and French subsidiaries pay $20 of tax to Country X on their $100 

of earnings. However, the U.S. company faces a “repatriation tax” on the dividend, 

but the French company does not. The U.S. tax bill of $35 on the $100 of foreign 

earnings is reduced to $15 because the company receives a credit of $20 for the taxes 

already paid to Country X by its subsidiary. This means that the U.S. multinational 

pays a total of $35 in tax: $20 to Country X and $15 to the United States. The French 

multinational, on the other hand, pays only $20 in tax to Country X. The French 

company faces a lower tax rate on investments in Country X than the U.S. company 

because France has a territorial tax system. 

Unfortunately, reality is not as simple as this example portrays it. As explained in 

Chapter Five, the U.S. multinational does not pay U.S. tax on its subsidiary’s earnings 

in Country X until the earnings are repatriated to the United States. The repatriation 

tax is elective and, as a result, distorts business decisions. If the U.S. multinational 

redeploys earnings abroad by reinvesting the $80 in an active business, for example, 

it may avoid the U.S. tax on the earnings. To do so, the U.S. company may forego 

more attractive investments in the United States or may have to fund investments at 

home through costly borrowing that would be avoided if there were no repatriation 

tax on the foreign earnings. Tax planners can devise elaborate strategies to avoid the 

repatriation tax, but the strategies employed may themselves be costly and wasteful to 

the economy. 

For some firms, arranging corporate affairs to avoid the repatriation tax involves costly 

and distortionary activity that would not take place except for tax considerations. 

As explained in Chapter Five, the combination of deferral and the foreign tax 

credit creates a situation in which the tax rate imposed on investment abroad differs 

among U.S. multinationals. For example, a multinational that can defer repatriation 

indefinitely (or avoid the repatriation tax at no cost) pays no repatriation tax. A 

multinational that is unable to structure operations to avoid the repatriation tax faces 

the U.S. tax rate. 

Under our current tax system, it is also possible for companies to face tax rates on 

marginal investments abroad that are lower than host country rates. For example, 

consider a U.S. multinational that finances additional investment in Country X 

through U.S. borrowing. If the multinational is able to indefinitely defer tax on 

earnings in Country X (or avoid any repatriation tax through tax planning) it will 

face a lower than 20 percent rate on its investment. This is because the U.S. company 
134

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The President’s Advisory Panel on

gets a deduction at the U.S. tax rate for interest payments with no corresponding 

taxation of income at the U.S. rate. Although territorial tax systems are designed to 

impose no home country tax on active foreign earnings, the goal of these systems is 

not to subsidize foreign investment. For this reason, provisions that allocate expenses 

associated with exempt foreign income against that income (or tax some otherwise 

exempt foreign income as a proxy for allocating those expenses) are necessary.

The Simplified Income Tax Plan would adopt a straightforward territorial method 

for taxing active foreign income. Active business income earned abroad in foreign 

affiliates (branches and controlled foriegn subsidiaries) would be taxed on a territorial 

basis. Under this system, dividends paid by a foreign affiliate out of active foreign 

earnings would not be subject to corporate level tax in the United States. Payments 

from a foreign affiliate that are deductible abroad, however, such as royalties and 

interest would generally be taxed in the United States. Reasonable rules would be 

imposed to make sure that expenses incurred in the United States to generate exempt 

foreign income would not be deductible against taxable income in the United States. 

Because insuring that related entities charge each other “arm’s length” prices for goods 

and services is even more important in a territorial system than under current law, 

additional resources would need to be devoted to examining these transfer prices. As 

is common in territorial systems around the world, income generated by foreign assets 

– such as financial income – that can be easily relocated to take advantage of the tax 

rules would continue to be taxed in the United States as it is earned. For example, if 

the U.S. company in our example was to invest the $100 of foreign profits in Country 

X in bonds instead of in an active business, the interest earned on the bonds would be 

subject to immediate U.S. taxation (with a credit for any taxes paid to Country X).

Such a tax system would more closely reflect the international tax rules used by 

many of our major trading partners. It would level the playing field among U.S. 

multinationals investing abroad. It would allow U.S. multinationals to compete with 

multinationals from countries using a territorial approach without having to bear the 

planning costs that are necessary under today’s system. In addition, it would make it 

easier for American companies to repatriate income earned in foreign nations tax-free 

and reduce the degree to which tax considerations distort their business decisions. 

Finally, commentators from both industry and academia have concluded that a 

carefully designed territorial-type system can lead to simplification gains.

Research on the consequences of adopting a territorial system for the United 

States suggests that this reform could lead to both efficiency and simplification 

gains. Economists have found that the financial decisions of corporate managers 

are extremely sensitive to the tax on repatriations – lower U.S. taxes on dividend 

repatriations lead to higher dividend payments and vice-versa. This correlation implies 

that repatriation taxes reduce aggregate dividend payouts and generate an efficiency 

loss that would disappear if active foreign source income were exempt from U.S. tax. 

Corporate managers would be able to arrange corporate affairs and financial policies 

to meet objectives other than tax avoidance if they were freed from worrying about 

how to time repatriations of foreign income to reduce U.S. taxes.
135

Chapter Six

At first glance, one might assume that exempting active foreign source income 

from U.S. taxation would lead to a substantial reallocation of U.S. investment and 

jobs worldwide. A careful study of how location incentives for U.S. multinational 

corporations may change under a territorial system similar to the one proposed for 

the Simplified Income Tax Plan provides different results. Researchers found no 

definitive evidence that location incentives would be significantly changed, which 

suggests that the territorial system the Panel has proposed would not drive U.S. jobs 

and capital abroad relative to the current system. This result is not surprising. As 

explained in Chapter Five, the U.S. international tax system is a hybrid of worldwide 

and territorial features. For some firms, the U.S. international tax system produces tax 

results that are as good or even better than those that would apply under a territorial 

system. Exempting active foreign-source income repatriated as a dividend from U.S. 

tax provides no additional incentive to invest abroad if, in response to the current tax 

system, firms have already arranged their affairs to avoid the repatriation tax. Instead, 

exempting dividends allows firms to productively use resources that were inefficiently 

employed under current law. The Simplified Income Tax Plan would produce no less 

revenue from multinational corporations than the current system, but would be less 

complex and more uniform in its application.

Additional information regarding the Panel’s proposals for a new system of 

international taxation under the Simplified Income Tax Plan can be found in the 

Appendix.

Strengthening Rules to Prevent International Tax Avoidance

The Simplified Income Tax Plan also would modify the definition of business subject 

to U.S. tax to ensure businesses that enjoy the benefit of doing business in the U.S. 

pay their fair share. Under current law, residency is based on the place a business 

entity is organized. This rule makes an artificial distinction that allows certain foreign 

entities to avoid U.S. taxation even though they are economically similar to entities 

organized in the United States. This rule may give businesses an incentive to establish 

legal place of residency outside the United States to avoid paying tax on some 

foreign income. Several large U.S. companies have used a similar technique to avoid 

taxes under our current system. Recently enacted legislation created rules to prevent 

existing corporations from moving offshore, but does not prevent newly organized 

entities from taking advantage of the rules. 

To prevent this tax-motivated ploy, the Simplified Income Tax Plan would provide 

a comprehensive rule that treats a business as a resident of the U.S. (and subject to 

U.S. tax) if the United States is the business’s place of legal residency or if the United 

States is the business’s place of “primary management and control.” The new twopronged residency test would ensure that businesses whose day-to-day operations 

are managed in the United States cannot avoid taxes simply by receiving mail and 

holding a few board meetings each year at an island resort.
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The President’s Advisory Panel on

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A Progressive Tax System

As discussed in Chapter Four, the Panel agreed to design tax reform options 

that would not materially alter the current progressive distribution of the federal 

individual and corporate income tax burden. The following estimates provided by the 

Treasury Department demonstrate that the Simplified Income Tax Plan meets those 

guidelines. While there are some minor differences, the overall distribution closely 

tracks current law.

Figures 6.5 and 6.6 show the results for 2006. Figure 6.5 breaks the population 

into fifths – or quintiles – according to their cash income. The figure also shows 

the taxes paid by the fifty percent of the population with the lowest incomes, and 

those in the top 10, 5, and 1 percent of the income distribution. Figure 6.6 presents 

similar information, but instead of assigning households to percentiles of the income 

distribution, it shows the distribution of taxes by taxpayer income levels. The figure 

presents income levels ranging from zero to $15,000 of income to $200,000 and over 

of income. 
137

Chapter Six

To provide additional information about the effect of the Simplified Income Tax 

Plan, the Panel asked the Treasury Department to provide a distribution of the 

Simplified Income Tax Plan for 2015, the last year of the budget window. Figures 

6.7 and 6.8 compare the effect of the Simplified Income Tax Plan and current law in 

2015, while holding constant the level and pre-tax distribution of income.

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The Treasury Department has also provided two additional sets of distribution tables 

that are explained and displayed in the Appendix. One table describes the tax burden 

under the Simplified Income Tax Plan for the entire ten-year budget period. The 

other shows the tax burden if the corporate income tax is distributed 50 percent 

to owners of capital and 50 percent to labor, rather than solely to owners of capital 

income. 

Another way to evaluate the distributional effects of a tax reform proposal is to 

consider the number of taxpayers who would face higher or lower taxes under the 

proposal. The constraint of revenue neutrality implies that any tax relief provided to 

one taxpayer must be financed with higher taxes on somebody else. Looked at solely 

from the perspective of one’s tax bill, the Simplified Income Tax Plan is certain to 

generate both “winners” and “losers.” The Panel recognizes that this comparison is 

inevitable, but at the same time urges taxpayers to recognize other benefits of tax 

reform. Greater simplicity in the tax system would allow taxpayers to save time and 

preparation fees, and would inspire confidence that the tax system is straightforward 

and fair, and not providing hidden loopholes to others. Greater economic growth 

should also benefit all Americans.

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Figures 6.9 and 6.10 demonstrate that in each income class, many more taxpayers 

would receive a tax cut than a tax increase. Overall, under the Simplified Income Tax 

Plan, there are more than twice as many taxpayers who would pay less in taxes.

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All of the above distributional information looks at the aggregate effects on groups 

of taxpayers. While this is informative, the Panel understands that many taxpayers 

would like to have a greater level of specificity and would like to know what would 

happen to their personal tax bill. To provide some information of that type, the Panel 

has developed an array of hypothetical taxpayers and calculated their taxes under the 

Simplified Income Tax Plan. 
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Before analyzing the results, it is important to describe how the Panel chose these 

examples. The Panel asked the IRS to construct a set of stylized taxpayers with 

different family structures, ages, incomes, and deductions. The IRS created these 

model taxpayers using data on actual taxpayers, divided into singles, married joint 

filers, and heads of households, and further sorted by whether or not the household 

head is over the age of 65. Within each of these taxpayer categories, households were 

ranked according to their adjusted gross income. This ranking was carried out using 

tax return data from 2003. Dollar figures were inflated to 2006 levels.

The Panel asked the IRS to consider the characteristics of taxpayers at the bottom 

25th percentile, median, top 25th percentile, and top 5th percentile of the income 

distribution, with particular emphasis on the composition of income and the use 

of various deductions. In determining the attributes of a stylized 25th percentile 

taxpayer, for example, the Panel asked the IRS to use data on taxpayers with 

incomes between the 24th and 26th percentiles. Averages of the amount of wage 

and salary income, the amount of capital income flows such as interest, dividends, 

and capital gains, and, in the case of itemizers, the amount of various deductions 

were calculated for each of the stylized taxpayers. In addition, the Panel asked the 

Treasury Department to estimate values of itemized deductions for taxpayers who 

did not itemize, and included these estimates in the averages. Although these stylized 

taxpayers may not correspond to actual taxpayers due to the averaging procedure 

for income and itemized deductions, they nevertheless provide an illustrative way to 

compare different tax systems.

Table 6.6 presents a set of Treasury Department calculations for how the Simplified 

Income Tax Plan would affect hypothetical taxpayers for 2006. These examples 

demonstrate an essential point, which is that looking at elements of the Simplified 

Income Tax Plan in isolation can result in very misleading conclusions. The plan 

is a carefully crafted combination of numerous individual provisions intended to 

achieve substantial improvements in the tax system while minimizing the changes in 

total tax liabilities experienced by individual taxpayers. While some elements of the 

plan, considered in isolation, may increase the taxes paid by some taxpayers, other 

elements will have offsetting effects. Rather than focusing on the effects of individual 

provisions, the focus should be on the overall changes in tax liability that would result 

from the Simplified Income Tax Plan in its entirety.
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Table 6.6. Examples of Taxpayers Under the Simplified Income Tax Plan in 2006

Taxpayer Characteristics 

and Placement in Income 

Distribution

Income

Salaries and Wages

Taxable Interest

Dividends

Capital Gain

Itemized Deductions

Income Tax 

under 2006 Law at 2006 

Levels

State and 

Local Taxes

Mortgage 

Interest

Charitable 

Contributions

Misc

(before 2% 

floor)

Current Law

Simplified 

Income Tax

Percentage 

Change in Tax 

Liability

Single Taxpayers Younger Than 65

1 Bottom 25th 12,300 12,300 369 385 158 -59.0%

2 50th 24,300 24,300 729 2,003 1,922 -4.0%

3 Top 25th 41,000 40,700 200 100 1,230 4,758 4,542 -4.6%

4 Top 5% 82,800 80,500 800 700 800 4,000 6,400 2,000 2,200 13,541 14,336 5.9%

Heads of Household Younger Than 65 

(bottom 25th and 50th percentile households have two child dependents; top 25th and top 5% household has one child dependent)

5 Bottom 25th 14,000 14,000 420 -4,941 -5,488 -11.1%

6 50th 23,100 23,100 693 -4,225 -4,242 -0.4%

7 Top 25th 37,200 36,700 200 100 200 1,116 1,960 1,202 -38.7%

8 Top 5% 71,800 71,300 300 100 100 2,900 8,300 2,400 2,500 7,042 8,112 15.2%

Married Filing Jointly Younger Than 65

(all have two child dependents)

9 Bottom 25th 39,300 38,600 300 200 200 1,179 -282 -833 -195.9%

10 50th 66,200 65,300 400 300 200 2,300 8,200 2,400 2,100 3,307 2,286 -30.9%

11 Top 25th 99,600 97,800 600 600 600 4,100 9,400 2,700 2,200 9,340 9,129 -2.3%

12 Top 5% 207,300 196,200 2,300 2,700 6,100 10,000 14,400 5,400 2,800 40,417 37,162 -8.1%

Single Taxpayers (and Surviving Spouses) Age 65 and Over*

13 50th 24,800 0 3,200 1,600 100 555 1,919 1,983 3.3%

14 Top 25th 42,800 0 4,000 3,200 200 1,130 5,731 5,820 1.6%

Married Filing Jointly Age 65 and Over**

15 50th 51,000 0 3,000 1,300 500 1,125 2,772 2,363 -14.7%

16 Top 25th 77,500 0 5,400 3,600 1,000 2,230 9,635 8,822 -8.4%

Note:

* The 50th percentile taxpayer has gross Social Security benefits of $6,300 and taxable pensions, annuities, and IRA distributions equal to $13,600. The top 25th percentile taxpayer has gross 

Social Security benefits of $12,000 and taxable pensions, annuuities, and IRA distributions equal to $23,400.

** The 50th percentile taxpayer has gross Social Security benefits of $18,400 and taxable pensions, annuities, and IRA distributions equal to $27,800. The top 25th percentile taxpayer has gross 

Social Security benefits of $21,000 and taxable pensions, annuuities, and IRA distributions equal to $46,500.

See text for further explanation of sample taxpayers.

Source: Department of the Treasury, Office of Tax Analysis.
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For 2006, a prototypical married couple under age 65 at the median income level of 

$66,200 would expect to pay $3,307 under current law. Under the Simplified Income 

Tax Plan, that couple would pay $2,286 in taxes, which would be a decrease of almost 

31 percent. A prototypical married couple under age 65 earning about $100,000 

would expect to pay $9,340 in taxes in 2006. Under the Simplified Income Tax Plan, 

that couple would pay $9,129, a decrease of about 2 percent.

Similarly, for 2006, a single taxpayer under age 65 at the median income level of 

about $24,000 would receive a tax cut of 4 percent. The tax bill of a head of household 

taxpayer at the median income of about $23,000 would remain roughly the same. Single 

taxpayers and heads of households who are at the 95th percentile of income would face a 

tax increase under the Simplified Income Tax Plan. 

The Panel also felt that it would be instructive to see how the plan affected taxpayers 

living in high tax and low tax states. Accordingly, the Panel asked the IRS to vary 

the amount of state and local taxes paid by each of the taxpayer groups under age 65. 

The Treasury Department then calculated how tax liabilities would change for those 

taxpayers who would have itemized and claimed state and local tax deductions under 

current law for “high” and “low” values of state and local tax deductions. The “high” 

value is the cut-off level for the top 10 percent of state and local taxes claimed in 2003 

(inflated to 2006 levels) and the “low” value is the cut-off level for the bottom 25th

percent. These figures are shown below for each group of taxpayers in Table 6.7. 

The examples in Table 6.7 show that because of the interaction between the 

alternative minimum tax and other provisions, there was no difference in the 

treatment of the stylized married couple earning about $100,000 or in the treatment 

of the married couple earning about $207,000. In other words, regardless of whether 

those couples lived in high-tax or low-tax states, they still came out ahead in the 

Simplified Income Tax Plan. The stylized couple earning about $66,000 living in a 

low-tax state receives a tax cut of $1,081 while the same couple living in a high-tax 

state receives a tax cut of $781. Both of these taxpayers would pay the same tax level 

under the Simplified Income Tax, regardless in which state they reside. For single 

taxpayers and head of households who itemized under current law, there would be a 

larger tax increase in taxes for those taxpayers who are living in high-tax states. This 

is due to the fact taxpayers in high-tax states currently pay less tax than taxpayers in 

the low-tax states. Under the Simplified Income Tax Plan this is no longer the case 

– taxpayers with similar income and characteristics face the same tax bill.
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Table 6.7. Examples of Taxpayers Living in ”High” and ”Low” Tax States 

Under Current Law and Simplified Income Tax Plan

Taxpayer Characteristics 

and Placement in Income 

Distribution

Income

State and Local Tax 

Deduction

Income Tax 

under 2006 Law at 2006 Levels Current Law Simplified Income Tax Percentage Change in Tax Liability

Single Taxpayers Younger Than 65

Top 5% in “low-tax” state 82,800 3,500 13,666 14,336 4.9%

Top 5% in “high-tax” state 82,800 6,400 12,941 14,336 10.8%

Heads of Household Younger Than 65 

Top 5% in “low-tax” state 71,800 2,400 7,167 8,112 13.2%

Top 5% in “high-tax” state 71,800 4,800 6,567 8,112 23.5%

Married Filing Jointly Younger Than 65

50th in “low-tax” state 66,200 1,900 3,367 2,286 -32.1%

50th in “high-tax” state 66,200 3,900 3,067 2,286 -25.5%

Top 25th in “low-tax” state 99,600 3,600 9,340 9,129 -2.3%

Top 25th in “high-tax” state 99,600 6,900 9,340 9,129 -2.3%

Top 5% in “low-tax” state 207,300 8,300 40,417 37,162 -8.1%

Top 5% in “high-tax” state 207,300 16,300 40,417 37,162 -8.1%

Notes: Taxpayers have same characteristics as those in Table 6.6 with the exception of state and local taxes. See text for further explanation of 

sample taxpayers.

Source: Department of the Treasury, Office of Tax Analysis.
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Improved Transparency and Lower Compliance Costs

An obvious benefit of this system would be a simple and straightforward process for 

computing taxes dramatically cutting the time spent keeping records and filling out 

forms.

Figures 6.11 and 6.12 demonstrate how much simpler the tax filing process would be. 

Figure 6.11 shows the current, two-page Form 1040 with over 50 forms, schedules, 

and worksheets that are frequently used to compute taxes. Figure 6.11 shows the tax 

return that would be used under the Simplified Income Tax Plan – not only is the 

form easier to use, but only a fraction of the forms would be required to compute tax 

owed. 

Making taxes of individuals and businesses easier to compute and report would also 

make our tax system fairer and more transparent. The IRS would be able to process 

returns and enforce the tax laws more efficiently, thus freeing up resources that could 

be better used to reduce the gap that exists between taxes owed and taxes paid.
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Figure 6.11. Current IRS Form 1040 with Related Schedules, 

Forms, and Worksheets
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Figure 6.12. Form 1040 SIMPLE with Related Schedules, Forms, and Worksheets
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Revenue Neutrality

The Treasury Department advises the Panel that the Simplified Income Tax Plan 

would be revenue neutral. The plan would collect the same amount of tax revenue 

as the current law baseline from both individual income taxes and corporate income 

taxes over the ten-year period.

As noted in Chapter Four, the Panel’s baseline for determining revenue neutrality 

includes the full effects of the AMT. Some members of the Panel believe that it is 

more likely that lawmakers will extend the current-law provision, often referred to as 

the AMT “patch,” that provides a higher exemption amount, and possibly index this 

higher amount for inflation. If the AMT patch was extended and indexed, the Panel 

would not have been required to account for that additional amount of tax revenue 

and could have used that revenue to lower tax rates under the Simplified Income Tax 

Plan by 5 percent. In such a scenario, the top rate would have been reduced from 33 

percent to 31.5 percent. 

A More Pro-Growth Tax System

The Simplified Income Tax Plan would provide a number of long-term economic 

benefits. First, it would use a cleaner tax base and would eliminate the need for the 

AMT, which represents a long-term tax hike for tens of millions of Americans. 

Second, the system would offer lower tax rates, which by definition improve the 

conditions for economic growth and job creation. In addition, the Save at Work, 

Save for Retirement, and Save for Family accounts would encourage more taxpayers 

to save, which would support greater individual wealth and ownership, as well as an 

increase in the capital stock. 

The Simplified Income Tax Plan also would provide a more uniform method for 

calculating the taxation of business investment, and would lower the cost of that 

investment. The removal of the double tax on corporate earnings would represent 

a significant reduction in the taxation of business investment. In addition, the 

Simplified Income Tax Plan would reduce the top tax rate on corporations from 35 

percent to 31.5 percent. And the new territorial-based international tax system would 

be simpler for corporations to navigate, and would reduce some of the distortions and 

wasteful tax planning in the current system. 

Estimates from the Treasury Department macroeconomic models described in the 

Appendix indicate that the Simplified Income Tax Plan could increase national 

income by up to 0.5 percent over the budget window, by up to 1 percent over 20 years, 

and by up to 1.2 percent over the long run. The Treasury Department models also 

suggest that the Plan could have a significant impact on the growth of the capital 

stock (the ecomony’s accumulation of wealth). The estimates for an increase in the 

capital stock range from 0.1 percent to 0.4 percent over the budget window, from 

0.3 percent to 1.4 percent over 20 years, and from 1.4 percent to 2.3 percent over the 

long run.
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Chapter Seven

The Growth and Investment

Tax Plan

The Panel evaluated a number of tax reform proposals that would shift our current 

income tax system toward a consumption tax. The Panel focused on consumption 

tax proposals that would collect taxes in a progressive manner. These proposals are 

designed to eliminate the disincentives to save and invest found in our current code, 

without dramatically altering the way the federal tax burden is shared.

The Panel considered a pure consumption tax that would completely eliminate the 

difference between the pre-tax and the after-tax return on new investment. It also 

considered a blended tax structure that would move the current tax system towards a 

consumption tax, while preserving some elements of income taxation. The Growth and 

Investment Tax Plan, which is one of the Panel’s two recommendations, is an example 

of a blended structure. It would combine a progressive tax on labor income and a 

flat-rate tax on interest, dividends, and capital gains with a single-rate tax on business 

cash flow. Under this tax system, households would file tax returns and pay tax on 

Courtesy of Marina Sagona
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their wages and compensation using three tax rates, ranging from 15 to 30 percent. 

Most households would face lower marginal tax rates than they do under the current 

income tax system. In addition, the individual tax structure would accommodate 

the common elements described in Chapter Five, including the Work and Family 

Credits, the deduction for charitable gifts and health insurance, and the Home 

Credit. The Growth and Investment Tax Plan departs from a pure consumption tax 

by imposing a 15 percent tax on household receipts from interest, dividends, and 

capital gains. 

Several panel members were concerned that the Growth and Investment Tax 

Plan would not move far enough towards a consumption tax because it retains a 

household-level tax on capital income. The Panel therefore developed a proposal 

for a consumption tax, referred to as the Progressive Consumption Tax Plan, which 

would not tax capital income received by individuals. Although the Progressive 

Consumption Tax Plan proposal did not emerge as a consensus recommendation, the 

interest in it led to substantial discussion. 

Under the Growth and Investment Tax Plan, businesses would file annual tax returns. 

They would pay tax at a single rate of 30 percent on their cash flow, which is defined 

as their total sales, less their purchases of goods and services from other businesses, 

less wages and other compensation paid to their workers. Thus, businesses would be 

allowed an immediate deduction for the cost of all new investment. Non-financial 

businesses would not be taxed on income from financial transactions, such as 

dividends and interest payments, and would not receive deductions for interest paid 

or other financial outflows. 

This chapter begins by summarizing the key differences between income and 

consumption taxes and explaining the likely impact of consumption taxes on the 

rate of economic growth. It then describes the Growth and Investment Tax Plan, 

which offers many of the benefits of a consumption tax even though it retains some 

elements of income taxation. Next, the chapter explores how adopting the Growth 

and Investment Tax Plan would affect the distribution of the tax burden. Finally, 

a brief discussion of the Progressive Consumption Tax Plan considers both how it 

would differ from the Growth and Investment Tax Plan and how it would affect the 

saving and investment incentives facing households and firms.

Shifting the tax structure toward a consumption tax would represent a fundamental 

change in the U.S. tax system. Such a shift would raise a number of implementation 

issues, many of which are addressed in this chapter. Other issues related to 

implementation are discussed in more detail in the Appendix.

Comparison of a Consumption Tax with an Income Tax

The key difference between an income tax and a consumption tax is the tax burden 

on capital income. An income tax includes capital income in the tax base, while a 

consumption tax does not. Taxing capital income reduces the return to savings and 

raises the cost of future consumption relative to current consumption. This is likely 

to cause people to spend more and save less, thereby depressing the level of capital 
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Chapter Seven

accumulation. 

Our current tax system has both income tax and consumption tax features, such as 

the provisions that permit tax-free saving for retirement (e.g., IRAs and 401(k) plans) 

and other purposes. Yet the current tax code imposes a penalty on the return to many 

types of saving. It also taxes different types of investment at different rates, which 

leads to a misallocation of capital in the economy. Projects treated relatively favorably 

by the tax code, such as debt-financed investment, are encouraged relative to projects 

that are heavily taxed, such as equity-financed corporate investment. A consumption 

tax would not distort saving and investment decisions, and would treat all investment 

projects the same way.

Although a consumption tax would remove the tax bias against savings and level 

the playing field between different types of investments, it is important to recognize 

that an income tax and the type of consumption tax discussed here would both 

tax a significant portion of the return to capital. To understand why, it is helpful 

to distinguish four different components of the return to capital. The first is the 

“normal,” or risk-free, return that represents compensation for deferring consumption. 

This is sometimes described as the “return to waiting.” The second is the expected risk 

premium for a project with uncertain returns – the return to risk taking. The third 

component is “economic profit” and represents returns due to entrepreneurial skill, 

a unique idea, a patent, or other factors. This component is sometimes referred to as 

“supernormal returns.” The last component is the unexpected return from good or bad 

luck. This is the difference between the expected return at the start of an investment, 

and the after-the-fact, actual return. 

A pure income tax and a “postpaid” consumption tax (described in Chapter Three) 

differ only in their treatment of the return to waiting. The other components of 

capital income are taxed similarly under both systems. The return to risk-taking and 

any additional returns that result from good or bad luck are treated similarly under 

both an income and consumption tax. In both cases, the government becomes a 

partner in the risks and rewards of the investment through increased tax revenues in 

the case of positive returns and reduced revenues if returns fall short of expectations. 

Supernormal returns are taxed equally under both a postpaid consumption tax and an 

income tax. 

Removing the tax on the first component, the return to waiting, is the key to 

removing taxes from influencing savings and investment decisions. As discussed later 

in this chapter, recognizing that these other components of the return to capital are 

taxed under both an income tax and the type of consumption tax discussed here has 

important implications for the distributional effects of this type of reform.
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Box 7.1. Differences in the Treatment of Returns to Business Investment 

Under a Consumption Tax and an Income Tax

To illustrate how a consumption tax treats normal returns differently than an income tax, 

consider an entrepreneur who has just earned $100 and can invest in a new machine that 

will earn a risk-free 10 percent return one year from now. If the tax rate is 35 percent, under 

an income tax, the entrepreneur pays $35 of tax on the $100 of profits and has $65 left to 

invest. In the next year, the investor earns $71.50 and subtracts $65 in depreciation for the 

cost of the machine (assuming for simplicity it is only good for one year), leaving taxable 

income of $6.50. After paying $2.28 in tax (35 percent of $6.50) the entrepreneur would be 

left with $4.22. The investor chooses between consuming $65 today or $69.22 in the future 

– an after-tax return of 6.5 percent.

In contrast, when new investments can be expensed, as under a consumption tax, the 

investor would choose between investing all $100 in the machine or receiving $65 after 

taxes for spending. If the entrepreneur invests, the entrepreneur would have $110 in 

receipts in the next year, but no depreciation deductions. After paying $38.50 in tax (35 

percent of $110), the investor will have $71.50 left. Thus, the investor can choose between 

consuming $65 today or $71.50 in the future – an after-tax return of 10 percent. 

To see how a postpaid consumption tax and an income tax treat supernormal returns equally, 

assume that the investment described above actually yields a return of 20 percent. Under 

an income tax, the investor now has $78 in profit. After subtracting the $65 depreciation 

allowance, the entrepreneur would have taxable income of $13 – representing normal 

returns of $6.50 plus an additional $6.50 supernormal return. After paying $4.55 in tax (35 

percent of $13), the entrepreneur would be left with $8.45. Thus under an income tax, the 

investor chooses between consuming $65 today or $73.45 in the future – an after-tax return 

of 13 percent.

Under the consumption tax, as before, the investor deducts the $100 investment in the 

first year, but pays tax of $42 (35 percent of $120) in the next year. This leaves $78 ($120 

less $42) after taxes. The investor chooses between consuming $65 today or $78 in the 

future – a 20 percent after-tax return. However, the investor pays $3.50 more in tax ($42 

less $38.50 in the first consumption tax example) as a result of the project’s supernormal 

returns. This additional tax represents 35 percent of the $10 of supernormal returns. Thus, 

the consumption tax described in this example levies the same tax burden as the income 

tax on supernormal returns.

A Consumption Tax Would Encourage Economic Growth

Taxing consumption rather than income would remove the saving disincentives 

that are central to income tax systems. Although one cannot know with absolute 

certainty the effect of raising the return on private saving by lowering the tax burden, 

most economic models suggest that such a change would result in higher household 

saving and a greater level of capital accumulation. Allowing businesses to deduct 

the cost of new investment immediately, rather than to depreciate assets over time, 

would encourage new investment. It also would eliminate the tax-induced differences 

between before-tax and after-tax returns on investment projects that are found in our 

current system. 

Numerous studies have evaluated the economic impact of replacing the current 

income tax with a consumption tax. These studies typically consider reforms that 
155

Chapter Seven

more closely resemble the Progressive Consumption Tax Plan, rather than the 

Growth and Investment Tax Plan discussed below. These studies use a range of 

different assumptions in analyzing tax reform, and they consider both the nearterm and long-run consequences of modifying the tax structure. While the studies 

produce different estimates of how taxing consumption rather than income would 

affect economic growth, virtually all such studies suggest that the long-run level of 

national income would be higher. The Treasury Department used three different 

economic models to evaluate both the long-run and short-run effects of adopting the 

Progressive Consumption Tax Plan. Their findings suggested a long-run increase in 

economic activity of between 2 and 6 percent. These findings are broadly consistent 

with the results of previous economic analyses, most of which yielded estimates of at 

least a 3 percent increase in long-run output. Most of these models do not consider 

the potential efficiency gains that result from an improved allocation of capital across 

investments, but focus instead only on the benefits of lowering the overall capital 

tax burden. The potential economic gains from shifting to a consumption tax may 

therefore exceed these estimates. 

To place these values in perspective, a 5 percent expansion of the U.S. economy in 

2005 would increase Gross Domestic Product by over $600 billion and would likely 

raise wages and compensation by over $400 billion. Such an increase in economic 

output would improve living standards for most Americans.

The increased level of capital accumulation that would follow the adoption of a 

consumption tax is likely to result in more rapid productivity growth, which is the key 

to raising standards of living for American workers. Figure 7.1 shows the historical 

relationship between changes in wages and productivity growth. The two move closely 

together: wages grow when productivity grows, and wages stagnate when productivity 

falls.

Productivity growth ultimately depends on investments in human, physical, and 

intangible capital. Human capital investment is affected by the tax burden that 

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individuals expect to face after they have invested time and money to acquire skills 

that raise their earning capacity. Both the level and the progressivity of tax rates 

are important. Low marginal tax rates on labor income make it more attractive for 

individuals to make investments in education. In contrast, large differences in labor 

tax rates when individuals forego earnings to obtain new skills, and when they earn 

the return on those investments, can discourage human capital investment. All of 

the Panel’s recommendations preserve incentives for human capital investment by 

avoiding increases in (and in many cases, reducing) the marginal tax rates on labor. 

The incentive for businesses and individuals to invest in physical and intangible 

capital is affected by the difference between the before-tax and the after-tax return to 

new investments. Taxing business investment reduces the aggregate stock of capital 

that is available to raise worker productivity. Moreover, under the current tax system, 

investments in physical capital, such as plant and equipment, are taxed at substantially 

higher rates than investments in marketing, research and development, and other 

intangibles. Business investments are also taxed much more heavily than investments 

in owner-occupied housing. This uneven tax treatment of investment leads to an 

inefficient allocation of investment resources. 

An Overview of the Growth and Investment Tax Plan

The Growth and Investment Tax Plan would raise revenue in a progressive fashion, 

while preserving many of the important features found in our current income tax. It 

would provide work incentives to low-income taxpayers through Family and Work 

Credits and encourage home ownership and charitable giving. Like the Simplified 

Income Tax, it would eliminate the worst features of our current income tax system, 

such as targeted tax benefits, phase-outs, and the AMT. It would simplify the tax 

system for individual taxpayers using an approach that is similar to the Simplified 

Income Tax Plan by incorporating a number of elements that are common to both 

plans. 
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Table 7.1. Growth Investment Tax for Households

Provisions Growth and Investment Tax Plan

Households and Families

Tax Rates Three tax brackets: 15%, 25%, 30%

AMT Repealed

Personal exemption Replaced with Family Credit available to all taxpayers: $3,300 credit for 

married couple, $2,800 credit for unmarried with child, $1,650 credit for 

singles, $1,150 credit for dependent taxpayer; additional $1,500 credit for 

each child and $500 credit for each other dependent 

Standard deduction

Child tax credit

Earned income tax credit Replaced with Work Credit (and coordinated with the Family Credit); 

maximum credit for working family with one child: $3,570; with two or 

more children, $5,800

Marriage penalty Reduced. All tax brackets, Family Credits, and taxation of Social Security 

benefits for couples are double those of individuals 

Other Major Credits and Deductions

Home mortgage interest Home Credit equal to 15% of mortgage interest paid; available to all 

taxpayers; mortgage limited to average regional price of housing (limits 

ranging from about $227,000 to $412,000)

Charitable giving Deduction available to all taxpayers (who give more than 1% of income); 

rules to address valuation abuses

Health insurance All taxpayers may purchase health insurance with pre-tax dollars, up 

to the amount of the average premium (estimated to be $5,000 for an 

individual and $11,500 for a family).

Education Taxpayers can claim Family Credit for some full-time students; simplified 

savings plans

State and local taxes Not deductible

Individual Savings and Retirement

Defined contribution plans Consolidated into Save at Work plans that have simple rules; AutoSave 

features point workers in a pro-saving direction

Defined benefit plans No change

Retirement savings plans Replaced with Save for Retirement Accounts ($10,000 annual limit) 

– available to all taxpayers

Education savings plans Replaced with Save for Family Accounts ($10,000 annual limit); would 

cover education, medical, new home costs, and retirement saving needs; 

available to all taxpayers; refundable Saver’s Credit available to lowincome taxpayers

Health savings plans

Dividends received Taxed at 15% rate

Capital gains received Taxed at 15% rate

Interest received (other than 

tax exempt municipal bonds)

Taxed at 15% rate

Social Security benefits Replaces three-tiered structure with simple deduction. Married taxpayers 

with less than $44,000 in income ($22,000 if single) pay no tax on Social 

Security benefits; fixes marriage penalty; indexed for inflation

For businesses, the Growth and Investment Tax Plan would establish a more uniform 

tax on investment by allowing immediate expensing of business assets and eliminating 

interest deductions. One measure that economists often use to describe the net effect 
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The President’s Advisory Panel on

of the tax system on investment incentives is the “marginal effective tax rate.” This 

yardstick is not the statutory tax rate, but rather a measure of the difference between 

an investment’s pre-tax and after-tax return. The higher the marginal effective tax 

rate, the lower the after-tax return relative to the pre-tax return, meaning that some 

investors would not undertake an investment because of the tax burden. If the 

effective tax rate is zero, any project that an investor would choose to undertake in a 

world without any taxes would still be undertaken in a world with taxes. 

Table 7.2. Growth and Investment Tax for Businesses

Provisions Growth and Investment Tax Plan

Small Business

Rates Sole proprietorships taxed at individual rates (top rate lowered to 30%);

Other small businesses taxed at 30%

Recordkeeping Business cash flow tax

Investment Expensing (exception for land and buildings under the Simplified Income Tax 

Plan)

Large Business

Rates 30%

Investment Expensing for all new investment

Interest paid Not deductible (except for financial institutions)

Interest received Not taxable (except for financial institutions)

International tax system Destination-basis (border tax adjustments)

Corporate AMT Repealed 

Under the current income tax system, effective tax rates differ widely across assets and 

across projects that are financed in different ways. The average marginal effective tax 

rate on all types of business investment under the policy baseline is approximately 22 

percent. The Growth and Investment Tax Plan would lower the marginal effective tax 

rate to 6 percent and equalize the tax burden on different types of investments. The 

Panel is confident that the very substantial reduction in the tax burden on investment 

would stimulate capital formation, keep American capital that would have gone to 

other countries at home, and attract foreign capital to the United States. 

The Growth and Investment Tax Plan for Households

For households, the Growth and Investment Tax Plan is nearly identical to the 

Simplified Income Tax. Under the Growth and Investment Tax Plan, households 

would be taxed on their wages, salaries, and other compensation. The Growth and 

Investment Tax Plan would incorporate the newly designed ways to help taxpayers 

receive tax benefits for home ownership, charitable giving, and health insurance 

coverage described in Chapter Five. It would incorporate the Family and Work 
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Credits, which would provide a tax threshold that is identical to the tax threshold 

under the Simplified Income Tax. Like the current system, the Growth and 

Investment Tax Plan would share the burdens and benefits of the federal tax structure 

in a progressive manner. 

Under the Growth and Investment Tax Plan, wages, compensation, and other 

compensation would be taxed at three progressive rates of 15, 25, and 30 percent, 

instead of the six rates used in our current system. As summarized in the Table 7.3, 

the rate brackets for married taxpayers are exactly twice the amounts for unmarried 

taxpayers, which would reduce the marriage penalties. 

Table 7.3. Tax Rates under the Growth and Investment Tax Plan

Tax Rate Married Unmarried

15% Up to $80,000 Up to $40,000

25% $80,001 - $140,000 $40,001 - $70,000

30% $140,001 or more $70,001 or more

An income tax collects more taxes from a family that saves for the future than it 

would from an identical family that spends the same amount today. The Growth and 

Investment Tax Plan would reduce, but not eliminate, this distortion. The Progressive 

Consumption Tax Plan discussed below, in contrast, would eliminate the tax burden 

on capital income and thereby make a family’s tax burden independent of when they 

choose to spend their earnings.

The Growth and Investment Tax Plan deviates from a traditional consumption tax by 

imposing a low-rate tax on all household capital income, while also retaining a system 

of tax-exempt saving accounts that would enable many households to avoid taxation 

altogether on returns to savings. All dividends, interest, and capital gains on assets 

held outside these accounts would be taxed at a 15 percent rate. Under current law, 

dividends and capital gains are taxed at a maximum rate of 15 percent, while interest 

is taxed at ordinary income tax rates. Lowering the household-level tax on interest 

income would further reduce the incentive for families to spend now instead of saving 

more.

The Growth and Investment Tax Plan would incorporate the Save for Retirement 

and Save for Family accounts proposed as part of the Simplified Income Tax. In 

addition, the refundable Saver’s Credit would provide a match for contributions made 

by low-income taxpayers. 

The Growth and Investment Tax Plan also would provide employer-sponsored 

retirement accounts that are similar to the Save for Work accounts under the 

Simplified Income Tax. However, the Save at Work accounts under the Growth 

and Investment Tax Plan would be “pre-paid,” meaning that contributions to these 
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The President’s Advisory Panel on

accounts would be made on an after-tax basis like a Roth IRA. This change would 

not affect balances in existing pre-tax retirement accounts, which would continue to 

be tax-free until withdrawn Allowing future contributions to employer-sponsored 

accounts to be made on an after-tax basis under the Growth and Investment Tax Plan 

would provide a uniform treatment of all tax-free saving. 

As with the Simplified Income Tax, these savings accounts would ensure that most 

American families would be able to save for retirement, housing, education, and 

health free of taxes. Given the opportunity and flexibility of these savings accounts, 

the Panel expects that relatively few families would pay the 15 percent tax on interest, 

dividends, and capital gains that would apply to assets held outside these accounts.

Box 7.2. Save at Work Accounts Under the Growth And Investment Tax 

Plan

The Growth and Investment Tax Plan incorporates back-loaded, or Roth-style Save at Work 

accounts. These accounts would be similar to recently enacted provisions that will permit 

taxpayers to make after-tax contributions to their 401(k) and 403(b) accounts beginning next 

year.

The Growth and Investment Tax Plan differs from the Simplified Income Tax, which 

provides pre-tax Save at Work accounts that are structured like traditional IRAs and 

provide a tax deduction for contributions and tax all withdrawals as ordinary income. If a 

household’s marginal tax rate is the same when contributions are made and withdrawn, the 

two structures offer the opportunity to accumulate assets at the before-tax rate of return. 

The Roth-style approach has the advantage of being simpler because the traditional IRA 

approach involves claiming a deduction when money is contributed and reporting income 

when the money is withdrawn. 

These approaches yield different revenue implications over the ten-year budget window. 

The revenue cost of traditional IRA accounts is recorded “up front,” when contributions are 

made. With Roth-style accounts, the pattern is reversed – there are no up-front revenue 

costs because contributions are included in taxable income. The discussion in Chapter Four 

noted that retirement saving programs affect revenues over horizons as long as three or 

four decades. The Simplified Income Tax Plan’s Save at Work accounts would raise less 

tax revenues during the ten-year budget window than those of the Growth and Investment 

Tax Plan, even if identical amounts were contributed to these accounts. The Growth and 

Investment Tax Plan would raise less revenue from these accounts in the years beyond 

the budget window. It is worth noting that other provisions of the Growth and Investment 

Tax Plan have the opposite effect – expensing of new investment, for example, overstates 

revenue losses because deductions are shifted inside the ten-year budget window.

The Panel supports the use of Roth-style accounts in the Growth and Investment Tax Plan 

on policy grounds. The availability of the tax revenue from the Roth-style approach also 

made it possible to set the corporate and individual income tax rates lower than they would 

have been if the traditional IRA structure had been used. Nevertheless, the use of Rothstyle accounts is not an essential feature of the plan, and it could be implemented with the 

traditional IRA-style accounts. If policymakers made the decision to use that structure, the 

tax rates would need to be higher in order to achieve revenue neutrality.
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Figure 7.2. Tax Return for the Growth and Investment Tax Plan

The Growth and Investment Tax Plan would make computing taxes dramatically 

simpler than our current system and would significantly reduce the amount of 

information required to be gathered and retained by taxpayers and collected and 

processed by the IRS. Like the Simplified Income Tax Plan, individual tax returns 

would be shorter and simpler and would free of the parallel tax structure created by 

the AMT. The new tax return that would be used under the Growth and Investment 

Tax Plan would easy to understand, and would be no longer than one page, as shown 

in Figure 7.2. 
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The Growth and Investment Tax Plan for Businesses

The Growth and Investment Tax Plan would impose a flat tax on all business 

cash flow, defined as sales or receipts less the cost of materials, labor services, and 

purchases of business assets. The Growth and Investment Tax Plan would modify 

the current corporate income tax base in four important ways. First, businesses would 

be allowed to write-off immediately, or “expense” their capital expenditures. Second, 

for non-financial firms, financial transactions would be excluded from the cash flow 

computation. Businesses generally would not be entitled to deduct interest paid or 

be required to include interest and dividends received and capital gains on the sale of 

financial assets. Special rules would apply to businesses that provide financial services. 

Third, firms that generate losses would be allowed to carry them forward and to offset 

them against future tax liability. In contrast to the current tax system, however, losses 

would accrue interest when carried forward. Finally, international transactions would 

be taxed under the “destination basis” principle. The cash flow tax would be rebated 

on exports, and imports would not be deducted from cash flow. The Panel embraced 

the destination-based system because it is consistent with the use of domestic 

consumption as the tax base and because it is easier to administer than any other 

alternative.

Business Cash Flow Taxed Once at a Flat Rate 

The Growth and Investment Tax Plan would apply a flat 30 percent tax on all 

businesses other than sole proprietorships, regardless of their legal structure. 

Removing the tax differential among business entities would eliminate economic 

inefficiency caused by the double tax on corporate firms that are unable to take 

advantage of flow-through treatment under current law for non-corporate 

organizational forms, such as limited liability companies (LLC), partnerships, or S 

corporations. The net positive cash flow of flow-through entities would be taxed at 

the business tax rate, although owners of these entities could report and compute the 

tax on business cash flow on a separate schedule of their individual returns. Similarly, 

the net positive cash flow of sole proprietorships would be reported on the tax return 

of its owner, but would be taxed at the graduated individual rates.

By focusing on cash flow, the new tax base would discard the complicated accounting 

rules that currently attempt to match income with deductions. Instead, for most 

businesses the tax base would be the difference between cash received and cash 

paid out. The business tax would resemble a “subtraction method” value-added tax 

(VAT), with the important exception that wages and other compensation would be a 

deductible expense. 
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Box 7.3. What is the Subtraction Method?

The business tax would be imposed on the difference between receipts and outlays – 

net cash flow. This is often referred to as the “subtraction method” because businesses 

subtract all expenses from receipts. It is one of two methods used to implement VATs. 

The other method is the credit or credit-invoice method. In that method, a business is 

taxed on all receipts but receives a credit for the amount of tax paid by the seller on the 

business’ purchases. While the credit method is based on transactions and the subtraction 

method is based on the aggregate accounts of a business, in practice, the two methods 

are virtually identical – the subtraction method aggregates all expenses and receipts during 

the year into accounts made up of individual transactions, while the credit method starts 

with transactions, but businesses must ultimately aggregate transactions into accounts to 

file returns.

Any amount deducted under the subtraction method can be converted to an equivalent 

credit and vice versa. Suppose a business spends $100 on supplies and the tax rate is 35 

percent. Under the subtraction method, the business gets a deduction of $100, saving it 

$35 in taxes that would otherwise be due. On the other hand, under the credit method the 

business would not be allowed to subtract the $100 of purchases, but would be given a 

$35 tax credit. 

Most countries with credit method taxes require invoices to help ensure that a buyer only 

receives a tax credit if the seller in fact pays tax on the sale. The Growth and Investment 

Tax Plan, although implemented using the subtraction method, would similarly require 

that deductible purchases be allowed only from businesses that are subject to the tax, 

and that these purchases be substantiated. For example, goods or services received from 

foreigners, who are not taxed in the United States, would not be deductible. 

The Growth and Investment Tax Plan would be implemented using the subtraction method 

because it is closer to current law methods of accounting, which would reduce the costs 

of switching tax systems.

The flat-tax rate of 30 percent on business cash flow would be the same as the top 

tax rate under the household tax, reducing tax planning strategies aimed at shifting 

income between the business and individual tax bases. 

Expensing for All Business Investments 

The Growth and Investment Tax Plan would enhance investment incentives by 

lowering the effective tax rate on new investment. It also would reduce distortions 

under current law that suppress and misallocate capital investment due to different 

tax rates across different types of business assets. 

Our current depreciation system permits businesses to deduct the cost of their new 

investments from their taxable income over time. Although accelerated depreciation 

and expensing of some assets under our current system lowers the tax burden 

on returns from new investment, depreciation deductions provide an imperfect 

mechanism for measuring the actual decline in value of an asset. Current depreciation 

rules result in effective tax rates that differ substantially among different types of 

assets. Mismatches between the actual decline in the value of assets, or economic 

depreciation, and tax depreciation may discourage new investment in plant and 

equipment and distort the allocation of investment across asset classes. 
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The Growth and Investment Tax Plan would encourage new investment by replacing 

the patchwork of current incentives and credits with a simple rule: all business 

investment can be expensed the year when it is made. Moving from depreciation 

allowances to expensing would lower the tax burden on the returns to new investment 

and level the playing field across different types of business assets. With expensing, 

each dollar spent on a new investment asset would generate a deduction worth one 

dollar, regardless of the asset’s type. It would also substantially simplify business taxes 

by eliminating the need to maintain detailed depreciation schedules and accounting 

for asset basis. 

Because the Growth and Investment Tax Plan retains a low-rate tax on dividends, 

interest, and capital gains at the household level, it continues to place a tax burden, 

estimated by the Treasury Department to be approximately 6 percent, on all types of 

investment. Nevertheless, many projects that are not economical to undertake under 

the current income tax system would generate an acceptable after-tax return under 

the Growth and Investment Tax Plan. 

Consistent Treatment of Financial Transactions

The business tax base under the Growth and Investment Tax Plan would not include 

financial transactions, such as interest paid and received. The elimination of interest 

deductibility would equalize the tax treatment of different types of financing and 

would reduce tax-induced distortions in investment incentives. Current law places a 

lower tax burden on firms that have access to debt financing than on those that use 

the equity market to finance new projects.

Eliminating the business interest deduction for non-financial firms is an essential 

component of the Growth and Investment Tax Plan. Allowing both expensing of 

new investments and an interest deduction would result in a net tax subsidy to new 

investment. Projects that would not be economical in a no-tax world might become 

viable just because of the tax subsidy. This would result in economic distortions and 

adversely impact economic activity. Moreover, retaining interest deductibility would 

preserve differences in the tax burdens on debt-financed and equity-financed projects, 

thereby retaining distortions across asset and firm types. The Growth and Investment 

Tax Plan would eliminate the complicated distinctions between debt and equity 

finance and remove the tax system as a factor in firms’ capital structure decisions. 

Removing the tax advantages of corporate debt also eliminates the tax code’s incentive 

for firms to increase their debt load beyond the amount dictated by normal business 

Current-law tax depreciation also fails to account for inflation. Businesses claim tax 

depreciation based on an asset’s nominal purchase price, even though inflation may 

have increased its replacement cost. This means that investors do not recover the full 

value of their investments. The current income tax leads businesses to forego investing 

in some projects that would have a positive net present value in a world without taxes, 

but that fail to earn enough to cover both taxes and the required return to investors. 

With a pure consumption tax, any project that is attractive in a no-tax world remains 

attractive.
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conditions. Figure 7.3 summarizes how the combination of expensing and more equal 

treatment of interest and dividends provides a lower, more uniform tax burden on the 

returns of marginal business investments.

Excluding financial transactions from the business tax of the Growth and Investment 

Tax Plan would create special difficulties in the case of businesses that provide 

financial services. To prevent distortions, financial services should be taxed like any 

other business good or service. The taxation of financial services is complicated, 

however, because “implicit fees” are typically imbedded in interest rate spreads and 

financial margins. For example, a bank typically pays interest to depositors at a lower 

rate than it collects from mortgage borrowers. Both of these transactions include two 

components – a service fee and a financial cost related to the use of money – that 

are included in a single payment of “interest.” The problems with separating the 

components of financial services are not unique to a consumption tax – income taxes 

also do not properly tax financial services, but the under-taxation is more visible in 

a consumption tax. As a result of this conceptual difficulty, countries that administer 

VATs have adopted special regimes for financial services, with most exempting 

financial services from the VAT tax base. 

The Panel determined that financial services should be taxed under the Growth and 

Investment Tax Plan. Exempting financial services from tax leads to a number of 

economic distortions and creates compliance and administrative difficulties. Absent 

special rules, however, businesses that primarily provide financial services would 

have perpetual tax losses under the Growth and Investment Tax Plan. This would 

occur because the cash flow tax base for these financial firms would not include the 

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revenues that they generate from lending and investing at rates above their cost of 

funds, but it would allow a deduction for the cost of compensation for workers as well 

as other purchases.

The Panel considered several options for the taxation of these firms, and recommends 

an approach under which financial institutions would treat all principal and interest 

inflows as taxable and deduct all principal and interest outflows. Customers would 

disregard financial transactions for tax purposes. To prevent the over-taxation of 

business purchases of financial services, financial institutions would inform business 

customers of the amount of financial cash flows that are attributed to deductible 

financial intermediation services. This amount would be deductible as an expense 

in computing the business customer’s taxable cash flow under the Growth and 

Investment Tax Plan. Rules would be required under this regime to identify which 

businesses should be subject to the financial institutions regime, especially in the 

case of businesses that have both financial and non-financial business activities. 

In addition, an interest rate that would be used as a proxy for the “financial cost” 

component of financial cash flows would have to be established to determine the 

value of the separate taxable service component; the simplest approach would be to 

compare financial inflows and outflows to a single, short-term inter-bank interest rate. 

The Panel recognizes that before implementing the Growth and Investment Tax 

Plan, it would be wise to consider alternative tax rules for financial firms and their 

potential impact on incentives for firm behavior. The Panel has identified some 

possible alternatives, which are discussed in more detail in the Appendix.

The Treatment of Tax Losses

The current tax system limits refundability of tax losses because of concerns that such 

losses can be generated through non-economic, tax-sheltering activity. Firms currently 

are allowed to carry back losses and to claim refunds for taxes paid in prior years, and 

to carry losses forward to offset tax liability in future years. Firms that in prior years 

earned positive income that exceeds their current losses, or that will earn such income 

in the future, will eventually be able to use their tax losses. 

When losses are not refundable, but firms are taxed when they have positive cash 

flows, the tax system discourages risky ventures with substantial loss possibilities. In 

effect, such tax rules provide the government with a larger share of favorable returns 

than of adverse returns, which reduces the after-tax return to undertaking such an 

investment. 

Denying current refunds of losses raises the effective tax rate on marginal investments 

relative to a system that features refundable losses. Consider a start-up firm that has 

substantial upfront capital expenditures but little initial revenue. In the early years, 

the firm has negative cash flow, but it expects to be profitable in the future. If the tax 

system does not refund losses until a firm is profitable, there is a delay in the receipt 

of the tax benefits associated with expensing its capital investments. The tax system 

would discourage firms from undertaking projects expected to have many years of 

negative cash flows. If there was some chance that the firm might go bankrupt before 
167

Chapter Seven

receiving the benefit of its start-up losses, this would raise the effective tax burden on 

new investment. 

Under the Growth and Investment Tax Plan, losses would not be refundable. To 

mitigate the impact that denying loss refundability would have on the effective tax 

rate on marginal investments, the Panel recommends providing interest on loss 

carryforwards. If the current interest rate is 10 percent, and a firm incurs a $1 million 

loss this year, it may claim a $1.1 million loss offset next year (adding 10 percent of 

$1 million), or a $1.21 million loss in two years (adding 10 percent of $1.1 million). 

Losses would be carried forward indefinitely. By providing interest on the amount 

of tax later refunded, the tax system would achieve nearly the same effect as having 

full loss refunds for firms that eventually earn positive cash flows, provided that the 

interest rate paid on loss carryforwards is equal to the firm’s borrowing rate. Allowing 

interest on losses carried forward alleviates the problem of firms losing the time value 

of money on carryforwards, but does not eliminate the risk of losing carryforwards 

entirely if a firm goes out of business. 

Another strategy for allowing firms to capture the full value of the tax benefits 

associated with negative cash flow is to allow losses to be traded from one firm to 

another. If trading is not costly to firms, then allowing such trading may be equivalent 

to allowing full and immediate loss refundability. The Panel decided that losses should 

not be tradable under the Growth and Investment Tax Plan. Allowing tradable 

or refundable losses may encourage tax avoidance schemes in which the taxpayers 

make investments that would not have been worth undertaking in a no-tax setting. 

The value of tax losses created by such an investment may be a key component of 

its appeal. In addition, allowing loss trading could make it much more important to 

police so-called "hobby losses" and losses generated by various forms of disguised 

consumption, rather than investment, because those losses could generate tax savings 

even when the person incurring them would never realize offsetting positive cash 

flow.

Under current law, several provisions prevent the transfer of losses to taxpayers with 

positive income and the transfer of income to taxpayers with losses. One set of rules 

generally limits the ability to apply the losses of one corporation against income from 

another when the corporations are combined. Similar rules would be adopted under 

the Growth and Investment Tax Plan to limit the transferability of negative and 

positive cash flow.

“Destination-Basis” Taxation of Cross-Border Transactions

International transactions, including both imports and exports of goods and 

services, as well as financial transactions such as the repatriation of earnings by 

corporate subsidiaries, pose important challenges for all tax systems. The Growth 

and Investment Tax Plan is no exception. The tax could be implemented on either 

a “destination-basis” or an “origin-basis” to address international transactions. The 

former treats all domestic consumption equally, while the latter treats all domestic 

production equally. The Panel recommends using the destination-basis to implement 
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the Growth and Investment Tax Plan. 

A destination-basis consumption tax levies the same tax on consumption that occurs 

in the United States, regardless of where the good was produced. Under this system, 

sales to customers in other nations (exports) are excluded from the tax base while 

purchases from abroad (imports) are included. Thus, if a domestic manufacturer 

produces a product in the United States at a cost of $90 that it sells abroad for $100, 

the manufacturer is not taxed on the $100. The manufacturer receives a rebate of the 

tax on the $90 of production costs. This has the effect of eliminating the tax burden 

on goods that are sold abroad. The tax rebate that the manufacturer receives at the 

point of export is commonly known as a border tax adjustment. Purchases from 

abroad are taxed by either making them nondeductible to the importing business or 

by imposing an import tax. 

The alternative “origin-basis” system taxes goods based on where they were 

produced – their origin. The tax base is domestic production, which equals domestic 

consumption plus net exports. Exports are included in the tax base because they 

are part of domestic production and imports are excluded because they are not. If a 

manufacturer produces a product in the United States at a cost of $90 that it sells 

abroad for $100, it is taxed on the sale. This means that identical items produced for 

domestic and for foreign consumption are taxed in the United States in exactly the 

same way. Purchases from abroad are either deducted by the importing business or 

not taxed at the point of entry into the United States.

Border Tax Adjustments and International Trade

The VATs imposed by our major trading partners are implemented on a destinationbasis. They include border tax adjustments. While these taxes are often viewed as 

subsidizing exports because they exempt exports and tax imports, economic analysis 

indicates that destination-based taxes do not affect the balance of trade. To illustrate 

this proposition, suppose that the United States was trading with a foreign country 

in a completely tax-free environment. Trade would be conducted at a level at which 

each country enjoyed comparative advantage – selling to others the products and 

services that nation produces best. Now suppose that the United States imposed a 

destination-basis consumption tax. A domestic exporter would still sell its product in 

the foreign country at the same price as without the tax.

Similarly, a good sold in the United States by a foreign producer would be subject 

to the U.S. consumption tax. As a result, the foreign importer would compete in 

the United States on the same basis as local sellers. Consumers in the United States 

would make the same choices regarding imports and domestically-produced goods 

as they had made before the tax was imposed, since both are subject to the same tax. 

Economic theory suggests, therefore, that imposing a destination-basis tax does not 

affect a country’s trade position. 

The preceding discussion might suggest, in contrast, that an origin-basis tax could 

disadvantage domestic producers relative to foreign producers in the worldwide 

market. However, border tax adjustments are not the only mechanism working to 
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maintain neutrality. Adjustments that take place through the market, such as changes 

in exchange rates or in other economic variables, including wages and the prices of 

other inputs, should wholly offset any potentially detrimental trade effects on the 

value of exported goods under an origin-basis tax.

Returning to the previous example, assume instead that the United States imposes 

an origin-basis tax. Before the tax is imposed, the United States is trading in a 

completely tax-free environment. Recall that under an origin-basis system, exports 

are taxed and imports are exempt. If markets are competitive, the exporter will not 

be able to reduce his price and remain in business after the tax on exports is imposed. 

However, the U.S. currency may depreciate so that although the nominal price 

increases by the amount of the tax, the price paid for the export by foreign consumers 

in their currency is unchanged from its before-tax level. Therefore, trade will not be 

affected. As explained above, however, if exchange rates did not fully adjust, the price 

adjustment could occur through adjustments in domestic prices and wages.

The observation that a neither a destination-basis nor an origin-basis tax distorts 

the pattern of trade that would exist in the absence of any taxes does not imply that 

moving from the current income tax structure to a consumption tax would not affect 

trade. The current tax system places heavier burdens on some industries than on 

others. Replacing the current tax system with a system that is equivalent to a system 

with no taxes at all could raise exports in the industries that are currently taxed 

heavily. 

Administration 

The Panel recommends imposing the Growth and Investment Tax Plan on a 

destination-basis because such a tax will be easier to administer than a comparable tax 

on an origin-basis. An origin-basis system will engender serious disputes as a result 

of “transfer pricing.” The term transfer pricing refers to amounts charged (or not 

charged) for sales and transfers between related entities, often controlled by a single 

corporate parent. Because the different entities are related, they do not really care 

what price they charge each other. If they are located in different taxing jurisdictions 

they may have an incentive to set prices to minimize overall taxes rather than to 

reflect the actual value of the goods and services they are providing one another. 

Current tax rules use the internationally accepted standard for setting transfers prices; 

these prices must be set at the level that would have prevailed if the parties had been 

dealing at “arm’s length.” The application of this standard raises difficult compliance 

and administrative problems.

Under a destination-basis tax, transfer prices do not affect the computation of tax 

liabilities. Border adjustments make the tax base domestic consumption, which at the 

business level equals domestic sales minus domestic purchases. As a result, the prices 

established for cross-border transactions are irrelevant, and there are no opportunities 

to use transfer prices to minimize tax liabilities. 

The same is not true under an origin-basis tax. Transfer pricing would continue to be 

a problem since export sales would be taxable and imports would be deductible. There 
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The President’s Advisory Panel on

is an incentive, as in the current system, to overcharge for imports and undercharge 

for exports to shift income out of the United States. Related but more complex tax 

avoidance schemes are more difficult to accomplish under a destination-basis system 

for similar reasons (see Box 7.4 for an example).

Box 7.4. An Example of a Tax Avoidance Scheme under an Origin-Basis 

System

A foreign company purchases a $100 product from a U.S. business by promising to pay 

$110 in one year (a purchase on credit). The transaction is documented as the purchase of 

a $90 good with $20 of interest. By overstating interest on the sale, the business reduces 

its taxable receipts under an origin-basis tax while not changing its cash flows. The foreign 

company is indifferent to how the transaction is structured. Under a destination-basis 

system, the transaction with the foreigner is not subject to tax since it is an export and, 

as a result, there is no incentive to engage in this tax avoidance scheme in the course of 

cross-border transactions.

Besides reducing incentives for tax-minimizing transfer pricing, a destination-basis 

tax is easier to apply to royalty income from abroad. Royalties received from abroad 

represent payments for exports of intangible assets, and so would be exempt from 

taxation under the Growth and Investment Tax Plan. The owner of the intangible 

would be taxed when he uses the proceeds to consume. Royalties paid for foreigncreated intangible assets would not be deductible since they are payments for imports. 

Transfer pricing problems may be particularly severe in the case of royalties, because 

it is difficult to establish arm’s length prices for intangible assets. The destination-basis 

tax closes down opportunities to inappropriately set transfer prices since the prices 

established for cross-border royalty transactions would be out of the tax base.

Choosing the destination-basis for the treatment of cross-border transactions 

under the Growth and Investment Tax Plan “closes” the tax system. This means 

that businesses are only able to claim deductions from the tax base that are offset 

by corresponding inclusions in the tax base. Closing the system through border 

adjustments precludes tax avoidance opportunities that involve structuring crossborder transactions to generate tax deductions for payments to foreigners who are 

outside the system. 

While closure is attractive on balance, it has some drawbacks. Deductions should 

only be allowed for purchases from domestic suppliers and sales should be exempted 

only if they are truly to foreigners. This makes it essential to monitor deductions 

and exemptions. Moreover, citizens of the United States can avoid import taxes by 

consuming foreign-produced goods purchased outside of the United States. This 

creates an incentive for citizens to buy goods abroad. 

Location Incentives

The presence of expensing for new investment under the Growth and Investment 

Tax Plan would make the United States an attractive place to invest foreign capital. 

The investment incentives discussed above would apply to all firms operating in the 
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Chapter Seven

United States, not just to firms headquartered in the United States. At the same 

time, the tax code would no longer give U.S. multinational corporations an incentive 

to move production overseas because the tax burden would be based on sales within 

the U.S., regardless of where the goods are produced. As explained in detail earlier in 

this chapter, the Growth and Investment Tax Plan also would eliminate many of the 

complex cross-border tax planning activities that reduce the revenue collected under 

current corporate income taxes. Reducing the incentive for such tax planning would 

be an important step toward simplifying the tax system.

Refunds for Exports

The border tax adjustment described above would provide tax refunds to exporting 

firms. The amount of the refund would be determined by the costs incurred in 

producing an export, including the firm’s labor costs. For firms that sell primarily in 

the export market, their border tax adjustment rebate could exceed any tax liability 

that they face on their domestic sales. Exporting firms whose border tax adjustments 

exceed their taxes on domestic cash flow would be provided a refund for their excess 

border tax adjustment. In addition, until exchange rates or domestic prices adjust after 

the imposition of the tax on imports, businesses that import significant amounts of 

goods could operate at a loss after taxes, because they would receive no deduction 

from income for the costs of their imports. They could thus be paying taxes greater 

than their net pretax cash income.

Although the excess deductions generated by an export business and those generated 

by a domestic business suffering losses are conceptually similar, they would be treated 

differently under the Growth and Investment Tax Plan. Domestic firms suffering 

losses would most likely prefer an immediate rebate of taxes if given a choice, 

notwithstanding that their loss carryforwards would be increased by an interest factor 

under the plan. Thus, special rules may be needed to police the allocation of expenses 

between domestic businesses generating losses and export businesses when both are 

operated within the same firm or through affiliates. 

Border Tax Adjustments and the World Trade Organization

Multilateral trade rules originally developed as part of the General Agreement on 

Tariffs and Trade (GATT), and now incorporated into the rules of the World Trade 

Organization (WTO), affect the use of border adjustments. GATT/WTO rules treat 

border tax adjusting “direct taxes” as a prohibited export subsidy. In contrast, “indirect 

taxes” on exports may be border adjusted so long as the amount remitted does not 

exceed the amount of indirect tax “levied in respect of the production and distribution 

of like products when sold for domestic consumption.” 

Many developed countries with border-adjustable VATs couple those VATs with 

a single-rate tax on capital income at the individual level. Some of these countries 

also have wage subsidies, progressive taxation of wages, or both. The Growth and 

Investment Tax Plan is equivalent to a credit-method VAT at a 30 percent rate, 

coupled with a progressive system of wage subsidies and a separate single-rate tax 

on capital income. The Panel therefore believes that the Growth and Investment Tax 
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The President’s Advisory Panel on

Plan should be border adjustable. 

However, given the uncertainty over whether border adjustments would be allowable 

under current trade rules, and the possibility of challenge from our trading partners, 

the Panel chose not to include any revenue that would be raised through border 

adjustments in making the Growth and Investment Tax Plan revenue neutral. If 

border adjustments are allowed, then the plan would generate about $775 billion 

more revenue over the ten-year budget window than is currently estimated in the 

scoring of this plan. 

Other Issues Associated with the Implementation of the Growth 

and Investment Tax Plan

The Growth and Investment Tax Plan, like any other tax system, will rely on rules and 

definitions that must be broadly applied to a wide variety of taxpayers and activities. 

Taxpayers inevitably respond to taxes by altering their behavior to minimize or avoid 

taxes. In addition, complexity is added as rules are crafted to prevent tax avoidance 

or abuses. For example, current law distinguishes between interest and dividend 

payments by corporations. This creates opportunities for tax planning and avoidance 

that, over the years, have spawned countless complex rules to clarify definitions and 

deny favorable treatment in specific circumstances. 

In designing the Growth and Investment Tax Plan, the Panel attempted to avoid 

distinctions between types of taxpayers, transactions, or activities that would create 

distortions and complexity. However, there would still be a need for some rules to 

delineate when specific transactions or activities are subject to tax. For example, rules 

to distinguish between financial and non-financial transactions, and rules regarding 

the treatment of transactions between businesses and taxpayers not subject to the cash 

flow tax (such as individuals and non-profits), are likely to be particularly important 

to the implementation of the tax. These issues, and others, are examined in more 

detail in the Appendix.

Transition

Replacing the current income tax with the Growth and Investment Tax Plan would 

affect the value of many assets. The Panel recognizes that transition issues are central 

to the analysis of fundamental tax reform, and therefore recommends providing some 

transition relief. 

The basic issues associated with transition relief can be illustrated by considering an 

owner of business assets that were recently purchased for $100 and that could be 

depreciated under the current income tax system over ten years. This business owner 

would not be able to recover this tax basis in an immediate and transition-free switch 

to a cash flow tax. Returns on the asset – either on the sale of the asset or through 

cash generated by deploying the asset – would be taxed, but pre-enactment basis 

could not be used to offset this income. For example, if the business owner sold the 

asset for $100 soon after the new tax system with a 30 percent tax rate was in effect, 

all $100 of the sales proceeds would be taxable and $30 of tax would be due – even 

though the owner’s economic position had not changed. On the other hand, investors 

who purchased new, but otherwise identical, physical assets after the Growth and 
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Chapter Seven

Investment Tax Plan took effect would be able to expense their purchases, effectively 

receiving $30 of tax benefits for purchasing $100 of new equipment. This transitional 

loss would be offset by future gains that the business owner would receive under the 

Growth and Investment Tax Plan, as returns from new investments would be taxed at 

a lower rate.

The Growth and Investment Tax Plan also would affect the tax treatment of existing 

financial assets, such as bonds and mortgages. For borrowers, eliminating interest 

deductions will increase future tax liabilities. For lenders, these effects will vary greatly. 

Individuals would pay a lower 15 percent tax on interest income, providing a windfall 

to these debt holders. Similarly, non-financial businesses will no longer pay tax on 

interest income and the value of their loans would increase.

The Panel recognizes that adoption of the Growth and Investment Tax Plan might 

have a negative impact on a number of households and on some business taxpayers. 

The Panel therefore recommends several types of transition relief. First, there should 

be transition relief on existing depreciation allowances. Depreciation allowances on 

assets put in place prior to the effective date for the Growth and Investment Tax Plan 

should be phased out evenly over a five-year period. In the year when the Growth 

and Investment Tax Plan is enacted, taxpayers with depreciable assets would be able 

to claim a deduction for 80 percent of the depreciation they would have been eligible 

to receive under the old system. In the second year this percentage will drop to 60 

percent, the third year it would be 40 percent, the fourth year it would be 20 percent, 

and it would be zero after five years.

Second, for businesses with outstanding debt, the Panel recommends the same 

five-year phase-out structure, followed by deductions of 60, 40, and 20 percent. 

Eighty percent of an interest deduction that would have been allowed under the old 

law would be permitted in the first year after the effective date of the Growth and 

Investment Tax Plan. A similar set of rules would apply to interest income that would 

have been taxed under the old tax regime. Eighty percent of such interest would 

be included in cash flow in year one, followed by inclusion shares of 60, 40, and 20 

percent. Any modifications to existing contracts would be treated as new contracts, 

and would terminate the transition relief for these contracts. Sales of physical assets 

would similarly terminate the benefits of pre-enactment depreciation allowances. 

As described in Chapter Five, transition relief would also apply to the deductibility 

of interest on home mortgages that were outstanding on the effective date of the 

Growth and Investment Tax Plan. 

Third, the Panel proposes special transition relief for firms that might be affected by 

border tax adjustments. If exchange rates do not adjust as rapidly as economic theory 

predicts they should, then border tax adjustments would place an undue burden on 

imports and importers. The Panel therefore recommends a four-year phase-in period 

for border tax adjustments. The phase-in rules would be administered on a firm-byfirm basis, and they would be limited to a base amount, calculated as the average 

value of import purchases, or export sales, in the two years before the Growth and 

Investment Tax Plan took effect. In the first year, an importer would be able to deduct 

90 percent of import purchases up to their import base. Imports that exceeded that 

base would not be deductible. Exporters would pay tax on 90 percent of exports up to 

the base amount. Exports that exceeded the base would not be taxed. In the second 
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The President’s Advisory Panel on

year, 60 percent of imports up to the firm’s base amount would be deductible and 60 

percent of exports would be taxed. The percentage would be reduced to 30 percent 

in the third year. In the fourth year, the border adjustment would be fully phased in: 

Cash flow taxes on exports would be rebated at the border and imports would not be 

deductible from cash flow.

Finally, the Panel recommends specialized transition rules for financial institutions. If 

the Panel’s recommended approach to the taxation of financial institutions is adopted, 

special transition rules would be needed to determine the status of outstanding loans 

made by these companies. Because financial firms never received a deduction against 

cash flow when raising the capital for outstanding loans, it would be unfair to levy tax 

on returns of capital when the lending firm receives them. Interest on loans extended 

prior to the effective date of the Growth and Investment Tax Plan, however, would be 

taxed as a component of individual cash flow. As with debt contracts for homeowners 

and non-financial businesses, any modifications to existing contracts would be treated 

as new contracts and not entitled to transition relief.

The Panel recognizes that there are other potentially important transitional issues, 

such as the tax treatment of existing tax loss carryforwards and tax credits and the 

treatment of inventory holdings when the Growth and Investment Tax Plan is 

implemented. In addition, the transition to the Growth and Investment Tax Plan 

would have a substantial impact on the financial statements of many large companies 

as the expected change in future tax liabilities – after considering transition relief 

– must be recorded for financial accounting purposes. The Panel does not specifically 

address these transition issues, but it recognizes that they are important concerns that 

would need to be addressed. 

There is a fundamental tradeoff between the amount of transition relief provided 

when a consumption tax is adopted and the growth and efficiency gains from the 

tax reform. Providing generous transition relief to households and firms that lose tax 

benefits that are available under an income tax, but not a consumption tax, reduces 

the efficiency gains of reform. This occurs because financing such transition relief 

requires raising tax rates in the consumption tax regime, which increases tax-induced 

distortions in labor supply and other aspects of household behavior. If transition relief 

is financed with a temporary increase in tax rates for some period after tax reform 

is enacted, then the efficiency costs will be concentrated in this period, and the net 

growth impact of adopting a consumption tax may be much smaller than the longrun analysis suggests. Once the transition period ends, however, the economy will 

ultimately achieve the long-run gains associated with the consumption tax. If tax rates 

are raised permanently to finance transition relief, then there will be some reduction 

in long-run economic growth relative to the benchmark case of no transition relief.

The revenue costs of the foregoing recommendations regarding transition relief are 

incorporated in the Panel’s calculations of the Growth and Investment Tax Plan’s 

ten-year revenue cost. More generous transition relief would require higher tax rates 

on businesses and individuals, or tighter limits on mortgage interest deductions, the 

exempt amount of employer-provided health insurance, or other tax subsidies. More 

limited transition relief, by comparison, could be paired with even more significant tax 

rate reductions.
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The Panel views transition relief as a critical and very difficult issue in moving from 

the current hybrid income tax to a consumption-based tax system. Ultimately, the 

political process must determine the appropriate level of transition relief. The Panel 

urges those who consider transition issues to recognize that the costs of transition 

relief are measured not just in the additional revenue needed to fund transition 

provisions, but also in the reduced efficiency gains that flow from higher marginal tax 

rates. 

A Progressive Tax System

The Growth and Investment Tax Plan removes impediments to saving and 

investment, and promotes long-term productivity growth, while largely preserving 

the current distribution of the federal income tax burden across income classes. While 

there are some variations in the income classes shown below, the overall distribution 

closely tracks current law.

The Treasury Department provided distribution tables for the Growth and 

Investment Tax Plan. Estimates for 2006 are shown in Figures 7.4 and 7.5. Similar 

to what was presented for the Simplified Income Tax Plan, Figure 7.4 breaks the 

population into fifths – or quintiles – and also shows the bottom 50 percent of 

the population (ranked by income), along with the top 10, 5, and 1 percent of the 

population. Figure 7.5 groups taxpayers by using income levels ranging from zero to 

$15,000 of income to more than $200,000 of income. 

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176

Federal Tax Reform

The President’s Advisory Panel on

To provide additional information about the effect of the Growth and Investment Tax 

Plan on the distribution of the tax burden, the Panel asked the Treasury Department 

to provide a distribution of the plan for the tax law that would be in place in 2015, 

the last year of the budget window, while holding income constant at 2006 levels. This 

distribution would account for provisions that change over time, such as transition 

relief for business and individuals and the rapid growth of the AMT under current 

law. 

One of the most expensive items in the Panel’s proposed reforms is the repeal of the 

AMT. Covering the $1.2 trillion cost of this repeal over the ten-year budget window 

requires changes in other components of the tax code. While taxpayers are aware of 

the cost of tax changes that may limit some itemized deductions, many taxpayers who 

are likely to pay the AMT in future years, but who have not yet paid this tax, may not 

recognize the benefits associated with AMT repeal. Figures 7.6 and 7.7 demonstrate 

how the distribution of the tax burden under the current income tax system, with the 

AMT, will evolve over the next ten years, as well as how the Growth and Investment 

Tax Plan will affect that distribution in 2015. 

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177

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The Treasury Department also provided two additional sets of distribution tables that 

are explained and presented in the Appendix. One table demonstrates the tax burden 

under the Growth and Investment Tax Plan for the entire ten-year budget period. 

The other shows the tax burden if the corporate income tax is distributed 50 percent 

to owners of capital and 50 percent to labor, rather than solely to owners of capital income. 

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178

Federal Tax Reform

The President’s Advisory Panel on

Another way to evaluate the distributional effects of a tax reform proposal is to 

consider the number of taxpayers who would face higher or lower taxes under the 

proposal. The constraint of revenue neutrality implies that any tax relief provided 

to one taxpayer must be financed with higher taxes on somebody else. Looked at 

solely from the perspective of one’s tax bill, any revenue neutral tax reform is certain 

to generate both “winners” and “losers.” The Panel recognizes that this comparison 

is inevitable, but at the same time urges taxpayers to recognize other benefits of tax 

reform. Greater simplicity in the tax system would allow taxpayers to save time and 

money, and would inspire confidence that the tax system is straightforward and fair, 

and not providing hidden loopholes to others. Greater economic growth, which is 

projected to occur under the Growth and Investment Tax Plan, would also generally 

benefit all Americans by increasing their incomes.

Figures 7.8 and 7.9 demonstrate that at each income level in both 2006 and 2015, 

there would be many more taxpayers who would pay less in taxes than those who 

would pay more in taxes. In total, under the Growth and Investment Tax Plan, there 

would be more than twice as many taxpayers who would receive a tax cut.

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179

Chapter Seven

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The preceding figures describe the overall effects on groups of taxpayers. While this is 

informative, the Panel understands that many taxpayers would like to have a greater 

level of specificity, and would like to know what would happen to their own tax bill. 

In order to provide that type of information, the Panel has developed an array of 

hypothetical taxpayers and calculated their taxes under the Growth and Investment 

Tax Plan. 

The Panel chose these hypothetical taxpayers using a methodology that has already 

been described in Chapter Six. In short, the Panel asked the IRS to construct a set of 

stylized taxpayers with different family structures, age, income, and deductions, using 

data from actual tax returns. These examples reinforce an essential point: looking at 

elements of the Growth and Investment Tax Plan alone can lead to very misleading 

conclusions. Just like the Simplified Income Tax Plan, the Growth and Investment 

Tax Plan has been carefully crafted to achieve substantial improvements in the tax 

system while minimizing the changes in total tax liabilities experienced by individual 

taxpayers and the overall distribution of the tax burden. While some elements of the 

plan, considered in isolation, may increase the taxes paid by some taxpayers, other 

elements will have offsetting effects. The focus should be on the aggregate changes in 

tax liability that would result from the Growth and Investment Tax Plan.

Table 7.3 shows how a set of hypothetical taxpayers would be affected in 2006. For 

example, a stylized married couple under age 65 earning about $100,000 would 

expect to pay $9,340 in taxes in 2006. Under the Growth and Investment Tax Plan, 

that couple would pay $9,004, a decrease of 3.6 percent. A stylized married couple 

under age 65 at the median income level of $66,200 would expect to pay $3,307 
180

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The President’s Advisory Panel on

under current law. Under the Growth and Investment Tax Plan, that couple would 

pay $2,349 in taxes, a decrease of 29 percent. 

Much like the Simplified Income Tax Plan, a single taxpayer under age 65 at the 

median income level of about $24,000 would receive a tax cut of 4 percent. A head of 

household taxpayer at the median income of about $23,000 would have his or her tax 

bill remain roughly the same. Single taxpayers and heads of households who are at the 

95th percent of income would face a tax increase under the Growth and Investment 

Tax Plan. 

The Panel also felt that it would be instructive to see how this plan affected taxpayers 

living in high-tax and low-tax states. Accordingly, the Panel asked the IRS to vary 

the amount of state and local taxes paid by each of the taxpayer groups under age 65. 

Using the methodology described in Chapter Six, the Treasury Department then 

calculated how tax liabilities would change for those taxpayers.

The examples in Table 7.4 show that because of the interaction between the 

alternative minimum tax and other provisions, there would be no difference in the 

treatment of the stylized married couple earning about $100,000 or in the treatment 

of the married couple earning about $207,000. In other words, regardless of whether 

those couples live in high-tax or low-tax states, they would still benefit from a 

reduced tax bill under the Growth and Investment Tax Plan. The stylized couple 

earning about $66,000 living in a low-tax state would receive a tax cut of $1,081 while 

the same couple living in a high-tax state would receive a tax cut of $781. Under the 

Growth and Investment Tax Plan, these taxpayers would pay the same level of tax, 

regardless of where they live.

For single taxpayers and heads of household who itemize and are not subject to the 

AMT under current law, there would be a larger tax increase for those who are living 

in high tax states. This is due to the fact that taxpayers in high tax states currently 

pay less in tax than taxpayers in low tax states. Under the Growth and Investment 

Tax Plan, this would no longer be the case – taxpayers with similar income and 

characteristics would face the same tax bill.
181

Chapter Seven

Table 7.4. Examples of Taxpayers Under the Growth and Investment Tax Plan in 2006 Model Taxpayer Percentile Income Salaries and Wages Taxable Interest, Dividends, & Capital Gains

Itemized Deductions

Income Tax under 2006 Law 

at 2006 Levels

State and Local Taxes

Mortgage Interest

Charitable 

Contributions

Misc

(before 2% floor)

Current Law

Growth and 

Investment Tax Plan

Percentage Change in 

Tax Liability

Single Taxpayers Younger Than 65

1 Bottom 25th 12,300 12,300 369 385 158 -59.0%

2 50th 24,300 24,300 729 2,003 1,922 -4.0%

3 Top 25th 41,000 40,700 300 1,230 4,758 4,447 -6.5%

4 Top 5th 82,800 80,500 2,300 4,000 6,400 2,000 2,200 13,541 14,523 7.3%

Heads of Household Younger Than 65

(bottom 25th and 50th percentile households have two child dependents; top 25th and top 

5th household has one child dependent)

5 Bottom 25th 14,000 14,000 420 -4,941 -5,488 -19.5%

6 50th 23,100 23,100 693 -4,225 -4,242 -2.4%

7 Top 25th 37,200 36,700 500 1,116 1,960 1,238 -9.5%

8 Top 5th 71,800 71,300 500 2,900 8,300 2,400 2,500 7,042 8,005 5.4%

Married Filing Jointly Younger Than 65

(bottom 25th and 50th percentile households have two child dependents; top 25th and 

top 5th household has one child dependent)

9 Bottom 25th 39,300 38,600 700 1,179 -282 -783 -178.2%

10 50th 66,200 65,300 900 2,300 8,200 2,400 2,100 3,307 2,349 -29.0%

11 Top 25th 99,600 97,800 1,800 4,100 9,400 2,700 2,200 9,340 9,004 -3.6%

12 Top 5th 207,300 196,200 11,100 10,000 14,400 5,400 2,800 40,417 37,959 -6.1%

Single Taxpayers (and Surviving Spouses) Age 65 and Over

13 50th 24,800 0 4,900 555 1,919 2,338 21.8%

14 Top 25th 42,800 0 7,400 1,130 5,731 6,529 13.9%

Married Filing Jointly Age 65 and Over

15 50th 51,000 0 4,800 1,125 2,772 2,723 -1.8%

16 Top 25th 77,500 0 10,000 2,230 9,635 9,750 1.2%

Note: * The 50th percentile taxpayer has gross social security benefits of $6,300 and taxable pensions, annuities, and IRA distributions equal to 

$13,600. The top 25th percentile taxpayer has gross Social Security benefits of $12,000 and taxable pensions, annuuities, and IRA distributions 

equal to $23,400. ** The 50th percentile taxpayer has gross social security benefits of $18,400 and taxable pensions, annuities, and IRA distributions 

equal to $27,800. The top 25th percentile taxpayer has gross Social Security benefits of $21,000 and taxable pensions, annuuities, and IRA 

distributions equal to $46,500. See text for further explanation of sample taxpayers.

Source: Department of the Treasury
182

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The President’s Advisory Panel on

Beyond the Growth and Investment Tax Plan: The Progressive 

Consumption Tax Plan

The foregoing discussion emphasizes that the Growth and Investment Tax Plan is not 

a true consumption tax because it imposes a 15 percent tax on the interest, dividends, 

and capital gains received by individuals. This feature affects the distribution of the tax 

burden by raising the tax burden on those with substantial income flowing from their 

financial assets. It also raises the tax on saving and capital investment. In addition, just 

like the Simplified Income Tax, this provision preserves important components of the 

income tax system, and thus retaines some of its compliance and administrative costs. 

For example, individuals would be required to keep track of their tax basis in financial 

and real assets. Many of the complex rules in the current income tax system, such 

as those that govern wash sales, hedges, and straddles, would be required under the 

Growth and Investment Tax Plan. It would also require firms to track earnings and 

Table 7.5. Examples of Taxpayers with “High” and “Low” State and Local Tax 

Deductions under the Growth and Investment Tax Plan in 2006

Taxpayer 

Characteristics and 

Placement in Income 

Distribution

Adjusted Gross 

Income

State and 

Local Taxes 

Deduction

Income Tax 

under 2006 Law at 2006 Levels

Current Law

Progressive 

Consumption 

Tax Plan

Growth and 

Investment Tax 

Plan

Single Taxpayers Younger Than 65

Top 5% in “low-tax” 

state 82,800 3,500 13,666 16,244 14,523

Top 5% in “high-tax” 

state 82,800 6,400 12,941 16,244 14,523

Heads of Household Younger Than 65 

Top 5% in “low-tax” 

state 71,800 2,400 7,167 9,154 8,005

Top 5% in “high-tax” 

state 71,800 4,800 6,567 9,154 8,005

Married Filing Jointly Younger Than 65

50th in “low-tax” 

state 66,200 1,900 3,307 2,727 2,349

50th in “high-tax” 

state 66,200 3,900 3,307 2,727 2,349

Top 25th in “low-tax” 

state 99,600 3,600 9,340 9,599 9,004

Top 25th in “hightax” state 99,600 6,900 9,340 9,599 9,004

Top 5% in “low-tax” 

state 207,300 8,300 40,417 42,868 37,959

Top 5% in “high-tax” 

state 207,300 16,300 40,417 42,868 37,959

Notes: Taxpayers have same characteristics as those in Table 7.4 with the exception of state and local taxes. 

See text for further explanation of sample taxpayers.

Source: Department of the Treasury
183

Chapter Seven

profits in a way that makes it possible to distinguish dividend payments from returns 

of capital.

The Panel developed a consensus in support of the Growth and Investment Tax Plan, 

but many members supported an even more fundamental change in the tax structure, 

such as adopting the Progressive Consumption Tax Plan. Even some members who 

did not support the Progressive Consumption Tax Plan agreed that the structure 

described below is the most attractive way to implement consumption tax in the 

United States, should the political branches decide to pursue such a shift in the tax 

base. Such a tax would closely resemble the Growth and Investment Tax Plan, but 

there would be several important changes. First, there would be no taxation of capital 

income at the household level. Second, because there would be no taxation of capital, 

there would be no need for special saving accounts, like the Save for Retirement and 

Save for Family accounts, that would exempt certain savings from taxation. All saving 

would be tax-exempt. This would eliminate the complex record-keeping associated 

with various types of tax-preferred investment accounts. While record-keeping would 

be much less onerous under the Growth and Investment Tax Plan or the Simplified 

Income Tax Plan than under the current system, such record-keeping would be 

eliminated with the Progressive Consumption Tax Plan. Third, in order to achieve 

revenue neutrality, the deduction and exclusion for employee-provide health insurance 

coverage would be lowered by approximately 25 percent and both the top individual 

tax rate and the tax rate on business cash flow would rise to 35 percent. Table 7.6 

summarizes the tax rate structure under the Progressive Consumption Tax Plan.

Table 7.6. Tax Rates under the Progressive Consumption Tax Plan

Tax Rate Married Unmarried

15% Up to $80,000 Up to $40,000

25% $80,001 - $115,000 $40,001 – $57,500

35% $115,001 or more $57,501 or more

The principal advantages of the Progressive Consumption Tax Plan relative to 

the Growth and Investment Tax Plan would be its more favorable treatment of 

saving and investment, and its greater simplicity and transparency. As summarized 

in Figure 7.10, the effective tax rate on new investment projects that are expected 

to just break even, the “marginal project” that economists consider in defining the 

investment incentives under different tax codes, would be zero under the Progressive 

Consumption Tax Plan. Moving from the low tax rate on capital under the Growth 

and Investment Tax Plan to the zero tax rate of the Progressive Consumption Tax 

Plan would provide additional stimulus to economic growth. The simplicity benefits 
184

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The President’s Advisory Panel on

of the Progressive Consumption Tax Plan would derive from eliminating the need for 

the record keeping and filing associated with capital income taxation of individuals. 

Although the conceptual difference between the Progressive Consumption Tax Plan 

and the Growth and Investment Tax Plan is substantial, with the latter a hybrid tax 

system combining income tax and consumption tax elements, it is important to point 

out that for most households, the effect of the two taxes would be virtually identical. 

Because the Growth and Investment Tax Plan includes a variety of provisions to 

provide tax-exempt saving opportunities, most individuals would find that the bulk, 

if not all, of their returns to capital would not be taxed under either the Progressive 

Consumption Tax Plan or the Growth and Investment Tax Plan. Save for Family and 

Save for Retirement accounts, in particular, would mean that most individuals could 

earn the full before-tax return on their investments. Since business investment would 

be fully expensed under both plans, the only tax provisions that would discourage 

investment in new, marginal investment projects would be the 15 percent tax on 

dividends, interest, and capital gains under the Growth and Investment Tax Plan. 

The Growth and Investment Tax Plan would move our system a long way toward 

the Progressive Consumption Tax Plan, and would capture most of the associated 

efficiency benefits, while still preserving some elements of the progressive taxation of 

capital income. 

The principal objection to the Progressive Consumption Tax Plan was that it would 

result in a less progressive distribution of tax burdens. While there would certainly 

be households that would not need to write any checks for taxes under this tax 

system, it is important to point out that they would still pay taxes. The Progressive 

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Chapter Seven

Consumption Tax Plan collects taxes from firms on supernormal returns to businesses 

investment, rather than from households. Thus, an individual who receives a dividend 

payment receives the distribution after the firm has already paid taxes. This tax 

burden on the business reduces the amount that the firm is able to pay in dividends 

to shareholders, but the shareholder does not write a check to the government and so 

does not appear to make a tax payment. Distinguishing between the economic burden 

of taxes and the point of collection of taxes is essential in analyzing the differences 

between various tax structures. 

Distribution of the Progressive Consumption Tax Plan

The Treasury Department computed the distribution of tax burdens under the 

Progressive Consumption Tax Plan, as under the Growth and Investment Tax Plan, 

and compared those burdens with the distribution under the current tax system. 

Figures 7.11 and 7.12 show the estimates for 2006.

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Just like for the Simplified Income Tax Plan and the Growth and Investment 

Tax Plan, the Treasury Department also produced an analysis of the Progressive 

Consumption Tax Plan for 2015, using 2006 income levels. Figures 7.13 and 7.14 

show those estimates. 

As shown in the above figures, a combination of tax credits for low- and middleincome households combined with the broadening of the tax base and the progressive 

tax rate schedule makes it possible to generate very similar distribution of the tax 

burden under the Progressive Consumption Tax Plan and the current system. This 

finding is important: Many previous analysts have dismissed structures like the 

Progressive Consumption Tax Plan as inevitably shifting the burden of taxes toward 
186

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The President’s Advisory Panel on

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lower-income households, on the grounds that such households spend a greater share 

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effect. 
187

Chapter Seven

Furthermore, the Treasury Department calculated the number of taxpayers who have 

tax decreases and tax increases under the Progressive Consumption Tax Plan. Figures 

7.15 and 7.16 show those estimates for 2006 and 2015. In both years, there are more 

taxpayers who have a tax decrease than who have a tax increase. However, there are 

more taxpayers with incomes of more than $200,000 who would have a tax increase. 

It is unclear why this occurs, but it is likely that the benefit of removing the tax on 

capital income was not enough to offset the effect of higher tax rates, which were 

increased to make this plan revenue neutral. 

Using the same methodology as the other plans, the Treasury Department provided 

examples of hypothetical taxpayers for 2006. These examples are shown in Table 7.7. 

Examples of hypothetical taxpayers in high-tax and low-tax states are shown in Table 

7.5.

Revenue Neutrality

The Treasury Department estimated that both the Growth and Investment Tax Plan 

and the Progressive Consumption Tax Plan would be revenue neutral. It is worth 

noting that the plans are balanced without using any revenues from the shift to a 

destination based tax system through border adjustments. The amount of revenue 

gained from border adjustments during the budget window would be approximately 

$775 billion under the Growth and Investment Tax Plan and approximately $900 

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billion under the Progressive Consumption Tax Plan. If policymakers were to 

propose either of these plans and decide to use the revenues from border adjustments, 

the additional revenue could be used to further reduce tax rates or make other 

adjustments to the plans. Both plans also provide transition relief, which has been 
189

Chapter Seven

described earlier in the chapter. The cost of transition relief in both plans is about 

$400 billion.

Moreover, as noted in Chapter Six, some members of the Panel believe that it is likely 

that lawmakers will extend a current-law provision, referred to as the “patch,” to ease 

the effects of the AMT on millions of unsuspecting taxpayers. If the Panel did not 

need to account for the cost of the patch, estimated to be about $866 billion, tax rates 

could be reduced further in both plans. For example, the tax rates in the Growth 

and Investment Tax Plan could be reduced across the board by 5.6 percent, so the 

top rate could be lowered from 30 percent to 28.3 percent. Similarly, the rates in the 

Progressive Consumption Tax Plan could be reduced by 5.3 percent, so the top rate 

could be lowered from 35 percent to 33 percent.

 Table 7.7. Examples of Taxpayers Under the Progressive Consumption Tax in 2006

Model Taxpayer Percentile

Income

Salaries and Wages

Taxable Interest, 

Dividends, &

Capital Gains

Itemized Deductions Income Tax 

under 2006 Law at 2006 Levels

State and Local Taxes

Mortgage 

Interest

Charitable 

Contributions

Misc

(before 2% floor)

Current Law

Progressive 

Consumption

 Tax

Percentage Change in 

Tax Liability

Single Taxpayers Younger Than 65

1 Bottom 25th 12,300 12,300 369 385 270 -29.9%

2 50th 24,300 24,300 729 2,003 2,034 1.5%

3 Top 25th 41,000 40,700 300 1,230 4,758 4,590 -3.5%

4 Top 5th 82,800 80,500 2,300 4,000 6,400 2,000 2,200 13,541 16,244 20.0%

Heads of Household Younger Than 65

(bottom 25th and 50th percentile households have two child dependents; top 25th and top 5th household has one child dependent)

5 Bottom 25th 14,000 14,000 420 -4,941 -5,600 -13.3%

6 50th 23,100 23,100 693 -4,225 -3,433 18.7%

7 Top 25th 37,200 36,700 500 1,116 1,960 1,177 -40.0%

8 Top 5th 71,800 71,300 500 2,900 8,300 2,400 2,500 7,042 9,154 30.0%

Married Filing Jointly Younger Than 65 (all have two child dependents)

9 Bottom 25th 39,300 38,600 700 1,179 -282 -94 66.6%

10 50th 66,200 65,300 900 2,300 8,200 2,400 2,100 3,307 2,727 -17.5%

11 Top 25th 99,600 97,800 1,800 4,100 9,400 2,700 2,200 9,340 9,599 2.8%

12 Top 5th 207,300 196,200 11,100 10,000 14,400 5,400 2,800 40,417 42,868 6.1%

Single Taxpayers (and Surviving Spouses) Age 65 and Over

13 50th 24,800 0 4,900 555 1,919 1,673 -12.8%

14 Top 25th 42,800 0 7,400 1,130 5,731 5,287 -7.8%

Married Filing Jointly Age 65 and Over

15 50th 51,000 0 4,800 1,125 2,772 1,853 -33.1%

16 Top 25th 77,500 0 10,000 2,230 9,635 7,973 -17.2%

Note: * The 50th percentile taxpayer has gross Social Security benefits of $6,300 and taxable pensions, annuities, and IRA distributions 

equal to $13,600. The top 25th percentile taxpayer has gross Social Security benefits of $12,000 and taxable pensions, annuuities, and 

IRA distributions equal to $23,400. ** The 50th percentile taxpayer has gross Social Security benefits of $18,400 and taxable pensions, 

annuities, and IRA distributions equal to $27,800. The top 25th percentile taxpayer has gross Social Security benefits of $21,000 and 

taxable pensions, annuuities, and IRA distributions equal to $46,500.

See text for further explanation of sample taxpayers.

Source: Department of the Treasury
190

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The President’s Advisory Panel on

Pro-Growth Tax Plans

The Growth and Investment Tax Plan retains a tax burden on capital income, while 

the Progressive Consumption Tax Plan eliminates this burden. Both plans would 

encourage economic growth, but the effects would be larger under the Progressive 

Consumption Tax Plan. The Treasury Department has evaluated the growth effects of 

both plans using a range of economic models.

The Treasury Department estimates that the Progressive Consumption Tax Plan 

could increase national income by up to 2.3 percent over the budget window, by up 

to 4.5 percent over 20 years, and by up to 6.0 percent over the long run. The Treasury 

Department models also suggest that the Plan could increase the capital stock (the 

economy’s accumulation of wealth), with estimates ranging from 0.7 percent to 5.1 

percent over the budget window, from 2.5 percent to 16.7 percent over 20 years, and 

from 7.6 percent to 27.9 percent over the long run. 

For the Growth and Investment Tax Plan, Treasury estimates that the plan could 

increase national income by up to 1.8 percent over the budget window, by up to 

3.6 percent over 20 years, and by up to 4.7 percent over the long run. The Treasury 

Department models also suggest that the plan could increase the capital stock, with 

estimates ranging from 0.5 percent to 3.64 percent over the budget window, from 1.7 

percent to 11.7 percent over 20 years, and from 5.3 percent to 19.8 percent over the 

long run.
Chapter Eight

Value-Added Tax

The Panel developed and analyzed a proposal to adopt a value-added tax (VAT) that 

would replace a portion of both the individual and corporate income taxes. The VAT is 

a type of consumption tax that is similar to a retail sales tax but is collected in smaller 

increments throughout the production process. 

The “Partial Replacement VAT” proposal studied by the Panel would combine a VAT 

and a lower-rate version of the Simplified Income Tax Plan described in Chapter 

Six. As shown in Table 8.1, a VAT imposed at a 15 percent rate would allow the 

top individual income tax rate in the Simplified Income Tax Plan to be reduced to 

15 percent. The top corporate income tax rate would also be lowered to 15 percent. 

Both the income tax and VAT rates are presented on a tax-inclusive basis, as is the 

norm for income tax rates and the way they are presented throughout this report. The 

tax-exclusive rates would be 17.6 percent. A discussion of the difference between taxexclusive and tax-inclusive rates is provided in Chapter Nine. 
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Simplified Income Tax Individual 

Rates - Modified with a VAT

Simplified Income Tax Individual Rates

Tax Rate Married Unmarried Tax Rate Married Unmarried

5% Up to 

$64,000

Up to 

$32,000 15% Up to $78,000 Up to $39,000

15% Above 

$64,000

Above 

$32,000 25% $78,001 - $150,000

$39,001 - 

$75,000

28% $150,001 

- $200,000

$75,001 - 

$100,000

33% $200,001 or 

more

$100,001 or 

more

Panel members recognized that lower income tax rates made possible by VAT 

revenues could create a tax system that is more efficient and could reduce the 

economic distortions and disincentives created by our income tax. However, the Panel 

could not reach a consensus on whether to recommend a VAT option. 

Some Panelists who supported introducing a consumption tax in general expressed 

concern about the compliance and administrative burdens that would be imposed 

by operating a VAT without eliminating the income tax or another major tax. Some 

Panelists were also concerned that introducing a VAT would lead to higher total tax 

collections over time and facilitate the development of a larger federal government – 

in other words, that the VAT would be a “money machine.” Other Panelists suggested 

that studies of the international experience and domestic political realities did not 

support the “money machine” argument. Some Panelists argued that adopting a 

VAT, whether to reduce income taxes or payroll taxes, would make it more likely that 

higher taxes would be used to solve the nation’s long-term fiscal challenges, especially 

unfunded obligations for the Social Security, Medicare, and Medicaid programs. 

Other Panelists expressed the opposite view and regarded the VAT as a stable and 

efficient tool that could be used to reduce income taxes, fund these programs, or serve 

as a possible replacement for payroll taxes. A proposal to use the VAT to replace 

payroll taxes was beyond the scope of the panel’s mandate, which focused only on 

income taxes.

Despite the lack of consensus to recommend a VAT option, the Panel views a 

Partial Replacement VAT as an option worthy of further discussion. This chapter 

will highlight issues that policymakers would need to consider in evaluating such a 

proposal. First, the chapter describes modifications to the Simplified Income Tax Plan 

that would be made possible by the VAT and the resulting distribution of the overall 

federal income tax and VAT tax burden. The chapter then discusses how businesses 

would compute their VAT liability and the advantages and disadvantages of a Partial 

Replacement VAT from a tax policy perspective. Finally, the chapter addresses 

Table* 8.1. Proposed Income Tax Rates for Married and Unmarried Taxpayers
193

Chapter Eight

arguments regarding whether the VAT would facilitate the growth of the federal 

government. 

How it Would Work: Adjustments to the Simplified Income Tax

The Partial Replacement VAT proposal studied by the Panel combined a VAT 

with a low-rate income tax modeled on the Simplified Income Tax Plan. This VAT 

would collect about 65 percent of the amount of revenue currently collected by our 

individual and corporate income taxes. As a result, tax rates under the income tax 

system could be substantially reduced. 

The Simplified Income Tax Plan does not materially alter the current distribution of 

the federal tax burden. By contrast, a VAT absent other modifications would change 

the current distribution because the VAT is imposed directly on consumption, and 

therefore would tax all families equally on each dollar they spend on items subject to 

the VAT. Households with lower incomes generally spend a larger portion of their 

income than higher-income households, and therefore the VAT would generally 

impose a larger tax as a percentage of income on lower-income households. In 

considering the Partial Replacement VAT, the Panel sought to relieve the additional 

VAT burden through an appropriate income tax rate and credit structure. The Panel’s 

goal was to maintain a distribution of the overall federal VAT and income tax burden 

that would be approximately distributionally neutral relative to current law.

In response to the Panel’s request, the Treasury Department modified the Family and 

Work Credits described in Chapter Five to alleviate the additional burden of the VAT 

on lower-income families. This approach would be more effective than exempting 

food and other necessities from taxation because it could be targeted to lower and 

middle-income families alone, rather than all taxpayers. 

The base credit amount of the Family Credit would be increased by $1,000 for 

married couples and $500 for all other taxpayers except dependent taxpayers. The 

additional Family Credit amount based on the number of children and other 

dependents would be increased by $500 for each child or other dependent. Like the 

Family Credit in the Panel’s recommended options, this Family Credit would not 

phase-out; it would be available to all taxpayers. 

The Work Credit would also be increased, so that the maximum credit amount in 

the first year would be: $1,832 for workers with no children, $6,820 for one child, 

and $9,750 for two children. The Work Credit would increase as the amount of work 

income increases, be refundable, and phase-out gradually above certain income levels. 

Further details regarding the modifications to the Family and Work Credits made by 

the Treasury Department in estimating the Partial Replacement VAT can be found in 

the Appendix.
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Box 8.1. Reducing the Number of Individuals Who Pay Income Tax

If the Family Credit and Work Credit were expanded as described in this chapter, 101.1 

million taxpayers would have no income tax liability, 51.1 million more than the 47.4 million 

taxpayers that would have no income tax liability under the Simplified Income Tax Plan. 

Some Panelists felt that it was inappropriate to increase the number of taxpayers who do 

not make a direct contribution to the cost of maintaining the federal government through 

income taxes. Other Panelists took the opposite position, commenting that taking additional 

lower and middle-income taxpayers off the income tax rolls would make the federal tax 

system simpler. Those taxpayers would continue to pay taxes, at the cash register through 

the VAT and through payroll taxes.

Who Pays the Tax?

As shown in Figures 8.1 through 8.4, the Family and Work Credits as modified by 

the Treasury Department would ensure that the tax system would be roughly as 

progressive as current law for families with incomes in the bottom two quintiles of 

the income distribution. However, for families in the third and fourth quintiles, the 

modified Work and Family Credits and rate structure presented here do not fully 

offset the increased burden of the VAT. Families in the highest quintile would bear 

less of the total tax burden. 

The Treasury Department did not develop a modified credit and rate structure that 

would make the Partial Replacement VAT proposal approximately as progressive as 

current law. While the Partial Replacement VAT described in this chapter does not 

entirely alleviate distributional concerns, the Panel believes that with additional work, 

it would be possible to develop an approximately distributionally neutral tax credit 

and rate structure. Such a structure might, however, require somewhat higher income 

tax or VAT rates. 
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Chapter Eight

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The President’s Advisory Panel on

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197

Chapter Eight

How it Would Work: Implementing the VAT

The VAT can be thought of as a retail sales tax that is collected in stages, instead of all 

at once from the final consumer. The tax is collected by all entities providing taxable 

goods and services and is imposed on sales to all purchasers. A business calculates 

its VAT liability by taking the total value of its taxable sales and multiplying by the 

VAT rate. The business is then permitted to offset its VAT liability by the amount of 

VAT paid for its purchases of goods and services. The simple example first provided in 

Chapter Three provides an easy way to understand the process. 

Imagine that a boot maker makes and sells custom-made cowboy boots. He buys 

leather and other supplies enough for one pair from a leather shop at a cost of $200 

before taxes. The boot maker sells each pair of boots he makes for $500 before taxes. 

If a 10 percent retail sales tax were in place, the boot maker would add the tax to the 

cost of the $500 pair of boots, and the consumer would pay $550 per pair. In the 

meantime, the leather shop would not impose a retail sales tax on its sale to the boot 

maker because such a business-to-business transaction would not be treated as a retail 

sale. 

Under a VAT, the tax calculation works somewhat differently. The VAT, like a sales 

tax, is separately stated on invoices or receipts. However, because the VAT is charged 

on all sales of goods and services, and not just sales to consumers, the leather shop 

would collect a VAT of 10 percent, or $20 on the $200 of supplies purchased by the 

boot maker. The boot maker would pay the leather shop $220, and the leather shop 

would send the $20 to the government. When the boot maker sells the boots, he 

computes the VAT as $50, and charges the purchaser $550 for the boots. 

Instead of sending $50 to the government, the boot maker would subtract the $20 

of VAT already paid to the leather shop and remit $30 to the government. The 

government would receive $50 total — $20 from the leather shop and $30 from the 

boot maker. The $20 credit that the boot maker applies against his VAT liability is 

called an “input credit,” and the invoice received from the leather shop showing $20 

of VAT paid serves as proof that the boot maker can take the credit. The government 

receives the same revenue under a VAT as it would under a retail sales tax, and from 

the consumer’s perspective the taxes look identical. 

Design Assumptions

In studying the proposal, the Panel made certain decisions about the appropriate 

design for a VAT if it were ever adopted at the federal level. 

• The VAT should be imposed on the broadest consumption base consistent 

with:

o The structure of our federal system of government, and

o The need to maintain neutrality between public and private sector 

provision of goods and services. 
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• The VAT should use the credit-invoice method.

• The VAT should be border adjusted. 

• The VAT should be imposed at a single uniform rate.

• The VAT should be set at a rate that is high enough to raise sufficient revenue 

to accomplish substantial income tax reform, justify the administrative burden 

of the VAT on businesses and government, and discourage subsequent rate 

increases. 

Tax Base 

The Partial Replacement VAT base considered by the Panel would be broad in 

order to prevent economic distortions between taxed and non-taxed goods and 

services. The proposed VAT base would include all domestic consumption except 

for non-commercial government services, primary and secondary education, existing 

residential housing, and charitable and religious services. Special rules would apply to 

financial services and certain other goods and services that are difficult to tax. A more 

detailed discussion regarding the proposed VAT base and the mechanics of VAT 

exemptions are provided in the Appendix.

Government Services

Noncommercial services provided by federal, state, or local government would be 

outside the VAT base. However, commercial activities conducted by the government, 

such as electricity supplied by a government-owned power plant, would be taxed 

like any private sector business. The rationale for this treatment is to prevent federal, 

state, or local government from having an advantage over the private sector in areas 

where the two might compete to supply similar products. Rules would be necessary to 

distinguish between commercial and non-commercial government services. Further 

discussion of these issues appears in the Appendix.

Box 8.2. State and Local Government Services

Taxing the imputed value of noncommercial state and local government services would be 

technically feasible. New Zealand, for instance, does this by requiring local governments 

to pay a VAT on the total value of the salaries they disburse to their employees. However, 

if the federal government assessed a VAT on state and local government services in this 

way, those governments would need to raise taxes to pay the VAT on their purchases and 

on the imputed value of their services. The Panel concluded that it may be inappropriate 

for the federal government to directly assess an excise tax of this sort on state and local 

governments in the context of our federal system. Instead, state and local governments 

would pay a VAT on their purchases, but would receive refunds from the federal government 

for VAT paid.
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Border Adjustments

Because the VAT is intended to tax domestic consumption, exports are outside the 

VAT tax base. However, because the VAT is assessed at every level of production and 

distribution, a “border adjustment” is necessary to exclude exports from the VAT. 

These adjustments are made by allowing businesses to claim input credits on exports 

while exempting their sales from the VAT. All of America’s major trading partners 

remove the VAT from their exports in this way, and the World Trade Organization 

specifically defines a VAT as border-adjustable tax. Border adjustments are discussed 

in greater detail in Chapter Seven. 

Small Business

Because the compliance costs associated with a VAT may be low overall but require 

a significant investment for some small businesses, it would be important to consider 

how to treat such businesses under a VAT. One advantage of the VAT is that it is 

possible to exempt many small businesses from collecting the tax without significant 

revenue loss. There are two reasons for this result. First, because the VAT is collected 

at every stage of production (rather than once at the retail level like a retail sales tax), 

and many small businesses buy many of their inputs from larger businesses, exempted 

small businesses would still pay tax on their inputs. As a result, much of the tax on 

any final good sold by a small business would still be collected. Second, exempted 

small businesses would be allowed to voluntarily register to collect the VAT. Some 

exempted businesses that sell primarily to other businesses would choose to collect 

VAT voluntarily in order for them and their customers to be able to claim input tax 

credits on their purchases. 

The Partial Replacement VAT designed by the Panel would not require businesses 

with less than $100,000 in taxable annual gross receipts to collect the VAT. The 

Government Accountablility Office estimated in 1993 that a VAT collection 

threshold at this level would reduce the number of businesses filing VAT returns 

from about 24 million to about 9 million. They further estimated that approximately 

19 percent of small businesses qualifying for the exemption would nonetheless 

voluntarily collect the VAT. Preliminary estimates for 2003 suggest that only 1.8 

percent of gross receipts are collected by businesses with less than $100,000 in annual 

gross receipts. Thus, a VAT collection threshold at this level likely would not lose 

significant revenue, particularly when voluntary collection is taken into account. 

Whether a higher VAT collection threshold would be feasible could be the subject of 

future study. 
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Tax Policy Considerations — Advantages and Disadvantages of 

Adopting a VAT

Economic Growth

A Partial Replacement VAT could achieve many of the advantages of moving to a 

consumption-based tax system discussed in Chapter Seven. Economic research shows 

that consumption taxes have a positive effect on economic growth compared with an 

income tax. 

A broad-based VAT applied at a single rate is economically efficient because it 

generally does not distort consumers’ choices among goods and services and does not 

discourage savings or distort the allocation of capital. Economists agree that a welldesigned VAT imposes a lower excess burden than most other taxes for any given 

amount of revenue raised. Reducing the excess burden of taxation on the economy is 

an important way that the tax system can encourage economic growth.

The Partial Replacement VAT also would make it possible to substantially reduce 

income tax rates for all individual and corporate taxpayers. Lower marginal income 

tax rates on individuals and businesses would strengthen incentives to save, invest, 

work, and innovate while making our tax system more efficient. 

U.S. Competitiveness

Reducing the corporate income tax rate should improve incentives for investment 

of capital in the United States by both U.S. residents and foreigners. U.S.-based 

multinational corporations and multinationals based in countries with territorial 

tax systems would have incentives to shift investment and operations to the United 

States to take advantage of the lower income tax rates relative to other countries. 

These incentives would be similar to those discussed in Chapter Seven, although the 

incentives would not be as strong as those discussed with respect to the Progressive 

Consumption Tax Plan because an income tax would be retained, albeit at lower rates.

The Partial Replacement VAT also would be compatible with existing bilateral tax 

agreements with our major trading partners because it would retain a corporate 

income tax. These agreements facilitate cross-border investment and ensure that U.S. 

multinationals operating in foreign markets receive tax treatment comparable to the 

tax treatment of companies based in the country in which the U.S. multinational is 

operating. 
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Chapter Eight

Benefiting from International Administrative Experience

In implementing the VAT, the United States would be able to take advantage of the 

wealth of worldwide experience in administering and complying with the tax. The 

VAT has been adopted by every major developed economy except the United States. 

Thus, the Treasury Department and IRS could study and apply best practices from 

around the world. Moreover, U.S. multinational corporations already have extensive 

experience in complying with the VAT, as they currently collect and remit VAT taxes 

in most countries in which they operate outside the United States. 

Compliance and Administration Costs

One significant benefit of the Simplified Income Tax Plan is that it would reduce 

administration and compliance costs for the government and taxpayers. In contrast, 

having to collect and pay both VAT and a business income tax might increase 

total compliance costs for businesses. It would also create an additional set of 

administrative responsibilities and costs for the IRS. 

On the other hand, the Panel heard testimony that taxpayers’ compliance costs for 

the current income tax amount to approximately 13 cents per dollar of tax receipts, 

whereas compliance costs for European VATs ranges from 3 to 5 cents per dollar of 

tax receipts. Further, compliance costs per dollar of income tax revenue could fall as a 

result of reduced incentives for income tax evasion due to the lower income tax rates 

accompanying the introduction of a VAT. Thus, it is not clear whether the overall 

compliance and administration cost savings from introducing a Partial Replacement 

VAT and lowering income tax rates would be larger or smaller than the cost to 

businesses of complying with the VAT. 

Box 8.3. Border Adjustments and Competitiveness

Border adjustability has been a longstanding priority for many American businesses with 

substantial export sales. All our major trading partners border adjust their VATs, and exporters 

of goods and services imported into the United States receive VAT rebates. 

American businesses sometimes argue that the lack of border adjustability of the U.S. 

income tax system puts U.S. exports at a competitive disadvantage in global markets. 

However, economists generally believe that exchange rate adjustments or other price level 

changes offset border tax adjustments in the long term and eliminate any advantage or 

disadvantage border adjustments might otherwise create. Regardless, a border-adjustable 

VAT that reduces corporate income tax rates could positively affect the competitiveness of 

U.S. goods and services in the global marketplace. Further discussion of border adjustments 

and the advantages of destination-based taxes appears in Chapter Seven.
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Noncompliance

Some evasion is inevitable in any tax system. For 2001, the IRS estimates that the 

evasion rate for the income tax was between 18 and 20 percent of taxes due. Some 

analysts suggest that evasion rates for a Partial Replacement VAT could be somewhat 

lower. One reason is that invoices used to claim input credits under a VAT create a 

paper trail based on third-party information reporting that facilitates audits and may 

induce businesses to comply more fully with both the VAT and the corporate income 

tax. Under the current income tax, compliance rates are highest where there is thirdparty information reporting or withholding. 

Further, business-level tax evasion is often concentrated in smaller businesses, and the 

VAT exempts many of these businesses from the collection process. To the extent that 

tax avoidance and evasion are motivated by high income tax rates, lowering income 

tax rates with a Partial Replacement VAT might also reduce incentives to avoid or 

evade the remaining income tax. 

However, the VAT would not put an end to tax evasion. Evasion in a VAT can 

range from simple non-filing and non-payment of tax by businesses to complex 

schemes in which goods pass through a series of transactions designed to generate 

counterfeit input tax refunds. The Organization for Economic Cooperation and 

Development (OECD) reports noncompliance rates of 4 percent to 17.5 percent 

in major developed economies with VAT systems. United Kingdom Revenue and 

Customs, which employs one of the most sophisticated approaches to estimating 

VAT evasion, found VAT evasion of 12.9 percent in the U.K. as of April 2004. One 

should note, however, that the U.K. VAT base is substantially narrower than the 

Partial Replacement VAT base studied by the Panel and includes more than one VAT 

rate. VATs are more prone to evasion when they exclude more categories of goods and 

services and utilize multiple rates. In its revenue estimates, the Treasury Department 

assumed a noncompliance rate of 15 percent for the VAT. 

Coordination of State Sales Taxes and the VAT

Coordinating between states’ retail sales taxes and the VAT would be a major 

challenge. States likely would view a VAT as an intrusion on their traditional sales 

tax base. Differing federal and state consumption tax bases, with different forms and 

administrative requirements, would be complex for business. In states that continued 

to apply their pre-existing sales taxes, the weighted average combined tax-exclusive 

state and federal tax rate would be approximately 24 percent. 

If states were to bring their sales tax bases into conformity with the broad federal 

base and coordinate their sales tax collection systems with the federal regime, the 

economic efficiency of state sales taxes would be improved. Compliance burdens 

for multistate businesses and administrative costs for states could be reduced. Even 

greater gains in terms of simplicity and lower compliance burdens might be achieved 

if the states moved to impose state level VATs. 
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Chapter Eight

However, the result of a similar harmonization effort in Canada is not encouraging. 

Canada considered adopting a unified federal and provincial VAT base in 1987, 

but intergovernmental discussions failed to produce an agreement to standardize 

the existing provincial sales tax bases with the base for Canada’s federal goods and 

services tax. The United States has many more sales tax jurisdictions than does 

Canada, and so it is quite likely that the U.S. experience could be fraught with even 

greater difficulties.

Macroeconomic Effects of Transition 

Some observers have worried about potential macroeconomic disruptions associated 

with moving from an income tax to a VAT. Although there may be some such 

consequences, those considerations were secondary in the Panel’s decision not to 

recommend the Partial Replacement VAT. Any consequences associated with price 

level adjustments under a Partial Replacement VAT would be less severe than those 

under a full replacement retail sales tax or a full replacement VAT, because the tax rate 

would be lower and therefore any required adjustments would be less extensive. 

Political Economy Concerns

The Partial Replacement VAT proposal would add a major new federal tax without 

eliminating any existing taxes from the federal system. One important factor in the 

Panel’s decision not to recommend the Partial Replacement VAT proposal was several 

Panel members’ concern about how introducing a supplemental VAT might affect the 

size of the federal government in the medium or long run. These Panel members were 

concerned that adding a VAT on to the current income tax structure could, over time, 

lead to growth of federal outlays as a share of GDP — as the tax rate for the Partial 

Replacement VAT could rise, or corporate and individual income tax rates could 

return to their present levels. The Panel members who were concerned about this 

possibility viewed growth in the government’s share of the economy as undesirable. 

Other Panel members were not concerned about this possibility, either because they 

were more confident that Congress would use the VAT only to offset existing taxes, 

or because they belived that allowing some growth in tax revenues as a share of GDP 

would offer a means to finance the growing cost of entitlement programs.

There are relatively few empirical studies on the relationship between the adoption 

of a VAT and the growth of government spending. None of these studies resolve 

the fundamental difficulty of determining the direction of causality between the 

tax structure and the size of government. Simple country comparisons suggest 

that countries without VATs, like the United States, have a smaller government 

sector than countries with a VAT. However, more sophisticated statistical studies 

that control for other factors that may affect the relationship between the size of 

government and the presence of a VAT yield mixed results. The evidence neither 

conclusively proves, nor conclusively disproves, the view that supplemental VATs 

facilitate the growth of government. 
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Even if the findings were conclusive, studies of VATs in other nations may not 

provide much guidance on the effect of adopting a VAT in the United States. Most 

developed countries initially used a VAT to reduce or eliminate other consumption 

taxes, such as existing sales or excise taxes. The VAT proposal studied by the Panel 

would replace part of the income tax with a VAT. The United States has no broadbased pre-existing federal consumption tax to replace. Thus, whether adopting a VAT 

would fuel the growth of U.S. federal spending remains an open question.

Some Panelists who opposed a Partial Replacement VAT suggested that once a VAT 

was enacted, it would never be repealed. International experience suggests that few 

countries retreat from a VAT, and that VAT rates generally do not decline. These 

Panelists were unwilling to support the Partial Replacement VAT proposal given 

the lack of conclusive empirical evidence on the impact of a VAT on the growth of 

government. Other Panelists were more confident that voters could be relied upon 

to understand the amount of tax being paid through a VAT, in part because the 

proposal studied by the Panel would require the VAT to be separately stated on each 

sales receipt provided to consumers. These Panelists envisioned that voters would 

appropriately control growth in the size of the federal government through the 

electoral process.

Box 8.4. Visibility of the VAT

Some critics of the VAT express concerns about its visibility to taxpayers, because in some 

countries VAT is included in marked prices and no reference is made to the tax on receipts. 

However, the Panel assumed the VAT would be separately stated on all sales, so consumers 

would know the amount of VAT paid with each purchase. 

Some Panelists suggested that even a separately stated VAT would be less visible to 

taxpayers than the burden of the income tax. These Panelists pointed out that taxpayers 

would not know their total VAT tax liability for any given year unless they kept all their 

receipts and added together all VAT paid. Other Panelists noted that a similar observation 

could be made about the income tax, which many taxpayers pay over time through 

withholding from their compensation, and about payroll taxes, where the employer-paid 

portion is “invisible” to most workers. These Panelists stated that taxpayers are much 

more likely to know the amount of the refund check they received as a result of excess tax 

withholding than the amount of their overall tax liability. Other Panelists responded that if 

true, these observations were an argument against tax withholding, not an argument for a 

Partial Replacement VAT.
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Box 8.5. Comparing the Enforcement of a VAT and a Retail Sales Tax 

Because the VAT is similar to a retail sales tax, one might ask why the Panel chose to study 

a VAT rather than a retail sales tax as a partial replacement to the income tax. Although they 

are similar taxes, there are four principal reasons for concluding that a VAT may be more 

enforceable than a retail sales tax. 

First, VAT taxpayers – especially intermediate producers – have an incentive to demand 

VAT invoices from suppliers because they are needed to claim the VAT credits that reduce 

the buyer’s VAT liability. The invoices used to claim a tax credit create a paper trail that 

may induce businesses to comply more fully with the law. Most taxable transactions will 

appear on two tax returns – the buyer’s and the seller’s – so that tax authorities will have 

two opportunities to detect evasion. Further, because sellers provide the tax administration 

a record of their purchases by claiming input credits, tax administrators are more able to 

estimate what sales and therefore VAT due should be and thereby can detect evasion more 

easily in a VAT than in a retail sales tax.

Second, the credit-invoice system eliminates the need for business exemption certificates. 

Under the credit-invoice system, every taxpayer pays tax on its purchases, and then 

taxpayers show proof to the government that they are entitled to input tax credits, rather 

than presenting an exemption certificate to a supplier. As described in Chapter Nine, the 

business exemption system requires retailers to play an enforcement role and is fraught 

with evasion opportunities.

Third, under the VAT the amount of tax liability at risk in most transactions is only a fraction of 

the total tax assessed on the sale of the good or service to a consumer. This is because the 

VAT is collected in smaller pieces at each stage of production, while the entire retail sales 

tax is collected on a final consumer sale. The lower effective tax rate on each transaction 

may reduce the incentive to evade the VAT. 

Finally, in contrast to a VAT, the proper administration of a retail sales tax would require all 

small retailers to collect tax. With a tax collected solely at the retail level, a small business 

exemption would be unworkable from enforcement, efficiency, and revenue perspectives. 

Because the compliance costs associated with a retail sales tax or a VAT may be low overall, 

but significant for small retailers, the need to require small retailers to act as collecting 

agents in a retail sales tax is a significant disadvantage.

The VAT’s advantages over the retail sales tax in minimizing evasion should not be overstated. 

Because large firms are less likely to cheat, evasion problems in either system are likely 

concentrated in smaller firms. When those firms are retailers, the incentive to cheat at the 

margin under the VAT and the retail sales tax is roughly equal, assuming the same tax rate 

applies.

Further, more transactions are subject to a VAT than to a retail sales tax, creating additional 

opportunities for evasion. Under a VAT, firms could fabricate invoices to claim input credits, 

even if such purchases were never made. Claiming excess input credits in a VAT also can 

produce a tax refund for a business. This temptation does not exist under the retail sales 

tax.
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Chapter Nine

National Retail Sales Tax

The Panel considered a number of proposals to reform the income tax, including 

replacing the entire income tax system with a broad-based national retail sales tax. 

A retail sales tax is perhaps the most obvious form of consumption tax because 

it is imposed on the final sales of goods and services to consumers. Like other 

consumption taxes, the retail sales tax does not tax normal returns to saving and 

investment and thus may lead to greater economic growth than our current tax system. 

After careful evaluation, the Panel decided to reject a complete replacement of 

the federal income tax system with a retail sales tax for a number of reasons. Two 

considerations were particularly important to the Panel’s decision:

• Replacing the income tax with a retail sales tax, absent a way to ease the 

burden of the retail sales tax on lower and middle income Americans, would 

not meet the requirement in the Executive Order that the Panel’s options be 

appropriately progressive.
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Box 9.1. Comparing “Tax-Exclusive” and “Tax-Inclusive” Rates

The 34 percent tax rate mentioned in the introduction to this chapter is a tax-exclusive rate. 

Sales tax rates are typically quoted on a tax-exclusive basis, while income tax rates typically 

are quoted on a tax-inclusive basis. If a good costs $100 and bears an additional $34 sales 

tax, the tax-exclusive sales tax rate is 34 percent. The tax-inclusive rate is 25 percent -- $34 

(the tax paid) divided by $134 (the total amount the consumer paid). An individual who earns 

$134 and pays $34 in income taxes would think of themselves as paying approximately 25 

percent ($34/$134 = 0.254) of their income in taxes. 

Although tax-exclusive and tax-inclusive rates are both valid ways of thinking about tax 

rates, the easiest way to compare the retail sales tax rate to the state sales taxes paid by 

most Americans is to consider the tax-exclusive rate. On the other hand, it is appropriate to 

compare the retail sales tax rate with current income tax rates by utilizing the tax-inclusive 

rate. For ease of understanding, this chapter uses tax-exclusive rates unless otherwise 

specified in the text. Tax-inclusive rates are provided in the Appendix. 

• Although a program could be designed to reduce the burden of a retail sales 

tax on lower-income and middle-income taxpayers by providing cash grants, 

such cash grants would represent a new entitlement program – by far the 

largest in American history. Adjusting the distribution of the burden of the 

retail sales tax through a cash grant program would cost approximately $600 

billion to $780 billion per year and make most American families dependent 

on monthly checks from the federal government for a substantial portion of 

their incomes. The Panel concluded that such a cash grant program would 

inappropriately increase the size and scope of government. 

The Panel also had additional concerns with replacing the current tax system with a 

retail sales tax:

• Even with favorable assumptions, a retail sales tax on a broad base with a cash 

grant program would require a tax rate of at least 34 percent, and likely higher 

over time if the base erodes, creating incentives for significant tax evasion. A 

discussion of the range of potential estimates of the tax rate is provided later in 

this chapter. 

• The federal administrative burden for a retail sales tax may be similar to the 

burden under the current system. A federal agency, such as the IRS, would be 

required to administer the tax in order to ensure adequate collection of federal 

revenues and uniform enforcement of the rules and regulations underlying the 

tax. Indeed, two types of administrations would be required – one to collect 

the tax and another to keep track of the personal information that would be 

necessary to determine the size of the taxpayer’s cash grant. 

• Taxpayers likely would continue to file state income tax returns, which would 

limit the potential simplification gains from replacing the federal income tax 

system with a retail sales tax. 
209

Chapter Nine

As explained in Chapter Three, the retail sales tax and the VAT represent similar ways 

to tax consumption of goods and services. A VAT and a retail sales tax that share the 

same tax base, tax rate, and compliance rates would generate the same amount of tax 

revenue. The Panel, therefore, analyzed a full replacement VAT at the same time it 

considered a full replacement retail sales tax. Although the Panel concluded that the 

full replacement VAT might mitigate some of the compliance challenges encountered 

with a retail sales tax, the Panel’s primary objections to a retail sales tax applied 

equally to a full replacement VAT. As a result, the Panel does not recommend the full 

replacement VAT as a tax reform option.

Retail Sales Tax with No Cash Grant

Forty-five states and the District of Columbia currently have retail sales taxes. Many 

states use multiple sales tax rates and exempt many goods and services from tax. The 

Panel, however, considered a single-rate tax that would be imposed on a broad tax 

base because such a tax would be simpler to administer and create fewer economic 

distortions. The Panel’s broad tax base would apply to sales of goods and services to 

consumers, but, to prevent multiple taxation or “cascading,” it would not apply to 

purchases of goods or services by businesss that are used to produce other goods or 

services for sale to households.

The Panel initially evaluated the federal retail sales tax using the broad tax base 

described by advocates of the “FairTax” retail sales tax proposal. That tax base (the 

“Extended Base”) would exempt only educational services, expenditures abroad by 

U.S. residents, food produced and consumed on farms, and existing housing (or what 

economists refer to as the imputed rent on owner-occupied and farm housing). The 

long-term likelihood of maintaining this broad tax base is addressed later in this 

chapter.

Using the Extended Base and assuming low rates of evasion, the Treasury 

Department calculated that the tax rate required to replace the federal income tax 

with a retail sales tax would be 22 percent on a tax-exclusive basis. This tax rate, 

however, does not include a program designed to ease the burden of the tax on 

lower-income Americans. Moreover, unless the states repealed their existing sales 

taxes, most consumers would pay both federal and state sales tax on many goods. 

The weighted average state and local sales tax rate is approximately 6.5 percent on a 

tax-exclusive basis. Thus, for sales subject to both federal retail sales tax and state and 

local sales taxes, the weighted average combined tax-exclusive sales tax rate would be 

approximately 28.5 percent. 
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The President’s Advisory Panel on

Figures 9.1 and 9.2 compare the current distribution of federal taxes paid with the 

distribution that would exist under a “stand-alone” retail sales tax at a 22 percent tax 

rate. Adopting this retail sales tax would impose a larger tax burden on lower-income 

households than the current system because a retail sales tax is imposed directly on 

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Chapter Nine

consumption and does not provide deductions, exemptions, or credits to reduce the 

tax burden on lower-income Americans. Replacing the current income tax with a 

stand-alone retail sales tax would increase the tax burden on the lower 80 percent 

of American families, as ranked by cash income, by approximately $250 billion per 

year. Such families would pay 34.9 percent of all federal retail sales taxes, more than 

double the 15.8 percent of federal income taxes they pay today. The top 20 percent of 

American taxpayers would see their tax burden fall by approximately $250 billion per 

year. Such families would pay 65.1 percent of all federal retail sales taxes, compared to 

the 84.2 percent of federal income taxes they pay today. 

Lower- and middle-income families would be especially hard hit by a stand alone 

retail sales tax. For example, the Treasury Department estimates that a hypothetical 

single mother with one child making $20,000 per year currently pays $723 in total 

federal taxes (including both the employee and employer shares of the Social Security 

and Medicare taxes). Under the stand-alone retail sales tax, her tax bill would go up to 

$6,186 – a tax increase of over 750 percent. A hypothetical married couple with two 

children making $40,000 per year would pay an additional $6,553 in taxes, an increase 

of more than 110 percent of total federal tax liability. In contrast, a hypothetical 

married couple with two children and $300,000 of income currently pays about 

$89,000 in total federal taxes. Under the stand-alone retail sales tax, this hypothetical 

family would pay about $72,000, a tax cut of 19 percent. Further discussion of the 

Treasury Department’s hypothetical taxpayer analysis appears in the Appendix.

The Panel concluded that the distribution of the tax burden under a stand-alone retail 

sales tax would not meet the requirement in the Executive Order that the Panel’s tax 

reform options be appropriately progressive.

Retail Sales Tax with a Cash Grant Program

Universal Cash Grant Program

Retail sales tax proposals generally recognize the distributional effects of a standalone retail sales tax. For this reason, such proposals usually include a cash grant 

program to relieve the burden of the retail sales tax on lower and middle-income 

families. 

The Panel considered the cash grant program advocated by proponents of the FairTax. 

This program (sometimes called a “Prebate”) would provide a monthly monetary 

grant to all U.S. citizens and residents. The goal of the program would be to provide 

families with cash sufficient to pay retail sales tax on all their spending up to the 

poverty level. The program would not be income based so there would be no need to 

have a federal agency to keep track of personal income. Nevertheless, it would require 

a federal agency to keep track of family characteristics, such as family size, on which 

the cash grant would be based.

This cash grant program would be expensive, and would require raising the retail sales 

tax rate. To pay for the cash grant program and remain revenue-neutral, the required 
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The President’s Advisory Panel on

tax rate, assuming evasion rates somewhat lower than those under the income tax, 

would be 34 percent. Using a higher evasion rate assumption, discussed further below, 

the tax rate would be 49 percent. If a narrower tax base were used instead of the 

Extended Base, the tax rate would be even higher. 

How would the cash grant program work? The federal government would be required 

to send monthly checks to every family in America, regardless of their income level. 

If the tax rate was 34 percent and the before-tax poverty level for an individual was 

$10,000, all single individuals would receive $3,400 a year from the government. 

The cash grant would also be adjusted for marital status and family size. For married 

couples with two children, the cash grant amount in 2006 would be $6,694 per year. 

The Prebate-type program would cost approximately $600 billion in 2006 alone. This 

amount is equivalent to 23 percent of projected total federal government spending 

and 42 percent of projected total federal entitlement program spending, exceeding 

the size of Social Security, Medicare, and Medicaid. The Prebate program would 

cost more than all budgeted spending in 2006 on the Departments of Agriculture, 

Commerce, Defense, Education, Energy, Homeland Security, Housing and Urban 

Development, and Interior combined. 

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213

Chapter Nine

Figures 9.3 and 9.4 show that low-income and high-income Americans would benefit 

from the retail sales tax with a Prebate, while middle-income Americans would pay 

a larger share of the federal tax burden. Separate figures with distributional estimates 

for 2015 law are not provided because the distribution of the retail sales tax burden 

in these estimates was identical to the distribution shown in Figures 9.3 and 9.4. 

American families with the lowest 20 percent of cash incomes currently pay negative 

0.5 percent of total federal income taxes because the tax credits they claim exceed 

their total positive tax liability. Under the retail sales tax with a Prebate, this group 

would pay negative 5.6 percent of the federal sales tax burden because the amount 

they would receive in monthly checks from the government would exceed what they 

would pay in retail sales tax at the cash register. In total, the bottom quintile would 

bear 5.1 percentage points less of the tax burden. Families with the top 10 percent 

of cash incomes would also benefit substantially from the retail sales tax. Their share 

of the tax burden would fall by 5.3 percentage points – from 70.8 percent to 65.5 

percent. 

Middle-income Americans, however, would bear more of the federal tax burden 

under the retail sales tax with a Prebate. The Treasury Department’s analysis of 

hypothetical taxpayers shows that married couples at the bottom 25th percentile, 50th 

percentile, and 75th percentile of the income distribution for married taxpayers would 

see substantial tax increases under a full replacement retail sales tax. A typical married 

couple at the bottom 25th percentile of the income distribution earns $39,300 per 

year and would pay $5,625 dollars in federal taxes in 2006. Under the retail sales tax 

with a Prebate, the same family would pay $7,997 in net federal taxes after subtracting 

the Prebate of $6,694, resulting in a tax increase of $2,372, or 42 percent. A typical 

married couple at the 50th percentile of the income distribution making $66,200 

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The President’s Advisory Panel on

would pay an additional $4,791, a tax increase of 36 percent, and a typical married 

couple in the 75th percentile, making $99,600 would pay an additional $6,789, a 29 

percent tax increase. A typical single mother at the bottom 25th percentile of the 

income distribution for head of household taxpayers has $23,100 of income per year 

and, compared to current law, would pay $5,866 more under the retail sales tax with a 

Prebate. 

Targeted Cash Grant Program

The Panel requested that the Treasury Department develop a more targeted cash 

subsidy program to alleviate the burden of a retail sales tax on lower- and middleincome American families. The resulting program required a cash grant of up to 

$7,068 to married couples, plus $2,570 per dependent per year, with a phase-in and 

a phase-out. Further details regarding the program are provided in the Appendix, as 

well as a brief discussion of an alternative targeted subsidy program. 

The Treasury Department’s proposed targeted cash grant program would cost $780 

billion in 2006. It would represent 30 percent of total federal government spending, 

and would dwarf all other federal entitlement programs and exceed the combined 

size of Social Security and Medicaid. To implement the program, the government 

would need to collect 34 percent more revenue and redistribute an additional 6 

percent of GDP. The Panel concluded that this substantial increase in the amount of 

revenue collected from taxpayers and redistributed by the federal government was 

undesirable. Some Panelists were also concerned that the precedent set by the large 

cash grant program could set the stage for further growth in the size and scope of the 

federal government. To pay for the targeted cash grant program and remain otherwise 

revenue-neutral, the tax rate would need to increase to at least 37 percent, assuming 

low evasion and using the Extended Base.

Administration of a Cash Grant Program Would be Complex

The proposed cash grant programs would require all eligible American families to file 

paperwork with the IRS or another federal government agency in order to claim their 

benefits under this new entitlement program. A federal agency would need to manage 

the program, verify individuals’ marital status and number of eligible children, and 

write checks to every family in the United States. Eligibility rules would be necessary, 

for example, to ensure that a child claimed as a dependent could not also file for his or 

her own separate cash grant. 

Substantial additional complexity would be imposed by a targeted cash grant 

program because determining eligibility would require additional information. For 

example, a program based on annual income would require the IRS or another federal 

government agency to make many of the same determinations now made under the 

current income tax. 
215

Chapter Nine

Evasion, the Tax Base, and the Required Tax Rate Revisited

The tax rate necessary to replace the revenues from the current individual and 

corporate income taxes is one key consideration in evaluating a retail sales tax. The 

two major factors that determine the tax rate are the size of the tax base and the 

level of evasion. The tax rates and rebate program cost estimates presented thus far have 

been based on relatively optimistic assumptions about the breadth of the tax base and the 

evasion rate. As explained above, even under these optimistic assumptions, the Panel does 

not recommend a full replacement sales tax at the resulting 34 percent tax rate. 

The Panel also had substantial concerns that a base as broad as assumed above would 

not be viable and that evasion rates could be higher than under the present income 

tax. The Panel believed that in evaluating the retail sales tax it was important to 

consider the tax rate required under less favorable assumptions regarding the tax base 

and evasion. Accordingly, the Panel requested that the Treasury Department estimate 

the required retail sales tax rate using the same tax base as the Partial Replacement 

VAT described in Chapter Eight and using a base equal to the average state sales tax 

base. 

The Partial Replacement VAT base described in Chapter Eight is slightly narrower 

than the Extended Base – primarily because it excludes the value of state and local 

government services. The Extended Base would require state and local governments 

not only to pay retail sales tax on their purchases from businesses, but also to pay tax 

at the retail sales tax rate to the federal government on the total value of the salaries 

that state and local governments pay their employees – this would be equivalent to 

the value of services provided by state and local governments to their citizens. The 

Panel concluded that it may be inappropriate for the federal government to directly 

assess a tax of this sort on state and local government in our federal system. For 

this reason, the Panel excluded state and local government services from the Partial 

Replacement VAT base discussed in Chapter Eight.

Existing state sales tax bases are substantially narrower than either of the broad bases 

studied by the Panel. Most states exempt a variety of specific products and many 

services from their sales taxes. For example, every state sales tax exempts prescription 

drugs, most states do not tax health care, approximately 30 states exempt food for 

home consumption or tax it at a preferential rate, and many states exempt clothing. 

These exemptions are often justified as a means to ease the burden of a sales tax on 

basic necessities, but are not well targeted because they often decrease the tax burden 

on higher-income taxpayers as much or more than they decrease the tax burden on 

lower or middle-income taxpayers. To illustrate the impact of extensive base erosion 

on a retail sales tax, the Panel requested that the Treasury Department estimate 

the tax rate using the average state sales tax base. The Panel acknowledges there are 

structural differences between state tax systems and a federal tax system that would 

rely on a retail sales tax instead of an individual and corporate income tax, and that 

these differences would affect the nature of any base erosion. Nevertheless, the Panel 

believes that estimating the tax rate using a base equal to the average state sales tax 

base is illustrative of the impact of base erosion on the tax rate. 
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Table 9.1. shows the Treasury Department’s estimates of the tax-exclusive retail sales 

tax rates required to replace the federal income tax using the alternative assumptions 

regarding evasion rates and the breadth of the tax base. The Extended Base and 

Partial Replacement VAT Base estimates include the Prebate-type universal cash 

grant program (calculated to provide all families with cash sufficient to pay a 34 

percent retail sales tax on a poverty level amount of spending). The average state sales 

tax base estimate includes no cash grant program, because exclusions from the base 

are assumed to fulfill the burden-easing function of the cash grant. These tax rates 

should be compared both to each other and to the overall burden an individual faces 

under both the corporate and individual income tax today. Tax-inclusive rates are 

provided in the Appendix.

Table 9.1. Retail Sales Tax Rate Estimates – Range of Tax-Exclusive Rates

Evasion Rate

Extended 

Base

Partial 

Replacement VAT 

Base

Median 

State Sales 

Tax Base

Low Evasion (15%) 34% 38% 64 %

Higher Evasion (30%) 49% 59% 89%

Source: Department of the Treasury, Office of Tax Analysis.
217

Chapter Nine

Evasion

Tax evasion occurs when taxpayers do not pay taxes that are legally due. Analysts 

agree that some evasion is inevitable in any tax, and that evasion rates for any tax 

tend to rise as the tax rate rises. At the request of the Panel, the Treasury Department 

estimated the revenue neutral retail sales tax rate assuming evasion rates of 15 and 30 

percent of personal consumption spending. The Treasury Department assumed no 

evasion by state and local governments. By comparison, for 2001 the IRS estimates 

that the evasion rate for the individual income tax was between 18 and 20 percent 

and the evasion rate of the entire U.S. tax system was about 15 percent. 

The retail sales tax would rely on retail businesses to collect all federal tax revenue and 

eliminate federal individual income tax filing. Therefore, the number of federal tax 

return filers would fall significantly under the retail sales tax. Further, the complexity 

of filing a business tax return would decline dramatically as compared to corporate 

income tax returns. Retail sales tax returns would indicate only total sales, exempt 

Box 9.2. Comparing the Treasury Department’s Revenue-Neutral Rate 

Estimate with Estimates Made by Retail Sales Tax Proponents

In their submission to the Panel, proponents of the FairTax claimed that a 30 percent tax 

exclusive sales tax rate would be sufficient not only to replace the federal income tax, but 

also to replace all payroll taxes and estate and gift taxes and fund a universal cash grant. In 

contrast, the Treasury Department concluded that using the retail sales tax to replace only 

the income tax and provide a cash grant would require at least a 34 percent tax-exclusive 

rate. 

Some may wonder why the tax rate estimated by FairTax advocates for replacing almost 

all federal taxes (representing 93 percent of projected federal receipts for fiscal year 2006, 

or $2.0 trillion) is so much lower than the retail sales tax rate estimated by the Treasury 

Department for replacing the income tax alone (representing 54 percent of projected federal 

receipts for fiscal year 2006, or $1.2 trillion). 

First, it appears that FairTax proponents include federal government spending in the tax 

base when computing revenues, and assume that the price consumers pay would rise by 

the full amount of the tax when calculating the amount of revenue the government would 

obtain from a retail sales tax. However, they neglect to take this assumption into account 

in computing the amount of revenue required to maintain the government’s current level 

of spending. For example, if a retail sales tax imposed a 30 percent tax on a good required 

for national defense (for example, transport vehicles) either (1) the government would be 

required to pay that tax, thereby increasing the cost of maintaining current levels of national 

defense under the retail sales tax, or (2) if the government was exempt from retail sales 

tax, the estimate for the amount of revenue raised by the retail sales tax could not include 

tax on the government’s purchases. Failure to properly account for this effect is the most 

significant factor contributing to the FairTax proponents’ relatively low revenue neutral tax 

rate.

Second, FairTax proponents’ rate estimates also appear to assume that there would be 

absolutely no tax evasion in a retail sales tax. The Panel found the assumption that all 

taxpayers would be fully compliant with a full replacement retail sales tax to be unreasonable. 

The Panel instead made assumptions about evasion that it believes to be conservative and 

analyzed the tax rate using these evasion assumptions. 
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sales (sales to businesses with exemption certificates plus export sales) and tax liability. 

From an enforcement perspective, both the reduced number of tax return filings and 

the simple nature of the retail sales tax return represent substantial advantages. 

Nevertheless, the Panel concluded that a number of features of the retail sales tax 

would make it difficult to administer and enforce at the high tax rate necessary to 

be revenue-neutral. A federal retail sales tax assessed at a rate of at least 34 percent, 

added on to state retail sales taxes, would provide a substantial inducement for evasion 

at the retail level. Retailers and shoppers could use a number of techniques to evade 

a retail sales tax. For example, unregistered cash sales to a consumer would allow 

a transaction to escape taxation. Retailers facing a high retail sales tax might also 

misapply exemption criteria, whether intentionally or unintentionally, and fail to tax 

goods that should be taxed. Or, the retailer might collect the tax from customers, but 

keep the money rather than remit it to the government. At high tax rates, the gain to 

retailers from evasion is high.

Empirical evidence suggests third-party reporting substantially improves tax 

compliance, particularly when tax rates are high. For the portion of income from 

which taxes are not withheld and there is no third-party reporting, income tax 

evasion rates are estimated to be around 50 percent. There is no third-party reporting 

in a retail sales tax. Retailers would add their retail sales tax to the pre-tax price for 

their goods and would remit that amount to the government, but shoppers would 

not separately report what they bought, and at what price, to the government. The 

government would rely on retailers alone to report their own taxable and exempt sales. 

To obtain exemption from tax, retail purchasers might try to fabricate exemption 

certificates or otherwise masquerade as tax-free buyers of retail products. For example, 

individuals might create “paper” businesses solely to obtain business exemption 

certificates and avoid taxes on purchases for personal use. A related problem involves 

individuals with legitimate businesses using their business exemptions for personal 

purchases or for goods or services to give to employees in lieu of cash compensation. 

Using their business purchase exemption would provide a discount equal to the retail 

sales tax rate.

With a retail sales tax, retailers would have the responsibility to determine whether 

the ultimate use of a good or service would be for a business purpose, and therefore 

would be deserving of the business purchase exemption. Retailers are often illequipped to carry out this role. State experience suggests that abuse of exemptions is 

common, in part because distinguishing between business and individual consumer 

purchases of so-called “dual use” goods and services – goods and services that are 

commonly purchased by both businesses and final consumers, such as a plane ticket 

– can be difficult and costly.
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Comparison with State Sales Tax Evasion and Administration 

Retail sales tax advocates often note that evasion rates with sales taxes are lower than 

evasion rates with the income tax. However, state sales tax evasion rates are not likely 

to be representative of the evasion rate of a full replacement retail sales tax for several 

reasons. 

First, state sales tax rates are a fraction of the tax rates required to replace the federal 

income tax. Among states that impose sales taxes, tax rates range from 3.5 percent in 

Virginia to 7.0 percent in Mississippi, Rhode Island, and Tennessee. When combined 

with local sales taxes, the highest sales taxes are found in Alabama (11.0 percent), 

Arkansas (10.625 percent), Oklahoma (10.5 percent) and Louisiana (10.5 percent). 

Higher tax rates provide greater incentives for taxpayer evasion and avoidance. Those 

incentives also make administration and enforcement more expensive – and any 

failure to effectively administer the tax requires a higher tax rate to compensate for 

lost revenue. No state or country has ever levied a retail sales tax at a tax rate that even 

approaches the 34 percent required to replace the federal income tax system. State tax 

administrators told the Panel that they would expect significant compliance problems 

at such rates. 

State sales taxes also do not broadly tax service providers, often because they are 

difficult to tax. For example, all U.S. state sales taxes exempt most financial services. 

Other dual-use services, such as utilities, transportation, and communication services 

are also difficult to tax properly and often are exempt from state sales taxes. It is 

reasonable to assume that trying to tax these services through a retail sales tax likely 

would result in more extensive evasion and higher compliance and administrative 

costs than existing state sales taxes. Although it is difficult to know with any measure 

of certainty what the evasion rate would be under the RST, the Panel believes that it 

would likely be at least as high as evasion under the current income tax and that a 30 

percent rate of evasion would not be an unreasonable assumption.

Box 9.3. Dual-Use Goods and the Problem of “Cascading”

The difficulty of identifying whether dual-use goods are used for business or individual 

purposes is one reason that states typically include a significant number of business-tobusiness transactions in their sales tax base. For example, states often do not ask retailers 

to determine whether a buyer will use a computer for entertainment at home (taxable) 

or to run a business (exempt). Instead, many states treat sales of computers as taxable 

unless the buyer certifies that they are purchasing the computer for resale. Thus, many 

businesses pay sales tax when purchasing computers. That tax then “cascades” into the 

cost of the goods and services the purchasing business sells to consumers. Taxing goods 

and services bought by businesses to produce other goods and services is economically 

inefficient because it haphazardly imposes double (or triple or quadruple) taxation on some 

consumer goods and services. 

Cascading taxes create incentives for business to produce fewer goods or services, shift 

resources into tax-favored activities, or adopt tax-driven business structures. Cascading 

taxes also may have a negative impact on U.S. competitiveness because they impose some 

tax liability on exports and result in less tax being assessed on imports relative to competing 

domestically-produced goods.
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Other Concerns

Response of the States to a Retail Sales Tax 

Although some retail sales tax proposals claim the administration of the retail sales 

tax could be left to the states and the IRS could be eliminated, such a system would 

likely be unworkable. Existing state sales tax bases are both narrow and varied and it 

may be difficult to persuade the states to adopt the federal retail sales tax base. 

The experience of Canada, which tried to federalize its provincial sales taxes, may 

be instructive. Canada considered adopting a unified federal and provincial sales tax 

base in 1987, but intergovernmental discussions failed to produce an agreement to 

standardize the existing provincial sales tax bases with the base for Canada’s federal 

goods and services tax. 

Variation in local sales tax rates within the United States could further complicate any 

effort to standardize U.S. sales tax bases and rates. As of 2001, Texas alone had 1,109 

separate city tax rates, 119 county tax rates, and 67 other special tax jurisdictions. 

Texas is not atypical in having numerous local sales tax jurisdictions. While some 

states might bring their sales taxes into conformity with a federal retail sales tax, it is 

unlikely that all would do so. States have not adopted identical definitions, standards, 

and rules in their own income tax regimes as those that exist for the federal income 

tax, even though there would be many administrative and compliance advantages to 

such an approach.

Given the tremendous variance in the current taxation of retail sales across the United 

States, the IRS or another federal agency with substantial personnel and resources 

would almost certainly have to define, administer, and enforce a federal retail 

sales tax. For example, detailed rules would be necessary to ensure that exemption 

certificates were issued uniformly and only provided to legitimate businesses for use 

in purchasing actual business tools, materials, and other inputs. Further, the IRS or 

another federal agency would likely need to administer the retail sales tax directly 

in the five states that do not currently impose a sales tax. The same might be true in 

those states that do not bring their sales tax bases into conformity with the federal 

retail sales tax base. Finally, because failure to effectively enforce the sales tax would 

lower federal revenues, Congress might decide that the IRS should maintain a 

significant enforcement function as a backup mechanism to state tax administration 

efforts.

State Income Tax

At the Panel’s public meetings, state and local tax officials suggested that a federal 

retail sales tax would encroach on a tax base that traditionally has been left exclusively 

to states and localities. Currently sales and gross receipts taxes account for about 

37 percent of state general tax collections and about 17 percent of local revenues. 

However, if a federal retail sales tax were put in place at a rate of 34 percent or more, 

it could become unattractive for states to add their own rates on top of the federal 

retail sales tax. 
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If the federal government were to cease taxing income, states might choose to shift 

their revenue-raising to the income base from the sales base. State income taxes could 

rise, while state sales tax rates could fall. In any event, unless states found a substitute 

source of revenue, they likely would maintain their income taxes. For that reason, it is 

reasonable to expect that taxpayers would need to continue to keep track of incomerelated information and file income tax returns, regardless of whether the federal 

government eliminates the federal income tax. Furthermore, with an income-based 

cash grant program, tracking income at the federal level would remain a necessity.

Today, 45 states and the District of Columbia have state income taxes. Most states use 

federal adjusted gross income as the starting point in determining the state individual 

income tax base. Eliminating the federal income tax would remove the common basis 

upon which most state income taxes are now structured. State and local income tax 

returns would likely become much more complex if they could not be based on a 

pre-existing federal income tax return that includes a calculation of annual income. 

Greater disparities among state income tax systems and potential distortions would 

likely develop as state income tax structures diverge from each other over time in the 

absence of a common federal income tax base as a starting point. 

State income tax compliance initiatives currently rely in large measure on information 

that the states receive from the third-party reporting structure created by the federal 

income tax – such as W-2 and 1099 forms as well as other standard tax forms that 

report income. In the absence of the federal third-party reporting system, states 

would need to impose information reporting requirements on individuals, employers, 

financial institutions, and others in order to maintain their income tax systems. States 

might bind together to coordinate enforcement of state income taxes and impose 

those reporting requirements. But if states chose to impose reporting requirements 

independently, multi-state businesses could face many different sets of reporting 

obligations. Simplification of the federal tax system through a retail sales tax might be 

achieved at the expense of greater overall complexity in the combined system of state 

and federal taxation.

Compliance Burden on Small Business

A retail sales tax also likely would place a disproportionate burden on small retail 

businesses. Few statistical studies exist on the compliance costs for retailers of 

different sizes. However, a well-regarded study conducted by the State of Washington 

Department of Revenue in 1998 suggests that, although such costs are low overall, 

they are disproportionately high for small retailers. In Washington, the cost of 

collecting sales tax for retailers with annual gross retail sales of between $150,000 

and $400,000 was 6.5 percent of sales tax collected. By comparison, firms with 

annual gross retail sales greater than $1.5 million spent less than 1 percent of sales tax 

collected on compliance.

Small vendors, particularly those operating on a cash basis, account for a significant 

share of the noncompliance in many state sales taxes as well as our current income 

tax. A retail sales tax would cover all retailers, including small service providers, 
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such as dentists, car mechanics, or beauticians, as well as small retail stores. Small 

service providers would likely find retail sales tax compliance costly and would have 

noncompliance incentives that would be similar to those for small retail stores. 

Macroeconomic Effects of Transition

Some observers have worried about potential macroeconomic disruptions associated 

with moving from an income tax to a retail sales tax. Although there may be some 

such disruptions, those considerations were secondary in the Panel’s decision not to 

recommend a retail sales tax. 

Full Replacement of the Income Tax with a VAT

The Panel considered replacing the income tax with a VAT at the same time it 

analyzed a replacement retail sales tax because of the similarities between the two 

taxes. The Panel concluded that fully replacing the income tax with a VAT would be 

substantially more administrable than fully replacing the income tax with a retail sales 

tax. The advantages of a VAT over a retail sales tax with respect to enforcement and 

compliance are described in Chapter Eight. However, the Panel’s objections regarding 

the increased tax burden on the middle class and increased size of government 

resulting from the full replacement retail sales tax apply equally to a full replacement 

VAT. Because of these concerns, the Panel did not recommend a full replacement 

VAT.

Conclusion

Like other consumption taxes, the full replacement retail sales tax has pro-retail 

growth features. Nevertheless, the Panel does not recommend a full replacement 

retail sales tax. Without a large cash grant program to ease the burden of the tax, a 

retail sales tax would not be appropriately progressive. A cash grant program to make 

the tax appropriately progressive would cost at least $600 billion per year – which 

would make it America’s largest entitlement program. The Panel concluded that it 

was inappropriate to recommend a tax reform proposal that required the federal 

government to collect and redistribute this amount in additional revenue from 

taxpayers. The Panel also was concerned with administrative and compliance issues 

associated with a retail sales tax, as well as difficulties involving coordination with 

existing state sales taxes.
Appendix

Additional Details 

During the course of its work, the Panel examined the current corporate and 

individual income tax systems and evaluated a variety of proposals for reform. The 

Panel relied on the help of experts who appeared before the Panel, the Panel staff, the 

Treasury Department, the Internal Revenue Service, and interested parties who 

submitted comments. 

The Panel had a finite amount of time to develop options, and, therefore, focused its 

efforts on the goals it hoped to achieve. Although the Panel could not consider every 

issue or problem, there were several issues for which the Panel developed detailed 

solutions, these are presented in this Appendix. Much of the discussion is intended 

to provide background regarding implementation of the Panel’s recommendations. 

The Panel believes that providing this information will aid in understanding its 

recommendations and will serve as a starting point as policymakers consider changes 

to the tax code.

This Appendix is not intended to be a comprehensive or systematic discussion of 

the issues addressed. Moreover, the range of issues addressed in the Appendix is not 

intended to imply that there are not other important issues. For every issue discussed 
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here, the Panel discovered that there were many more that could not be thoroughly 

analyzed in the limited amount of time the Panel had to accomplish its mission.

The Appendix is organized by report chapter. Additional distribution tables for 

the Simplified Income Tax Plan, the Growth and Investment Tax Plan, and the 

Progressive Consumption Tax Plan, and sample tax forms appear in the last section of 

this Appendix.

Chapter Four: Our Starting Point

Details on the Macroeconomic Analysis of the Tax Reform Proposals

The Treasury Department used variants of three standard economic growth models to 

estimate the dynamic response associated with the Panel’s reform options. The use of 

multiple models reflects both the uncertainty in these types of estimates and provides 

a reasonable range of results that are consistent with the range of estimates found in 

the economic literature. These types of models have been used in academic research 

on the dynamic effects of tax reform and by the staffs of the Joint Committee on 

Taxation and the Congressional Budget Office. 

The three models used by the Treasury Department were a neoclassical growth 

model, an overlapping generations (OLG) life-cycle model, and a Ramsey growth 

model. The Treasury Department used the OLG model developed by Tax Policy 

Advisors, LLC. All three models are supply-side models that emphasize the effects on 

economic growth of reducing the effective tax rates on capital and labor income. The 

models ignore demand-side or cyclical variations in the economy, assuming instead 

that the economy is always at full employment. The neoclassical and Ramsey growth 

models are closed economy models that ignore international capital flows and foreign 

trade. The OLG model includes a simple international sector. 

 The Ramsey growth model, which assumes fixed labor supply, but an infinitely 

elastic supply of capital at a fixed after-tax required return, yields the smallest growth 

effects over the ten-year revenue window. This is because it does not account for 

the labor supply responses that are built into the other models. The intertemporal 

elasticity of substitution in the Ramsey growth model is smaller (0.25) than that 

in the overlapping generations model (0.35). The within-period substitution 

elasticity between labor and goods is greater in the Ramsey model (0.80) than in the 

overlapping generations model (0.60). 

Each of the three models is calibrated to replicate certain economic aggregates using 

the Administration’s policy baseline over the ten-year budget window. The changes 

to the tax system are assumed to occur simultaneously and without anticipation 

by households or firms. As households and firms respond to the effect of the tax 

changes on after-tax wages and interest rates, savings and investment increase, the 

capital stock increases and individuals change the amount of labor they are willing to 

supply. These changes occur for many years until eventually the economy returns to 

the original steady-state growth rate, at a higher level than the previous steady-state 
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Appendix

growth path. Before the tax changes are imposed, the economic growth rate equals 

the combined population growth rate and rate of growth in technological change, 

both of which are held fixed over time.

Each of the recommended plans has been estimated by the Treasury Department to 

be revenue neutral over the budget window. Yet given the level of aggregation in the 

dynamic models, as well as the embedded behavioral responses, there is no reason 

to expect that budget neutrality would be maintained for any particular year by 

applying the implied labor and capital tax rates that result from Treasury’s standard 

revenue estimating analysis into the dynamic models. There are numerous fiscal policy 

responses that could be applied to maintain the government’s intertemporal budget 

balance through the period of reform. The analysis in this report assumes that average 

and marginal tax rates are adjusted in each year to maintain a constant level of real 

government spending for each year after the reforms. 

The treatment of the initial tax system in the model, while similar across the 

models, is also slightly different. The initial tax system for the Ramsey model and 

the neoclassical growth model includes a flat rate tax on wages and an effective tax 

rate on capital income. Investment incentives (e.g., accelerated depreciation and tax 

exemption of the return to owner-occupied housing) reduce the effective tax rate 

on capital income below the statutory tax rate. The OLG model has a more detailed 

treatment of the tax system in that labor income taxes are progressive over the life 

cycle. The OLG model also includes state taxes and a simplified Social Security 

system, with both state spending and Social Security transfers held constant during 

the reform. Because the tax system is modeled in a stylized way in each of these 

models, and the models make simplifying assumptions about a variety of factors, 

including international capital flows and investment risk, they provide only rough 

guidance about how tax reforms might affect economic growth. Nevertheless, these 

models are representative of the types of models that are commonly applied in 

academic and government research. 

Chapter Five: The Panel’s Recommendations

Consolidated Family and Work Credit 

Eligibility for Family and Work Credits

Chapter Five describes the Family and Work Credits that individuals would be 

entitled to claim instead of the complex system of tax benefits provided for families 

under current law. The base amount of the Family Credit depends on family status, 

as described below. It also allows an additional non-refundable tax credit of $1,500 

for each child dependent and $500 for each other dependent. The refundable Work 

Credit provides higher credits and income ceilings for taxpayers who have at least one 

child dependent. 

Chapter Five describes the Panel’s recommendations for simpler set of eligibility 

rules for the Family and Work Credits. Under current law, each family tax benefit, 
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such as the personal exemption, the child tax credit, and the EITC, requires its own 

complex determination of whether the taxpayer can claim the benefit. The Panel 

recommends that simple rules be used to determine whether taxpayers qualify for 

the Family Credit, and that eligibility for the Work Credit flow intuitively from that 

determination. For the vast majority of taxpayers who qualify for the Family Credit, 

the question of whether they also qualify for the Work Credit will turn only on the 

amount of their unused Family Credit and their income.

The Working Families Tax Relief Act of 2004 made eligibility for family tax benefits 

more uniform by simplifying the test for whether a taxpayer can treat a child or 

another person as a dependent in order to claim a personal exemption, child tax 

credit, or EITC for that person. The Panel adopted the approach of the legislation, 

but recommends additional reforms aimed at further simplifying eligibility tests for 

the Family and Work Credits. 

The following discussion illustrates how a taxpayer would determine whether he 

or she qualifies for the Family Credit and Work Credit. The Panel recommends an 

approach that carefully balances the need for simple rules against the need to target 

the credits appropriately. These rules are designed to allow the IRS to determine each 

taxpayer’s eligibility for the credits, and to be able to calculate the Work Credit if 

asked to do so by the taxpayer. This design mandates streamlined rules that also would 

make it easier for taxpayers to calculate the tax credits for themselves.

Amount of the Credits

The Panel’s recommendations would eliminate much of the complexity flowing from 

current-law rules that reduce the value of various tax benefits as a taxpayer’s income 

increases. Under current law, taxpayers must apply a different mechanism under the 

personal exemption, the child tax credit, and each of a number of other tax provisions 

to determine what portion, if any, of the tax benefit they can claim. Thus, for example, 

the amount of personal exemptions and itemized deductions the taxpayer can deduct 

and the amount of child tax credits the taxpayer can claim decline as the taxpayer’s 

adjusted gross income rises. The rules limiting or reducing the tax benefits are not 

uniform, however, forcing many taxpayers to do several different complex calculations. 

By contrast, the Family Credit would not phase out as income rises. This would 

represent a meaningful simplification for many taxpayers. 
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What Family 

Credits are

available?

Family Credits For: Would be:

• A single taxpayer with no child dependent $1,650

• A single taxpayer with one child 

dependent

$2,800

• Married taxpayers filing joint returns $3,300

• A taxpayer who could be claimed as a 

dependent by another taxpayer $1,150

And for each of the following: An additional:

• A child dependent $1,500 

• Other dependent $ 500

Under current law, a taxpayer may be entitled to a tax refund if his child tax credit 

exceeds his income tax liability (determined before the credit), provided he meets 

certain other complex tests. These tests are especially burdensome. As discussed earlier 

in Chapter Five, the options would be much simpler for these taxpayers because the 

Family Credit would be effectively refundable for low-income workers through the 

operation of the Work Credit. 

The Work Credit, like the EITC, would increase with a taxpayer’s earnings up to 

a ceiling, and would then decrease as the taxpayer’s earnings rise further. Like the 

EITC, this is intended to encourage work while also limiting the credit to lowincome taxpayers. 
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What Work Credit 

is available? The Work Credit would approximate the EITC and 

refundable child tax credit under current law. Taxpayers 

would determine the amount of their Work Credit by 

consulting two simple schedules included at the end of 

this section of the Appendix. The following explains the 

formulas on which those schedules are based.

The Work Credit would be the amount by which the 

taxpayer’s Family Credit exceeds tax liability before the 

credit limited to:

• No child dependent: the lesser of 7.65 percent of 

work income or $412;

• One child dependent: the lesser of 34 percent of 

work income or $2,120

• Two or more child dependents: the lesser of 40 

percent of work income or $3,200.

With an additional credit of:

• up to $1,450 if the taxpayer has one child 

dependent

o phased in at a rate of 34 cents for every dollar 

of work income (or taxable income, if lower) 

over $6,235;

• up to $2,600 if the taxpayer has two or more child 

dependents

o phased in at a rate of 40 cents for every dollar of 

work income (or taxable income, if lower) over 

$8,000;

The additional credit would phase out at a rate of 12.5 

cents for every dollar of the taxpayer’s work income (or 

taxable income, if higher) above $17,000 (or $21,000 if 

the taxpayer is filing a joint return). Taxable income for 

these purposes would include any tax-exempt interest 

and dividends.
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Appendix

The amount of Work 

Credit a taxpayer 

can claim depends 

on work income. 

What is a taxpayer’s 

work income?

Work income would include a taxpayer’s taxable wages 

and salaries, self-employment income, and labor income 

for a statutory employee. If a taxpayer makes an election, 

non-taxable combat pay would be included in work 

income. This would allow some active duty military 

families to qualify for a greater Work Credit than they 

otherwise would have.

Could a taxpayer 

have investment 

income and still 

qualify for the 

Work Credit?

The Panel recommends simplifying the eligibility rules 

by eliminating the investment income test for the Work 

Credit. Under the current-law EITC, a taxpayer who 

earns more than $2,800 of investment income in 2006 is 

ineligible for the credit. This rule discourages low-income 

workers from saving, because a taxpayer who earns 

one dollar more than the limit forfeits the entire amount 

of the EITC. 

Under the Panel’s options, investment income would be 

taken into account to determine how much Work Credit 

the taxpayer could claim. The portion of the Work Credit 

that is in addition to any excess of the Family Credit 

over tax liabilities would phase in with the lesser of work 

income or taxable income, and phase out with the greater 

of work income or taxable income. Taxable income would 

include the taxpayer’s taxable investment income and, for 

this purpose, tax exempt dividends and interest on state 

and local bonds as well. Taxpayers would not be required 

to satisfy a separate investment income test to claim the 

Work Credit. 
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Taxpayer Eligibility

A taxpayer must meet certain qualifications to be eligible to claim the Family and 

Work Credits. These qualifications are similar to the tests that apply to taxpayers 

claiming standard deductions, personal exemptions, child tax credits, and the EITC 

under current law, but are simpler and more consistent. The requirements for claiming 

the Family Credit are the foundation for Work Credit eligibility. Because the Work 

Credit is intended as a subsidy for low-income working families, a person who qualifies 

for the Family Credit must satisfy several other tests to claim the Work Credit.

Who could claim 

a Family Credit?

Almost anyone who files an individual income tax return 

could claim the Family Credit. 

A taxpayer who could be claimed as a dependent or child 

dependent on someone else’s return, however, could claim a 

Family Credit of only $1,150. The Panel recommends this 

approach to limit available credits when a person’s income 

does not reflect his or her financial status. This represents a 

simplification of current law, which denies the dependency 

exemption, the child tax credit, and the EITC to any taxpayer 

who can be claimed as a dependent or qualifying child on 

another’s return, and imposes a complex formula to calculate 

how much of the standard deduction the taxpayer can claim. 

Who can claim 

the Work Credit?

A taxpayer would be eligible for the Work Credit if:

• The taxpayer’s Family Credit exceeds tax liability before 

the credit;

• The taxpayer has one child dependent and income 

below $28,600 ($32,600 if married); or

• The taxpayer has two or more child dependents and 

income below $37,800 ($41,800 if married).

The Work Credit would not be available if the taxpayer or 

the taxpayer’s spouse could be claimed as a dependent on 

someone else’s tax return.
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Appendix

Does it matter 

whether the 

taxpayer is single 

or married? 

Generally, a family’s aggregate Family Credits would be the 

same regardless of the taxpayer’s filing status, but married 

taxpayers who file as singles may lose a portion of some 

credits.

The Panel has recommended that a married taxpayer be 

allowed to choose between filing returns jointly with his 

or her spouse and filing as a single person, and the Panel’s 

recommendations would reduce the significance of this 

choice. Moreover, there would be no married-filingseparately status and no head-of-household filing status. This 

would significantly reduce complexity for many taxpayers. 

Instead of having special filing categories, there would be a 

higher Family Credit available to a person filing as a single 

taxpayer who has a child dependent (in addition to the credit 

that could be claimed for the child). A married taxpayer who 

files as a single taxpayer would generally be unable to claim 

this higher Family Credit.

In addition, a married taxpayer who files as a single taxpayer 

would generally be ineligible for the Work Credit. 

This limit on the Family and Work Credits for married 

taxpayers filing as singles would not apply, however, to a 

taxpayer who lived apart from the taxpayer’s spouse for an 

entire year, and who satisfied certain other conditions that 

show that the taxpayer and the taxpayer’s spouse are no 

longer a family unit. These rules would be consistent with 

special rules under current law for separated spouses, but 

would be somewhat simplified.

The Panel believes this approach would balance the need to 

simplify the arcane filing status rules and the restrictions on 

married taxpayers who file separate returns with the need to 

provide fair and administrable rules for families.

Would a taxpayer 

have to be a 

certain age to 

qualify for the 

credits?

There would be no age restrictions on taxpayers who claim 

the Family and Work Credits (although there would be for 

the taxpayer’s dependents, as discussed below). The Panel’s 

recommendations would eliminate the current-law rules that 

limit the EITC to childless taxpayers between the ages of 25 

and 65. The Panel saw no compelling reason to retain this 

rule in light of other recommendations. 
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Would the 

taxpayer need to 

be a citizen or 

resident of the 

United States to 

claim the credits?

The Family Credit would not apply a citizenship or residency 

requirement. Like the current law EITC, the Work Credit 

would be available only to U.S. citizens or individuals who are 

residents of the United States for the entire year. A taxpayer 

also would need a Social Security number authorizing work 

in the United States to claim the Work Credit. In addition, 

a taxpayer could only qualify for the Work Credit if he lived 

in the United States for at least half of the year for which the 

credit is claimed. Special rules would apply to individuals on 

active duty with the military.

The Panel recognizes that these special Work Credit 

requirements would impose a burden on a small minority of 

taxpayers, but believes they are necessary to insure the credit 

is targeted to low-income workers who live in the U.S. 

Would a taxpayer’s 

spouse need to 

be a citizen or 

resident for the 

taxpayer to claim 

the credits?

A taxpayer who is married to a non-resident alien could 

not file a joint return or claim the Family Credit for his or 

her spouse. Thus, in general, under rules described above for 

married taxpayers filing as singles, the taxpayer could only 

claim the Family Credit for a single taxpayer, and not the 

higher amount available to a single taxpayer with a child 

dependent. The taxpayer would, however, be entitled to claim 

the additional $1,500 Family Credit for any child dependent. 

The taxpayer would not be able to claim the Work Credit. 

The restriction on filing a joint return would not apply, 

however, to a taxpayer who is a citizen or full-year resident of 

the United States if the spouse elected to be taxed as a fullyear U.S. resident. This is consistent with current law, which 

prohibits a taxpayer who is married to a non-resident alien 

from filing a joint return or from claiming a dependency 

exemption for the spouse unless the spouse makes the 

election to be taxed as a full-year U.S. resident.

Are credits 

available to 

U.S. citizens or 

residents who 

work abroad?

Family Credits would be available to taxpayers who claim 

an exemption for income earned abroad. The Work Credit 

would not be available for these taxpayers. 
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Credits for Children and Other Dependents—Eligibility

Under the Panel’s recommendations, a taxpayer could claim a $1,500 Family Credit 

for each child who was the taxpayer’s “child dependent.” A taxpayer could also take 

such a child into account under the Work Credit if certain other tests are met. A 

taxpayer would be able to claim a $500 Family Credit for other individuals whom the 

taxpayer supports but who would not qualify as child dependents.

Who would qualify 

as a taxpayer’s child 

dependent?

A child dependent would be someone who meets three 

simple eligibility tests: relationship with the taxpayer, age, 

and residency.

Who meets the 

relationship test?

An individual would meet the relationship test if, as under 

current law, he or she is the taxpayer’s child, stepchild, 

adopted child (including a foster child officially placed 

with the taxpayer), stepchild, sibling or stepsibling, or 

descendants of any of these relations.

Who meets the age 

test?

The age test would be met by an individual who is 18 years 

old or younger or is permanently disabled. A child who 

is 19 or 20 years old and a full-time student would also 

meet the age test. As discussed earlier in Chapter Five, the 

age requirement would be a change from current law and 

reflects the Panel’s view that credits should be available for 

children over 18 if they are still dependent on their families. 
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Who would meet 

the residency test?

The residency test would be satisfied if a child lived with 

the taxpayer for more than half of the year, including 

periods when the child is temporarily away from home. 

For example, a student who does not live with his parents 

while attending college could still meet the residency 

requirement. This approach follows current law. Unlike 

current law, however, if parents are divorced or legally 

separated, the noncustodial parent generally would not be 

able to satisfy the residency test and thus could not claim 

the couple’s children as child dependents. The Panel did 

not adopt the special rule under current law that allows a 

custodial parent to release the dependency exemption and 

child tax credit to a noncustodial parent because it creates 

unnecessary complexity.

Would a taxpayer 

be required to show 

he or she supported 

a child dependent?

There would be no general support test for child 

dependents under the Panel’s recommendations. If a child 

is self-supporting (i.e., provides more than half his own 

support), however, the child may not be claimed as a child 

dependent. This test would simplify the rules under current 

law and preserve the ability of financially independent 

children to claim credits on their own returns.

What if two or 

more taxpayers 

claim the same 

child dependent?

Only one person would be able to claim the child on a 

tax return. If two or more people entitled to treat a child 

as a child dependent cannot agree on who will claim the 

child, the Panel recommends application of the so-called 

tie-breaker rules of current law. In general, if both a parent 

and a non-parent claim the child, only the parent would be 

eligible to take the Family Credit and higher Work Credit 

for that child. If two parents who do not file joint returns 

claim the child, only the parent with whom the child lived 

longest (or if time is equal, the parent who had the highest 

adjusted gross income) would be eligible. If neither of the 

taxpayers claiming the child was the child’s parent, only the 

taxpayer with the highest adjusted gross income would be 

eligible.
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If an individual does 

not meet the tests 

for being a child 

dependent, can the 

taxpayer still claim a 

Family Credit for that 

person?

Yes, a $500 Family Credit could be claimed for a 

dependent who is not a child dependent. But only child 

dependents would be taken into account for purposes of 

the Work Credit.

Who would qualify 

as a taxpayer’s 

dependent?

A dependent would be someone who is a relative of the 

taxpayer or a member of the taxpayer’s household, has 

gross income below $3,300, is provided with more than 

half his or her support by the taxpayer, and cannot be 

claimed as a child dependent by any other taxpayer. The 

income limit is the approximate amount that, if taxed 

at the lowest 15 percent marginal rate, would result in a 

tax liability of $500. The Panel’s options would waive the 

income test for full-time students ages 21 to 23. Thus, 

for example, if a full-time, 22-year-old student met all 

of the tests for being a child dependent except that he 

exceeded the age limit of 20, the student’s parents could 

claim a $500 Family Credit regardless of the student’s 

income. 

These requirements are similar to the rules under 

current law that allow a taxpayer to claim the personal 

exemption for a qualified relative who is not a qualified 

child, but do not allow the taxpayer to claim the EITC 

or child tax credit for that person. 

The Panel recognizes that the lower Family Credit for 

dependents who do not qualify as child dependents 

introduces additional complexity into the Panel’s 

recommendations. The Panel believes that the balance 

between fairness and simplicity weighs in favor of 

allowing a Family Credit when a taxpayer financially 

supports an individual for whom the taxpayer cannot 

claim the higher credit. Moreover, the Panel believes that 

most taxpayers will not need to apply these additional 

tests. 
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The preceding discussion describes the rules that the vast majority of taxpayers would 

have to apply to claim the Family and Work Credits. The Panel would recommend 

additional special rules for determining whether an individual could be claimed as 

a taxpayer’s child dependent or other dependent, but the application of those rules 

would be limited.

Would there be 

any other general 

requirements to claim 

a child dependent or 

dependent?

A taxpayer could not claim an individual as a dependent 

or a child dependent without providing the individual’s 

name and valid social security number on the federal 

income tax return. This is generally consistent with the 

current-law requirement that a taxpayer provide a child’s 

name and taxpayer identification number to claim the 

dependency exemption and the child tax credit, but is 

more liberal than the rule for the EITC, which requires 

the child to have a social security number that is valid 

for work in the United States.

Could a married 

individual qualify as 

a child dependent or 

dependent?

If an individual is married and files a federal income tax 

return jointly with his or her spouse, no taxpayer could 

treat that individual as a dependent or child dependent. 

This would be consistent with the current-law rule for 

the personal exemption and the EITC. 

Could an individual 

who is a nonresident 

alien qualify as a 

child dependent or 

dependent?

To qualify as a child dependent or as a dependent, an 

individual would have to be a resident or citizen of the 

United States. Thus, a parent of a non-resident alien 

child could not claim the Family Credit for that child or 

qualify for the higher Work Credit for that child. This 

rule is consistent with current law, but provides more 

uniformity: the rules for the dependency exemption 

under current law allow taxpayers to claim children who 

are residents of Canada and Mexico. 

Would there be 

any additional U.S. 

residency rules to 

qualify for the higher 

Work Credit available 

to taxpayers with child 

dependents?

Yes. To qualify for the Work Credit, a taxpayer’s child 

dependent would be required to have lived with the 

taxpayer in the United States for more than half of the 

year. This is identical to the requirements under the 

current-law EITC. Although this rule adds complexity 

by creating an additional eligibility test under the Work 

Credit, it was retained to ensure the Work Credit would 

be limited to families that reside within the United 

States. 
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The Panel believes that navigating these rules should be as simple as possible for 

taxpayers and has recommended a structure that gives taxpayers the option of 

allowing the IRS to compute the Work Credit for them. For those taxpayers who 

choose to compute the Work Credit themselves, the Panel developed the worksheet 

and instructions shown in the last section of this Appendix to illustrate the process.

Home Credit

As discussed in Chapter Five, the Panel recommends that the current home mortgage 

interest deduction be converted into a tax credit of 15 percent of home mortgage 

interest. The Panel also recommended limiting the credit to interest on a standard 

principal amount, based on the average price of single-family homes in the United 

States, adjusted annually to take into account regional variations in housing costs. 

Each year, taxpayers would apply the current year’s mortgage limit. Thus, the amount 

of home mortgage debt for which the interest credit could be claimed would increase 

each year if home prices rise.

The Panel recommends basing the average home price on the ceilings that the Federal 

Housing Administration (FHA) sets for the amount of a home mortgage loan that it 

will insure. The ceilings are determined using median home prices and are provided 

on a county-by-county basis to account for regional variations in housing costs. These 

amounts would be adjusted to reverse a discount the FHA applies and to account for 

the difference between median and average prices. To determine mortgage loan limits, 

the amount the FHA reports would be grossed-up to 100 percent of median values 

and then increased by 125 percent. This is the equivalent of dividing the FHA amount 

by 0.76. If the credit were in place today, the limits would be between approximately 

$227,147 and $411,704. The IRS currently provides guidelines for average sales prices 

using a similar methodology for other tax purposes. Thus, if an individual living in 

Los Angeles, California (a high-cost area) had a home mortgage loan of $400,000, 

all of the interest on that loan could qualify for the credit because the loan principal 

would be below the $411,704 ceiling for high-cost areas. If the principal amount of 

the loan was $500,000, interest on the first $411,704 of loan principal would qualify. 

Currently, banks and other lending institutions that service home mortgage loans 

are required to report deductible interest and points to the IRS and borrowers 

annually on Form 1098. Under the Panel’s recommendations, these institutions 

would determine how much of each borrower’s interest payments qualify for the 

Home Credit using the information available from the FHA and would provide 

that information to borrowers and the IRS. Borrowers who had only one mortgage 

on their principal residence could simply use the information provided by the 

lending institution to claim the Home Credit. Borrowers who did not receive annual 

information statements from a lending institution, or who received a report on more 

than one loan, could calculate creditable home mortgage interest themselves, using 

information provided by the IRS.

As under the current law deduction, the Home Credit would be available for interest 

on a loan that is used to buy, build or substantially improve an individual’s principal 
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residence, and that is secured by the residence. It would also be available for the 

refinancing of such a loan (limited to the loan’s outstanding principal amount). 

Current rules determine how a loan is used by tracing the loan proceeds. In light 

of the recommended limitations on benefits for home mortgage interest, these 

rules should be simplified and should provide straightforward guidelines to reduce 

complexity for taxpayers.

To claim the credit for home mortgage interest, an individual would have to be 

legally liable on the mortgage and actually have paid such interest. This rule is the 

same as current law. Married couples would face the same interest limitation as single 

taxpayers. Thus, as under current law, married taxpayers who file as singles would 

have to divide the limit on their one primary residence among themselves. Together, 

they would only be entitled to claim credits for a single property, which must be the 

principal residence of one of them. 

As described in Chapter Five, the Panel recommends that the changes to the 

mortgage interest deduction be phased in over five years. During the transitional 

period, taxpayers would be allowed to claim either the Home Credit or the mortgage 

interest deduction on existing mortgages. The current-law $1 million mortgage 

interest limit would be reduced annually during the five-year transition period. Table 

A.1 summarizes the transition schedule. 

Table A.1. Transition Rules for the Home Credit

Year Mortgage Interest Limit Tax Benefit

1 $900,000 of principal Deduction

2 $700,000 of principal Deduction

3 $500,000 of principal Deduction

4 Regional limit of principal Deduction

5 Regional limit of principal 15 percent Home Credit

Interest on a second home or a home equity loan would not be eligible for transition 

relief. Interest on new or refinanced mortgages would not qualify for the transitional 

mortgage interest deduction, but would be eligible for the new Home Credit.

Charity

As described in Chapter Five, the Panel recommends a number of reforms that would 

improve the deduction for charitable giving. Among these reforms are information 

reporting for large gifts and better standards for valuing non-cash gifts.

To minimize the recordkeeping burden associated with information reporting, the 

Panel recommends that information reporting be required only for donors whose 

total annual contributions to a charity exceed $600, which is consistent with currentlaw information reporting thresholds for mortgage interest and trade or business 
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payments. All cash and non-cash contributions of $250 or more would count toward 

the $600 threshold. The Panel also recommends that small charities that do not 

receive (1) more than 250 contributions of $600 or more, or (2) total contributions 

of more than $150,000 be exempted from the information reporting requirements. 

Taxpayers would not be required separately to substantiate contributions for which 

the charity reported to the taxpayer and the IRS.

The lack of clear, objective standards for establishing the fair market value of donated 

property has led to many recent valuation abuses. The Panel recommends new rules 

requiring that appraisals be prepared by a qualified appraiser in accordance with 

generally accepted and customary appraisal standards. New guidelines should also 

specify that fair market value is the price that would be received if the property 

were sold in the appropriate market. For a taxpayer or charity selling property, this 

would generally be the price received from selling to a dealer or other private party. 

Standards for appraisers would be imposed to ensure that appraisers have achieved a 

minimum level of certification or education, have not been barred from practice, are 

independent and unrelated to the donor or donee, and do not have an interest in the 

outcome of an appraisal. 

To improve the reporting of valuations of contributed property for which a taxpayer 

is entitled to receive a fair market value deduction, the Panel recommends that 

appraisers be required to report the value of the contributed property directly to the 

IRS, the donor, and the charity. The charity would use the appraiser’s valuation as the 

basis for its information reporting. 

The Panel believes that current law penalties applicable to appraisers for aiding and 

abetting the understatement of tax by taxpayers are inadequate to prevent valuation 

abuses. Accordingly, the Panel recommends that new penalties be imposed on 

appraisers who misstate the value of property by more than 50 percent.The penalty 

would be imposed as a percentage of the valuation overstatement up to a maximum 

penalty. 

Chapter Six: The Simplified Income Tax Plan

Territorial Tax Regime

Under the new territorial regime, income earned abroad by controlled foreign 

corporations and foreign branches of U.S. corporations would fall into one of two 

categories: (1) “Foreign Business Income,” which would generally be exempt from 

U.S. taxation, and (2) “Mobile Income,” which would be taxed by the United States 

on a current basis. 

Foreign Business Income

Income earned abroad by a controlled foreign corporation (a “foreign affiliate”) in 

the conduct of an active business (“Foreign Business Income”) would not be subject 

to U.S. tax at the business level when repatriated as a dividend. Foreign Business 
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Income is net income after deductions. The general rule is that any payment that is 

deductible abroad would be taxed in the United States. Thus, non-dividend payments 

from foreign affiliates to U.S. corporations (e.g., interest, royalties, payments for 

intercompany transfers) would be subject to U.S. tax. A hybrid security rule would be 

required to prevent a payment that is treated as deductible interest abroad from being 

treated as an exempt dividend in the United States.

The Simplified Income Tax Plan would provide that exempt earnings of foreign 

affiliates could be redeployed to other foreign affiliates in different foreign 

jurisdictions without losing the benefit of exemption. There would be no tax on the 

gains from the sale of assets that generate exempt income and losses from the sales of 

such assets would be disallowed. 

Businesses would not receive foreign tax credits for foreign taxes (including both 

corporate level taxes and dividend withholding taxes) attributable to Foreign Business 

Income because this income would not be subject to tax in the United States. As a 

result, the foreign tax credit system would serve a more limited function than it does 

under present law.

Income of foreign branches would be treated like income of foreign affiliates under 

rules that would treat foreign trades or businesses conducted directly by a U.S. 

corporation as foreign affiliates. These rules would be needed to place branches and 

foreign affiliates on an equal footing. For example, a rule would be needed to impute 

royalties to foreign branches. All trades or businesses conducted predominantly 

within the same country would be treated as a single foreign affiliate for this purpose. 

Further rules would be needed to address the taxation of Foreign Business Income 

earned by a U.S. multinational that owns at least 10 percent of the stock of a foreign 

corporation that is not controlled by U.S. shareholders (so-called “10/50” companies).

All distributed earnings of foreign affiliates would be subject to the new international 

tax regime following the effective date, regardless of whether such distributions were 

paid out of pre-effective date or post-effective date earnings.

Mobile Income

Passive and highly mobile income (“Mobile Income”) would be subject to tax when 

earned. Mobile Income would include foreign personal holding company income (e.g. 

interest, dividends, rents, and royalties arising from passive assets), certain types of 

foreign active business income that is not likely to be taxed in any foreign jurisdiction 

(e.g., certain income from personal services and income from international waters 

and space), and income from the sale of property purchased from or sold to a related 

person by a foreign corporation located in a country that is neither the origin nor the 

destination of that property. Small amounts of Mobile Income (measured using a de 

minimis rule based on a percentage of gross income or total assets) would be ignored 

for simplicity.
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A foreign tax credit would be available to offset foreign tax paid (including 

withholding taxes) on Mobile Income. The current complex foreign tax credit basket 

rules would be replaced with a single overall foreign tax credit limitation. 

Financial services businesses, such as banks, securities dealers, and insurance 

companies, earn interest and other types of Mobile Income in the conduct of their 

active business. Special rules would need to provide that qualifying financial services 

business income is treated as Foreign Business Income to the extent such income is 

earned through active business operations abroad. Anti-abuse rules would be needed 

to prevent passive investment income earned by financial services businesses from 

being treated as Foreign Business Income. 

Expense Allocation

Under the Simplified Income Tax Plan, the active business earnings of foreign 

affiliates would not be subject to U.S. tax at the business level. Accordingly, business 

expenses that are attributable to these foreign earnings should not be allowed as 

a deduction against U.S. taxable income. For example, interest and other expenses 

incurred by a U.S. business to earn exempt foreign earnings would be allocated to 

those earnings and therefore disallowed. The question of how to allocate expenses to 

exempt foreign income is a difficult one. Detailed expense allocation rules similar to 

current law would be necessary. These rules would inevitably involve some complexity, 

but could be simpler than current-law expense allocation rules. 

Interest expense should only be disallowed to the extent that the U.S. operations 

of a U.S. multinational are more heavily leveraged than the multinational’s foreign 

operations; that is, interest expense should be disallowed to the extent that the ratio 

of foreign debt to foreign assets is lower than the worldwide ratio of debt to assets. 

Therefore, the Panel recommends that interest expense be allocated between U.S. and 

foreign affiliates under rules similar to those recently enacted as part of the American 

Jobs Creation Act of 2004. 

General and administrative expenses that are not charged out to foreign subsidiaries 

or otherwise recovered by intercompany fees (such as certain stewardship expenses) 

would be allocated to gross foreign affiliate income in the same proportion that gross 

foreign affiliate income of the U.S. multinational bears to overall gross income of the 

worldwide affiliated group. General and administrative expense allocated to foreign 

affiliate income would then be further allocated between exempt and non-exempt 

foreign income, with expenses related to exempt foreign affiliate income disallowed.

The Panel recommends that research and experimentation expenses be allocated 

between domestic source income and foreign-source Mobile Income only. No 

research and experimentation expenses would be allocated against exempt foreignsource income because all royalty income associated with those research and 

experimentation expenses would be taxable at the U.S. rate. 
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Transfer Pricing Enforcement

In a territorial system, U.S. multinationals would have incentives to use transfer 

pricing to minimize taxable income generated by domestic operations and maximize 

lightly-taxed income generated in foreign operations. These pressures also exist under 

current law, and a large body of rules has evolved to enforce “arm’s length” transfer 

pricing among related parties. Because these pressures are more pronounced in a 

territorial system, it would be necessary to continue to devote resources to transfer 

pricing enforcement. 

Taxation of Foreign-Source Dividend Income by OECD Countries

Table A.2 provides information regarding the tax treatment of resident corporations 

on their receipt of direct (non-portfolio) foreign dividends paid out of active business 

income in OECD countries. Some countries generally exempt such income, while 

other countries generally tax it with a credit for foreign taxes paid. However, the exact 

treatment of dividends paid out of active business income varies by country and often 

is not straightforward. For example, many countries that are classified as “exemption” 

countries tax some (low-tax) active income currently and exempt other (high-tax) 

active income. New Zealand and France are examples. 
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Table A.2. Home Country Tax Treatment of Foreign-Source 

Dividend Income Received by Resident Corporations Paid out of 

Active Business Income

Exemption Foreign Tax Credit

Australia* Czech Republic

Austria Iceland

Belgium Japan

Canada* Korea

Denmark Mexico

Finland New Zealand

France# Poland

Germany United Kingdom

Greece* United States

Hungary

Iceland

Italy#

Luxembourg

Netherlands

Norway

Portugal*

Slovak Republic

Spain

Sweden

Switzerland

Turkey

Note: In general, tax treatment depends on qualifying criteria (e.g. minimum ownership level, minimum 

holding period, the source country, the host country tax rate). The table reports the most generous treatment 

of foreign direct dividends in each case. 

* Exemption by treaty arrangement.

 # Exemption of 95 percent.

Source: Table compiled from information provided by the OECD Secretariat. Information as of January 2005.

Calculating the Dividend Exclusion Percentage

Under the Panel’s proposal, shareholders of U.S. corporations could exclude from 

income 100 percent of the dividends paid from income of the corporation reported 

as taxable in the United States. Corporations would report each year on their 

information reports to shareholders the total dividends paid and the amount which 

is taxable. For corporations that report all their income in the U.S., 100 percent of 

dividends paid would be nontaxable to their shareholders. Corporations which earn 

part of their worldwide income in the U.S. would have to compute the fraction 
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of worldwide income that is reported as taxable in the U.S. each tax year, and this 

fraction would be used to calculate the dividend exclusion for dividends paid in 

the following year. Because of the clean tax base recommended by the Panel, the 

Panel believes that rules specifying how this percentage is calculated can and should 

emphasize simplicity over precision. For example, this percentage can be calculated 

simply by dividing taxable U.S. income each year by worldwide pretax income as 

reported on the corporation’s financial statements for the same year. For simplicity, 

foreign tax credits on foreign Mobile Income reported as taxable in the U.S. could be 

ignored in this calculation. Taxpayers who wished to adjust for the difference between 

accelerated depreciation allowed in the U.S. and book depreciation could be allowed 

to do so by adding back the difference to U.S. taxable income before calculating the 

fraction of worldwide income taxable in the U.S., but other adjustments would not 

be allowed or required.

Disclosure of Foreign Earnings

The Simplified Income Tax Plan would require additional disclosures that would 

complement the new international tax regime. U.S. businesses with Foreign Business 

Income would be required to file with their tax return a schedule showing their 

consolidated worldwide revenues and income before taxes, as reported in their 

financial statements. The new schedule would disclose the proportion of domestic and 

foreign revenues and income. In addition, businesses would be required to reconcile 

the consolidated revenues and income reported on their financial statements with the 

taxable revenues and income reported on their tax returns.

This disclosure, combined with the exclusion of dividends paid out of domestic 

earnings, would provide disincentives for corporations to understate the amount 

of income subject to U.S. tax. A business that understates the amount of income 

reported on its tax return would increase the amount of tax required to be paid 

on dividends received by its shareholders. In addition, businesses whose securities 

are publicly traded would be required by existing disclosure rules to report in their 

financial statements the proportion of United States and foreign income and revenues 

computed under tax and accounting rules. This public disclosure would increase the 

transparency of the business’s calculations and provide a better top-down view of a 

corporation’s global operations to shareholders, potential investors, and regulators.

Chapter Seven: The Growth and Investment Tax Plan

As described in Chapter Seven, the Growth and Investment Tax Plan would 

shift our current tax system towards a consumption tax. Making this shift would 

represent a substantial change to the U.S. tax system that would present a number of 

implementation issues. Among these issues are the treatment of financial transactions 

and financial institutions, transactions between businesses and taxpayers not subject to 

the cash flow tax (such as individuals and non-profits), and cross-border transactions. 

The following sections identify some of the issues considered by the Panel and 

potential approaches for addressing them. There are additional issues that would need 
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to be covered in greater detail and require additional rules. Some of these rules would 

be similar to those that exist under current law.

Distinguishing Between Financial and Non-Financial Business Transactions

One of the central issues in implementing the Growth and Investment Tax Plan 

would arise in distinguishing between non-financial, or “real” business transactions, 

whose receipts are generated from business operations, and financial transactions, 

whose receipts are generated from interest, dividends, or other financial returns. The 

Growth and Investment Tax Plan excludes financial transactions by non-financial 

firms from the business tax base, so firms with positive tax liabilities would have an 

enormous incentive to characterize transactions as financial rather than non-financial. 

For example, a car dealership would have an incentive to post a low sales price for 

cars, but to sell cars on credit with a high financing charge. The dealership would 

benefit by characterizing the interest proceeds from the sale as a financial transaction, 

making it tax-free. 

Another area where there may be an incentive to recharacterize non-financial 

transactions is the treatment of derivatives. Purchases and sales of commodities 

generally are cash flows subject to the cash flow tax. Derivatives on commodities, 

in contrast, are generally thought of as financial in nature, the gains and losses on 

which generally should not be treated as cash flows subject to the business cash flow 

tax. However, there may be circumstances in which purchases and sales of these 

derivatives should be subject to the cash flow tax. For example, a derivative entered 

into to hedge a non-financial business asset or liability should be treated similarly to 

the underlying asset as a non-financial business transaction subject to the cash flow 

tax. Absent special rules, businesses would be able to use combinations of derivatives 

to create deductions without offsetting income. 

Implementation rules would be required to avoid creating incentives for firms to 

disguise non-financial transactions as financial transactions, and vice versa. For 

example, transactions that bundle financial and non-financial components could 

be required to be treated as taxable cash flow. Such implementation rules serve two 

functions. First, they prevent firms from devoting resources to complex tax planning 

with the objective of reducing tax liability. While expenditures on such planning may 

yield private benefits for the firm, they do not have any broader business purpose and 

they absorb resources that could be deployed elsewhere in more productive manner. 

Second, tax avoidance reduces the revenue collected from the tax system, which in 

turn requires higher tax rates to raise a required level of revenue. 

Financial Services

As described in Chapter Seven, the taxation of financial services presents difficulties 

in both consumption and income taxes. Rather than exempting these transactions as 

is done in most VATs, the Growth and Investment Tax Plan would adopt a special 

regime for financial institutions that includes both real business and financial cash 

flows in their business tax base. 
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There are several alternative approaches that could be used instead of this regime. 

One alternative approach would be to tax all businesses, not just financial institutions, 

on the full amount of all transactions between businesses and non-businesses that 

combine financial and non-financial transactions. This approach would eliminate 

the necessity of determining whether a business is a financial institution. It would, 

however, make it necessary to identify those transactions that have both a business 

and a financial component. Another alternative would be to subject financial 

institutions to the cash flow tax like other businesses. The disadvantage of this 

approach would be that, to the extent a transaction includes both real business and 

financial components, the real business components would be untaxed, which is 

inconsistent with the general approach of the Growth and Investment Tax Plan. 

This approach, however, avoids distinguishing between financial and non-financial 

institutions and transactions that have both real and financial components.

Tax-Free Formations and Mergers and Acquisitions of Businesses

Under current law, there are a number of rules that permit tax-free formations and 

combinations of businesses. These rules generally provide that no gain or loss is 

recognized when assets are exchanged for an ownership interest in an entity.

Rules could be crafted to allow for the tax-free treatment of a transfer of assets by 

an individual to a business and by a business to another business in exchange for an 

equity interest. These rules could be similar to those under current law, which provide 

for tax-free treatment for certain transfers of property to a corporation or partnership. 

In addition, the Growth and Investment Tax Plan could include rules permitting taxfree business combinations similar to the reorganization rules of current law. 

The adoption of these rules, however, may create opportunities to transfer losses 

between businesses. For example, a business could easily transfer assets without tax 

by contributing them to a subsidiary and selling the stock in a tax-free financial 

transaction. The rules described in Chapter Seven to address the transferability of 

negative and positive cash flow may mitigate some of these concerns. It may be 

necessary, however, to incorporate additional rules similar to current-law judicial 

doctrines, such as the step transaction doctrine and the business purpose test, which 

recharacterize or disregard transactions carried out to achieve tax advantages.

Taxation of Employee Stock Options

Employee stock options may present a challenge under the Growth and Investment 

Tax Plan because they are a form of compensation that is difficult to value. Current 

tax law has two sets of rules for employee stock options. The first set of rules, which 

apply to incentive stock options, do not create deductions for the employer and 

provide employees capital gains tax treatment when they eventually sell the stock that 

is purchased upon exercise of the options. In contrast, the second set, which apply 

to nonqualified options that do not have an ascertainable value, create a deduction 

for the employer when the options are exercised equal to the difference between the 

market price when exercised and the strike price; employees include the same amount 

in ordinary income at the exercise date. 
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Under the Growth and Investment Tax Plan, rules similar to those for incentive stock 

options could be adopted. Business would not receive a deduction for employee stock 

options at any point in time; the employee would not recognize any compensation 

from the option. The effect of this tax treatment would be that options would 

increase tax collections from business taxation to the extent that employees accept 

options in lieu of wage compensation. Firms that include employee options in their 

compensation packages would have a larger tax base, holding other factors equal, than 

firms that did not use employee stock options. Alternatively, firms could be required 

to calculate the value of the options at the grant date and would be entitled to a 

deduction equal to the value of the options when they are granted, with employees 

recognizing taxable wages at the grant date. Under this approach, the options would 

have no further consequences for the firm; the transaction would be considered a 

financial transaction of the firm and capital income for the employee after the grant 

date.

Small Businesses

The taxation of small businesses, such as sole proprietorships, presents some special 

issues. Most countries that administer a value-added tax (VAT) provide an exemption 

for small businesses. However, these countries typically administer an income tax 

in addition to a VAT. If small businesses were exempted from the Growth and 

Investment Tax Plan, there would be an incentive for small businesses to pay little or 

no wages and to retain earnings within the business. Moreover, the U.S. income tax 

does not provide a small business exemption. The Panel, therefore, concluded that 

small businesses should be taxable under the Growth and Investment Tax Plan.

One approach to taxing sole proprietorships would be to treat them like other 

business entities subject to tax on cash flow at the 30 percent rate. A sole 

proprietorship would be permitted to pay its owner deductible wages and to make 

distributions of positive cash flow that would be treated as dividends. The difficulty 

with this approach is that a sole proprietorship would have to file tax returns and 

maintain separate records even though it is indistinguishable from its owner. 

The Panel adopted an alternative approach that would tax positive cash flow from 

sole proprietorships on individual tax returns and at the graduated individual tax 

rates. Some have suggested that this approach properly reflects the fact that sole 

proprietorship income represents a return to labor rather than a return to capital. 

Cash flow of the sole proprietorship subject to the cash flow tax would not be subject 

to the 15 percent capital income tax. To the extent that the sole proprietorship 

receives cash flow that is not subject to the business cash flow tax (e.g., stock gains, 

dividends, and interest), such cash flow would be subject to the capital income tax 

when received by the sole proprietorship.

As under our current system, rules would be needed to distinguish between personal 

activities and business activities. In addition, special issues arise with respect to 

business assets withdrawn from a sole proprietorship if those assets have been 

previously expensed. Once withdrawn from the sole proprietorship, the asset future 
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cash flow attributable to the asset would not be subject to the cash flow tax. Therefore, 

it may be necessary to treat a withdrawal as a disposition of the asset that results in 

cash flow equal to the fair market value of the asset.

Use of Businesses to Avoid Tax on Capital Income

One consequence of adding the 15 percent tax on dividends, interest, and capital 

gains under the Growth and Investment Tax Plan is that individuals may have an 

incentive to hold financial assets indirectly through a business entity rather than 

directly. Absent special rules, non-financial businesses could be used to defer tax on 

returns from financial assets until the business makes distributions to its owners, or 

permanently if current law rules providing for a step-up in basis to fair market value 

at death are retained. This potential for tax deferral may contribute to perceptions of 

unfairness, and may lead to additional tax planning to avoid tax on capital income 

altogether. 

Under current law, there are a number of so-called “anti-deferral” regimes designed 

to discourage the accumulation of untaxed amounts within a corporation. In some 

cases, these rules require that the income of a business be imputed to the owners of 

the business, and in other cases tax is imposed at the business level. One or more of 

the current anti-deferral regimes could be adopted, or modified, under the Growth 

and Investment Tax Plan to limit opportunities to defer the capital income tax. For 

example, to address situations involving individual owners of closely-held businesses, 

each owner might be required to report his share of the entity’s financial income 

on his U.S. tax return. Similar rules might be adopted to address other situations. 

Special rules would be required to determine when the anti-deferral rule should 

apply. Although anti-deferral rules may prevent some tax avoidance, these rules often 

require factual inquiries and may not be completely effective in preventing deferral of 

capital income in a realization-based tax.

Additional Issues in the Tax Treatment of Cross-Border Transactions

Under the destination-basis Growth and Investment Tax Plan, purchases from 

businesses outside the United States would not be allowed as a deduction against 

sales in calculating taxable business cash flow. The resale by the importing business 

would give rise to a taxable receipt. The reseller might “gross up” the resale price to 

cover the tax cost to the importer of the denial of the deduction for the cost of the 

import. Alternatively, some importers may try to avoid the tax burden.

If the “importer” is not a taxable U.S. business, it would be outside of the tax system 

and, as a result, border adjustments would be ineffective. This would be a particularly 

challenging problem with respect to taxing internet sales and other businesses that 

have a minimal presence in the United States. Appropriate mechanisms would have 

to be developed to enforce the tax collection responsibilities for consumption in the 

United States.
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Sourcing the Destination: “Domestic” versus “Foreign” Consumption

Determining when and if goods have been “exported” for foreign consumption would 

be necessary in order to make border adjustments. Rules exist under current law to 

determine when a sale of goods occurs (i.e., when beneficial ownership and risk of 

loss have passed to a buyer either within or outside the United States). A set of rules 

similar to these so-called “passage-of-title” tests could be used to track the intended 

ultimate destination of sales of goods under the Growth and Investment Tax Plan.

Determining when and if services have been exported is also necessary to make 

appropriate border adjustments. Rules would need to be developed to ascertain 

where services are used or consumed. These rules would be similar to those used in 

countries that operate a VAT. Service businesses include a range of technical and 

professional service providers, such as law firms, accounting firms, engineering firms, 

and management consulting firms. 

Tax Treaties

Bilateral income tax treaties that facilitate cross-border investment may need to 

be renegotiated to account for the new business tax system under the Growth and 

Investment Tax Plan. Bilateral income tax treaties help prevent double taxation and 

ensure that U.S. individuals and corporations investing in foreign markets and foreign 

individuals and corporations investing in the United States receive tax treatment in 

the treaty country that is comparable to the tax treatment received by home country 

residents. For example, these treaties provide for interest expense to be deducted by an 

entity carrying on business through a permanent establishment in the other country 

for purposes of determining income tax liability to that other country. 

Some of the benefits the United States currently provides to foreign businesses 

through its bilateral tax treaties would be less valuable if the Growth and Investment 

Tax Plan were adopted. For example, the Growth and Investment Tax Plan would not 

provide interest deductions to permanent establishments of treaty partner businesses. 

As a result, foreign governments could seek to renegotiate or terminate their tax 

treaty arrangements with the United States. The Panel suggests that the Growth and 

Investment Tax Plan retain withholding taxes on dividends and non-portfolio interest 

consistent with current law, but these taxes could be reduced or eliminated by treaty. 

Chapter Eight: Value-Added Tax

VAT Exemptions

In evaluating a proposal to adopt a broad based value-added tax (VAT), the Panel 

assumed that all domestic consumption would be included in the tax base unless 

specifically exempted. Exemptions for goods and services could be provided either 

with or without a credit for “input tax” previously paid on goods or services used to 

produce the exempt good. When a good or service is “exempt with credit,” a supplier 

of that good or service is allowed to claim input tax credits associated with the exempt 
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good or service even though no tax is assessed on the exempt sale. If a supplier’s 

input tax credits exceed VAT liability, the supplier would receive a refund from the 

government. In contrast, when a good or service is “exempt without credit,” the good 

or service supplier would not assess VAT on sale of the exempt good, but could not

claim input tax credits associated with that sale. 

Substantial administrative complications arise in a VAT when business entities sell 

both taxable and exempt goods, or assess different VAT rates on different goods. In 

these cases, administrative rules must be established to allocate input credits between 

exempt, preferred-rate, and taxable sales. A broad based VAT that taxes virtually all 

goods and services using a single rate and implements necessary omissions from 

that base using an exemption with credit minimizes economic distortions and 

simplifies compliance and administration. For this reason, providing exemptions with 

credit would generally be preferable to exempting goods or services without credit. 

Charitable and religious services are a special exception to this general rule. 

It is inappropriate to tax exports in a destination-based VAT because exports do not 

represent domestic consumption. Exports would therefore be exempt with credit 

under the VAT. Further discussion of this issue appears in Chapter Eight. Other types 

of goods and services that would be excluded, exempt with credit, exempt without 

credit, or receive other unique treatment under the VAT studied by the Panel are 

described in Table A.3.

Table A.3. Domestically Consumed Goods and Services Receiving Distinctive 

Treatment

Exempt with Credit 

(Zero-rated)

Exempt without Credit Other

• Noncommercial 

government 

services

• Primary and 

secondary 

education

• Charitable and 

religious services

• Food produced 

and consumed on 

farms

• Residential housing 

(prepayment 

method) 

• Financial services 

(same as the 

Growth and 

Investment Tax 

Plan treatment)

Government Services

For reasons of administrative simplicity and to preserve economic neutrality between 

the private sector and the public sector, governments would pay VAT on purchases 

just like other businesses and individuals. However, like a business selling taxable 

goods and services, governments would be entitled to claim input tax credits on all 

inputs used to provide services. 
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Non-commercial government services provided to the public for a fee would be 

exempt with credit. Other noncommercial government services and intra-government 

transfers would be excluded from the base. No VAT would be imposed on taxes or 

fines, because these charges are not paid in return for a specific good or service. 

Commercial services provided by government (state, local, or federal) for a fee would 

be taxed. For example, VAT would be collected on services such as transportation 

services provided by a local transit authority or water provided by a governmentowned utility. Rules would be needed to distinguish between commercial and 

noncommercial government activities, and would inevitably entail some substantial 

complexity. 

Education

Most primary and secondary education is provided by state and local governments 

at public schools, generally free of charge. Applying a VAT to privately provided 

primary and secondary education would discriminate against private education 

by making it more expensive relative to public schools. The Panel concluded that 

introducing the VAT should not change the competitive balance between public and 

private education. Thus, primary and secondary education would be exempt with 

credit, regardless of whether provided by government or private institutions. Rules 

would be needed to prevent non-educational exempt consumption through schools 

(such as cafeterias set up on school premises to avoid VAT). 

Postsecondary education is provided by public and private institutions for a fee. In 

addition to educating students, postsecondary institutions engage in a broad array 

of research activities, many of which overlap with activities conducted in the private 

sector. For these reasons, the Panel determined that it would be appropriate to 

apply the VAT to postsecondary education, whether provided by public or private 

institutions. 

Charitable and Religious Services

Charitable and religious services provided by non-profit organizations would be 

exempt without credit. When a charitable or religious organization supplies goods 

or services free of charge, no VAT would be assessed. However, when a charitable 

or religious organization supplied new goods or services that compete with other 

businesses and are offered at market prices, those goods and services would be taxed. 

For example, memberships that provide access to cultural or recreational institutions 

would be taxable. Rules would be needed to define the boundary between exempt 

charitable or religious services and commercial services. These rules could also exempt 

charitable or religious services provided for a nominal fee. Donations and government 

grants received by charities would not be considered payments in return for goods or 

services and therefore also would not be taxed.
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Charitable and religious services would be exempted without credit because 

of the sector’s heavy reliance on used goods and donations and the consequent 

administrative complications and abuses that might arise under a regime providing 

exemption with credit. Any charitable or religious service provider would remain 

eligible to claim input tax credits with respect to their VAT liability for any 

commercial services they provide, just like any other business. The threshold for 

mandatory VAT collection of $100,000 in annual gross taxable receipts would allow 

charitable and religious organizations that provide only a small amount of commercial 

services to remain outside the VAT system entirely, even if their non-taxable 

operations were quite extensive. For those charitable and religious organizations with 

receipts from commercial services in excess of the VAT threshold, or that elect to 

collect VAT, allocation rules would be required to distinguish input credits related 

to tax-free charitable and religious services from input credits related to commercial 

services. 

Housing

The purchase price of new residential real estate would be taxed. Taxing housing 

services in this way is more administratively feasible than taxing the imputed value 

of owner-occupied housing, but excludes pre-existing housing from VAT. Activities 

related to renovating existing housing (e.g., purchasing building materials or repair 

and maintenance services) would be taxed. To ensure both that renters and owners 

receive comparable treatment and that new residential real estate that is subject to a 

lease would not be double taxed, leases of residential housing would be exempt from 

VAT, as would the imputed value of owner-occupied housing services. Rules would 

be needed to define the appropriate VAT treatment if real estate were to be converted 

from residential to non-residential use or vice versa. 

Financial Services

Financial services would be taxed using an approach similar to that proposed for the 

Growth and Investment Tax Plan.

Modified Family Credit and Work Credit for Partial Replacement VAT

Modified Family Credit

The modified Family Credit described in Chapter Eight would be computed by 

starting with a base amount for household type and adding additional amounts for 

the number of children and other dependent members of the household. The base 

Family Credit amounts are provided in Table A.4.
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Table A.4. Family Credit Amounts under Partial Replacement VAT

Household Type Base Credit

Married Taxpayers Filing Joint Returns $4,300

Single Taxpayers With Dependent Children $3,300

Single Taxpayers with no Child Dependent $2,150

Taxpayers Who Could be Claimed as a Dependent $1,650

Each family would add to the base credit amount $2,000 for each child and $1,000 

for each other dependent. The Family Credit amounts would be adjusted annually for 

inflation. 

Modified Work Credit

The modified Work Credit would be the amount by which the taxpayer’s modified 

Family Credit exceeds tax liability before the credit limited to:

• No child dependent: the lesser of 17.65 percent of work income or $1,832;

• One child dependent: the lesser of 44 percent of work income or $4,870;

• Two or more child dependents: the lesser of 50 percent of work income or 

$6,650

With an additional credit of:

• up to $1,950 if the taxpayer has one child dependent

o phased in at a rate of 44 cents for every dollar of work income (or taxable 

income, if lower) over $11,100;

• up to $3,100 if the taxpayer has two or more child dependents

o phased in at a rate of 50 cents for every dollar of work income (or taxable 

income, if lower) over $13,300;

The additional credit would phase out at a rate of 12.5 cents for every dollar of the 

taxpayer’s work income (or taxable income, if higher) above $22,000 (or $26,000 if 

the taxpayer is filing a joint return).

Evolution of VAT Rates in Developed Economies

In addition to reviewing econometric research relating to the money machine 

argument, the Panel examined the evolution of VAT rates in developed countries. The 

table below shows the basic VAT rates in OECD countries for the period from 1976 

to 2005.The shaded years represent the most recent periods during which the basic 

VAT rate either did not change or was lowered.

In examining the Table A.5, it is worth noting that more than half of the countries 

represented are members of the European Union (EU). The European Economic 
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Table A.5. Standard VAT/GST in OECD Member Countries

1976 1980 1984 1988 1990 1992 1994 1996 1998 2000 2003 2005

Australia - - - - - - - - - 10.0 10.0 10.0

Austria 18.0 18.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0

Belgium 18.0 16.0 19.0 19.0 19.0 19.5 20.5 21.0 21.0 21.0 21.0 21.0

Canada - - - - - 7.0 7.0 7.0 7.0 7.0 7.0 7.0

Czech Republic - - - - - - 22.0 22.0 22.0 22.0 22.0 19.0

Denmark 15.0 22.0 22.0 22.0 22.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0

Finland - - - - - - 22.0 22.0 22.0 22.0 22.0 22.0

France 20.0 17.6 18.6 18.6 18.6 18.6 18.6 20.6 20.6 20.6 19.6 19.6

Germany 11.0 13.0 14.0 14.0 14.0 14.0 15.0 15.0 16.0 16.0 16.0 16.0

Greece - - - 16.0 18.0 18.0 18.0 18.0 18.0 18.0 18.0 18.0

Hungary 0.0 - - 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0

Iceland - - - - 22.0 22.0 24.5 24.5 24.5 24.5 24.5 24.5

Ireland 20.0 25.0 23.0 25.0 23.0 21.0 21.0 21.0 21.0 21.0 21.0 21.0

Italy 12.0 15.0 18.0 19.0 19.0 19.0 19.0 19.0 20.0 20.0 20.0 20.0

Japan - - - - - 5.0 3.0 3.0 5.0 5.0 5.0 5.0

Korea - 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0

Luxembourg 10.0 10.0 12.0 12.0 12.0 15.0 15.0 15.0 15.0 15.0 15.0 15.0

Mexico - - 10.0 10.0 10.0 10.0 10.0 15.0 15.0 15.0 15.0 15.0

Netherlands 18.0 18.0 19.0 20.0 18.5 17.5 17.5 17.5 17.5 17.5 19.0 19.0

New Zealand - - - - - - 12.5 12.5 12.5 12.5 12.5 12.5

Norway - - - - - - 22.0 23.0 23.0 23.0 24.0 24.0

Poland - - - - - - - - 22.0 22.0 22.0 22.0

Portugal - - - 17.0 17.0 16.0 16.0 17.0 17.0 17.0 19.0 19.0

Slovak Republic - - - - - - 25.0 23.0 23.0 23.0 20.0 19.0

Spain - - - 12.0 12.0 13.0 16.0 16.0 16.0 16.0 16.0 16.0

Sweden 17.65 23.46 23.46 23.46 23.46 25.0 25.0 25.0 25.0 25.0 25.0 25.0

Switzerland - - - - - - 6.5 6.5 6.5 7.5 7.6 7.6

Turkey - - - - - - 15.0 15.0 15.0 17.0 18.0 18.0

United Kingdom 8.0 15.0 15.0 15.0 15.0 17.5 17.5 17.5 17.5 17.5 17.5 17.5

Unweighted average 14.0 16.9 17.2 17.5 17.7 16.9 17.4 17.6 17.9 17.8 17.8 17.7

Note: Shaded years represent most recent periods during which the VAT rate either did not change or was lowered. 

Source: OECD Secretariat. Rates as of January 2005.
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Community, the predecessor to today’s EU, required member countries to impose 

a VAT in the late 1960s. Thus, Belgium, Denmark, France, Germany (then West 

Germany), Ireland, Italy, Luxembourg, the Netherlands, and the United Kingdom 

all adopted VATs between 1967 and 1973. Similarly, Greece, Portugal, and Spain 

adopted VATs in the late-1980s in preparation for EU membership. 

Chapter Nine: National Retail Sales Tax

Tax-Inclusive Rates

As explained in Box 9.1, it is equally valid to think of tax rates in tax-inclusive or taxexclusive terms. The most appropriate way to compare a national retail sales tax rate 

to the state sales taxes paid by most Americans is to consider the tax-exclusive rate. 

On the other hand, it is appropriate to compare the retail sales tax rate with current 

income tax rates by utilizing the tax-inclusive rate. Table A.6 provides the tax-inclusive 

rates that correspond to the tax-exclusive rate estimates provided in Table 9.1. 

Table A.6. Retail Sales Tax Rate Estimates Reported as Tax-Inclusive Rates

Evasion Rate / Base Extended Base

Partial 

Replacement 

VAT Base

Median State Sales Tax Base

Low Evasion (15%) 25% 28% 39 %

Higher Evasion (30%) 33% 37% 47%

Source: Department of the Treasury, Office of Tax Analysis.

Uniform Cash Grant Program

The Treasury Department calculated the uniform cash grant program as the 

retail sales tax (inclusive) rate times the poverty guideline amount defined by 

the Department of Health and Human Services, providing double the single 

person amount for married couples. The projected poverty guideline amounts in 

2006 are $9,820 for a single person and $3,360 for each additional person in the 

household. With this cash grant program, assuming 15 percent evasion for personal 

consumption spending, the revenue-neutral rate would be approximately 25 percent 

on a tax-inclusive basis (34 percent on a tax-exclusive basis). The rebate amounts in 

2006 would therefore be $2,494 ($4,988 for married couples) plus $853 for each 

dependent. 

Targeted Cash Grant Program

The Treasury Department developed a targeted cash grant proposal with a phase-in 

range and a phase-out range. The proposal required providing an annual cash subsidy 

of as much as $7,068 for married couples ($3,534 for singles), plus $2,570 for each 

dependent. Like the EITC, the program would phase in over a range. The program 

would begin to phase out when family income exceeds ten times the maximum 
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available rebate and be completely phased out when income reached 20 times the 

maximum available rebate. For example, a married couple with no children would 

receive a higher rebate as income increased up to an income level of $17,670. This 

couple’s rebate would begin to phase out once income exceeded $70,680 and phase 

out completely once income exceeded $141,360. By comparison, a married couple 

with two children would receive a higher rebate as income increased up to an income 

level of $30,520. This family’s rebate would begin to phase out once income exceeded 

$122,080 and phase out completely once income exceeded $244,160. Families that 

qualify under current law for the EITC would continue to receive those amounts as 

an additional cash subsidy.

Hypothetical Taxpayer Analysis

Standard distributional estimates, revenue estimates, and hypothetical taxpayer 

calculations performed by the Treasury Department for any tax proposal assume 

that the Administration’s economic forecast, including the price level, is unchanged 

over the ten-year budget period. A retail sales tax would create a “wedge” between 

the prices producers receive for their goods and the amount that they would have 

left to pay wages and other forms of labor compensation and to pay the suppliers of 

capital (interest and profits). Since by standard assumption the price level cannot rise, 

this wedge must cause wages and payments to capital to fall. The reduction in wages 

reduces the payroll tax base, and therefore payroll taxes paid. This reduction in payroll 

taxes must be accounted for in hypothetical taxpayer examples for proposals, such as 

a retail sales tax or a value-added tax, that produce a wedge between producer and 

consumer prices. 

An Example of a State Sales Tax Base: Florida

Existing state sales tax bases are narrower than the broad tax bases evaluated by the 

Panel, and the breadth of these tax bases may be illustrative of potential base erosion. 

For example, it is estimated that Florida has the 11th broadest tax base among states 

that impose retail sales taxes. In relative terms, Florida has a limited number of 

exemptions from its sales tax. Nevertheless, Florida’s retail sales tax imposes sales 

tax on only a small number of services and has at least 90 exemption categories. 

For example, neither financial nor medical services are taxed. All sales to the U.S. 

government, a state or any county, municipality, or political subdivision of a state, 

and nonprofit religious, charitable, scientific or educational institutions are exempt. 

Moreover, churches and the federal government are exempt from the requirement to 

collect and remit sales tax. 

Florida also exempts a wide variety of goods, including Bibles, hymnals, prayer 

books and other religious publications; church service and ceremonial raiment and 

equipment; food and drink for human consumption that is classified as “general 

grocery items,” but not when sold by restaurants, cafeterias, concession stands, or 

other similar places of business; water (except certain mineral or carbonated water); 
257

Appendix

any food or beverage that is donated to a food bank by a retailer that sells food 

products; hospital meals and rooms; prescription medication and other products 

and supplies dispensed at retail by a licensed pharmacist on a physician’s order; 

hypodermic needles; test kits used to treat or diagnose human disease; artificial eyes 

and limbs; hearing aids, crutches and prosthetics; sales or rentals of guide dogs for 

the blind and sales of food or other items for such dogs; certain prepared meals sold 

by a nonprofit organization to handicapped, elderly, or indigent people; rentals of 

more than six months’ duration; school books and lunches sold at institutions of 

higher learning; firefighting and rescue service equipment and supplies purchased 

by volunteer fire departments; admissions to athletic or other events sponsored by 

schools; solar energy systems, fertilizers, insecticides, seedlings, and cuttings; sales 

of U.S. and Florida flags; purchases of office supplies made by the Florida Retired 

Educators Association; and the sale of a racing dog by its owner if the owner is also 

the breeder of the animal.

Additional Distribution Tables

Alternative Distribution of the Corporate Income Tax

As explained in Chapter Three, for the purpose of distributional analysis, the 

Treasury Department assumes that the burden of the corporate income tax is borne 

entirely by owners of capital. The alternative distribution figures presented below 

show the distribution of the income tax burden under current law and each of the 

plans assuming that half of the burden of the corporate income tax is distributed to 

labor, while the other half is distributed to owners of capital. However, the change 

in corporate tax burden associated with the options is distributed to just owners of 

capital. This reflects the assumption that over the budget window owners of capital 

are the group that bears the burden of this tax. Over time, however, some (or all) of 

the burden of corporate taxes is likely to be shifted to workers and consumers. 
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The President’s Advisory Panel on

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Federal Tax Reform

The President’s Advisory Panel on

Distributional Analysis Over the Ten-Year Budget Period

The Treasury Department provided the Panel with distributional analysis of the 

Simplified Income Tax Plan, the Progressive Consumption Tax Plan, and the Growth 

and Investment Tax Plan over the ten-year budget period. The technical explanation 

of the estimates that follows was provided by the Treasury Department at the request 

of the Panel. 

The analysis uses a model that traces the income and taxes paid in each year for a 

sample of “tax families” constructed from income tax returns. A tax family is defined 

as the non-dependent primary taxpayer, the taxpayer’s spouse, and their dependents 

for income tax purposes. The analysis begins with the distribution of the individual 

income and corporate income tax to “tax families” in each year. Individual income tax 

liabilities are distributed to payers (which includes dependent filers) and corporate 

income tax liabilities to capital income generally. Tax liabilities are aggregated at the 

family level. The cash income of all family members is also aggregated at the family 

level.

Family-level income and tax liabilities in each year are then divided by an equivalence 

scale. The equivalence scale is based on family size and adjusts for economies of scale 

as family size increases. Each family’s “equivalenced” income and tax liabilities are 

then attributed to each member of the family in that year.

The present values of year-by-year “equivalenced” income and tax liabilities are then 

computed for each individual present in the first year of the ten-year budget period. 

The discount rate used is the sum of the forecast inflation rate (as measured by the 

CPI-U) and an assumed four percent real rate of return. These present values are 

converted to real level annuities over the ten-year budget period with the same 

present value. The real level annuity values of income are used to place individuals into 

income quintiles, and tax shares are computed from the real level annuity values for 

taxes and income.
265

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Additional Tax Forms

As discussed in Chapters Six and Seven, the tax returns that would be used under 

both the Simplified Income Tax Plan or the Growth and Investment Tax Plan 

would fit on a single page. These tax returns could even fit on the front and back of a 

postcard. Figures A.16 and A.17 show how these forms would appear if printed on 

a postcard instead of a regular sheet of paper. Figure A.18 shows the Work Credit 

worksheet and instructions.
267

Appendix

Figure A.16. Form 1040-Simple

Postcard - Front

U.S. Individual Income Tax Return For the year Jan. 1–Dec. 31, 200X, or other tax year beginning , 200X, ending , 20 OMB No. 1545-XXXX

Your first name and initial Last name Your social security number L

A

B

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E

If married, spouse’s first name and initial Last name Spouse’s social security number

Home address (number and street, city, town or post office, state, and ZIP code).

If you have a P.O. box or a foreign address, see page xx.

1 Wages, salaries, tips, etc. Attach Form(s) W-2 1

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page xx. Cat. No. 00000X 1040-SIMPLE (200X)

1040-SIMPLE 0X (99)

2 Business income or (loss). Attach Schedule C, C-EZ, E, or F 2

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15

16

Taxable interest and dividends

Subtract line 15 from line 9. If zero or less,

enter -0-

3

9

10

15

16

� �

You must enter your SSN(s) above.

Important!

Taxable income =

+

–

Add lines 1 through 8 Total income =

+

Charitable contributions

Multiply line 9 by 1% (.01)

Subtract line 11 from line 10. If zero or less, enter -0-

9

Health insurance deduction

11

12

+ 14

Add lines 12 through 14

Gain or (loss) on stock. Attach Schedule D + 4

Other gains or (losses). Attach Form 4797 + 5

Taxable distributions (retirement and savings) + 6

Social security benefits + 7

–

8 Other income. List type and amount � + 8

13 Social security benefits deduction (see

page xx) + 13

Postcard - Back

1040-SIMPLE (200X)

17

18

Family credit. Attach Schedule A if required

Subtract line 20 from line 19. If zero or less, enter -0-

Self-employment tax

19

20

21

23

29

32

–

+

Total payments =

Amount you owe =

Figure your tax (see page xx) 17

18

Add lines 21 through 23. If zero or less, enter -0- Total tax = 24

19

20

21

22

24

26

25 25

26

28

Federal income tax withheld

Work credit

Estimated tax and other payments

Add lines 25 through 28

If line 29 is more than line 24, subtract line 24 from line

29. If you want to use direct deposit, attach Form XXXX

Amount of line 30 you want applied to your 200Y estimated tax

Amount overpaid = 30

+

+

If line 24 is more than line 29, subtract line 29

from line 24

31

27 Savers credit. Attach Form XXXX + 28

29

30

32

27

Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and Sign belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Here Your signature Date

Keep a copy

for your

records.

� Spouse’s signature. If filing with spouse, both must sign. Date

Your occupation Married? See

page xx.

If married but not

filing with spouse,

check here �

Spouse’s occupation

( )

Daytime phone number

Tax =

Home credit (see page xx)

Subtract line 18 from line 17. If zero or less, enter -0-

31

Date Preparer’s SSN or PTIN Preparer’s

signature Check if

self-employed Paid

Preparer’s

Use Only Firm’s name (or

yours if self-employed),

address, and ZIP code

EIN

Phone no.

�

� ( )

–

23 Other taxes and foreign tax credit. Attach Schedule O

+ 22
268

Federal Tax Reform

The President’s Advisory Panel on

Figure A.17. Form 1

Postcard - Front

Add lines 11 through 13

1 U.S. Individual Tax Return

For the year Jan. 1–Dec. 31, 200X, or other tax year beginning , 200X, ending , 20 OMB No. 1545-XXXX

Your first name and initial Last name Your social security number

(See

instructions

on page xx.)

L

A

B

E

L

H

E

R

E

If married, spouse’s first name and initial Last name Spouse’s social security number

Use the IRS

label.

Otherwise,

please print

or type.

Home address (number and street). If you have a P.O. box, see page xx. Apt. no.

City, town or post office, state, and ZIP code. If you have a foreign address, see page xx.

1 Wages, salaries, tips, etc. Attach Form(s) W-2 1

Attach Form(s)

W-2 here. Also

attach Forms

W-2G and

1099-R if tax

was withheld.

Taxable

Amount

Cat. No. 00000X

Label

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page xx. Form 1 (200X)

0X (99)

� �

You must enter

your SSN(s) above.

Form

2 Business cash flow. Attach Schedule 1 2

7

8

9

10

11

13

14

15

Other income. List type and amount � 7

14

15

9

10

Health insurance deduction

Taxable amount. Subtract line 14 from line 8. If zero or less, enter -0-

11

Important!

Charitable contributions

Multiply line 8 by 1%

(.01)

Subtract line 10 from line 9. If zero or less, enter

-0-

13

8

3 Taxable interest and dividends 3

4 Gains or (losses) 4

5 Taxable distributions (retirement and savings) 5

6 Social security benefits 6

12 Social security benefits deduction 12

Total cash flow. Add lines 1 through 7 �

Postcard - Back

Form 1 (200X)

16

17

18

19

20

22

23

24

25

26

27

28

29

30

22

20

Tax (see page xx)

Family credit. Attach Schedule A if required

Subtract line 19 from line 18. If zero or less, enter -0-

Other taxes. Attach Schedule O

Total tax. Add lines 20 through 22

Home credit (see page xx)

Subtract line 17 from line 16. If zero or less, enter -0-

17

18

Tax and

Credits

Payments

Refund or

Amount

You Owe

Federal tax withheld

Work credit

Estimated tax and other payments

Total payments. Add lines 24 through 26

24

25

26

Amount of line 28 you want applied to your 200Y estimated tax

Amount overpaid. If line 27 is more than line 23, subtract line 23 from line 27.

If you want to use direct deposit, attach Form XXXX

Amount you owe. If line 23 is more than line 27, subtract line 27 from line 23

Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and Sign belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Here Your signature Date

Keep a copy

for your

records.

Spouse’s signature. If filing with spouse, both must sign. Date

Date Preparer’s SSN or PTIN Preparer’s

signature Check if

self-employed Paid

Preparer’s

Use Only Firm’s name (or

yours if self-employed),

address, and ZIP code

EIN

Phone no.

�

�

�

Your occupation Married? See

page xx.

If married but not

filing with spouse,

check here �

( )

Spouse’s occupation

( )

27

19

16

23

28

29

30

Daytime phone number

Form 1 (200X) Page 2

21 Self-employment tax 21
269

Appendix

Figure A.18. Work Credit Worksheet and Instructions
270

Federal Tax Reform

The President’s Advisory Panel on
271

Appendix
272

Federal Tax Reform

The President’s Advisory Panel on
Acknowledgements

On behalf of all the Panel Members, the Chair and Vice-Chair would like to express 

their deep appreciation to the Panel staff. Working on a project that lasted much 

longer than they had originally anticipated, the staff provided invaluable support and 

guidance. Their dedication, knowledge, and good cheer was truly impressive.

Full-time staff:

Jeffrey Kupfer, Executive Director

Jonathan Ackerman, Senior Counsel

Rosanne Altshuler, Senior Economist

Tara Bradshaw, Communications Director

Itai Grinberg, Counsel

Kanon McGill, Special Assistant 

Travis Burk, Staff Assistant

Mark Kaizen, Designated Federal Officer

Kirsten Witter 

Part-time or temporary staff and consultants:

Jon Bakija

William Gentry

Ben Getto

Seth Giertz

Jonathan Mable 

Noam Neusner

Clarissa Potter 

Julie Skelton 

David Weisbach

We would also like to recognize the support of the Department of the Treasury and 

the Internal Revenue Service. The Panel relied on them for many essential tasks, from 

providing expertise and analysis of our tax reform proposals to assisting with meeting 

logistics and the printing of our report. Numerous people made the extra effort to 

assist the Panel, and in particular, we would like to thank the Offices of Tax Analysis 

and Tax Policy.

In addition, we would like to acknowledge the assistance of the Council of Economic 

Advisors, the Government Accountability Office, the Organization for Economic 

Development and Cooperation; the nearly 100 witnesses who appeared at the Panel 

meetings, and the thousands of interested parties who contributed their views and 

insights to the Panel.